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December 3, 2006
Strategies
When Wall St. Looks Like Pamplona, Sound an Alarm
By MARK HULBERT



INVESTMENT newsletter editors are about as bullish as they have been in nearly five years — and that doesn’t bode well for the stock market.

When investors are wildly optimistic, head for the hills; when they are truly pessimistic, buy stocks. That, at least, is the counsel of contrarian analysis, which derives its name from the idea that the market, in the near term, rarely does what the majority expects it to do.

When pessimism and despair reach extreme levels, for example, contrarians believe that the market is at or near a bottom. That’s because any short-term traders who are likely to sell their stocks when conditions are unfavorable will have already dumped them — removing potential selling pressure that could drive the market still lower. The reverse is the case, the contrarians say, when optimism is extremely high.

Consider the sentiment that prevailed when the stock market hit a low in June this year. According to The Hulbert Financial Digest, investment newsletters that focused on timing the stock market’s short-term trend recommended, on average, that their subscribers allocate 88 percent of their equity portfolios to cash and the remainder to shorting the stock market — an aggressive bet that stocks would fall further. Far from declining, of course, the Dow Jones industrial average is now almost 1,500 points higher.

By Nov. 24, by contrast, the average recommendation of this same group of newsletters had changed greatly — to allocating nothing to the short side of the market and 71 percent to the long side. Though the newsletters cut their average recommended exposure by 12 percentage points on Thursday, to 59 percent on the long side, the level is still very high — double the average since the bull market began in October 2002.

Contrarians appear justified in their worry about the high sentiment level. The digest recently compared the stock market’s average three-month returns after days with extreme sentiment readings (defined as the 10 percent of trading days when sentiment was highest and the 10 percent when it was lowest). In the three months after the most pessimistic days, the market gained 11.9 percent more, annualized, than it did after the most optimistic days.

Further support for contrarian analysis comes from a study published in the August issue of The Journal of Finance. Entitled “Investor Sentiment and the Cross-Section of Stock Returns,” its authors are Malcolm P. Baker, an associate professor of finance at Harvard Business School, and Jeffrey Wurgler, an associate professor of finance at New York University’s Stern School of Business.

The professors focused on those companies that economic theory suggests would be most vulnerable to investor sentiment: small-cap growth companies, which have relatively few assets and little or no record of consistent earnings. Traditional balance-sheet analysis provides relatively little insight into these stocks, so their valuations can be subjective, supported largely by investor enthusiasm. The professors studied the period from the beginning of 1963 to the end of 2001.

They found just what a contrarian would expect: after periods when sentiment was particularly high, like the months and years leading to the bursting of the Internet bubble in early 2000, small-cap growth stocks proceeded to perform very poorly. That makes sense, because investor enthusiasm would have bid the prices of these stocks to very high levels and made them vulnerable to even the slightest decline in that enthusiasm.

The reverse was the case after periods of low sentiment, the professors found. Small-cap growth stocks are punished particularly harshly when investors become discouraged, and from such low levels they can provide handsome subsequent returns.

WHAT about companies for which traditional balance-sheet analysis is more useful — larger companies, generally, and those in the so-called value category? The professors found that investor sentiment has relatively little effect on these stocks. That also makes sense, according to the professors, because such stocks’ valuations are less vulnerable to the way the sentiment winds are blowing.

Given this research and the current level of market optimism, there are a couple of strong implications for investors. First, it would be wise to take some money off the table and to build up some cash until sentiment drops to less-lofty levels. And, second, you might want to shift exposure away from small-cap growth stocks.

Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch. E-mail: strategy@nytimes.com.