When What ‘Everybody Knows’ Turns Out to be Wrong
Everybody knows that the dice are loaded.
Everybody rolls with their fingers crossed.
Everybody knows that the war is over.
Everybody knows the good guys lost.
Everybody knows the fight was fixed.
The poor stay poor, the rich get rich.
That’s how it goes,
Leonard Cohen, “Everybody Knows”
Looking at the gains over the past three years and eight months, you would think investors would be overly optimistic. After all, the gains in this particular bull market compare favorably to virtually every other bull market in the historical series. If you measure the current bull from the market bottom in March of 2009 through last Friday’s close, the S&P 500 Index has gained 115% with dividends reinvested, or an annualized gain over more than three and one half years of 23%. In contrast, the previous 27 bull markets since 1921 averaged gains of 78%. Or, if you care to characterize last year’s 19% market decline as a bear market, then from the market bottom on October 3, 2011 to the present (including the recent 7% market sell-off), the S&P 500 Index has gained 27%. Client portfolios have achieved strong gains from the market bottom, and while returns have understandably been less than expected, they are still positive if measured from the market top in late 2007.
Yet my totally unscientific, anecdotal take on the mindset of our clients is that many are depressed about the general state of affairs in the country and the stock market. And I am not alone in my assessment. A recent piece by Bob Veres, a well-known commentator on the financial planning industry, asked financial planners “what keeps you up at night?” The number one answer was “constantly, gradually eroding investor confidence in the investment markets, in the fairness of the investment system, and in the stability of the global economy.” It sounds like financial planners are worried that their clients have been spending too much time listening to “Everybody Knows” (recently re-recorded by Don Henley, lyrics by Leonard Cohen). The number two concern of financial planners? “Another self-inflicted global economic meltdown triggered by Wall Street and the players in the derivatives markets, along with crony capitalist scammers and Ponzi schemers who are — like Bernie Madoff and Jon Corzine — too tight with the regulators to be properly regulated.” Ouch!
Lest you think that individual investors and financial planners are the only ones afflicted by the current malaise, there are many indicators showing that institutional analysts and investors are also showing signs of extreme pessimism. The chart to the right shows the Merrill Lynch “sell-side indicator,” which asks institutional sell-side representatives (analysts employed by brokerage firms) if they are bullish or bearish about the market outlook. You can see that the bearish sentiment is extreme.
The good news for investors is that when everyone knows that the news is likely to be bad, it turns out that what everyone knows is often incorrect. One example of this was pointed out by Bianco Research in their November 21 blog post: Experts have been notoriously bearish (predicting higher yields) about the bond market for many years. They give the following data points from a monthly survey of economists conducted by Bloomberg:
- 116 months of surveys have been completed since December 2002.
- 112 of 116 (97%) of these surveys predict higher yields.
- 37 of 116 (32%) show more than 80% of economists predicted higher yields, including the last survey (November 2012).
- On three different occasions, 100% of economists predicted higher rates.
Bianco concludes “The world has been very bearish on bonds for years and has been very wrong.” Smart investors know that investor sentiment is a classic contra-indicator. When investors are all bullish, it’s time to take the other side of the trade. And the same is true when investors are overly bearish — the sell-side indicator shows that extreme bearishness is considered to be bullish for stocks. In fact, it is easy to see that institutional analysts have not been overly bullish about the market since it bottomed in 2009. And the chart shows a level of bearishness not seen since the series began in 1985. Sean Dillon, Pinnacle’s technical analyst, has observed that the AAII investor survey, the Rydex Bull-Bear survey, and the NDR Crowd Sentiment indicator all show a high level of bearish sentiment.
I have often remarked that optimism is not highly valued by investment analysts. Instead, investors look for “realism” and “objectivity” in assessing risk. Yet, there are times when optimism is a valuable commodity, and one of those times is when everyone around you is pessimistic. So, in the spirit of the holidays, let’s entertain a few optimistic scenarios that will be supportive of risk assets as we consider the investment outlook for next year. In no particular order:
- The Fed’s zero interest rate policy continues to put a floor under stock prices and significantly lowers the odds of a recession.
- The Fed’s $2 trillion balance sheet continues to leak money into risk markets and give investors a large disincentive to be risk averse.
- U.S. corporate balance sheets continue to be among the strongest in the world.
- Proposed corporate tax restructuring makes U.S. corporations more competitive internationally and gives U.S. companies a reason to bring huge amounts of cash home after being parked overseas.
- The fiscal cliff is averted and the negotiations for a Grand Bargain are successful. Political uncertainty gives way to a renewed sense of investor optimism as a framework, modeled around Simpson Bowles, is adopted to address long-term economic concerns.
- Corporate profit margins remain well supported as the pace of technological change continues to make corporate productivity soar above expectations.
- Europe does not disintegrate into a set of Feudal states.
- China does not disintegrate into a set of Feudal states.
- The recent recovery in U.S. real estate prices — created in part by the Federal Reserve’s determined effort to lower mortgage interest rates — leads to a sustainable recovery in U.S. consumer spending, which in turn provides the catalyst for a virtuous recovery in the economic cycle.
The good news is that these things don’t have to occur for investors to enjoy higher stock prices. The news only has to beat what are obviously lowered expectations. It is time for us to start wondering if the pessimistic outlook that everybody knows is symptomatic of overly bearish sentiment. That’s not to say that Pinnacle’s Investment Team is adopting an overly positive view of market risks, and recent blog posts have clearly catalogued the many dangers on the near and far horizon. But try not to get swept away by what ‘everybody knows.’ They are likely to be wrong.