Investor Sentiment is Awful

The stock market failed to build on the rally from Friday.
The S&P 500 fell below support at 1,050 yesterday.

Right now, sentiment is just awful across the board. And
we’re heading into what’s traditionally the worst two months of the year for
stocks: September and October.

Volume in the stock market has been extremely light. This
suggests that individual investors are not buying stocks. And we can see that
in mutual fund flows. In July, bond funds attracted $25 billion dollars. And
investors pulled $12 billion out of
equity funds.

Individual investors seem to be saying that they don’t
believe the economic recovery is for real, and they don’t want to be
blindsided again by a steep drop in the stock market.

It’s not just individual investors. Analysts currently rate
54% of stocks as “holds.” “Buy” recommendations are at their lowest level
since 1997.

Sentiment is as bad as it’s been since March 2009, when the
stock market bottomed…

“Contrarian investing” is based on the idea that the masses are usually wrong at the extremes.
In other words, when investors are overwhelmingly bearish, it’s time to buy.
And when investors think there’s no end to the upside for stock prices, it’s
time to look for the exits.

Contrarian investing is not a new, or a radical, concept.
Warren Buffett expressed the very essence of contrarian investing when he
advised investors “… to be fearful when others are greedy and to be greedy
only when others are fearful.”

During the height of the Internet bubble in 1999 and 2000,
investors shoveled $497 billion into stock mutual funds. They were just in
time for an historic market crash. In the last two years, investors have
poured $480 billion into bond funds. While I’m not forecasting an imminent
crash for the bond market, the parallels are intriguing.

Of course, no
discussion of contrarian investing is complete without mentioning another
stock market saw: financial markets can remain irrational longer than you can
remain solvent.

There were plenty of investors who saw the insanity of the
Internet bubble and started shorting stocks in 1999. I bet shorting Qualcomm
QCOM) at $450 a share
in early December of 1999 looked like a great idea. And I can only imagine
what it felt like when the stock crested $700 a share three weeks

Are bonds a bubble right now? I don’t know that you can call
bonds a bubble. But it’s hard to imagine prices going much higher (and yields
much lower).

As we know, bond and stock prices tend to move in opposite
directions. With seemingly limited upside for bonds, the contrarian investor
should be asking if it’s time to buy stocks.

My answer for both bonds and stocks is the same: trying to
pick a top for bonds or a bottom for stocks is risky venture. And while I
fully endorse any investor’s desire to be greedy when other are fearful, it’s
also important to look for signs that stocks will rally.

Right now, we
should be watching the banks and oil prices. Oil is a near-perfect gauge of
investor sentiment about economic growth expectations. And financials must
lead any market advance.

Financial stocks have certainly led the recent decline. The
Financial Spider ETF (XLF) peaked on August 2 and has been in a steady
downtrend. Bank of America peaked at $14.50 on August 2 and now trades at
$12.30 a share. That’s a 52-week low.

Bank of America is now trading below tangible book value of
$12.40 a share. That means is selling at its “bricks and mortar” price. And
the reason is simple: Bank of America is more leveraged to American
households than any other bank. So it should be most vulnerable to the
weakening economy.

While we haven’t seen a clear sign that the stock market is
set to rally, it’s probably a good time to nibble on stocks with extremely
low valuations, like Bank of America.

Economic data released today has been better than expected. The Case-Schiller home
price index rose 4.2% when expectations were for a 3.5% gain. Consumer
confidence for August jumped to 53.5. That’s much better than the 50.5
economists were expecting.

When consumer confidence rises, it’s assumed to mean that
they (we) may spend more. But consumer confidence is also a very volatile
indicator. We’ll see if today’s positive reading is the catalyst we’ve been
waiting for…

As always, please send me your comments and questions:

[email protected]

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