Are Investors Too Hopeful of a Republican Victory?

A survey by Citigroup (C) of large professional investors, released Monday, showed confidence about the stock market surging with the level of the market itself. Investors foresee a modest year-end rally taking the Standard & Poor's 500-stock index to 1,204 from recent levels in the 1,150s. In July their average year-end forecast was 1,138.

Befitting a rally of the scope of the one that began in early September, investors in the Citi poll said that cash had fallen to 7.5 percent of the value of their portfolios from 11 percent in July. It had been 6 percent in March, a month before the stock market embarked on a swift decline of nearly 20 percent.

While investors are more bullish, they're far from euphoric. After reaching 1,204 at the end of the year, the index is expected to advance only to 1,266 a year after that. That reflects, in part, a somewhat subdued outlook from company analysts, who collectively anticipate 9 percent earnings growth next year.

Tobias Levkovich, Citi's chief U.S. equity strategist and the one who conducted the poll, has been saying for several weeks that investors were sufficiently skeptical about the stock market for prices to keep moving higher. In an analysis of the survey results, he pointed out that if investors do decide to buy stocks more aggressively, they have the wherewithal to do it, despite the apparently limited cash in portfolios:

Plenty of Ammo
"...Some cash was put to work this summer when markets backed off. Nonetheless, pure cash readings leave out the leverage capacity of hedge funds and the enormous amounts of cash sitting on corporate balance sheets and in household deposits, such that there is abundant dry powder."
What might have caused them to take potshots at stocks in the last month is the prospect of a big Republican victory in midterm elections in November. The survey highlighted great enthusiasm about the prospect of that outcome:

"More than 85 percent of institutional investors see the GOP taking the House next month. While political polls suggest that changes are likely in Washington, a staggering number of professional investors think that the Republicans will win back the House of Representatives in November and that may be adding to their sense of a better business environment going forward. Since government policy error remains the biggest fear of investors, according to the poll, the view of DC trends matters."
Such overwhelming expectations raise a strong possibility that investors will be disappointed. The Democrats may yet hold on to the House, which could provoke a huge sell-off. Even if Wall Street gets the result it wants and expects, it could be priced into the market already, producing a sell-the-news effect.

The cautiously optimistic long-term view that investors have is a healthy, benign backdrop for the stock market. The big rally over the last month and high hopes for Republican gains could be setting the market up to create some acute disappoint over the short term, however.