MONEY MATTERS: 'Irrational pessimism' has taken over the stock market

By Kevin Fusco The Daily Record Newswire On December 5, 1996, while speaking on stock market valuations, then Federal Reserve Chairman Alan Greenspan uttered a phrase that has ever since been carved into the financial lexicon, and has come to define those periods when sentiment roars into positive territory at the expense of facts, logic and sometimes common sense. Those two little words, "irrational exuberance," now have 15 years worth of history from which its legacy is built, and investors now have a simple catch phrase on which inexplicable risk taking can be blamed. Exuberance, though, has been absent for a number of years, especially in the context under which Greenspan was speaking. Stock valuations have fluctuated wildly since 1996 as equity markets entered and recovered from two massive corrections. The first correction, corresponding with the bursting of the "Tech Bubble," came on the heels of Greenspan's exuberance comment, and the second correction, in the wake of the sub-prime mortgage fiasco and resulting credit crunch, has seemingly cemented investors, at least recently, in a state of irrational pessimism. It makes sense that if "irrational exuberance" can coerce investors into forgoing risk aversion, that an overwhelming pessimism can deter them from applying logic and some common sense when valuations actually do look very attractive. Third-quarter earnings alone should have provided enough motivation for equity investors to at least question their doubts, yet many still sit on the sidelines. The Standard & Poor's 500 saw reported third-quarter earnings grow year over year at a 14.9 percent rate, which easily eclipsed pre-season expectations of 9.7 percent. Top-line revenue growth also came in at an impressive 11.25 percent year-over-year growth rate, and full-year expectations for 2011 are now ranging north of 14 percent as well. Equity investors should be shedding some of their reservations and letting at least a small piece of the exuberance back into their outlooks. Corporate America is flush with cash, and dividend payout rates, while rising, still have not reached pre-2008 levels. Share buybacks have also jumped over the past year and a half. Even with the unexpected drop in the unemployment rate in November, companies have illustrated that they are not willing to commit cash stockpiles to hiring, thus investors should look for dividend rates to continue their rise, and for equities to remain attractive. Just how attractive is always the question though, and earnings will certainly be one of the driving factors. Third-quarter earnings on an operating basis for the S&P 500 reached $24.86 per share, the highest measure since the second quarter of 2007, which was also the highest measure of the past decade. Yet the forward price-to-earnings ratio of the S&P 500 index was at a paltry 10.6x as of the end of the third quarter, which is roughly equal to the same level experienced during the 2008 market low. There are a number of key concerns still facing the markets and economy, but are price levels equivalent to those during one of the biggest market collapses in history justified? The recent pessimism would be understandable if the third quarter was the first or second to break a string of negative results, but it was actually the 10th quarter in a row of positive earnings growth. Economic data has remained resilient heading into the end of the year, and even though consumer sentiment reflects the same pessimism applied to stocks, the holiday season got off to a tremendous start with Black Friday shopping posting a 6.6 percent increase over 2010. Investors are likely to hold their irrational pessimism in place well into next year, as volatility is likely to continue and valuations will continue to be ignored. Proactive investors though, will use this period of low valuations to buy solid earnings at a discount and position themselves for increased dividend returns, if current trends do in fact hold. As much as "irrational exuberance" served to define the investment landscape of the late '90s, there is a chance that it will one day return to describe a new period of investor euphoria. It is paramount to keep in mind that this feeling is as dangerous to investors as the cynicism and distrust that has gripped the markets over the past few years. Prudent investors are well served to keep their emotions in check and pay close attention to what the data and facts, more so than sentiment, are telling them. ---------- Kevin Fusco is senior vice president of Fusco Financial Associates Inc. of Towson. He can be reached at 410-296-5400, extension 109, or Kevin.Fusco@LPL.com. Published: Tue, Jan 3, 2012