As Market Pessimism Grows, Should You Buy Stocks?

Americans continue to be wary of stocks. The Standard & Poor's 500-stock index is almost unchanged since the end of 2009, and mutual fund investors have yanked money from equities for four straight months. Activity in the options market shows that concern has never been higher that stocks will plunge. At the same time, other indicators, including cash flow and dividend yields, suggest equities are attractively valued. It all adds up to a contrarian's dream and a plausible case for buying stocks.

"Just look at three things: compelling valuation metrics, the sheer fundamentals in some areas like profitability, and this huge disconnect between how people are perceiving things and the reality of how they are," says James Paulsen, chief investment strategist at Minneapolis-based Wells Capital Management, which manages $342 billion. "Therein lies the big opportunity."

One argument for buying stocks now is that individual investors seem to have lost faith in them—which in the past signaled a rally was imminent. People burned by the 2008 financial crisis got another reason to be wary on May 6, when the market plunged, erasing $862 billion from U.S. equities in 20 minutes, before recovering. Investors have withdrawn almost $57 billion from mutual funds that invest in U.S. stocks since the beginning of May, the most in any four-month period since 2008, according to data compiled by the Investment Company Institute, a Washington-based trade group.

At the same time, they have put about $597 billion into bond funds, according to ICI, even though stocks appear to offer better values. As of Aug. 31, 68 stocks in the S&P 500 paid dividends that exceeded the average corporate bond yield of 3.8 percent, more than any time in at least 15 years, data compiled by Bloomberg and Bank of America (BAC) show. Free cash flow produced by companies outside the financial industry represented 6.8 percent of their stock prices last month. That's the highest since 1960 when measured against the average investment-grade corporate bond yield, according to Zurich-based Credit Suisse (CS).

"I think the confidence in bonds is a bit misplaced," says John Carey, Boston-based money manager at Pioneer Investments, which oversees about $230 billion. "People who have been burned by the stock market are putting money there, but now they're underweight in equities."

Professional investors are also nervous. Futures on the CBOE Volatility Index are pricing in a three-month volatility increase of more than 30 percent, meaning traders expect the markets to get even more wobbly. The VIX, as the index is called, measures the cost of options that protect against losses in the S&P 500. Expectations for higher volatility suggest too much pessimism, according to Pierre Lapointe, global macro strategist at Brockhouse Cooper in Montreal. His firm oversees $500 million and advises more than 200 asset managers worldwide. "Negativity in the market is very, very high," Lapointe says. "We're still bullish and think the recent soft patch is normal in an economic recovery pattern."

At least some investors share Lapointe's view: Commodity producers are fetching the richest valuations in the S&P 500, a sign of confidence in the global recovery. The 32 mining companies, seed makers, and chemical suppliers in the S&P 500 recently traded at 18.7 times the past year's earnings. That's the highest price-earnings ratio among the 10 industries in the index and 3.9 points above the S&P's average p-e of 14.8. When the group's valuation was that much higher than the S&P 500's in 2004, the index was at the start of a five-year rally in which it doubled.

Signs of recovery continue to accumulate. The labor market has improved, with initial jobless claims falling in the week ended Sept. 4 by more than economists forecast. Companies added more jobs in August than projected. Retail sales climbed more than expected for a second straight month, while factory production increased. Pending home sales unexpectedly rose. The outlook for corporate profits remains robust, with analysts projecting gains of 36 percent in 2010, the highest since 1988, and 15 percent in 2011, according to estimates compiled by Bloomberg. S&P 500 companies that have reported second-quarter earnings since July 12 have beaten forecasts by 11 percent.

Yet no one knows when a prolonged rally might begin—or what it will take to ignite one. Sustained job growth, consistent improvement in the housing market, or stabilization in the European Union economies may lure money back to stocks, says Alan Gayle, senior investment strategist at RidgeWorth Capital Management in Richmond, Va., which oversees $63 billion. "For a lot of retail investors, investing in equities has been like slogging through the rain the past 10 years," he says. "They need a sign. They want something they can see, they can touch, they can feel. The question is going to generate that sustained growth?"

The bottom line: Signs of nervousness about stocks are convincing contrarian investors that this is a smart time to put money into the market.

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