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Investors grow confident — or is it overconfident? — as stocks hit record highs

The Wall Street bull

It’s far easier to read the mood of the market than to predict the next twist in its story.

Investors have come into 2014 with an exceptionally chipper attitude, judging by plenty of quantifiable clues and accumulated anecdotes. Seasoned market observers are prone to fear any widespread cheer as one precondition for an unpleasant break in a relentless rally.

Yet it’s not quite as simple as betting against an upbeat crowd. Wedding parties, after all, are as happy (or happier) when they usher in a marriage filled with bliss as one drenched in bile.

Sure, when a nasty downturn arrives, it almost always comes as a surprise to an optimistic majority  – but just because the majority is cheery doesn’t mean things must get nasty.

Whoever said this game is easy?

A crowded bullish camp

An array of investor sentiment gauges is in broad agreement showing the bullish camp began the New Year crowded and perhaps overconfident: Separate surveys of investment newsletter writers, the active investment managers and individual investors have all reached levels of optimistic opinion that have often preceded sharp pullbacks.

Traders of options and market-timing mutual funds are also behaving with little heed to potential short-term downside. SentimenTrader.com maintains an index of “dumb money” and “smart money” trading indicators, and on the last day of 2013 “dumb money” confidence exceeded that of the “smart money” by a record spread.  An Associated Press year-end stock-market review featured among the investor lessons to be gleaned from 2013, “Don’t wait for the dips.”

At minimum, all this is a cause for caution, a reason to temper short-term expectations for hefty quick gains. Excessive bullishness and aggressive speculative positioning can be worked off by a quick and jarring market dip, a skein of buzz-kill headlines (whether relevant to stocks or not) or simply a stalled, sideways run that, for a time, breaks the cycle of easy rewards to the greedy.

Stepping back a few steps, though, why wouldn’t most investors involved in the market be feeling pretty pleased and confident? The major indexes were up around 30% in 2013; the Dow and S&P 500 finished at never-before-witnessed heights. A machine-gun nest of policy and macroeconomic risks did little harm as the stock market’s refusal to succumb to a variety of potential threats – including the halting start of the end of the Federal Reserve’s asset-buying program – left players feeling nearly invulnerable.

Morgan Stanley’s market strategist, Adam Parker, quipped in his 2014 outlook report: “The only thing people are worried about is that no one is worried about anything. That isn’t a real worry.”

Too much heedless happiness?

There’s some truth in this glib notion, that almost “everyone” is saying “everyone else” is too heedlessly happy. The intense scrutiny of consensus opinion has bordered on self-parody among market types the past year or more – a remnant, perhaps, of a decade of volatile range-bound trading in which the winner’s gains seemed to come from a loser’s pockets.

All the same, one of the great drivers of the nearly five-year-old bull market has been the persistence of huge perceived threats (from Europe, Washington, Cyprus or China) that either were never a “real worry” or were defused before they became calamities.

The failure of uncontained crises to erupt was itself enough for risk appetites to awaken and stock prices to catch up – and perhaps overtake – the multi-year improvement in corporate profitability.

Now, share prices are already up quite a bit and are pricier than the historical average, which likely means 2013 was the “easiest” year of the bull market. When stock prices shoot 30% higher and rise 170% in less than five years, it means equities have become more – not less – risky, and a fair portion of future potential returns have been realized.

As Fed policy moves to a new phase and investor expectations build for a drama-free, orderly economic acceleration, it’ll probably take genuine good fundamental news and not just the absence of bad to satisfy Wall Street - but not so much good nwes that the Fed is seen turning hostile.

Nick Colas, chief market strategist at ConvergEx Group, says, “Viewed through the lens of investor attention, the key issue for capital markets in 2014 is straightforward: What simple message can replace the age-old mantra of ‘Don’t fight the Fed'?

“The fourth quarter of 2013 seemed to find some footing with ‘Stocks are working, get on board.’ That message can’t last forever, if only because equity valuations are fair (rather than cheap) and interest rates are slogging higher.”

On some level, of course, investors’ warm feelings represent nothing more than a bull market engendering typical bull-market attitudes. The great virtue of the 2013 market, though, was that each small wiggle lower – there were a few drops of 3% to 6% – spurred a quick and unusually extreme spasm of evident anxiety.

With each little setback, traders hedged fearfully, bearish commentators got loud, aggressive bets were laid on a persistent surge in hazardous volatility. This rapid fear response itself, arguably, ensured dips were brief shakeouts and not the start of a true drubbing.

For this reason, if you own stocks to start 2014, then when the market hits an air pocket, you don’t want to see others acting calm and cool. You should hope the next blip lower in the indexes prompts folks to lose their heads, succumbing to the brain chemicals that trigger acute fear of loss even if the red ink in their portfolios represents only a trickle from last year’s generous gains.

Phil Pearlman, Yahoo Finance interactive editor and former hedge-fund trader (who also recently launched the Yahoo Finance reader sentiment poll), frames the current tactical moment nicely: “I am more interested in how sentiment responds to these extreme readings than the readings themselves. In May we got a 5% correction but that turned out to be the pause that refreshes. Sentiment turned more bearish quickly from those extreme bullish levels and I called this high-sentiment reactivity at the time.

“My best guess is we get a pullback and the key will be how sentiment responds. If sentiment reactivity remains high and bearishness increases quickly, it implies we'll get a shallow correction that can be bought. If indicators continue to suggest complacency, perhaps we get a deeper correction and longer lasting.”

If the next decline is met with aplomb, that is, don't applaud.

Given this backdrop, it’s moderately encouraging the reservoir of skepticism has not been fully depleted. Bank of America Merrill Lynch notes the consensus recommended investment mix of brokerage-house strategists remains cautious, at levels that in the past have foreshadowed continued strong equity performance. Even bullish forecasts are of the "yeah, but..." variety, with modest gains anticipated  – not a repeat of the ripping '13 rally.

And the Yahoo Finance reader sentiment poll shows building but not extreme levels of optimism: While 44% of respondents said they expect stocks to head higher in 2014, a combined 43% said the indexes will either pull back slightly or undergo a big downward correction.