Don't Be the Dumb Money as Markets Rise

NEW YORK (TheStreet) -- Bullish sentiment has helped lift the S&P 500 more than 7% so far this year, but it's far from a signal to start blindly piling money into the market. In fact, data suggests that even increasingly bullish money managers are keeping their enthusiasm in check.

Analysts at Credit Suisse point out that sentiment has improved dramatically, but risk appetite among money managers remains low. "Bullish sentiment, for instance, is now above historical average levels, while hedge fund positioning is still cautious and three-month inflows into money market funds are still strong," writes the firm in a recent report on anomalies in the market.

"If we are right that asset allocators are still cautiously positioned, this suggests markets will likely be marked by a 'buy-on-dips' mentality in coming months."

Indeed, investors seem to be taking things slowly. A case in point is Wayne Lin, portfolio manager of Legg Mason Asset Allocation. Lin says that he feels "pretty good" about equities, but is still positioned defensively, including being underweight commodities, in case of negative surprises out of Europe.

"It doesn't surprise me that volumes are relatively low," he says. "People are still putting their toes in the water but the more people jump in, the more positive momentum gets".

The U.S. housing market seems to be seeing a bottom, the economy is adding jobs across sectors, China has signaled it will ease liquidity, food prices are falling and the European Central Bank's three-year long-term refinancing operation has reduced the risk of a banking collapse in Europe and global contagion. Hedge fund managers were 42% more bullish on the S&P 500 index in the third week of January than they were in December, according to a TrimTabs survey of 108 managers, the second highest level since December 2010.

Nevertheless, there are plenty of signs that money managers aren't acting on how they really feel. Credit Suisse says its clients acknowledge that economic data and news flow have improved, but that investors are "focused primarily on downside risks." Possibilities of bad news from Europe and a U.S. slowdown remain on the table and reflecting these fears, the bond market has been on a run. The rallying amongst Treasuries hasn't been as pronounced as that in equities, but yields are still sitting near historic-lows.

Some analysts are even noting that bearish-looking positions may signal a possible stock market downturn. TrimTabs says it is far less optimistic than hedge fund managers. Its demand index, which tracks 21 key sentiment indicators, has fallen more than 50% since the start of the year.

"This sudden reversal in January is cause for caution," says TrimTabs analyst Leon Mirochnik. The firm's demand index was on the mark in late November, reading strongly bullish just before stocks surged.

At the same time, there's no guarantee that the misalignment between sentiment and stocks predicts an imminent turnaround in the market. Feelings of optimism may sustain themselves yet.

A study by Jason Goepfert showed that "extreme optimism readings" can last a good amount of time, as they did in 2010. The study arrives at its reading by calculating the spread between "smart money confidence" and "dumb money confidence" - smart money being those that buy during a dip and dumb money being those that miss that opportunity and buy just before the market declines.

"The extreme optimism readings mostly led to minor corrections (although some of them were monsters)," according to the blog Dynamic Hedge on the study. "Obviously the lesson is context. Yes, we are currently at a sentiment extreme, just within a larger context of a bull market." Unlike measuring the level of optimism by polling money managers, Goepfert's reading, as Dynamic Hedge notes, is calculated with real-money gauges.

Dynamic Hedge goes on to write that "the pullbacks are most likely buying opportunities and sentiment will remain optimistic for extended periods." In short, "caution is warranted but don't expect Armageddon around the corner."

All of this begs the question of what can fuel steady growth for stocks. Portfolio manager Wayne Lin says that a "pain trade" is helping the market higher -- the sense of getting left behind if stocks do rally is prompting investors to buy reluctantly.

A broader poll on investor sentiment seems to leave room for further rallying. Bullish sentiment, or the expectation that stock prices will rise over the next half year, fell by 4.6 percentage points, but remained above the historical average, according to the American Association of Individual Investors' sentiment survey for the week ended Feb. 1. For the same week, bearish sentiment, or the expectation that prices will fall over the next half year, rebounded at 6.2 percentage points, but remained below its historical average.

Furthermore, in reaction to the Federal Reserve's decision to keep interest rates low until 2014, the majority of respondents in the survey said they felt more bullish, especially toward dividend-paying stocks.

Most analysts don't rule out a pullback in the near term but say that the long run outlook for stocks is bullish. On that note, stocks and sentiment won't stay on two separate tracks. It's just a matter of timing.

-- Written by Chao Deng in New York.

>To contact the writer of this article, click here: Chao Deng.

>To follow the writer on Twitter, go to: @chao_deng

>To submit a news tip, send an email to: [e-mail].

>To order reprints of this article, click here: Reprints