Updated Aug. 13, 2014 7:51 p.m. ET
With stock prices high and the globe unsettled, investors are feeling unusually anxious. Paradoxically, that could be a fine thing for markets, some stock strategists say.
“When everyone thinks things look bad, that is when you want to buy,” said Savita Subramanian, chief U.S. stock strategist at Bank of America Merrill Lynch. “It is when everyone is positive that you want to sell.”
Historically, markets typically fall apart when euphoria leads to reckless investing, as before the collapses of 2000 and 2008. It is less common for markets to fall hard when investors are acting cautiously.
After some sharp price swings, the Dow Jones Industrial Average is down 3% from its July 16 record of 17138.20. On Wednesday, it rose 91.26 points to 16651.80. It is up just 0.5% for 2014 but up 154% from its 2009 low.
The volatile Russell 2000 small-stock index is 5.5% below its record, which dates from March. Earlier this month, the Russell was down almost 8%.
Anxiety levels have grown since the spring of 2013, when the Federal Reserve indicated it would trim the stimulus that has supported markets since 2008. The Dow is up 154% from its March 2009 low.
Professional investors such as pension funds, insurance companies and hedge funds have reduced stock ownership since the spring of 2013, according to government data. Investors have shifted toward Treasury bonds. The 10-year U.S. Treasury note Wednesday yielded just 2.41%, its lowest level in more than a year. (Yields fall when bond prices rise.)Money managers are sending clients reports discussing whether stocks are in a bubble. To protect themselves from declines, people are buying options at higher rates than at any time this year, said Phil Roth, an independent market analyst. These are signs of caution, not euphoria.
His conclusion: The stock market “doesn’t show significant vulnerability right now.” If investors get overly optimistic this autumn, stocks could sell off, but he would be surprised to see a big drop now, he said.
Merrill’s strongest indicator in this domain is one it has been tracking since 1984. When the indicator has been at its current level, stocks have risen 98% of the time, Ms. Subramanian said.
The indicator is based on the advice offered by Wall Street strategists like Ms. Subramanian. In fact, it includes her recommendations. Embarrassingly, Wall Street advice is a contrarian indicator.
When investment strategists are very bullish, it typically is a sign of excess optimism. Stocks generally do poorly then.
When strategists are very bearish, stocks usually do well.
Wall Street strategists today are bearish. They recommend that investors hold just 51% of their money in stocks, far below the average recommendation of 60% over the past 15 years. That is well below the peak of 66% before stocks started to crumble in 2007. For Merrill, any average recommendation below 54% is a buy signal.
This indicator currently forecasts a 22% stock gain in the next 12 months.
Ms. Subramanian herself forecasts only half that big a gain, but the indicator has made her wonder. Of all the indicators she follows, this was the only one that accurately forecast a 30% gain for the S&P 500 last year.
Merrill also tracks the exuberance of money managers, who also are bearish. Its surveys show money managers holding 5% of assets in cash, the most since June 2012. That is up from 4.5% a month ago.
Mutual-fund data, meanwhile, indicate the same pessimism. Mutual-fund holdings of stocks whose performance depends on strong economic growth are the lowest since 2009, Merrill said.
“They are basically in the bunkers from a positioning standpoint,” Ms. Subramanian said.
History isn’t a perfect predictor, of course. The current era is exceptional, with stocks heavily dependent on Fed support. History may be less useful than usual.
And despite all the signs of nervousness, there still is excess in parts of the market, such as social-media stocks, biotechnology stocks and junk bonds, said Jason Pride, director of investment strategy at Glenmede Trust, which oversees $ 26 billion in Philadelphia.
He, too, thinks the broad market will rise, but the riskier stocks could fall further, he said. If they do, there is always the danger that investors who have made big bets with borrowed money could sell not just the risky stocks but also their broader holdings. That could pull down many stocks.
“It isn’t our base case, but it is possible something could leak over” from risky stocks to the broader market, Mr. Pride said.
Mr. Roth added that surveys of futures traders and newsletter writers suggest that some investors still are overly optimistic. If they panic, their selling could hurt the broad market.
Others worry about valuations being above their long-run average and point to signs of complacency. The fear gauge known as the CBOE Volatility Index, or VIX, was at 13 on Wednesday, well below its long-run average of 20. The current bull market is fourth-longest on record at 1,982 days.
Mr. Pride’s firm has turned away from economically sensitive stocks and toward those tied to dividends or to sales of staple products. He also shifted some money to foreign stocks from areas like junk bonds. He finds many foreign stocks more attractively priced than U.S. stocks.
The most likely scenario is that U.S. stocks will grind slowly higher, Mr. Pride said. But he considers the risk of a decline greater than the likelihood of a big gain.
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