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Rational Optimism and the Bull Market Cycle

A question I’ve noted in the media of late: With sentiment noticeably more positive these days, should we be worried about the bull market's imminent end?It's a valid question. Remember Sir John

A question I’ve noted in the media of late: With sentiment noticeably more positive these days, should we be worried about the bull market’s imminent end?

It’s a valid question. Remember Sir John Templeton’s legendary quote: “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” Sentiment is a powerful indicator of where a bull market is in its lifespan, and sentiment improves with age.

As I type, this bull market’s 30 days shy of its fourth birthday. For much of that time, investors have waffled between pessimism and skepticism—news was either bad, good couched as bad, or good but it couldn’t possibly last. Lately though, there’s certainly been some less skeptical headlines. Here’s a sample:

Don’t Be Fooled by the GDP Report: The Economy Is Gaining Strength

Whisper It, But the British Economy May Be in Better Shape Than You Think

Public Hearing Better News About Housing and Financial Markets

Home Prices, Stock Rallies, and the Wealth of the Nation

Housing Recovery Gained Pace in 2012

Retail Investors Warming to Stocks as Equity Inflows Turn Positive

With positivity returning, should we be worried the end is nigh?

Not yet, in my view. For one, headlines aren’t uniformly sunny—there’s plenty of skepticism. More importantly though, these optimistic headlines aren’t out of touch with reality. Rather, they’re closer to an accurate appreciation of today’s positive fundamentals and a willingness to look beneath seemingly negative economic news for signs of underlying strength.

Take the recent advance estimate of Q4 US GDP, which showed a -0.1% contraction. Just one year ago, most coverage would likely have focused on the headline drop and warned of a fresh recession. This time though, that wasn’t the case—while some headlines questioned whether recession was in the fore, other observers were more willing to open the hood and check the economic engine. In doing so, they found falling government spending obscuring a healthy and growing private sector. They also found shrinking private inventories and asked the right question: Did inventories shrink because firms anticipated weaker demand ahead, or—more likely—was it because holiday sales were stronger than expected, implying firms will need to restock in Q1? Looking at it that way, you could be forgiven for thinking strong business investment and rising consumer spending point to continued economic strength—a very rational analysis.

A similar behavioral phenomenon took hold when December housing data showed a continued slump in new home sales. Rather than decry renewed housing weakness, some commentators took a measured view. They noted that low inventories, not low demand, were behind the drop, and they pointed out that prices were still rising and the housing market had its overall best year since 2007. And the outlook? Ultra low inventories and improving demand should continue boosting home prices.

There’s decent sentiment to be found internationally, as well. Many see improving Chinese economic data as signs of reacceleration, not a blip. In the UK, a smattering of positive December and January data are fueling hopes of a return to growth. And improving export and economic growth in Taiwan—a key exporter of computer, tablet and smartphone components—is driving optimism for Tech.

So some optimism exists! Pockets of rational optimism, and nowhere close to runaway optimism, considering other headlines. Political upheaval in Spain and Italy has renewed eurozone jitters, and most observers had a too-dour (in my view) take on UK Prime Minister David Cameron’s plans to renegotiate his country’s place in the EU. China and Japan’s escalating dispute over the Senkaku/Diaoyu islands is fueling fears of geopolitical conflict and its impact on markets. Ditto for North Korea’s impending nuclear test and fighting in Syria and Mali. And a weaker Indian growth forecast was enough to drive worries of slowing Emerging Markets growth. Thus, it seems safe to say we’re only just entering the bull’s maturing stages.

As the bull matures and sentiment continues improving, stock prices should get a nice boost. This bull market has seen any number of similarly positive developments, but many investors have been slow to notice, and they’ve largely sat on the market’s sidelines while awaiting the “all clear” (even though markets never give one—something many fail to realize, and at great cost). But as more investors awaken to the US and global economies’ strong underpinnings, and as they realize the things they fear are the same issues they’ve hashed and rehashed for years while stocks have risen, they should gain confidence in stocks and wade back in to equity markets—to the greater benefit of those who’ve been in the market all along.

And as long as improving sentiment accurately reflects reality, we likely needn’t worry about the market entering its final stage, euphoria. Euphoria comes when expectations broadly are too positive and perceptions too rosy. When fundamentals deteriorate and no one notices, that’s likely the time to think long and hard about whether stocks are the right place to be. But when sentiment’s only starting to be thaw to reality, as it is now, stocks are likeliest the best place for long-term growth investors.

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