With yesterday’s action, the Dow Jones Industrial Average took out its pre-Lehman Brothers-debacle price level, as can be seen in the chart below. Not that you care, but I was home on that Monday when the market opened after the news of Lehmans’ declaration of bankruptcy, after months of Alfred-E-Newman-esque claims of adequate liquidity and other stuff. We were making pear butter after a bountiful harvest that year, but the pit in my stomach sort of spoiled a good time with the kids.
Now that’s a real testimony to buy-and-hold investing. If you’d only sat tight and done nothing you’d be just fine. Hopefully, your experience didn’t include any of the casualties of the drop. That’s one of the problems with buy-and-hold: the dead bodies don’t talk. Put more politely, there’s a Survivor Bias. Only the survivors from the Titanic could tell their stories. For example, in September 2008–yep, the same September–a couple of companies were removed from the index . . . strike up the Phantom of the Opera music . . . Citigroup and General Motors.
Phwew, glad that’s over.
Trouble is, it’s all happening amidst a huge bout of complacency.
Here are the problem items:
- Individual investors, as gauged by the American Association of Individual Investors, are as bullish as they’ve been since 2008
- Investors Intelligence maintains the oldest sentiment survey, its Advisors Sentiment survey, and that one is as bullish as it’s been since 2007′s peak
- the so-called Fear Index, the CBOE’s index of implied optimism (VIX), is at a multi-year low
- the ratio of puts:calls transacted at the CBOE is at the lowest levels of 2005
- the breadth of the advance is narrowing; that is, fewer stocks are participating in the push to new highs; that’s not healthy
Naturally, contrarians cite these as signs of the herd mentality in action, and they embody Warren Buffett’s saw, “be fearful when others are greedy.” There’s really no problem with any of indicators so long as nothing goes wrong. However, the market will be ripe for a correction if anything goes wrong. On the Monty-Python-Meaning-of-Life side of things, I think most of our services view any correction as a buying opportunity for what should be a strong first half of 2010.
I came across the following in a JPMorgan report titled US Equity Strategy FLASH; Bullish sentiment is not contrarian in a bull market. I generally agree with the idea. The herd is usually right until the herd’s sentiment becomes extreme.
Key to sentiment (contrarian or not) was stage of market: Bull or Bear. One thing bothering investors in recent weeks is the seeming rise in bullishness, evidenced by positive 2011 outlooks recently (including J.P. Morgan) and positive sentiment surveys (i.e., AAII survey, or Investors Intelligence). We believe these concerns are misplaced. As shown on Figure 4, sentiment readings take a totally different context depending on the stage of the market—”bull” or “bear.” In bull markets, AAII readings (% bull less % bear) of 0 to +40 have been consistent with forward 6-month gains of 6%-7% while associated with declines of 11%-14% in “bear” markets. This makes sense to us—after all, why is it bad if we acknowledge broadening improvements?
Extreme readings remain high-quality contrarian signals. An AAII reading over 50 (% bulls less % bears) led to declines regardless of bull or bear (see Figure 4). Similarly, AAII readings of -40 or worse saw positive gains of 22% (6-mo forward) regardless of bull or bear. The current reading of 23 (% bulls less % bears) is NOT AN EXTREME READING.