As the new year gets off to a relatively quiet start, investors are already looking for signs of what 2010 may bring. Will stocks post a repeat of their solid 2009 performance, or will economic concerns weigh on the market and drag it into the red? Ultimately, where we'll be a year from now is anybody's guess, but according to recent data, investors are more optimistic than ever -- which could mean big trouble for all of us.
Follow the crowds
Recent numbers from several investment organizations show that folks are shaking off their fears and becoming more bullish on the market's prospects. The Hulbert Financial Digest tracks the average recommended equity exposure among short-term market timers. That number recently jumped to 65.2%, the highest level since December 2006. To put that in perspective, back in early November of last year, average recommended equity exposure stood at just 3.2%.
Likewise, the American Association of Individual Investors conducts a weekly survey asking participants their thoughts on the general trend of the market in the near future. The ratio of bullish investors to investors who are either bullish or bearish stands at 68.2% now, the highest level since February 2007. A similar survey done by Investors Intelligence revealed a bullish ratio of 74.1%, the highest reading since October 2007. All signs point to an increasingly positive near-term outlook for the stock market.
Up is down and down is up
While it may seem like an encouraging sign that investors are finally getting their toes back into the water, increasing short-term optimism in the stock market is typically a contrarian sign. Looking back at all three of the surveys mentioned above, measures of optimism and market sentiment typically peak right before market downturns.
Conversely, when market sentiment reaches a cyclical low, that has been a pretty good indicator that a bottom is not too far away. Unfortunately, investors are collectively notoriously reactive and only seem to adjust their expectations after seeing extended market performance in one direction or another.
So do these new levels of positive market sentiment mean that another downturn is right around the corner? It could be. While I don't think we're in store for another rout on the scale of what happened in 2008 and early 2009, I think a slight correction is possible.
Given that stocks have risen more than 60% since their March 2009 lows without a breather, it's pretty likely that at least a minor downturn is in the cards. PIMCO investment guru Mohamed El-Erian thinks so, and I'm willing to bet that we'll encounter some rough waters in the near future.
But don't go shifting your money into bonds just yet. Regardless of whether or not a correction is waiting for us in 2010, you should be more concerned with the long run. Given that the past decade was pretty much a wash for most folks, odds are pretty good that the next 10 years will be much better for the stock market. You can't avoid every single drop in the market, so don't waste your energy trying. Investing for the long haul is one of the best ways to avoid worrying about shorter-term corrections.
Furthermore, you can use the concept of contrarian investing to position your portfolio to benefit from trends likely to emerge in 2010. Since last March, the rally has been led by lower-quality stocks and troubled names like financials Citigroup
But looking to 2010, the market is likely to have new leaders, and they won't be what investors have been favoring up to this point. I think larger, high-quality blue-chip companies are likely to outperform in the coming months. That means "safer" names like consumer stocks Home Depot
In the meantime, keep an eye out on investor sentiment. If it continues to reach higher levels, be aware that a market drop could be on the horizon. On the other hand, if the market stumbles and sentiment turns decidedly negative, look at it as an opportunity to buy. If there's one thing collective investors know how to do, it's invest at the wrong time, so don't be afraid to go against the grain.
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Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. Home Depot is a Motley Fool Inside Value pick. Heinz and Johnson & Johnson are Motley Fool Income Investor recommendations. The Fool has a disclosure policy.