Last Updated Jan 17, 2010 4:42 PM EST
Investors, the same ones who anticipated a depression at the bear market bottom, now expect - despite little supporting evidence - a full, fast economic recovery with no after-effects from the recession and the extraordinary measures taken to mitigate its damage. Meanwhile, various indicators of market health, like trading volume, momentum and the number of new 52-week highs each day versus new lows, have been eroding for weeks.
A new survey, compiled by Tobias Levkovich, chief U.S. equity strategist for Citigroup Investment Research & Analysis, confirms that expectations for continued stock market strength are racing ahead of real-world developments. Institutional clients of the bank, such as fund managers, have become noticeably more bullish in the last three months.
The proportion of respondents stating that they are overweight in stocks, compared to corporate bonds, rose to more than 80 percent this month from just over 60 percent in July, and these investors say they're not finished. Slightly more than 60 percent say they expect to allocate more money to equities next year.
That reflects their heightened forecast for share prices. About two-thirds expect the Standard & Poor's 500-stock index to finish 2010 somewhere between 1,000 and 1,300, meaning that they see little risk from recent levels and much potential for further gains.
Levkovich detected some anomalous thinking among the survey takers. More than 60 percent say they expect the mounting budget deficit, a result of programs to revive the economy (and programs to do everything else under the sun) to become an issue for the markets, especially around the middle of next year. Yet that apparently isn't dampening their bullishness.
"There is some inconsistency in optimistic market expectations amidst concerns around potential policy errors," he noted in a report discussing the survey results.
The investors' optimism is so great that a mere 3 percent expect bonds to beat the returns of global stocks next year. The asset classes that they foresee doing best are the ones with a justified reputation for outperforming when an appetite for risk is high: commodities and emerging markets in Asia and Latin America.
They say their intention is to put more money into stocks, but where will it come from? The most worrisome piece of information in the survey, if you're banking on the rally persisting, is that cash has shrunk to 10 percent of the assets in their portfolios from 16 percent in July, a precipitous drop over such a short period.
Levkovich has had a good track record calling the markets during the last few years. He was decidedly cautious in the headlong run to the cliff's edge last year, and he is cautious again, predicting a correction.
He too may be early, not wrong. As stocks continue to rise without a significant pullback, they become more overvalued, less money is available to keep the advance going, and expectations become harder to meet or beat.
That increases the odds that the correction will be swifter and more severe when it finally arrives than it otherwise would have been. It also gives investors a chance to prepare by selling some of their holdings at prices that probably seemed unattainable a few months ago and may seem unattainable again.
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