Are Investors Getting Too Optimistic About the Stock Market?

Last Updated Jan 5, 2011 2:51 PM EST

It certainly was a December to remember for stock investors. The Standard & Poor's 500 index rose 6.5 percent during the month, pushing the benchmark stock index to a robust and not-so-new-normal 15.1 percent gain for 2010. Moreover, the broadest stock market index, the Wilshire 5000, posted a 17.9 percent total return for the year.
The big December move came amid an outbreak of optimism on Wall Street and Main Street. In a survey of leading Wall Street strategists in mid December, the consensus forecast was that the S&P 500 would reach 1,379 in 2011. Even after the late-year rally, that still is 8.6 percent above where the market opened today.

The mood of individual investors picked up as well; a Gallup poll reported that 52 percent of Americans expect the economy to be better in 2011 than it was in 2010. That's more than twice the percentage who expect the economy to be either the same (21 percent) or worse (25 percent). That optimism seems to have finally pushed individual investors back into the stock market. Liz Ann Sonders, chief investment strategist at Charles Schwab, recently noted that inflows to stock mutual funds hit $335 million in the third week of December following net outflows from such funds of $90 billion since last May's Flash Crash.

Fundamentals or Froth?

At the risk of being the designated driver at the party, I'd point out there seems to be another consensus growing as well: that the run-up in the markets isn't so much about clear economic and market fundamentals as it is about Washington policy that is unlikely to be repeated.

The Federal Reserve's $600 billion Quantitative Easing II policy that it announced in August and began to implement just after the mid-term elections has worked like a stimulative charm, setting off the desired shift from bonds to stocks. Then the late December tax deal provided its own stimulative jolt, with the somewhat unexpected deal to keep tax rates where they are, and give workers a 2 percent payroll tax holiday in 2011. Both moves are akin to a parent giving a big push to a child learning to ride a bicycle; the push generates momentum, but then it's up to the kid to keep going.

And that last part is where the trouble may arise. After the effects of QE2 and the tax bill play out, does the economy have enough mojo to keep the markets humming? FusionIQ's Barry Ritholtz, who casts a very sharp eye on the markets in his blog, The Big Picture, isn't optimistic. In a size-up of what to expect in 2011, Ritzholtz noted:

Government policies have been key drivers of gains, and everyone now knows that zero percent Fed fund rates are unsustainable. Organic growth is required for a self-sustaining recovery, and there is little of that to be found.

David Rosenberg, chief strategist at Glushkin Sheff, who has long held a bearish attitude toward the U.S. equity markets, is also wondering where the fundamental growth will come from once Washington stops providing the push. In his note to investors yesterday, he wrote:
"The stock market is clearly being fueled by ongoing dramatic government actions....there is still nothing organic about the macro economic backdrop. Investors are focused on not fighting the tape."
Not fighting the tape, along with the related maxim to not fight the Fed, seems to be the crux of what is fueling the markets right now. Noted long-time investor Jeremy Grantham of GMO made much the same case in his fall investor letter in which he said stimulus would be good for the markets, if only in the short term. But Grantham, Ritholtz, and Rosenberg are all also just as clear that once the stimulus plays out, the picture of where further economic growth will come from gets a whole lot murkier. And if that stalls out, so too will the market rally.

Reasons to Be Less Optimistic?
While the stock market's performance is always ahead of that of the economy, what's going to be important in the coming months is whether the double-shot of 2010 growth engineered by Washington stimulus will segue into the "organic" growth needed to keep the economy (and markets) humming.

Here are a few measures and statistics that everyone will be watching to determine whether that organic growth is indeed materializing :

  • Job growth. Unemployment stuck near 10 percent isn't going to cut it. And the consensus seems to be we will be lucky if it gets down to 9 percent this year. At some point, we'll need to stop claiming victory from the fact that we're no longer shedding jobs; sustained economic growth requires job growth.
  • Home prices. This is where the bulk of household net worth resides, so without at least a stable housing market -- and preferably a rising one -- it's hard to envision strong macro economic growth. And the latest numbers from the S&P/Case-Shiller home price indexes were not encouraging; 18 of the 20 metro areas tracked lost ground in October. The slow sales pace, high inventory, and sizable backlog of foreclosures prompted S&P's index chief David Blitzer to remark that "the double-dip is almost here." Not exactly a signal of economic growth.
  • State and city budget solutions. Even a modest economic recovery is unlikely to produce the revenue many states and cities need to close huge budget gaps. Spending cuts and/or tax hikes seem to be likely solutions. Depending on their size and scope, these moves could put a damper on growth as well.
  • Stock market valuations. The price-earnings ratio is a popular gauge of determining whether a stock -- or market index -- is undervalued, fairly valued, or, well, frothy. Looking at the S&P 500's p/e ratio using estimated 2011 earnings, the market looks like a pretty good deal right now, with a forward p/e of 13.3 But that's riding on those earnings estimates actually materializing. Another useful p/e measure is the Shiller p/e, which uses 10 years of inflation-adjusted earnings to gauge the market's level. The long-term median for the Shiller p/e is about 16. Today it is sitting at 23.3, a far cry from an "undervalued" signal.
So what's an investor to do? Well, for starters, no one is suggesting the party is ending anytime soon. Sentiment tends to persist, both on the upside and the downside. And the stimulus still has some push to provide. But as the year progresses, if we don't begin to see significant improvement in job growth and home prices, sentiment might just begin to shift. I can think of no better move than to follow the advice of MoneyWatch's Allan Roth to embrace the boring: Rebalance and stick to your long-term allocation strategy.

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