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Bull-Market Behavior Flares as Stocks Melt Up

Michael Santoli

Already 50 months old, the bull market in stocks has finally started to act like one.

With the latest sprint in the indexes to all-time highs, the action is belatedly, but unmistakably, starting to follow the bulls’ old offensive playbook. While plenty of Americans remain unmoved to return to a stock market that has subjected them to two devastating collapses in 13 years, those who are in the market are increasingly displaying the kind of confident, risk-seeking behavior that typically accompanies strong uptrends.

Wall Street image
Wall Street image

This is evident in heavy borrowing in investment accounts, a surge in trading volume of penny stocks, the ferocious surge in heavily shorted stocks, eager bidding for initial stock offerings, the lionizing of anointed bullish gurus and a rediscovered habit to buy minor dips.

Ample anxiety remains in the broader public about the legitimacy of Wall Street’s celebration amid a trudging economic advance, even if the pervasive label of “most hated rally in history” has outlasted its original accuracy. And the official brokerage-house handicappers are still rather reserved. Few are predicting much upside for the Standard & Poor’s 500 atop the 13% year-to-date gain, and the highest strategist target is only 7% above the current level.

No doubt the Federal Reserve's aggressive and open-ended injection of liquidity is helping to support asset values and confidence, even if the common line that the rally is "all about the Fed" is suspect. Maybe, just maybe, investors are like the child learning to ride a bike, believing a parent is still steadying them from behind even as they pedal away freely.

They want to believe

The markers of revived animal spirits, of greed shouldering aside fear, generally reflect the kinds of activity one would expect in a market methodically clicking to new highs -- eddies of speculative froth have gathered here and there. The market is getting stretched, with the highest proportion of stocks making new 52-week highs in 25 years Wednesday.

Yet the posture of more investors has not quite crossed the line into recklessness, and, for the moment, warrants just the raising of an eyebrow rather than a glare of deep suspicion. Here are some areas to monitor to determine when investors’ justified confidence morphs to dangerous arrogance:

* Margin debt in brokerage accounts as of March was $380 billion, around the level reached at prior major stock-market peaks in 2000 and 2007. Netting out cash in those accounts, investors were in the hole by some $92 billion, less than in 2000 but slightly more than the 2007 peak.

In one sense, it’s intuitive that debt levels would roughly track underlying stock values. It’s also unclear how one should adjust these borrowing totals and cash holdings for the fact that interest rates are at record lows, making debt-service cheap and cash an unattractive asset. Lenders have become aggressive, pitching cheap loans against securities accounts via Twitter.

As margin debt keeps step with rising stock values, it represents a self-reinforcing cycle of confidence, or, as financial blogger Andrew Kassen puts it, an “emerging bubble in certainty." In other words, it’s something to watch cautiously, a positive until it runs wild or reverses.

* Volume traded in speculative penny stocks, as reported by Nasdaq, was up 200% in the six months through April, an extreme acceleration by historical standards. Yet Jason Goepfert of www.SentimenTrader.com, who tracks investor-psychology indicators, notes that even with this rise the absolute level of stock flipping of this sort is below peak levels of recent years.

He categorizes it, along with other attitudinal measures, as a reason for caution, but not extreme worry -- yet. Another such clue is the ratio of assets in bullish Rydex market-timing mutual funds to the amount in bearish funds, which is approaching the 5:1 level that has preceded market tops in recent years, but isn’t yet there. The stock-bond ratio, a gauge of stocks' recent performance relative to Treasuries, is now stretched essentially to its 50-year upper limit.

An unusually sharp rebound in small-investor optimism, as surveyed by the American Association of Individual Investors, likewise is best read as more a reflection of the evident strength in stocks than as a foreboding outbreak of exuberance. Context matters when evaluating people’s emotional display. Shouting and high-fiving everyone in sight is standard behavior at the stadium when the home team wins; the same behavior on a dark, quiet sidewalk implies an unhinged personality.

* U.S. companies executing initial stock offerings reached $16.8 billion year to date, and last week saw the greatest new-issue haul since late 2007. Many deals were driven by private-equity funds harvesting gains from buyouts done in recent years. But their reception has been strong, with eager investors looking for new ideas and operating in a market where buybacks have been slurping more shares out of the market than new companies have been putting in.

Data firm Dealogic reports that the after-market performance has been upbeat, with a smaller percentage of deals declining on the first day of trading than was the rule even in the bull-market years of 2005-2007.

* The bum-rush on short sellers has again become a favored game, with heavily-shorted story stocks surging in excess of the broad market. Tesla Motors Inc. (TSLA), the thinly profitable cult maker of electric cars, and Netflix Inc. (NFLX) are the poster children, each rising more than 130% year to date.

Still, not all shorts have been scared away, maintaining a helpful reservoir of worry that the market can continue feeding from. Short interest has declined in 2013, but not to the lows of the past few years, when stock prices were lower.

* The market’s willingness to canonize the positive investment outlook offered by emerging financial celebrities such as David Tepper of hedge fund Appaloosa Management is certainly reminiscent of past ebullient markets.

The “Tepper Rally,” so called after he laid out a win-win case for stocks in 2009 based on Federal Reserve support for risk assets and improving economic conditions, has been reinforced in his subsequent TV appearances, even though his analysis is unremarkable in most respects. The “celebritization” of other hedge-fund chiefs such as Carl Icahn, Daniel Loeb, David Einhorn and others shows a suggestible investment audience craving can’t-miss ideas.

Examinations, not emotions

Set against all these indicators of speculative sap rising, though, is the unusually well-behaved, low-drama cadence of this year’s stock-market climb, reminiscent in many respects of the tireless rally of 1995.

Truly bubbly markets are driven by emotional, under-informed investors, with more unhelpful encouragement from the Wall Street sales machine.

As it stands, analysts are rather sober. Schaeffer’s Investment Research points out that as stocks have gained some 30% since late 2011, the percentage of all analyst stock ratings that were buys has ebbed from 55% to 49%. Not exactly evidence of worrisome euphoria.

Nothing says this rally has to roll on long enough for this bull-market swagger to escalate into all-out risk binge on fabulously overvalued stocks. But if the market is destined to enter the sort of full overshoot to the upside that would encourage such a public frenzy, we’re not quite there yet.