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Mood Shift Can Send Shorts Scrambling

Gary Douglas Smith

I have heard and read numerous bears insinuate or flat-out state that they are the only ones who are bearish, which is one of the surreal aspects of the current U.S. "negativity bubble."

My colleague Doug Kass says to look at what investors are doing, not what they are saying. However, I look at both. I would argue that gauges of herd sentiment, more than any other single investor tools, have been the best at timing the market over the long term. The trick is interpreting these gauges properly.

Few Looking for a Real Rally

As far as what investors are saying, the UBS survey of investor sentiment recently rose to a three-year high. Although I don't closely follow this indicator, its findings are very interesting. Notwithstanding the rise in the headline index, I would hardly call the overall survey "bullish," much less "excessively bullish."

Only 37% of those surveyed expect the Dow Jones Industrial Average to rise this year. Of that 37%, only 11% see a gain of more than 10%, while 22% predict a meager gain of 1% to 4%. Another 46% expect the Dow to remain unchanged for the year. I believe that this survey, which began when the bubble was bursting in 2000, exemplifies how deep-seated and ingrained the pessimism really is.

So let's examine what investors are doing. Both the general public and professional investors alike are shorting with reckless abandon, as short interest is very near another all-time high. Last year, inflows into U.S. stock mutual funds were the lowest in 17 years, and that was in a rising market. Moreover, the percentage of U.S. mutual fund assets in domestic stocks fell to 78% last year, the lowest since at least 1984.

Most single-stock investors are now traders, as they seem to believe the buy-and-hold strategy is a loser and don't want to be left holding the bag again like they were in 2000. The tax consequences of excessive trading are completely being ignored. There has been a historic explosion of hedge funds created with absolute-return, low-correlation or negative-correlation U.S. stock strategies. For instance, the UltraShort QQQQ ProShares (QID Quote) continues to see surging volume.

But the glass-half-empty view doesn't end there. The most widely read stories on most financial Web sites are written with a pessimistic slant. Wall Street analysts have made the fewest buy calls on stocks this month since Bloomberg began tracking them in 1997. Buy calls have been trending lower for six months through most of last year's rally. The ISE Sentiment Index, which I believe is a slightly better contrary indicator than the total put/call ratio, continues to average low levels, hitting depressed levels on several days recently.

Finally, high-profile companies, such as Google (GOOG Quote) and Apple, (AAPL Quote), which have the potential to get the general public somewhat interested in U.S. stocks, are constantly under attack outside Wall Street despite their stunning stock gains, business execution and hugely positive impact on the U.S. economy.

This is what I see investors doing in the current U.S. "negativity bubble." I reiterate my belief that pessimism by the general public about U.S. stocks has never been higher, with the Dow hitting all-time highs. I continue to believe the lifting of this irrational pessimism with regard to U.S. stocks will eventually result in the mother of all short-covering rallies.