Explosive optimism

This weekend's Barron's has the usually bearish Alan Adelson put up a big warning in "Signs of a Top?"

Market sentiment following the surging December is characterized as "explosive optimism." Indeed, forecasts from Goldman Sach's Jim O'neill's 20% stock market gain and "Year of USA" proclamation, to various market gurus that Barron's has assembled, to the recent low in VIX all seem to agree on a very good year ahead.

Could this be the sign of a temporary market top before the real economies produce sufficient results to support it?

This is probably the most important question to ask heading into the first week of 2011. Perhaps the December surge was really just an amplified "window dressing" and short-covering effect when all the under-performing portfolio managers tried to buy the year's big winners and short sellers ran for the cover. If so, these stocks are over-bought and can see sell offs in January.

As noted by Adelson, one important area to watch is indeed the commodities-related stocks which seem to have not reflected the new policy stand by China trying to reign in inflation and the potential bubble in property markets. China has raised interest rates multiple times and bank reserve requirement multiple times. And RMB has not appreciated much. It seems pretty clear that the easy bank-lending policy of the crisis era is now on reverse.

Yet, from copper, iron ore, to other industrial metals and the companies engaged in their productions, the market continues to assume an ever-expanding appetite out of China. FCX has hit 120/share! Can this continue in the new year? If that reverses, it could be a leading signal for things to follow. For a good anlysis of the copper market, and a fair warning, see this Seeking Alpha article.

Nothing to Fear but Fear Itself?

There are a lot of talks about market psychology in recent days as the market went through a deep correction. For instance, the Wall Street Journal has a piece today that tries to argue that "[t]he biggest threat to recovery is the markets themselves." That is, the economic recovery would be back on track if the markets just believe it.

As if to confirm it, the market had a good rally today without any good news.

I do believe there is certain amount of truth in it, although I think there is far more than just investor psychology that's involved.

To a large degree, our modern economy is now very asset-based, in that consumers can spend based on the value of their assets such as homes and mutual funds. So if the markets for these assets are supported either by the Fed, or by optimistic views, we may see very positive effects on consumption and hence on recovery. That in turn may lead to higher asset values.

But that was how we got into the credit crisis, believing for example that home values would always go up. Consumers are now working hard to repair their balance sheets. In such an environment, we need actual income generation to support the economic recovery. That is, jobs.

This is probably why PIMCO's El-Erian thinks that unemployment has shifted from a lagging indicator to a leading one and is warning government policymakers to confront the structural problems in the economy. Eight millions of jobs have been lost since the beginning of the great recession. Despite historically low interest rate and trillions of dollars in stimulus spending, jobs are still scarce and are being added too slowly.

Investors have to ask, why these profitable corporations are not adding more jobs and who are going to lead job creation?

Why the Crowd Maybe Sheep Again

(This article was later published on Seeking Alpha titled "Pessimistic Investors Are Missing the Boat in 2010, Again.")

There is an abundance of pessimism in the investment crowd. Unemployment, foreclosure waves, federal deficits, enemic home sales, ... there is little wonder why so many commentators dwell on the negative side of every piece of economic data. If you go with the wisdom of this crowd, you should be shorting the market in general.

Yet short sellers have been frustrated so far this year. Nothing seems to work. In particular, the home building sector has been one of the top performers of the year so far (simply check LEN, DHI, SPF, PHM, or XHB). It is truely frustrating for investors who just cannot see any light in the housing sector, and cannot accept the fact that government support is sometimes necessary.

After a disasterous 2008, investors pulled record amount of money out of equities, and put them into bond funds and/or cash. Despite a roaring "V-shape" recovery in the equity market in 2009, narrowed credit spreads and expected rise in the yield curve, investors continued to pour $89 billions into bond funds in the first quarter of 2010.

PIMCO has been the prime beneficiary of this inflow. Its "new normal" thesis has been well-argued and publicized which has also help draw money into bond funds. All this money however may make it extremely hard to keep up with the performance, given the potential inflation and potential rise in rates.

Finally, PIMCO warned that bond funds may have seen best days. They have even started to offer stock funds.

One clearly can see at least two different types of herds here: the avoid-equity-at-all-cost crowd that stampeded into bond funds and the pessimism-dwelling short-selling crowd. One would think that the second crowd may be more sophisticated and better informed, yet they may be just one-year behind the curve after investor like John Paulson has already made his killing in 2007-2008 and went long into financials.

The trait of the investment sheep makes them dwell on one direction for too long. Such sheep showed up in force in the last housing boom. And we may be seeing them again in the abundance of extreme pessimism in 2010.