We’re three weeks into the New Year. And so far, so good.
After returning a measly 2.1% for all of 2011, the S&P 500 Index is already up 4.7%. That’s the strongest rally at a year’s start since 1997.
But will it last? And will the January uptick turn into a more meaningful and prolonged upswing for the market?
I believe it will. And here are three reasons why…
Crash Course in Confidence
Everyday investors are notorious for their bad timing. Many bailed out of stocks in February 2009, just weeks before stocks bottomed and then doubled in just 707 days – the fastest doubling since 1936.
It’s no coincidence that the Yale Crash Confidence Index hit a low point at exactly the same time. The Index is a measure of the confidence of individual and institutional investors that there will not be a stock market crash in the next six months.
Or more simply, it gauges investor fear.
The funny thing is that when investors fear a stock market crash most, stocks tend to do the opposite and rally. Mightily.
Well, guess what? Last year’s volatility pushed this contrarian indicator back down almost to 2009 levels for individual investors.
So with fears spiking, the Yale Crash Confidence Index could once again be signaling an imminent stock market rally.
Simply gauging fear isn’t enough. We also need confirmation that investors are acting on those fears. Turns out, they are.
Case in point: Investors yanked $161 billion out of U.S. stock mutual funds in 2011. And almost half of those outflows came in the fourth quarter alone.
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As Lipper analyst, Matthew Lemieux, said, “Even though we have seen good returns, some investors are not convinced and continue to pull out of [stock funds].” I’ll say!
Rest assured, the disdain for stocks continues into the New Year, too. Bloomberg reports that trading volumes on U.S. exchanges in the last 50 days hit their lowest level since 2008.
Such universal avoidance of stocks brings the words of Humphrey B. Neill to the forefront of my mind: “When everybody thinks alike, everyone is likely wrong.”
And I expect that sentiment to be proven correct once again, especially when you consider how cheap stocks are right now.
In terms of price, it’s true that the S&P 500 finished 2011 almost exactly where it started. The Index began the year at 1,257.62 and ended the year at 1,257.60.
But in terms of valuation, the same can’t be said.
You see, earnings for S&P 500 companies increased by about 20% last year. As a result, stocks began the year trading at a price-to-earnings (P/E) ratio of 16, but ended the year at a P/E ratio of 13.
That’s the cheapest stocks have been since 1990, and about 15% below the long-term average P/E ratio of 15.35. So for the S&P 500 Index to trade in-line with the average P/E multiple, stocks would need to rally 18% in 2012.
If we look at stock valuations based on price-to-book (P/B) ratios, the story is much the same.
The current P/B ratio stands at 2.05, compared to a long-term average of 2.43. That means the S&P 500 would have to rally 18.5% higher in 2012 to trade in-line with the average P/B multiple.
Bottom line: The latest investor sentiment and trading activity – and stock market valuations – paint a bullish outlook for 2012. Don’t be too afraid to act on it.
Ahead of the tape,