Is there a pessimism bubble?

Low expectations on Main Street set the stage for further gains on Wall Street.

By Anthony Mirhaydari Dec 22, 2009 2:15PM

MirhaydariInstead of holiday cheer, the air is thick with gloominess these days. Not so much the stock market, where the sentiment indexes show bulls dominate bears by slightly more than 52%. But among the general public. 

 

President Obama's approval rating has fallen below 50% for the first time. A recent NBC/Wall Street Journal poll found that 55% of all Americans feel the nation is heading the wrong direction. This is the highest level since January -- when the financial crisis was red hot.

 

A CNBC Wealth in America report found more negativity. Sour sentiments were expressed about the economy, stocks, home values, and wage growth. Faith in institutions like the Federal Reserve, the U.S. Treasury, and the financial sector were very low. 

 

Merrill Lynch researchers have picked up this theme and in a recent note to clients said 2010 would be the year we exit the "pessimism bubble." I couldn't agree more. There is a lot to be optimistic about. The economy continues to make progress towards a robust and powerful recovery. The financial system has been nursed back to health with bailout recipients now about to repay taxpayer money. Net job creation and payroll expansions are just over the horizon.

 

10 Year Returns

 

This is all quite a contrast from where the public was ten years ago. Back in 1999, optimism reigned. In the ten years that followed we had two recessions, two asset bubbles, two wars, and an acrimonious political climate. Faith in U.S. stocks as a superior long-term investment was shaken as every other major asset class beat equities and delivered positive returns over the last decade.

 

We've moved from abundant optimism in 1999 to plentiful pessimism in 2009. But from this environment of low expectations, wonderful things can happen. Even a less bad economic scenario would be a pleasant surprise to many. Stock prices, which are a reflection of public optimism about the future, will be a direct beneficiary of exceeded expectations.

 

Poll

 

Historically, periods of widespread pessimism have coincided with excellent times to buy stocks for the long haul. Just look at the chart above, which comes from Gallup and displays percentage of Americans that feel satisfied with the way things are going with the way things are going. You can see that the current reading of 24% matches levels reached in 1983 and 1996 -- both of which marked the beginning of very exciting and profitable bull cycles. We appear to be on the verge of another one.

 

In fact, there is evidence that investor pessimism has reached levels not seen since the mid-1970s. According to Merrill Lynch, investors are buying stocks at a "growth discount" for the first time in 30 years. The metric is based on the S&P 500's trailing 12-month price-to-earnings ratio compared to a "fair" steady state price-to-earnings ratio based on the estimated equity risk premium.

 

The bottom line is that it's unlikely that the worst-case 2010 scenarios that bears are promoting are likely to come about. With pessimism high, interest rates low, more fiscal stimulus poised to pour into the world's financial arteries, corporate earnings on track to surprise with upside and so many investors still on the sidelines, waiting for the right moment to re-enter stocks, my expectation is for a 10%-20% advance over the next year, from start to finish.

 

Strong early-cycle sectors like industrials, tech, energy, and materials will do better than that. These include stocks like ExxonMobil (XOM), Halliburton (HAL), and Terex (TEX) which are part of my portfolio at Wall Street Survivor. I'm up 7.9% this week against a 1.6% return for the S&P 500. Be sure to check back here for trading updates.

 

Disclosure: The author does not own or control a position in any of the funds or companies mentioned.

 

Anthony Mirhaydari is a researcher for the Strategic Advantage investment newsletter. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.

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