2011 Outlook: Stocks

Entering 2011 the American stock market is coming off of an incredible 22 month run from the lows of 666 in March 2009 on the S&P 500 to end the year at 1257.

The consensus across the board is for this amazing growth to continue into 2011 and the euphoria in the market has reached a fever pitch.

This is known as sentiment, and it is an important indicator to track to determine major turning points in the market.

To understand why, imagine there are 5 investors in the market that each have $100 to invest. If they are only 20% bullish on the market, they probably have $20 dollars invested. This leaves each one of them with $80 in new capital to invest in the market, which would push the stock market higher.

If they are 100% bullish, they probably have $100 of their money in the market. They have no additional money to invest so if anyone begins to sell, the market will fall.

This is a very simple example to a very complicated market, but hopefully provides the understanding of why sentiment is important to consider, and why Warren Buffet says he likes to be brave when others are fearful, and fearful when others are brave.

The following shows the front page article of December 17th's USA Today titled, "5 Wall Street Heavyweights Say It's Time To Get Back Into Stocks."

In other articles within the Money section of the paper, experts offer 11 ways to make money in 2011.  They are all essentially telling investors to buy stocks.

Bloomberg conducted a poll of the chief market strategists for 13 of the largest banks in the world.  All 13 of them predicted stocks to be higher next year, and some are even calling for new all time record highs in the market.  The following chart shows each one of their predictions:

The AAII bullish/bearish sentiment indicator is a polling of retail investor's optimism on the current direction of the market.  Last week we topped out at a 63.8%, the most optimistic reading in over 6 years!

The put/call index, which is a measure of how many investors are buying puts (betting against the market) or calls (betting the market is going higher) last week hit its most optimistic level in over 4 years!

USA Today last week conducted an extensive interview on where market participants see stocks going in the year ahead.  40% said stocks would rise by more than 10%, 48% said stocks would rise by 10% or less, 7% felt stocks would be flat for the year.

Only 5% felt the market would fall, and less than 1% said stocks would fall by more than 10%. 

This type of bullish sentiment is astonishing.  All sentiment indicators across the board are at multi-year highs, even higher than they were at the stock market's peak back in October 2007.

In addition to sentiment, it is important to look at “value” or how expensive or cheap stocks are based on price to earnings. (P/E)

In December the Shiller P/E ratio shows stocks trading at 22.7. The higher the P/E, the more investors are willing to pay for a company’s earnings. In normal economic times the P/E ratio is between 14 and 16 times earnings. Coming out of a bursting credit bubble the P/E ratio is historically 12. At major secular bottoms the ratio is under 10. (Investors do not want stocks and refuse to pay a high premium for earnings)

P/E ratios are determined based on analysts estimates of current and future earnings.  Therefore, if an analyst uses a target of high earnings as a future projection, and earnings disappoint, then the P/E ratio will be even higher and stocks will be even more "expensive."

I believe analysts are painting too rosy a picture for 2011, and while stocks are already expensive using their high earnings projections, investors will realize they are extremely expensive when earnings disappoint.

Purchasing stocks means you are purchasing ownership in a company. As a reward for investing, companies pay investors a portion of the earnings through dividend payments.

Stocks are more attractive when they pay a higher dividend payment and are considered overvalued when paying a lower dividend payment. (Investors are willing to take a lower payment when they feel they will earn money on stock appreciation)

The following chart shows the historical dividend payment on the S&;P 500. As you can see we currently find ourselves at the lower range providing another indicator that stocks are “expensive.”

Based on current euphoric sentiment levels, a market that is overvalued in terms of price to earnings and dividend payments provide a dangerous outlook for stocks in the year ahead.

Let's now look at another major headwind that could impact the economy in 2011: Real Estate.