Market Meltup Creates Pressure to Own Stocks
Thursday, February 23, 2017

One term used to describe the market’s post-election move is “meltup.” It’s a financial industry antonym for meltdown. During both meltups and meltdowns, there is a strong element of psychology at play.

Market observers have attributed the ongoing post-election rally to the election of President Donald Trump. Regardless of what you think of his policies, actions and proposals, expectations for stronger domestic economic growth, a looser regulatory environment and tax cuts are being priced in. Tax cuts, in particular, would directly flow to earnings and cash flow. This, in turn, would support higher valuations. (The actual benefit to earnings and cash flow will depend on what’s actually changed in the tax code.)

Nonetheless, the markets are melting up on expectations not only that tax reform will be passed, but also—along with the President Trump’s other initiatives—that economic growth will accelerate. As the meltup continues, the psychological pull to buy stocks grows stronger and stronger. At the same time, money managers face increasing short-term risks by not taking a bullish stance with their portfolio actions.

Those whose job it is to manage money face what is often referred to as career risk. Career risk, in investment terms, is the risk of being fired for underperformance, particularly short-term underperformance. An example would be the struggles value managers faced during the dotcom boom of the late 1990s. Career risk corresponds to game theory, with a manager feeling pressure to take a more aggressive stance because his or her returns will be measured against other managers who may be perceived as taking a more aggressive stance. (Why risk being fired if you think your competitors will buy stocks in an attempt to keep their short-term returns similar to the market benchmarks?) Add in loss aversion—in this case, aversion to missing out on the potential profits by not owning stocks—and there is psychological pressure to buy stocks. Put another way, ask yourself if you’d want to be the underperforming manager who has to explain why he or she didn’t participate in the rally.

There are reasons to expect further gains in stock prices, beyond just psychology and optimism about the new administration. Fourth-quarter revenues are projected to have risen by 4.3% once all S&P 500 companies have reported, according to Thomson Reuters. Earnings are projected to have risen by 7.6%. Interest rates remain low even with the Federal Reserve’s intention to continue raising rates at a gradual pace. (The CME’s FedWatch Tool still calls for no hike being announced at next month’s Federal Open Market Committee meeting.)

Valuations are a potential stumbling block. Thomson Reuters calculates the S&P 500’s price-earnings ratio as 19.9. The small-cap Russell 2000 trades with a P/E of 31.7. Not supporting the valuations is the overall downward trend in earnings growth estimates for large-cap stocks. It is also reasonable to consider the possibility that the market is overestimating or, at least, already pricing in an acceleration of economic growth.

Stocks, and other asset classes, can continue to rise in the face of higher valuations. As long as expectations are positive and psychological forces are at play, prices may rise for what seems like an extended period. The reverse is also true, with negative expectations and psychological forces causing prices to drop. (A recent research paper concluded that “behavioral factors are more significant than informational factors in explaining stock market crashes.”)

It can be tough to fight the short-term trends, especially when you are benefiting from them, know you are missing out or are being adversely affected by them. Yet all investors, both individual and institutional, must be like Odysseus’ sailors and plug their ears whenever Mr. Market sings a siren song. Not doing so risks moving away from a well-thought-out long-term strategy.

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Highlights from this month's AAII Journal

The Week Ahead

Earnings season begins to wind down with 28 members of the S&P 500 scheduled to report. Several of the reporting companies will be retailers, including Target (TGT) on Tuesday and Best Buy (BBY) and Lowe’s Companies (LOW) on Wednesday.

The week’s first economic reports will be January durable goods orders and January pending home sales, which will be released on Monday. Tuesday will feature the first revisions to fourth-quarter GDP, January international trade, the December Case-Shiller home price index, the February Chicago Purchasing Managers Index (PMI) and the Conference Board’s February consumer confidence survey. January personal income and spending, the February PMI manufacturing index, the February ISM manufacturing index, January construction spending and the periodic Beige Book will be released on Wednesday. Friday will feature the February ISM non-manufacturing index.

Eight Federal Reserve officials will make public appearances: Dallas president Robert Kaplan on Monday and Wednesday; Kansas City president Esther George, San Francisco president John Williams and St. Louis president James Bullard on Tuesday; and vice chairman Stanley Fischer, Chicago president Charles Evans, Richmond president Jeffrey Lacker and chair Janet Yellen on Friday.

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AAII Sentiment Survey

Optimism among individual investors about the short-term direction of the stock market is at a six-week high, according to the latest AAII Sentiment Survey. The rebound is occurring as neutral sentiment is at a seven-week low. Pessimism, however, is essentially unchanged from a week ago and remains above its historical average.

Bullish sentiment, expectations that stock prices will rise over the next six months, jumped 5.4 percentage points to 38.5%. Optimism was last higher on January 11, 2017 (43.6%). The rise puts bullish sentiment even with its historical average of 38.5%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 5.3 percentage points to 29.2%. Neutral sentiment was last lower on January 4, 2017 (28.6%). The historical average is 31.0%.

Bearish sentiment, expectations that stock prices will fall over the next six months, is 32.3%—a decline of just 0.1 percentage points. Pessimism remains above its historical average of 30.5% for the fifth time in six weeks.

Though bullish sentiment had been below average over the five previous weeks, it was never unusually low. Rather, optimism had merely fluctuated within the lower half of its typical range before rebounding to back to its historical average this week.

This week’s rebound in optimism comes as both large- and small-cap stocks rose to new record highs. Not all individual investors are encouraged by the continued rally, however, with some worrying about valuations or a forthcoming pullback.

The potential impact that President Trump could have on the domestic and global economy continues to cause uncertainty or concern among some investors, though encouraging others. Also influencing investor sentiment are earnings, consumer sentiment and the magnitude and timing of future interest rate increases.

This week’s Sentiment Survey results:

Bullish: 38.5%, up 5.4 points
Neutral: 29.2%, down 5.3 points
Bearish: 32.3%, down 0.1 points

Historical averages:

Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
Take the Sentiment Survey.

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