Is the Contrarian Bell Clanging for Stocks?

Sentimental Feelings Let's start with the caveat: There is no proof that investors can profit by considering market sentiment.

Betting against current sentiment makes intuitive sense. If equity investors are happier than usual, the process of reversion to the mean suggests that their mood is likelier to worsen than to brighten, causing stocks to suffer accordingly. Conversely, if shareholders are gloomy, the odds favor improvement. Eighty years ago, John Maynard Keynes discussed how "mob psychology" affected stock prices. Surely, it still does.

Profiting from that pattern is tricky, however. One can measure company earnings or bond yields, but not investor sentiment. There exist various proxies, such as consumer-confidence indexes, short-interest calculations, or the Shiller CAPE Ratio, that indirectly attempt to assess sentiment. Several of those indicators appear to have modest predictive power, in the sense that their output is loosely correlated with future stock market returns, but the results have not been statistically significant.

That said, I can't help but to pay attention. Today, I am reminded of a time nearly 20 years back.

The Y2K Specter In late 1999, investors feared the "Y2K" bug--computers that had been coded to represent dates with two digits rather than four, so that the upcoming shift to the year 2000 would be indistinguishable from 1900. Some believed that this problem was so widespread, and the ripple effects from the upcoming misdating so large, that global communications would suffer major, long-standing problems. Stock market pundits were concerned.

Several times in autumn 1999, I was interviewed about the next year's investment prospects. The conversations went something like this:

Reporter: "Is now a good time for investors to consider selling technology?"

Straight Man: "The same as any other time, I suppose."

Reporter: "But Y2K is coming."

Straight Man: "Yes, it is. I can't cross the street without hearing about Y2K. That means that whatever bad news exists should already be in the stocks' prices."

Reporter: "What if it's a disaster?"

Straight Man: "Then technology stocks might go down. But perhaps not. If the disaster is very bad, but still better than the consensus investor expectations, then the stocks will probably rise."

Reporter: "So this isn't a worse time to hold technology stocks than usual?"

Straight Man: "Yep. Who knows? It might even be better."

Reporter: "Hey, I have another call coming, I need to go now. Thanks for your help."[Hangs up without checking the spelling of Straight Man's name, or confirming his title.]

As it turned out, the onset of Y2K was about as eventful as the opening of Al Capone's vault. Investors breathed a sigh of relief, and the Great Tech Stock Rally rolled into the New Millennium. January and February 2000 were among the sector's best months ever. The big menace had been avoided; nothing now stood in technology stocks' way.

Then March came, and technology stocks fell. And fell. And fell. Over the next two and a half years, the Nasdaq stock index dropped from its peak of 5,132 to its bottom of 1,335--a cumulative loss of 74%. All despite, not because of, the effect of Y2K.

Boogeyman Trump Flash forward to the summer of 2016. As was the case in 1999, investors feared an event. There were ongoing warnings about how stocks would fare if Donald Trump won the election, given the uncertainty surrounding his policies and his protectionist bent. In apparent support of the thesis, the U.S. stock market's performance tended to move with Hillary Clinton's poll numbers; for example, the Dow Jones Industrial Average gained 133 points on Sept. 27, the day after she was said to have won the first Presidential debate.

Wrote CBS MarketWatch: "The advance in stocks suggests that U.S. equity markets are betting that Clinton benefited the most from Monday's presidential debate. Stocks are rising on the prospect of a Clinton presidency because the Democrat is viewed as a known quantity while some view Trump as being more unpredictable--a bad thing for stock investors."

Then the dreaded event occurred, with Mr. Trump winning the election … and it wasn't so bad. In fact, decided investors, it might actually be good. Yes, the new president is unpredictable, and might generate a trade war or two, but he will give American companies a jolt by sweeping away regulations and cutting tax rates. Thus came the "Trump bump." Summer's worries vanished.

In fact, pretty much all worries seem to be gone, to judge from what I've been reading recently. The prevailing mood is in stark contrast to 12 months ago, when commodity prices were falling, and economists were discussing the possibility of a global recession. At that time, leading U.S. bond fund manager Jeff Gundlach of DoubleLine predicted poor 2016 performances from the U.S. dollar, junk bonds, and emerging-markets stocks. (He was wrong on all three but did redeem himself by being among the very earliest to forecast Donald Trump's victory.)

Once More, for Luck? That pessimism has been replaced by today's optimism. Last year carried the danger that recession would occur--those concerns were not misplaced, it was a genuine possibility--but the consolation was that if the bad news did not come true, stocks might rally on relief. What relief will come now? The market has already celebrated twice, first that global economies are steady (if not exciting), and then that business will carry on under the Trump administration. Something unexpected will be required for a third celebration. Unexpected positives do happen--but that's not generally the way to bet.

All this comes as rumination, not advice. I haven't changed my portfolio, and given the difficulty of timing the markets, neither probably should you. That said, I am happy that my equity-heavy portfolio favors companies that have relatively low debt and stable businesses; that is, lower-beta stocks that tend to withstand downturns better than most. This might be one of those years that test a stock investor's patience.

Good Times, Bad Times Adding to my sense of foreboding is the news that the investment firm Grantham, Mayo, Van Otterloo (GMO) has been shedding assets. Because GMO is very conservatively positioned, its funds perform their relative best during bear markets, and their relative worst when stocks are soaring. For business purposes, the good times are the bad times for GMO, and the bad times are good.

Which makes GMO something of a contrarian indicator. In the late 1990s, when it would have been helpful to lighten up on stocks, GMO shareholders were fleeing. A decade later, following the 2008 market crash, GMO's business boomed--but its funds trailed in the ensuing rally (although not as badly as they could have, given the firm's gloomy investment outlook). Now investors are again redeeming their shares.

The sell-off is into its third year, meaning that GMO's business fortunes are an imperfect signal. One could have seized upon the indicator 18 months ago, concluded that stocks were due for losses, retreated to cash, and missed Dow 20,000. So, I wouldn't wish to overstate the indicator's value. But … it is a bit worrisome. I feel as if I have been here before.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.