Anthony Mirhaydari: For investors, optimism about the market could pay

Extra9/15/2010 6:00 PM ET

Why investors shouldn't be so glum

There's growing evidence that investors and company execs are far more negative than the data justify. That's an opportunity for those who see past the pessimism bubble.

By Anthony Mirhaydari
MSN Money

Economists like to cast us all as logical actors who thoughtfully weigh costs, benefits and potential risks. But that's not how people actually behave.

We're susceptible to all kinds of biases, stereotypes and other cognitive shortcuts that have developed over eons -- and that frequently trip us up in modern life.

These instincts power economic bubbles like the ones we've lived through in technology and real estate. And right now we're seeing another bubble -- in pessimism.

Most investors associate bubbles with market booms and excessive greed. But fear is arguably a more powerful emotion than greed.

And right now, as debt troubles in Europe have caused the U.S. economic recovery to slow, just when we'd started to put the banking crisis behind us, a paralyzing state of fear has taken hold of many everyday investors and corporate executives.

How else can you explain the fact that investors in short-term Treasury bills are happily accepting negative inflation-adjusted returns? Or that U.S. businesses are letting their machinery rust away, sitting on money instead of paying for basic maintenance? Or the rare disconnect that's developed between bond yields and corporate earnings?

Like all bubbles, this one, too, will end -- and sooner rather than later. If we want to use that end to our advantage, we need to understand why fear and uncertainty have reached such unjustified levels. Let's consider first what drives bubble psychology.

Follow the herd

The study of market bubbles is in flux, but some answers are starting to emerge. They suggest that humanity's tendency to get its social cues from others -- so-called herd behavior -- is responsible. This means that risky actions, such as stretching budgets to buy homes or to buy tech stocks on margin, become contagious across an economy as we mimic the way those around us are acting.

In a recent experiment, Sheen Levine of Singapore Management University and Edward Zajac of Northwestern University found evidence to support this theory (.pdf file). Participants were given fake money to buy fake stocks. Before trading started, all learned how to properly value the "stocks" they were about to trade. But as trading progressed, prices became more and more separated from fair value. The test subjects forgot their training and focused more and more on what everyone else was doing.

Economist Douglass North, who won a Nobel Prize in 1993 for his work on the subject, notes, "We form mental models to explain and interpret the environment . . . (which) may be continually redefined with new experiences, including contacts with others' ideas."

Simply put, we can't help but observe and adopt the behavior of others. It's how our brains are wired.

The experiment by Levine and Zajac shows, on a small scale, that this dynamic plays out even in efficient, transparent markets in which investors have all the information they need to make reasoned decisions. That means that despite all the advances we've made to create a better, safer and more responsible financial system, we can still be brought down by our natural urge to follow the crowd.

Continued: Is a bubble blowing?

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Is a bubble blowing?

Understanding what drives bubble-forming behavior is one thing. It's quite another to declare that a new bubble, a pessimism-fueled bubble in bonds and other so-called safe assets, is in fact under way. We need to know whether there is too much fear relative to economic reality.

In my recent columns and blog posts, I've laid out a number of reasons to remain optimistic about the future. Although growth has slowed lately, it hasn't stopped. Recent data points, including the August manufacturing and employment reports, have come in better than expected. For now, the picture is clearly improving. I also think another bout of deflation, which has been cited as a big justification for purchasing low-yielding Treasury bonds, just won't happen.

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With solid fundamentals, the most intriguing evidence of a pessimism bubble comes from what's happening in the markets.

Money is fast being pulled out of equities: According to TrimTabs Investment Research, retail investors have withdrawn nearly $50 billion from U.S. stocks this year. This exceeds the total annual outflows of 2007 and 2009. Professional investors aren't far behind, with hedge funds losing nearly $3 billion in July as assets under management sank to the lowest levels since last November.

On the other hand, money continues to flood into the bond market. So far this year, retail investors have invested nearly $223 billion in fixed-income mutual funds. And despite the 66% rebound in the S&P 500 Index ($INX) from its bear market low, retail investors continued to focus on bonds, with fixed-income funds receiving inflows of $20 billion or more in all but one month since April 2009.

These lopsided fund flows have come despite a return in corporate profits to pre-recession peaks. As a result, some strange things are happening in the relative valuation of stocks versus bonds. Normally, corporate bonds and stocks should move in lockstep, because the returns to both are tied to the financial health and future profitability of the businesses that issue them. Bonds for a long period outperformed stocks by a wide margin, because so many more people want to buy bonds.

But as you can see in the chart below, the earnings yield, or return, on the stocks in the S&P 500 Index has now moved over corporate bond yields in a big way for the first time since 1980. Remember that prices move inversely to yield, so the higher earnings yield on stocks is a reflection of stock market weakness, while the drop in bond yields reflects buying interest.

Stock returns vs. bond returns © MSN Money
The crossover of these two lines is a clear sign that equities are now generally undervalued relative to bonds -- on a scale not seen in 30 years. And the last time this happened, in early 1980, it represented one of the stock market's greatest buying opportunities and ushered in a 20-year bull market for equities.

Citigroup strategist Tobias Levkovich chimes in with another indication that stock market anathema is becoming irrational. He finds that investors are discounting the future earnings potential of the U.S. stock market so severely that nearly 115% of the total value of the stock market right now is attributable to earnings simply staying at current levels. Since 1971, this reading has averaged about 70% as investors assigned a positive value to future growth prospects.

In layman's terms, investors are acting as if corporate America won't ever grow again.

Not only is this the most extended this measure has been in 40 years, but it means that future growth is being assigned a negative value. For reference, throughout the 20th century, company earnings per share grew an average of 4.8% per year. But investors now expect something much worse.

Is the end near?

A number of factors suggest the pessimism bubble will soon burst.

The first factor is that long-term interest rates tend to move up and down on 60-year cycles -- a characteristic highlighted by Tom McClellan of the McClellan Market Report.

Interest rate cyles © MSN Money
Low points, like the one we're in now, tend to mark ebbs in the flow of economic progress. The late 1830s marked a period of recovery from a banking panic tied to a real-estate bubble. The 1890s were a time of turmoil as railroads were consolidated and the value of the dollar fluctuated wildly. The 1940s and 1950s were accompanied by demobilization and the transition to a post-Depression, post-World War II economy.

The second factor is that stocks don't tend to underperform for very long. The chart below illustrates the rolling 10-year total return to the S&P 500 Index -- which has been extended back to 1800 by the folks at Global Financial Data. The idea for the chart comes from Ned Davis Research.

Rolling 10-year cumulative total return of SP 500 index © MSN Money
Interpret it like this: The line represents the total return, including dividends and price gains, for an investor holding the S&P 500 for 10 years. So right now, the total return between 2000 and 2010 is in negative territory. Compare this to the recent peak return of nearly 500% for an investor who held the S&P 500 between 1990 and 2000.

As you can see, when the 10-year return goes close to zero or below it, major generational lows tend to form. These are rare events, with the most recent occurrences in the mid-1970s and the late 1930s.

You can see how many of the time frames align in these last two charts: Interest-rate lows of the 1890s and the 1940s coincided with lousy 10-year stock returns. The periods leading up to the interest-rate lows were bond bull markets, which helped pull money out of equities, just as we are seeing now.

If the pattern repeats, then interest rates will put in a low this year before heading for dramatically higher levels through 2040. And that means the bond market is headed for a multidecade bear market -- because prices fall as yields rise.

Continued: The tax man cometh

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The tax man cometh

There is one more big issue that poses a threat to the bond bubble.

Should the Bush administration's tax cuts expire for the wealthiest Americans, the tax rate on investment income will spike from 15% now to 39.6%. Eventually, the tax rate on dividends and interest income will rise above 43% when the new tax to support the health care reform kicks in. In the end, all that income that investors are so obsessed with right now -- from bonds and high-dividend stocks -- could end up carrying a tax burden three times that of income from capital gains.

The obvious solution to this problem is for investors to reallocate their asset mixes back toward growth stocks and away from income-producing securities. This would weigh on bonds and dividend plays in the utility, real-estate and energy pipeline sectors. The iShares Dow Jones U.S. Real Estate (IYR, news, msgs) and JPMorgan Alerian MLP (AMJ, news, msgs) exchange-traded funds would surely come under selling pressure. Stock prices overall would rise.

It's time to prepare

It wouldn't take much to reorient your portfolio to prepare for the inevitable unwind of this bubble in doom and gloom. Reduce your exposure to bonds, especially low-yield Treasury securities. And start increasing your allocation toward growth-focused stocks, especially those with exposure to the continuing rebound in business spending.

Technology and semiconductors are a good place to focus with the Technology Select Sector SPDR (XLK, news, msgs) and Semiconductor HOLDRs (SMH, news, msgs). Bernstein Research analyst Toni Sacconaghi recently pointed out that tech shares are now trading at the lowest relative valuation levels to the S&P 500 seen in nearly 20 years. So shares in this area are in undervalued sectors, in an undervalued asset class, and are carrying loads of cash on the balance sheet to boot.

Of course, if you want to get fancy and bet directly against the pessimism bubble, you can use the Direxion 30-Year Treasury 3x Bear (TMV, news, msgs). This is a leveraged ETF that returns three times the inverse return of Treasury bonds. So if a bond's return drops $1, this bear issue rises in value $3. Since long-term bonds are intrinsically more sensitive to changes in price, even before adding the leverage, consider this a highly speculative holding.

At the time of publication, Anthony Mirhaydari did not own shares of any company or fund mentioned in this column.

Be sure to check out Mirhaydari's advisory service, the Edge, which is launching this month. He can be contacted at

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Recent Articles by Anthony Mirhaydari

1/13/2011 12:51 PM

If the interest rate goes to 7% on the federal debt that is $3000 per person in America a year. If the truth known it is probably double that. Foreign countries are starting to buy Euro debt instead of American treasuries. Interest rates could go wild.

9/20/2010 6:26 PM

Plagiarism occurs when you don't announce that you took it from someone else's work. I provided credit where it is due. All I hear from you is a lot of screaming and not a lot of reasoning.

Conservatives are just as guilty as anyone of those practices you described in different areas of life. The conservative equivalent of such movements are labeled Fascists and there are plenty of historical examples of this in Europe, Japan and American history (the Nazis, Tories, LePen, WWII Japan, McCarthyism anyone?).

Al-Qaeda is considered a "conservative" element in the Middle  East and no one would argue that they support anything other than ruthless control and domination based on their narrow interpretation of how social justice is defined or what the Quran states.

As for the rest of the ramblings: I fail to see what Yucca Mountain has to do with this subject - there are other issues with nuclear energy other than storage (not that I am opposed to nuclear energy BTW). Ethanol exists due to the farm lobbyists and many of those lobbyists are from conservative states so be careful where you point fingers. In Texas, the school board tried to exclude discussions by packing the committee (American sharia anyone?). Home schooling is about isolation and not about "quality". Do any of those things seem inclusive to you? And, what about the damage created by 8 million people losing their jobs when the financial system crashed? Was that helpful to anyone (because it was directly due to the lax standards that were in place due to the policies you advocate)?

And, I think you should re-read that preamble in the Constitution closely one more time with an open mind and see what it could mean.

9/19/2010 1:45 PM
Liberals actually love our Constitution as well--we just happen to believe that "We the People" and "our Posterity" are concepts without qualification. Progress in the United States of America has never been marked by who we exclude, but by our ability to include.

Plagiarism is a CRIME,  but that rarely bothers liberals!  You took it from NY Tx 16th from PKH.


In reality,  LIBERALS only love the constitution when they can bend it to their ends.  The same as Communists, Terrorists, and those who want SHARIA LAW to replace the US Constitution.


Doubt my word?  Just look at liberal universities  where  they refuse to allow anyone from the Conservative side to speak without violence, or  other abuses.


Looney Liberals go so far as to push for changes to force people out of cars,  raise taxes for fund their projects  and ignore the damage to the working poor that most programs bring.


Why is ETHANOL still allowed, when it produces less energy then it provides and requires IMPORTED OIL to manufacture?

Not to mention trying to force  the MIDDLE CLASS to switch to E-85, despite the devastation to their incomes and financial assets.


TEA PARTY only wants the govt to handle govt matters.  Not Detroit, not Wall St, not  Banks,  not decimate the one solution to our oil import problem:  Yucca Mtn Project; something that was put into LAW by 75% of Congress and undone by Obama/Reid for political, not science grounds.



9/19/2010 11:32 AM

Ask yourself this question: did you have any hand in the TMT crash, Enron/WorldCom/Adelphia (ad nauseam), the real estate crash, Madoff/Stanfaord (ad nauseam), the credit bubble, the flash crash, the corporate debt bubble created by private equity, our Middle East policy, etc.?


Many of these things did not involve the actions of most Americans but we are paying for it in lower personal incomes, higher debt, lost opportunities and national reputation while the small % of wealthy Americans that did are being swaddled in comfort.


Unproductive chaos (basically what a society looks like when it has no rules) is not a substitute for real policy. A nation built on lies (have you watched the multiple media BS lately that has been propagated as the truth on the Internet before it was exposed as a scam or ploy?) look like dictatorships. A nation that is built on corrupt, weak governments look like Third World nations which cannot control their destiny. A nation that is dominated by the uncontrolled ramblings of fringe groups look like the Middle East.


We are at a cross-roads. Be careful of what you choose because you will be living with the consequences of decisions made in anger/disappointment/fear for a long, long time.


9/19/2010 11:19 AM

My pessimistic analysis has less to do with economics than with the fraying fundamentals of American society. Economics makes no difference if you don't get the other basics correct.


I found the following posted somewhere and I think it captures everything in my thoughts that need to be said about the current state of the nation and why we are "stuck" looking backwards and not understanding the meaning of things:


Please do not include me in what you see as "We the People" and do not distort the definition of progress. The phrase "we the people" comes from the Preamble of our Constitution--"We the People, in Order to form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defence, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity..."


I cannot think of one thing that the Tea Party movement stands for that promotes any of these ideas--unless in some twisted way one equates anhiliation of the Federal government (<the only mechanism that connects the nation's diverse political body and drives the nation's economic and moral direction>) as securing the Blessings of Liberty for our Posterity. Liberals actually love our Constitution as well--we just happen to believe that "We the People" and "our Posterity" are concepts without qualification. Progress in the United States of America has never been marked by who we exclude, but by our ability to include. As such, electing Right Wing extremists is not progress. Rather, it's a sad state of regression, which if unbridled, has very sad and disastrous consequences for all Americans--Tea Partiers included.


9/19/2010 10:58 AM
Big problem with this guys thinking.  Under normal circumstances maybe. But lets digress into what exactly has transpired over the years.
We can start with the fine meltdowns of Enron and Worldcom.  Then we have the banking issue we are in now, and the bernie madoff's, and I forget the guys name who owns that fund in some island that screwed the investors.
"In layman's terms, investors are acting as if corporate America won't ever grow again."
So this line should read.
In laymans terms investors got smart and realized the markets are highly manipulated entities and cant be trusted.  It is safer to make less and place in low risk investments such as bonds. Since I am near retirement I cant afford to lose my money to a big con game.
9/19/2010 2:24 AM

"Economists like to cast us all as logical actors who thoughtfully weigh costs, benefits and potential risks.

Allowing economists to play in the real world is our first mistake.


As to why we are GLUM, its because the promised HINDENBURG OMEN was just a ruse, and MSN is no longer producing reliable and current info.


Instead, they went to extremes to bash GLENN BECK and pitch Obama is smart  SPIN.


Guess  THINKorSWIM and other resources  are going to replace MSNmoney soon enough.



9/18/2010 11:49 PM
Very thoughtful article, extremely helpful is understanding the next 10-40 years.
9/18/2010 8:50 AM
This market is 'fixed&#39;. Goldman called it selling sh_t,flash crash,dark pools,ratings rigged,buy-sell recommendations bought with bribes,madoff,snakeoil salesmen etc etc.Volumn down and going lower and the squeeze is on. The vultures deserve this lack of fleecing us small investors and hopefully the sec and finra will finish off the crooks and maybe we can get back to a level playing field. Good quality bonds and cheap real estate that can generate income is a decent investment that wall street cant easily corrupt. Support our troops and Buy American.
9/18/2010 7:16 AM
Anthony, you wrote an article a couple of months back about the Dow possibly going to 1,000.  And now this.  You seriously need some sort of counseling.  It's beyond my comprehension why MSN still allows you to write anything.  You simply write to see your name on the internet.  You know nothing.  Everyone needs to stop reading anything by you.  You really know nothing.  I could get a better reading of the economy by going to my local barbershop, or talking to the checkout lady at the gas station.  Get another job.  This one is way over your head.  You trying to comment on the economy or anything business-related is simply amusing.  You must be related to someone to get a gig like this with so little knowledge.  Your own articles prove I am correct.   
9/17/2010 10:53 PM

Big wonder why investors are pessimistic, it's call experience.  Will it get better?  Sure, long enough to sucker in a new generation of investor, who think their hard earned money will grow into a retirement some day.  But don't count on it, there are too many greedy mouths to feed on Wall Street.

9/16/2010 6:47 PM

Look around you. Your friends and neighbors and relatives laid off in 2008 and 2009 are still looking for work and cannot find it. They ran out of unemployments benefits and dropped out of job search. Even those that found a job it pays 1/2 to 1/3 of their last pay. You say this is good for companies and the stock market. Yes companies do well but not most of the citizens. They are scared they cannot buy food.

9/16/2010 6:03 PM
This is one of the best articles ever written by this author.
9/16/2010 12:46 PM

Anthony, You may consider using a crude but effective method of finding out when the economy is turning around.

It involves getting out of the chair.

Leaving the office is helpful.

Walking around town is educational.

Note how many business's are open for business or empty.

Note how many are still sitting empty and any new empty places.

When a person starts to see formally empty places filled they know the turn around is here.

I have not noticed empty places filling up.

I have noticed new empty places that were once full.

I am continuing to monitor the economy in this way.

9/16/2010 12:40 PM
The author asks "How else can you explain" every ones unwillingness to participate in this sham economy perpetrated by the financially illiterate media. Let me explain. People have realized that ther is no "there" there and are trying to hang on to what they still have. If you have 20 or 30 years to wait the the author MAY have a good point. Otherwise it's just a pump and dump tactic.
9/16/2010 8:52 AM

It is so nice to see a comment with a positive spin....For All Is Not DOOM AND GLOOM. There is some real great buying opportunities out there , from stocks to real estate, and yes i did say real estate, people have to live some place .... the smart person is starting some place and letting these DOOM AND GLOOM SOOTH SAYERS ,well..... GOOD JOB , ANTHONY. M FOR NOT FOLLOWING THE SHEEP EITHER...

9/15/2010 11:49 PM
Another well written well reasoned article article by Anthony M. Sure hope he's right.
9/15/2010 10:24 PM
Interesting.   BUY BUY BUY!  But I've been buying since March last year, so I'm happy.

How else can we explain America "letting its machinery rust away?".  Are you kidding me?  Have you been asleep the last 10 years?  Pick a product, any product.  Then get it quoted across the world.  Where will those quotes drive production? Michigan?  The math has been done.  Check the labels in your local Walmart.  99 times out of 100, the answer is some country in Asia. 

This isn't due to any prejudices or fears developed over eons of evolution.  This is the result of fundamental economic forces.  Production goes to the lowest cost provider.  If it doesn't, your competitor will get it there faster than you can say "Made in China".

The machines are not just rusting.  They are waiting.  Waiting for honest currency valuations, an end to unfair subsidies from World trade "partners" , and someone to give a damn in Washington.





9/15/2010 8:43 PM
Are Investors Rational or Irrational? Does Behavior trump Logic? I remember back in Undergraduate School taking Industrial Psychology with emphasis placed on B.F.Skinner's theories. I remember the Grad Student who taught the class was working on his PHD, and he said that B.F. Skinner Conditioning really worked. He said, "I have conditioned a Pigeon to undergo enough shock to acquire food that feathers are flying everywhere." So, no one is killing us to eat, but are we fearful of getting slaughtered in the market? It must say something that investors have pulled out of equities into bonds in large numbers. I honestly do not have a crystal ball that will tell you what will happen next month much less tomorrow, but is it possible that Pessimism can make a Bubble? Tech Stocks and Real Estate both created Bubbles, but Investors negative attitudes towards the market?
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