U.S. Stocks Will Reward Optimistic Investors in 2010

I have been surprised to see the air thick with pessimism in recent weeks. Not so much the stock market, where the sentiment indexes show the bulls dominating the bears by slightly more than 52%. But among the general public.

An NBC/Wall Street Journal poll last week found that 55% of all Americans feel the nation is heading the wrong direction. This is the highest level since January of this year - when the financial crisis was red hot and U.S. President Barack Obama was just entering the White House! That's amazing.

A recent CNBC "Wealth in America" report found more negativity. Negative sentiments were expressed about the economy, stocks, home values, and wage growth. Faith in institutions like the U.S. Federal Reserve, the U.S. Treasury, and the financial sector were very low. President Obama's approval rating has fallen below 50% for the first time.

However, Merrill Lynch & Co. Inc. researchers picked up on this theme, and said in a recent note to clients that 2010 would be the year we exit the "pessimism bubble."

And I couldn't agree more. In fact, there might not be a better time to buy stocks.

[mm-toolbar]Trust me, I was there back in 1999 when optimism reigned. Investors were incredibly excited about the coming decade, and bid shares of Qualcomm Inc. (Nasdaq: QCOM) up to $1,000 in anticipation of the awesome prospects for wireless. Online portfolios I provided to readers were up over 1,000% that year, and even the proverbial shoeshine boy was day trading and giving stock tips.

In the ten years that followed, we suffered two recessions, two bear markets, two wars, and an acrimonious political climate. Faith in U.S. stocks as superior long-term investment was shaken as every other major asset class beat equities and delivered positive returns over the last decade.

This shouldn't be any great surprise. It is the way of Wall Street. High expectations lead to disappointment. And now what? Well, we've moved from abundant optimism in 1999 to rampant pessimism in 2009. But from this environment of low expectations, great things can happen.

Historically, periods of widespread pessimism have coincided with excellent times to buy stocks for the long haul. Just look at the chart below, which comes from Gallup and displays the percentage of Americans that feel satisfied with the way things are going. You can see that the current reading of 24% matches levels reached in 1983, 1992 and 1996 - all 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.

The bottom line is that the worst-case 2010 scenarios that bears are promoting are unlikely to come about. The economy continues to make progress towards a robust recovery, though of course there will be missteps. The financial system has been nursed back to health with many bailout recipients already paying back taxpayer money. Net job creation and payroll expansions are just over the horizon.

With pessimism high, interest rates low, more fiscal stimulus poised to pour into the nation's financial arteries, and corporate earnings on track to surprise with upside, my expectation is for a 10% to 20% advance over the next year, from start to finish. Strong early-cycle sectors like industrials and tech will do better than that.

The tricky part of next year is going to come when we see evidence that the major indexes are on track to consolidate into their 12-month averages. This kind of consolidation is hard to play because the indexes will decline for several days or weeks in a row, then correct higher in a flash before breaking down again. It will be frustrating and aggravating. The key thing to recognize is that it is normal and not likely to lead to a massive 2008-style breakdown.

If it plays out like major consolidations in the past, the total move from high to low would be around -5% to -12% before buyers return in a big way to take the market higher again into the next leg of the bull cycle. In the past, consolidations in similar situations have started in late January and persisted into August-October.

2009 Set to Go Out with a Bang

Technically, the Standard & Poor's Equal Weight Index continues its upward climb after last week breaking out of multi-month resistance. The fact that more closely followed indices such as the Dow Jones Industrial Average and the regular Standard & Poor's 500 Index continue to languish near the bottom of recent trading ranges may suggest that Wall Street insiders are accumulating positions in smaller stocks while shunning big-caps like CVS/Caremark Corp. (NYSE: CVS) and General Electric Co. (NYSE: GE).

Allow me to explain. For its benchmark S&P 500 Index, Standard & Poor's assigns portfolio weights based on a company's market capitalization. So a behemoth like Exxon Mobil Corp. (NYSE: XOM) is assigned a 3.5% share while video game retailer GameStop Corp. (NYSE: GME) gets a 0.04% weighting.

When this chapter of market history is written, it may turn out that Wall Street insiders were buying small and mid-sized stocks abundantly while pessimism reigned on Main Street. This would be typical of the manipulations that I witnessed in my research into the stock market of the 1860s through the 1920s. Crafty bulls were always putting one over on the bears, whipping up fear before jerking the market higher and creating a speculative frenzy among the public.

Journalist and author Edwin Lefevre wrote frequently on the topic. Lefevre used to roam the streets of lower Manhattan in the early 1900s, ducking in and out of the offices of Wall Street movers and shakers. He compared the practice I'm describing to advertising stocks to "coax and cajole outsiders to come into the market" in an article in Munsey's Magazine in 1901.

Once convinced, Lefevre said, outside investors would create a "dizzying upward whirl of security values" that would allow the professionals to cash out at top dollar. Despite the Dow's 18% gain this year, we've yet to see this happen yet - not even close. But that may be set to change.

Old practitioners of this dark art, men like James R. Keene who helped J.P. Morgan float U.S. Steel Corp. (NYSE: X) back in 1901, are long gone. But their tactics live on and are utilized by the likes of Goldman Sachs Group Inc. (NYSE: GS) and big hedge funds like D.E. Shaw.

And right now, all signs point to a significant market rally heading into the end of the year and continuing into at least the first two weeks of 2010.

Why? Over the last few months, we've spent a lot of time looking at currencies, interest rates, economic indicators, and market internal data. While this all forms a compelling investment rationale, it isn't as potent or as easily understood as evidence that Wall Street pros are scooping up shares. And that appears to be what's happening now, especially among smaller riskier stocks in cyclical sectors like energy, materials, and industrials.

It's no secret that the average investor has largely ignored the recent stock rally. At first, cash holdings grew. Then, we saw a flood of money pour into bonds. More recently we've seen defensive, dividend-paying stocks in the utility, health care, and consumer staples sector attract attention. Soon, once the Wall Street insiders are ready, we'll see big movements in the likes of GE and Exxon force the average investors back into stocks. Once this happens, the S&P 500 will close the gap with its Equal Weight cousin as it trades over the 1,200-level.

Indeed, on Friday the Investment Company Institute (ICI) provided more evidence this shift by average investors towards risky assets is gaining momentum: Some $51 billion was pulled out of money-market funds for the week, continuing a string of cash outflows as investors seek higher returns. For now, this cash is mainly finding its way into bonds and "safe" stocks. Soon, we should see a shift back into equity mutual funds and exchange-traded funds (ETFs).
The folks at Lowry Research Corp. note that their proprietary measure of investor demand, or buying power, has moved to its highest level since Oct. 16. In contrast, their measure of selling pressure is making new lows. That is great news as it's the opposite of the data you would see at a top. I know there are a lot of bears saying that investor sentiment today is as high as it was at the October 2007 peak, but they are using fuzzy "how do you feel" surveys rather than the raw volume data compiled by Lowry's. Watch what people do, not what they say.

Bottom line: Make no mistake, stocks are under accumulation. Since stock prices are merely a reflection of the balance of supply and demand, the evidence continues to suggest higher prices are on the way. Expanding measures of market breadth, such as the increasing number of stocks in the Nasdaq Composite Index, corroborate this idea.

At the sector level, materials and energy stocks led the day with technology and consumer discretionary names bringing up the rear. The Materials SPDR (NYSE: XLB) ETF has gained thanks to impressive moves by mining stocks. Gold miners in particular benefited from the rise in gold futures on dollar weakness. Similarly, the Energy Select Sector SPDR (NYSE: XLE) has been helped by rise in crude oil.

Within the materials sector one particular stock has caught my eye: The Dow Chemical Co. (NYSE: DOW). This is the type of mega-cap stock that isn't just a toy of hot-shot hedge fund prop desk traders. This is a tough, center-of-the-economy, bare-chested-with-tattoos kind of stock. It's not very volatile. It's not easily pushed around. But once it gets going, it puts together long strings of consecutive up closes. Right now, it's going higher.

[Editor's Note: With the U.S. economy picking up steam, there has seldom been a better time to invest. Valuations are low and the potential for profit is extraordinarily high. And Jon Markman, a veteran portfolio manager, commentator and author, is offering investors a unique opportunity to capitalize on the current bull market by subscribing to his Strategic Advantage newsletter. For more articles like the one you just read or more information about Jon Markman's Strategic Advantage, please click here.]

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