Skittish stock investors sit out while bull market runs

With the money-losing memories of the financial crisis still fresh in their minds, investors are having a tough time embracing the new bull born in early March.

Despite the best back-to-back quarters of gains since 1975 for the U.S. stock market and a 56.2% rise in a 6 1/2-month span, many investors are questioning whether the good times can last.

Who can blame them, given all the dire warnings about another Great Depression earlier this year? Many investors are behaving as if they're suffering from a Wall Street form of post-traumatic stress disorder. Unlike normal bull markets, when the most common question investors ask tends to be, "How high can stocks go?" This time around, jittery stockholders can't stop asking: "Is the rally almost over?"

"This is one of the most unloved and disbelieved bull markets that I can remember," says James Stack, a money manager, market historian and editor of InvesTech Research newsletter

The disbelief comes despite mostly encouraging data that point to an economic recovery and rebound in corporate earnings. Skepticism abounds even though the Federal Reserve says the recession is likely over, and growing signs point to a housing market on the mend. Not even upbeat comments from bulls who say the direction of the market remains up have been able to alleviate fears.

Signs of investor distrust of stocks and the current rally are plentiful.

The latest poll measuring the sentiment of members of the American Association of Individual Investors shows that bears (45%, vs. a long-term average of 30%) outnumber bulls (39%). That lack of faith in stocks is reflected in AAII members' current allocation of stocks, which made up just 54% of their portfolios at the end of August, below the long-term average of 60%.

Angst on Main Street is evident in the wariness of Arlene, 58, and Mike Armstrong, 59, a working couple from Columbus, Ohio. They stayed the course during the brutal bear market, but are now considering selling. Arlene quotes husband Mike as saying: "The stock market has left me feeling as if I've been betrayed by a mistress. Now, I feel as if I can never trust her and have to keep a watchful eye on her all the time."

Similar thinking can be found on some Wall Street trading desks. For example, Mohamed El-Erian, the CEO and co-chief investment officer at giant money management firm Pimco, is advising investors to lower their allocation of stocks. The reason: to reduce risk in what the firm refers to as a "New Normal" world, characterized by slower economic growth and lower asset price appreciation going forward. But despite all the skepticism, the fact remains that the stock market has been performing well. After Wednesday's 0.3% drop to 1057.08, the Standard & Poor's 500 index posted a 15% gain in the just-completed third quarter — its best third-quarter gain since 1970.

There is a healthy contingent of bulls who say the ingredients are in place for a continuation of the stock rally. The key ingredient, of course, is that the economy is in recovery mode, which historically has been a good time to own and profit from stocks. Bulls also note that stocks have a history of climbing higher when most people are calling for the market to decline.

Trying to find consensus on whether stocks have come too far too fast — and are pricing in too rosy a scenario for the economy — or are heading higher simply because economic expectations are improving is like getting Republicans and Democrats on Capitol Hill to agree on health care changes.

The partisan nature of the bull vs. bear debate is illustrated best by recent research reports sent to clients by Strategas Research Partners and David Rosenberg, chief economist and strategist at Gluskin Sheff.

In an ongoing string of bearish missives sent recently to clients, Rosenberg, the former chief economist at Merrill Lynch who warned early about risks posed by the financial crisis, ticks off many reasons the current stock rally is doomed to fail.

Rosenberg's thesis is that current stock prices have "far too much growth priced in." He argues that stocks are trading at valuations generally reserved for the "third year of economic expansion." He warns that the consumer shift to more frugal spending patterns to pay off debt and rebuild lost wealth is a longer-term phenomenon that will impede the economic recovery. He also argues that last week's Federal Reserve statement that reiterated its belief that the recession was effectively over, that it would keep short-term interest rates low for an extended period, and that inflation remains subdued amounts to a "sweet spot" for investors. The problem, according to Rosenberg? The market is "already priced" for this sweet spot.

Other warnings from Rosenberg are highlighted in his reports in bold-faced subheads: incomes under pressure; equity market est tres expensif; the economy looks sick outside of government stimulus; Ma and Pa Kettle are not driving the equity rally; more problems with valuation; employment outlook still grim; housing sector still soft; confidence takes a tumble.

He also points out that Japan's Nikkei stock average posted six 20%-plus rallies and four 50%-plus rallies since its stock bubble burst in 1990, yet the index is still down more than 70% from its peak.

The point: There's no shortage of reasons Rosenberg — and other bears, for that matter — thinks stocks are due for a fall.

Contrast that with the bullish stock update released Wednesday by Strategas analysts Christopher Verrone and Nicholas Bohnsack. The headline: "8 Reasons Why the Market's Rally Can Continue Through Year-End." (The report doesn't address the 2010 outlook.)

A big reason to be bullish is that credit markets, which had frozen during the peak of the crisis, have improved dramatically, the report says. Also bolstering the case for more gains, the analysts say, is that 10% stock market corrections rarely occur in the first year of a bull market, and as stocks are heading into a strong seasonal period, particularly November through January. Some of the nearly $3.5 billion still sitting on the sidelines in money market mutual funds yielding close to 0% may also find its way into the stock market, which could generate more buying power.

A main point espoused by the bulls is that many of the market's biggest worries and headwinds — the longer-term impact of massive government deficits; the drying up of government stimulus; the impact of higher borrowing costs when the Federal Reserve starts raising short-term interest rates — won't play into investor decisions until sometime in 2010. Stack is also certain that the Fed will not raise rates until Fed Chairman Ben Bernanke is certain the economy is on solid footing in an effort to avoid a so-called double-dip recession.

"These worries will not become valid until we are further into the economic recovery," says Stack, who currently has 97% of his clients' money invested in stocks — the most since the early stages of the 2002-07 bull market.

A key for stocks will be how the market fares in October. The 10th month of the year is not only known for Halloween but also for scary stock market crashes. The most famous: "Black Tuesday" of Oct. 29, 1929, and the 22% crash on Oct. 19, 1987. If stocks can survive October, Stack says a year-end rally of 10% to 15% can't be ruled out.

And while October has a reputation for being a spooky month for investors, the S&P 500 has gained an average of 3.2% in the 14 Octobers following a bear market (and finished lower only four of 14 times), according to a study by Sam Stovall, chief investment strategist at S&P.

Meanwhile, investors will base investment decisions on traditional market drivers: corporate profits, price-to-earnings ratios, economic statistics.

The third-quarter earnings season is key. Investors are expecting better-than-expected reports from companies, as was the case in the first two quarters of the year. Overall, the S&P 500 is expected to post negative growth of 24.7% in the July through September period, according to Thomson Reuters. Positive profit growth is expected to resume in the final three months of the year, with analysts expecting growth of nearly 200%.

It's common for earnings to be depressed coming out of a recession, so investors will be more focused on what companies say about the business outlook. Investors will also be scrutinizing how companies earned their profit. In past quarters, much of the profit improvement has come from cost-cutting and job cuts. This quarter, investors want to see revenue improvement and clear signs that business is improving, both at home and abroad, says Edward Yardeni, president of Yardeni Research.

"Investors want to see a lot of positive earnings surprises, and I think we'll get them," Yardeni says.

On the valuation front, many investors who focus on stock prices relative to operating earnings, or those who strip out one-time write-offs, say the market is still priced for more upside. The S&P 500 is currently trading at less than 14 times next year's earnings estimates, which is below the long-term average of 15 and well below the 30-plus P-Es of the 1990s dot-com era.

According to a study by Brian Belski, chief investment strategist at Oppenheimer, the current P-E of the S&P 500 is in line with historical averages. More important, the market is not trading at an excessive premium when compared with other bear market periods. Despite calls for a correction, Belski says the investment environment is ripe for long-term investors: "We would much rather be investors and accept this is a new bull market and invest accordingly."

David Kelly, chief market strategist at JPMorgan Funds, says the economy has clearly embarked on a recovery. But he uses an analogy from the 2000 movie Cast Away starring Tom Hanks, in which Hanks is stranded on an island after a plane crash, to describe the economic challenges.

"When Hanks finally got his boat past the reef and into the ocean, the good news was he was on his journey. The bad news was there were sharks on the horizon." While Kelly thinks the bulk of the recovery is still ahead, he says "the bad news is it will take a long time to get back to normal."