by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
January 3, 2011
Key points
- Setting targets doesn't make sense to us, but we do believe in reading the market's tea leaves, and the outlook is healthy.
- However, frothy sentiment has us a little concerned in the very near-term.
- Investors need to be mindful of complacency, but also to make sure they're not still loaded up on bonds—a major capitulation from bonds to stocks is possible.
It's that time of year again. We wade through all the year-end prognostications in the hopes of finding the keys to better investment results in the new year. From forecasting the next year-end value of various indexes, to lists of (sometimes bombastic) surprises and everything in between, experts pontificate about the year to come.
Amazingly, many investors hang on every new prognostication and often take them as near gospel, without looking back at how this game has turned out in years past.
Tips are for good service, not investing
Who out there, at the beginning of 2010, predicted the flash crash, the election results, the Federal Reserve's second round of quantitative easing (QE2), all the nuances of the European debt crisis, the BP oil spill, booming holiday retail sales, and the many other market-moving events during the course of the year?
In short, we suggest that Schwab investors take predictions with a large grain of salt, and that's why you won't hear us putting out specific targets we think will be achieved this year. The market's behavior is not beholden to the calendar year even though investors might be.
We believe we can better serve you by interpreting the current economic and equity trends and attempting to explain what it may mean for markets in 2011. Tips should not be used by investors … they should be given for good service.
One of the most common questions I get when being interviewed by a reporter or sitting on a panel discussing the year to come is, "What is your single best idea?" My consistent response to that question is, "Beware of single best ideas."
The power of psychology
No one has control over the stock market's behavior, nor can divine it precisely. What we can do is glean some understanding from what the stock market is saying.
As important as the fundamentals of earnings growth, economic growth, valuations, and the market’s technical health are, I will always believe that investor sentiment and the psychology of the market is at least as important—if not more important—in the short-term.
Here's where things get tricky as we start the new year. As most readers know, we've been optimistic about both the economy and the stock market since the spring of 2009. Back then, I always felt I needed to apologize for that optimism given the grim mood of most investors and consumers.
That skepticism (at best) about and disdain (at worst) for the bullish view slowly morphed into begrudging acceptance and finally submission.
On the surface, it may feel good to be optimistic finally, especially if you're joined in that optimism by your friends, neighbors, colleagues and your favorite talking heads on financial TV. But this is where contrarian sentiment comes into play.
Just before I left for Christmas vacation, I penned a short note to Schwab's financial and portfolio consultants about the present sentiment environment, and I want to pull some of that information into this report for you.
Sentiment gets a bit frothy
The general consensus presently is that things are pretty good. Stocks were strong performers for the past two years and 2011 is looking good, too. Europe's sovereign debt crisis is seen as troublesome, but contained, while China's monetary tightening won't trigger a major disruption to its or the global economy.
QE2, while still having its merits debated, is generally seen as good for asset prices. Strong global growth is viewed as supportive of still-rising commodity prices. There's less and less talk of potential blow-ups to this rosy scenario.
I remain very optimistic, especially about the economy, as we start the new year. I think the consensus of about 3% US gross domestic product (GDP) growth is probably too low and that we'll finally see some meaningful traction on the job creation front this year.
Although we're starting to see investors reallocate some money from bonds to stocks, I believe there's a lot more of that to come. But I'll admit to feeling a tad skittish in the very near term thanks only to the sentiment environment.
Tracking the indexes
Let's start with a couple of sentiment indexes that I watch. The first is SentimenTrader's index measuring the spread between "dumb money" and "smart money" optimism.
Smart Money Much Less Confident
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Source: FactSet and www.sentimenTrader.com, as of December 31, 2010.
As you can see, a yawning 50-point gap opened at year-end between the two measures of confidence, with dumb money optimism having soared, while smart money optimism became decidedly more subdued. The good news is it's starting to narrow, but this is a potential warning of some market vulnerability, which would likely be necessary to close this gap further.
Another note of caution from SentimenTrader: During the past month, traders and investors have shown a clear preference for favoring individual stocks over broad-based exchange-traded funds (ETFs) in terms of volume flow. That shows a high degree of comfort, which has led to much poorer returns going forward than if they were at the opposite end of the spectrum.
Moving on, let's have a look at the spread between the bulls and bears as per the American Association of Individual Investors (AAII) sentiment poll.
Individual Investors More Bullish
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Source: American Association of Individual Investors and FactSet, as of December 29, 2010.
Although it too has narrowed, it moved to an exceptionally large 47 percentage point gap. The last time the spread was this wide was in March 2009 when, of course, they were opposite—bearishness was way on top. That turned out to be the mother of all market bottoms. Don't worry, though, I'm not calling this the mother of all market tops.
What tempers my concern is that fact that AAII is an attitudinal metric: In other words, it's measuring what investors are saying, not what they're doing.
