MARKET OPTIMISM IS OMINOUS SIGN / THE WALL STREET JOURNAL ( HIGHLY RECOMMENDED READING )

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NOVEMBER 17, 2010, 9:31 A.M. ET.

Market Optimism Is Ominous Sign

By BRETT ARENDS.

Oh, brother.


As if Tuesday's sell-off on the stock market weren't enough to be worried about, now comes some more ominous news. Global money managers have just turned dangerously optimistic. The booming market rally of September and October, and the Fed's new promise of easy money for all, proved too much for their self-control. They bounded into this month like eager puppies, their ears perked up and their tails a-wagging, eager to play.


Like I said: Oh, brother.


Bank of America Merrill Lynch says its latest survey of big fund managers, conducted between November 5 and 11, found "market sentiment at its most bullish since April 2010."


April? Hmmmm. Say, wasn't that just before the market slumped again?


Money managers have just dramatically raised their forecasts of economic growth (and inflation). And they have thrown as much money into stocks as they possibly could. Average cash holdings are down to just 3.5%–one of the lowest readings on record.


Even hedge fund managers, those skeptical souls, have cautiously joined in. The survey shows their bets on rising shares, minus their bets on falling shares, have surged alarmingly since the summer. The most popular assets? Commodities, where institutions have become heavily over-invested, and emerging markets–where they appear to have gone "all in."


This is ominous news. Big institutional investors move the market. If they have already invested most of their cash, it means there are fewer investors on the sidelines waiting to come in. Bank of America's survey polls around 200 big institutional investors around the world, with about $630 billion under management.


Among the other highlights from the survey: Money managers continue to shun gold, which they deem "overvalued." Relevant note: They have been saying that all the way up. The equities they like the least: Utilities, banks and Japan. (This columnist, who does not like crowds, has some money invested in the iShares Japan exchange-traded fund, EWJ.).


Investor optimism could be the first sign of dark clouds on the horizon for markets.


The Bank of America survey can be a great contrarian indicator–although, as always in markets, it is far from infallible. In June/July 2007 it showed money managers were hugely bullish of European equities–Merrill Lynch, as it then was, coined the term "EU-phoria." That proved the best possible moment to sell European equities, just before they went into freefall. And in April 2003 the survey was deeply bearish of Japanese equities. That proved an extremely good moment in which to buy Japanese equities.


In isolation, the latest survey might be reason enough for caution.


And it is not in isolation.


Look at the valuations. Stocks are already trading at rich prices according to several long term measures. A lot of smart people have been increasingly pessimistic. Any investor looking to invest fresh money has for some weeks been struggling to find anything worth buying. Even blue chip equities with good dividend yields, one of the last assets that were offering some value, have been playing catch-up.


Now look at the broader picture. The latest debt panic in Europe is among a number of reminders that the financial crisis is not entirely in the rearview mirror. And now, maybe most ominously of all, come signs that the bond market mania is finally cracking. Treasury and corporate bonds have tumbled in the past couple of weeks, after hitting giddy–and absurd–heights. That suggests Ben Bernanke's confidence game may be coming to an end. Mr. Bernanke is promising to print money to buy up bonds. If investors had total confidence in his legerdemain, that would send bond prices higher, or at least keep them high. Apparently they may not have quite that degree of confidence after all.


When bonds fall, yields rise. Higher yields are bad for stocks as well as bonds. Why? First, they make it more expensive for companies to borrow money. That's a cost borne by equity holders. Second, they make bonds more attractive, putting pressure on stocks. And third, higher interest rates make future profits less valuable in present day terms. What should you do? Be aware that there is a distinct chance we could be in for some serious turbulence. This is not a prediction, but a caution. Could you handle it? In these circumstances I would only want to hold assets in which I had plenty of faith. There is always the risk you may need it.


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