(SOURCE: Yahoo! Finance)

U.S. stock prices have climbed dramatically in recent years because a steady flow of good news about American corporate performance and economic conditions has boosted investors' expectations to record heights. Subdued price inflation and steadily falling interest rates have created ideal conditions for unhampered economic growth and rising profits. This positive economic environment, mixed with more than a trillion dollars poured into mutual funds by small investors, has driven equity prices higher and higher. Nowadays investors are about as optimistic as is possible.

There is reason to believe that the Great Bull Market may now be reaching an end. Since stock prices have been rising for a decade without a significant bear market, investor confidence and optimism has built to a historic extreme. Based upon the level of "irrational exuberance" on Wall Street along with technical analysis of the stock market, it appears that a multi-year, if not multi-decade, bear market is likely to get underway.

One of the most important signs of major tops in stock prices is a high-level of over-optimism among investors (1). At the high-point in stock prices prior to substantial bear markets there is rampant collective optimism about the future. For instance, at the stock market tops in 1929 and 1973, two of the most significant U.S. market tops in the 20th Century, almost everyone was in agreement that economic prosperity and rising stock prices lied ahead. Investors' expectations, however, were about as irrational as could be at those tops as the subsequent trend in stock prices was dramatically down- by some 90% between 1929 and 1932 and by some 50% between 1973 and 1974. The situation today is a close parallel of major stock market tops in the past where there is excessive optimism about the future.

To understand the current outlook for the U.S. stock market, it is important to first set aside any exposure one may have had to contemporary market theories taught in finance and economics. Furthermore, one must be able to think against the predominately bullish consensus opinion in the investment community. The truth of the situation is that the collective optimism prevailing today is most likely irrational and wrong.

According to contemporary market theory, investors think and behave rationally when buying and selling stocks, bonds and other such investments. Specifically, investors are presumed to use all available information to form "rational expectations" about the future in determining the value of companies, the general health of the economy and the worthiness of alternative investment choices . Consequently, financial market prices should accurately reflect fundamental values and only change when there is unexpected news relevant to perceived values. Financial markets are thought to be efficient, stock prices are expected to follow a "random walk" and the overall economy should experience steady growth over time.

Unfortunately, this highly optimistic assessment of human behavior and markets by academicians is dangerously unrealistic. In reality, investors do not think and behave rationally when buying and selling stocks. To the contrary, driven by excessive greed and fear, investors speculate stocks between unrealistic highs and lows. In other words, investors, misled by extremes of emotion, subjective thinking and the whims of the crowd, develop irrationally optimistic and then pessimistic expectations over time about the future performance of companies and the overall economy such that stock prices swing above and below fundamental values and follow a somewhat predictable, wave-like path (3).

One way to better understand how investors' expectations swing between extremes of optimism and pessimism is by directly examining investors' expectations over time compared to the direction of stock prices. In order to determine the popular sentiment of investors, there are regular opinion polls of small investors, floor traders, institutional investors, and advisory services. These polls typically check whether someone is bullish or bearish, i.e., whether they expect stock prices to trend higher or lower in the future. Historically, whenever there is a consensus opinion among investors or investment advisors with regard to the future direction of market prices, i.e., whenever there is a consensus bullish or bearish opinion, the stock market tends to subsequently head in the opposite, unexpected direction. In fact, the greater the consensus, the more substantially the market will head in the opposite direction. Below are a chart and table of the "forecasting" record of stock market advisors that reflects just how consistently wrong consensus market opinions can be at the extremes.

(SOURCE: Zweig, 1990, pp.138-139)

Recent polls of investor sentiment indicate extreme optimism on Wall Street. When the DJIA was trading above 11000 recently, Investor's Intelligence, the most reputable investor polling service, found more than 60% of investment advisors to be bullish- a multi-year high. The percentage of investment advisors that are bearish has fallen to around 25%- close to a five-year low (4). Amongst newsletters infamous for "fearless forecasting" (i.e., aggressive market speculation) the level of bullishness is now at alarming levels. As can be seen in the chart below, as of late-July, 69% of such forecasters were bullish compared to 19% that were bearish. All in all, the consensus outlook of investors is currently extremely optimistic as reflected by opinion polls, a sign that stock prices may be heading unexpectedly lower in the near-future.

(SOURCE: Decision Point)

As can be seen below, the put-to-call ratio reached a multi-year low-point recently, indicating extreme investor optimism. In fact, on a moving average basis, this ratio reached a lower level than occurred with the stock market top in July of 1998 after which a stock market decline of 20% took place. Thus, there is further evidence of over-optimism on Wall Street at the present time that suggests a new downtrend in stock prices lies ahead.

(SOURCE: Decision Point)

Another way to get an idea of the sentiment of investors is to see if they are putting their money where their mouths are. In other words, is the bullish sentiment that has been showing up in opinion polls of, in particularly, institutional investors reflected in relatively large stock holdings? One way to track this is by paying attention to mutual fund cash levels. When the cash levels of mutual funds reach relative lows, the stock market tends to reach important tops. Likewise, when mutual fund cash positions are relatively high, the market is likely near or at an important low-point (see table and chart below).

(SOURCE: Zweig, 1990, pp.132-133)

By May of this year, mutual funds had cash positions of 4.7% on average (6). This is near a record low and indicative of extreme optimism on Wall Street and an important stock market top.

Another indication of recent extreme optimism on Wall Street is the degree to which the stock market is "overvalued". The way in which one can determine whether the market is over- or under-valued is by paying attention to the average price-to-earnings (P/E) ratio, dividend yield and price-to-book value of the S&P500 and/or DJIA. (NOTE: The price-to-earnings ratio of stocks is the price of a given share of stock divided by the earnings of a company per share; the dividend yield is determined by dividing the dividend paid per share by the price per share of a given stock; the price-to-book value is a measure of a company's valuation based upon a ratio of the company's stock market value and actual book value.)

Historically, the P/E ratio on the S&P500 has fluctuated around an average of 14. When the P/E climbs above 18, the market is relatively overvalued and usually around a major top. When the PE falls below 10, the stock market is undervalued and typically near a bottom. (The exception to this is when the P/E is inflated by extraordinarily low earnings, like during recessions and the Great Depression, such that high P/Es occur during extreme phases of bear markets and thus toward important market lows.)

(SOURCE: Martin Zweig's investment newsletter)

At present, the average P/E for the S&P500 is almost 37, indicating extreme overvaluation and a major stock market top. Likewise, the average P/E for the DJIA recently climbed above 28. (Notably, each time the market P/E has risen above 20 for two or more consecutive quarters without depressed earnings, and right now the market P/E has been above 20 for more than three years, a stock market crash followed: this occurred in 1929, 1946, 1962, and 1987.) (7)

A more stable indicator of market valuation is the average dividend yield on the DJIA. Historically, when the average dividend yield on the Dow falls below 3%, the stock market is overvalued and near a top. When it climbs above 7%, the market is undervalued and near a bottom. (8)

During the last couple of years the stock market has seemingly achieved the impossible in that the dividend yield on the DJIA fell below 3%, and then below 2% (!), but stock prices have kept climbing. Today the dividend yield on the Dow is 1.53% following an extreme low of 1.45% reached in May. This historically low dividend yield on the DJIA indicates gross stock market overvaluation and a major top.

A high average price-to-book value for stocks is also signaling an extremely overvalued market. Before the 1929 and 1987 stock market crashes, the average price-to-book value for the 30 stocks comprising the DJIA climbed above four, a shocking level at the time. In recent years, top market analysts have been frightened by the fact that the price-to-book value of the DJIA rose above five. However, in recent months complete insanity has been signaled by a price-to-book value for the DJIA well above six!

When risk factors like stock prices relative to earning, dividends and interest rates are brought together, it is possible to construct an index that measures general market risk. This is precisely what is done to generate the Barnes Market Risk Index:

(SOURCE: Decision Point)

As can be seen in the chart above, current stock market risk is well beyond anything that has developed before in U.S. history. According to the Barnes Market Risk Index, stocks are far more risky now than in 1987, after which the DJIA plunges more than 35% in a few short weeks.

The combined message of investor polls, put-to-call ratios, mutual fund cash positions, price-to-earnings ratios and dividend yields is that an historic extreme of investor optimism and possibly an important top is at-hand in the U.S. stock market. The consensus among investors is that stock prices are headed higher. Acting on those expectations, options investors have purchased large amounts of calls relative to puts and mutual fund managers are almost fully invested in stocks. Heavy investing has pushed stock market valuations to unprecedented extremes as indicated by extraordinarily low dividend yields and high P/Es and price-to-book values. All in all, most investors today have very high expectations for the future performance of stocks and have become fully invested in an overvalued market in anticipation of future gains. Accordingly, a major upset of investor expectations and a significant decline in stock prices should lie ahead.

FOOTNOTES

Psychology & The Stock Market (©1977).
The New Contrarian Investment Strategy (©1982).

2. For the academic view, see:

Sheffrin, Steven. Rational Expectations. Cambridge, UK: Cambridge University Press, ©1983.

3. Robert Prechter, the "Elliott Wave Theorist" describes the market this way: "The Elliott Wave Principle is a detailed description of how markets behave. The description reveals that mass investor psychology swings from pessimism to optimism and back in a natural sequence, creating specific patterns in price movement."

4. Investor's Business Daily, Psychological Market Indicators, 7/16/98, pA27.

5. Barron's, 12/97.

6. Investor's Business Daily, 7/16/98, pA27.

7. Wall Street Journal, "Stocks are in Stratosphere by Some Measures", 3/4/98, pC1.

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