How to Beat the "Mania of Pessimism"

This article published with permission from InvestmentU.com.

Two weeks ago, I opined that the biggest obstacle a stock market investor faces today is “headline risk.”

That is, relentless media negativity.

The idea seems to be gaining traction. On last week’s “This Week” on ABC, Pulitzer-Prize Winning columnist George Will said, “The very least the media should do right now is not detract from the nation’s understanding or add to the synthetic hysteria.”

In the

September 17 issue of USA Today James Paulson, chief investment strategist at Wells Capital Management said, “We are in the middle of a mania of pessimism. The nation is suffering from ‘Armageddon hypochondria.’”

Again and again, the media reminds us about the weak dollar, high unemployment, the soft housing market, problems in the Euro Zone, political dysfunction in Washington, trouble in the banking sector and the down and out consumer. After a few hours of this, you’d expect to walk outside and see bread lines and angry mobs.

That’s not what you see, however. What you see instead are ordinary people going about their everyday business

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and getting bombed periodically with media sensationalism calculated to attract viewers and sell advertising.

It works, too. In fact, it works so well that few people see all the positives that exist today.

“Positives?” a friend asked me the other day, genuinely perplexed.”What positives?”

Exactly. We’ve gotten to the point where people have had so much downbeat news dripped on them for so long that they can’t even imagine there is a positive side to recent events or that any logical case can be made for owning stocks to meet their financial goals.

So let me take a stab at it now.

For starters, realize that it is not possible for anyone to accurately and consistently predict economic growth or stock market performance. But here’s an insight you can take to the bank: share prices follow earnings. (Earnings, of course, are the net profits of a business.)

In the third quarter of last year, the companies that make up the S&P 500 reported all-time record earnings. In the fourth quarter, those record earnings were exceeded, as they were again in the first quarter of this year and yet again in the recently reported second quarter.

If you didn’t hear that we are in a period of all-time record corporate profits, you really ought to think twice about who is delivering your newsworthy information. Or at least who is providing your investment guidance.

As investment legend Peter Lynch once noted, “People have all this data and yet they look at all the wrong things… It’s about earnings. They need to follow the earnings.”

Of course, just because corporate earnings have hit an all-time record four quarters in a row, it doesn’t mean they will continue. And, conversely, it doesn’t mean that they won’t.

If you can’t imagine why stocks would rally from here, just imagine what will happen if the much ballyhooed double-dip doesn’t appear.

There are plenty of good reasons to be bullish on stocks right now. But if you are developing your investment perspective from gloom-and-doom media reports, you may not recognize the positive factors. So I’ll tick off four big ones for you now:

• Interest rates are at historic lows and inflation is negligible. That isn’t likely to change any time soon.
• Energy and food prices are moving lower and Bernanke has pledged to hold short-term rates at zero for two more years.
• Valuations are cheap. When the S&P 500 traded at these levels 11 years ago, it sold for 44 times earnings. But because profits have hit new records lately, the S&P 500 today sells for just 13 times trailing earnings, well below the long-term average of 16.4.
• Investors are anxious and afraid. This may seem like a negative but it’s not. Investor sentiment is an excellent contrarian indicator, especially when accompanied by low valuations. Think back to the market low of March 2008, when the consensus was that the world was coming to an end and the Dow briefly traded below 6,500. From that point the market put on an impressive rally, essentially doubling in 2 ½ years. As investment pioneer John Templeton rightly said, “Bull markets are born on pessimism, grow on skepticism, peak on optimism and die on euphoria.” Do you know anyone who’s feeling euphoric right now? Not me.
• Mutual fund investors have yanked money out of stocks over the past six weeks. It may seem counterintuitive but that is yet another positive. A 25-year study published last year in the Journal of Financial Economics found that if you had simply invested in the S&P 500 when equity fund flows were negative (redemptions exceeded new investments) and into 90-day Treasury bills when fund flows were positive (new investments exceeded redemptions) you would have substantially outperformed the market while spending nearly half the time in riskless T-bills. In other words, it pays to buck the consensus.

Don’t get me wrong. More bad news from the Euro Zone and political wrangling here at home will still push stocks around from day to day. That’s not important. What is important is whether you’re confident

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The Oxford Club

as is

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that the companies you own are set to report dramatically higher profits in the weeks ahead.

You may be reluctant to invest in stocks. I understand. It takes nerve and resolve to go against the trend and invest in times like these. But you should.

FDR was wrong about some things. But he got one big thing right. The only thing you have to fear… is fear itself.

Alexander Green is the chief investment strategist at InvestmentU.com. See more articles by Alexander here.