I have used this space many times to discuss how fundamentals drive stock prices over the long run. Additionally, in the midst of (sometimes severe) volatility and rising uncertainties that come with it, I’ve often made the point to stay focused on what really matters in terms of equity prices these days including:
- U.S. GDP expected to expand at a roughly 2% rate in 2016
- Earnings weakness in the first half of the year with an expected recovery of double digit growth in the second half of 2016
- Europe poised to gain growth momentum with an expected full-year growth of around 1%
- U.S. inflation could pick up to a comfortable 1%-1.5% as the year progresses and crude prices stabilize further
- Interest rates remain low globally. In the U.S., the Fed raises overnight rates more gradually than expected, and pressure on the 10-year eases (making for an upward sloping yield curve—good for growth)
- Global GDP expected to post in the ~3% range—modest but healthy
In Zacks Investment Management’s view, each of these fundamental factors makes a strong case for expansion in 2016, not recession. And, as I’ve said many times, only very rarely have we seen a bear market without a recession.
But, there’s the sentiment factor. We just saw how sentiment can drive markets in the first three months of this year. In the first six weeks, as fears mounted over China’s slowdown and government intervention, the S&P 500 fell some -10%. But, as pessimism continued to grow, this eventually paved the way for the market to climb the proverbial ‘wall of worry,’ and markets love climbing that wall. Indeed, by the end of the first quarter, the S&P 500 was already back in positive territory.
Can Sentiment Derail a Bull Market?
The short answer is ‘yes.’ But, in my experience, market ‘derailment’ is more likely to occur when sentiment becomes too positive (and not the other way around).
Legendary investor John Templeton famously said, “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” In the short term, when pessimism builds on false or overblown fears, we would usually expect the market to power through it—like we saw in the first three months of the year.
This can, and does, happen often during bull markets. That’s why you often see me ‘raise an eyebrow’ when rapid-onset downside volatility is accompanied by negative news stories that aren’t likely to be impactful (the fiscal cliff, European sovereign debt crisis, Greece leaving the European Union, Ebola, China slowdown, etc.…).
In my view, what we really need to look for in the current market is growing optimism, which may emerge as complacency (versus outright optimism or euphoria).
Many times, we’ve seen Templeton’s quote play-out nearly perfectly. For example, the late 1920’s euphoria that erupted as Americans migrated to cities seeking a slice of industrial sector riches, resulted in the banking sector boom. Similarly, in 2000, the tech bubble saw investors pouring money into start-ups with billion dollar valuations and negative earnings. In both cases, euphoria caused equity prices to balloon and overly positive sentiment killed the bull.
Today, with modest growth rates likely here to stay, I’m not convinced that we’ll see outright euphoria this late in the cycle. There isn’t enough artificial wealth being created for investors to grow euphoric over. But, we could see complacency seep into the markets. Complacent investors tend to ignore risk, meaning they could be more likely to pay too much for already overvalued stocks. And, when that happens the market could easily move from fairly-valued to over-valued. If fundamentals quietly start to break down as that’s happening, I think that could trigger the next bear market.
Bottom Line for Investors
While fundamentals remain strong, I still think plenty of pessimism remains. In my view, that’s a recipe for a market that can, and should, grind higher. The things to watch out for, from a sentiment point of view, are:
- Geopolitical tensions in the Middle East eased
- Oil prices stabilize and fade as a news story
- Europe and China post convincing growth
- U.S. earnings turn out much better than expected.
If all of these things happen, which is possible, then sentiment could improve dramatically to the point of supporting complacency. And, that’s when I’d start becoming more cautious.