Another Sign the Market Is Headed Up

"This is a bearish bet on volatility, which could be viewed as a positive bet on the marketplace."

That quote refers to the fact that the VIX -- also known as the "fear gauge" -- has fallen to levels last seen before the financial crisis caused Mr. Market to wet his pants. Now that may sound like a bit of investment gobbledygook, but it's actually something worth considering.

Over the past 20 years, the VIX has had a pretty consistent relationship with the S&P 500. When the VIX (fear) rises, the market falls, and when the VIX falls, or remains at low levels, the market tends to rise.



Source: Yahoo! Finance.

Intuitively, this makes a lot of sense. When investors are scared, they panic and hit the sell button, and when they're feeling good -- or are at least complacent -- they buy.

After spending a couple of years above its long-term average -- including an unheard-of spike during the worst of the crisis -- the VIX has fallen back below its long-term average of 20.4. On the first of the month it closed at 17.63, but midway through last month, before the unrest in Egypt kicked up fear again, it was as low as 15.46.

Source: Yahoo! Finance and author's calculations.

Buy, hold, or run like heck?
I try to be a contrarian investor. If the market has kicked a stock to the gutter, I start to get interested. If everyone suddenly loves a certain asset class, I start to get cautious. So when the VIX is falling, and therefore investors are getting more bullish, it means it could be a good time to sell, right?

While that may seem like a plausible story, even a quick look at the chart above shows that quick reversals in investor sentiment -- as measured by the VIX at least -- only seem to happen during volatile downturns. Using history as a guide, we could reasonably expect that once the VIX makes a solid move below its long-term average, it may well stay there for a few years or more.

And investors seem to have plenty of fuel to drive bullishness right now. As of February 1, 71% of the S&P 500 companies that reported fourth-quarter earnings had beaten analysts' estimates, which is above the long-term average of 62%. If fourth-quarter earnings for the S&P 500 companies end up in line with Standard & Poor's estimates, then year-over-year earnings per share will have jumped 33%. Current projections have S&P earnings growing another 14% in 2011. And while valuations are certainly a concern, the S&P's price-to-earnings ratio on 2010 earnings is currently 16.7, which is below its 1988-to-present average of 22.5.

Commodity prices and inflation could rain on the parade, particularly if it forces the Federal Reserve to hastily backtrack on its easy-money policies. But for now at least, the inflation measures that the government tracks have stayed tame and the Fed has pledged to not only keep rates low, but stoke the market through Treasury purchases.

Bulls on parade
For investors with a shorter-term view who might utter phrases like "don't fight the tape," this could end up being a great time to be a bull. Stocks with momentum behind them, even if they appear overvalued, could continue to charge ahead. Netflix (Nasdaq: NFLX  ) and Acme Packet (Nasdaq: APKT  ) are two that immediately jump to mind. Late last month, Netflix blew the doors off of expectations, while Acme did the same this week. The valuations on both companies' shares are at nosebleed levels, but that hasn't slowed the charge yet.

Expensive stocks getting more expensive is only part of the story though, as the rising tide will very likely lift all -- or at least most -- boats. While this could mean that cheaper large-caps might catch back up to small-caps, it may just mean that both groups will find room to run.

So is it time to party? Frankly I wouldn't be surprised if investors begin to feel like that soon. A continued stretch of bullishness (aka complacency) will rekindle the feeling that stocks can do no wrong -- and this generally happens just as valuations and risks are rising.

Slow down, you're moving too fast
I don't want to get too ahead of myself here, because I don't think we've gotten anywhere near that point of unattractive valuations and wild-eyed optimism quite yet. For now, there are still a slew of stocks with tempting valuations.

Some, like utility Exelon (NYSE: EXC  ) and health-care giant Abbott Labs (NYSE: ABT  ) -- which are trading at 10.5 and 9.9 times next year's earnings estimates, respectively -- could run with a bull market and also provide protection if the market's optimism doesn't hold. Others, like Teva Pharmaceuticals (Nasdaq: TEVA  ) and Gilead Sciences (Nasdaq: GILD  ) , that are trading out of line with growth expectations, could see investors start waking up to the opportunity.

Obviously there aren't nearly the same kinds of bargains available now that there were in the depths of the crisis. However, I still think we're at a point where investors don't have to strain too hard to find good investments. But as Mr. Market continues to regain his mojo, it will be the investors that maintain their discipline and don't get swept up in the excitement that will end up with the strongest portfolios.

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Exelon is a Motley Fool Inside Value recommendation. Acme Packet is a Motley Fool Rule Breakers recommendation. ad Sciences and Netflix are Motley Fool Stock Advisor picks. The Fool owns shares of Exelon and Teva Pharmaceutical Industries. Motley Fool Alpha owns shares of Abbott Laboratories. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Fool contributor Matt Koppenheffer owns shares of Abbott Labs, but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


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