The stock market had a very nice month in November and moving hand-in-hand, investor sentiment has become quite bullish. In fact, here at Kobren Insight, we took more calls from clients last month than we have in several years asking why we were not more aggressive in positioning their portfolios.

While some components of the portfolios are indeed defensive in nature, the overall portfolios are not defensive. To be honest, they are actually fairly neutral, if not slightly aggressive, in terms of market exposures and risk characteristics, which is consistent with our current market outlook of being "cautiously optimistic."

Before we get into reasons for optimism, I want to discuss one of the main reasons we see caution flags flying, and that is the aforementioned investor sentiment. We look at several investor sentiment indicators on a regular basis. These measures attempt to capture extremes in sentiment and in turn provide an indication that the market could move in the opposite direction of the sentiment reading in the near future. For example, if investors are mostly bullish, which they are now, how much more fresh buying interest will enter the market and continue to push prices higher? When buying interest is exhausted, or so the theory goes, the market is more likely to go lower than higher.

One sentiment indicator that we regularly look at is the American Association of Individual Investors survey of bullish and bearish investors. The chart shown below, courtesy of Ned Davis Research, plots the percentage of total investors in that survey who say they are bullish (bulls/bulls + bears). This sentiment measure is currently signaling a bullish extreme with a reading of 67.9%. Over the past 20 years, when the reading rises above 67.5%, the S&P 500 has on average, lost 2.6% over the next year. Other individual sentiment measures are registering similar bullish extremes.

Individual Investors Are Overly Bullish

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Now I must point out that, like any "single" indicator, investor sentiment is not infallible and should only be a part of one’s analysis. For example, heading into 2004, this same indicator was at even higher bullish extremes (coming off such a strong 2003 market) with readings in the 80’s and unless December is awful (and we don’t think that will be the case - see below), the S&P 500 will end the year solidly in positive territory.

But you may also remember that after starting strong last year, the market had a very tough March and April and was, in fact, flat through the first seven months. This caused sentiment to plunge all the way down to extreme pessimistic levels, helping to pave the way for the fourth quarter rally.

There are a list of other items that concern us as well, including (still) above-average valuations, a vulnerable dollar (more on this a bit later) rising interest rates, declining liquidity, and decelerating economic growth. In fact, these factors, sentiment, valuations, liquidity and economic growth, along with corporate earnings comprise our "Five Factor Equity Model" which you will find updated each month on our website at www.kobreninsightmanagement.com/5factors.html.

Why We Like December
But, there are also clear positives heading into December. One leading reason is the calendar itself. For starters, since 1900, December has been the best month of the year for the stock market with both the highest percentage of months in which the market has gained (73% vs 105-year average of 57%) and largest average percent gain (1.5% versus long-term average of +0.6%). One reason for strong year-ends includes a desire to put money (often bonuses) to work, often moving into securities that have had a prior good eleven months.

Republican Incumbent Winners = Good Decembers

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Another positive seasonal factor is the Election Year Cycle that we have talked about in past Reports. While we think there are some notable flaws to this study (for starters, not a lot of data points), there is an element of logic behind it – the removal of some political uncertainty, which in turn allows various private and public decision-makers to finally commit to new initiatives, including increased investments. And when an incumbent Republican wins, that effect is particularly strong in December. There are other positives as well, including strong market action itself: “the trend is your friend.” As of this writing, for instance, nearly 20% of the New York Stock Exchange stocks hit new 52-week highs over the past week while less than 1% hit new 52-week lows. Several months ago, we witnessed the weekly new highs hitting over 30%. While we don’t make any investment decisions on this data point alone, it does testify to the strength of the market.

Professional Bets Against Stocks Another Potential Plus
Perhaps one of the more interesting supports for the bullish case is a the large amount of stock that has been sold short, or the "short base." When you short a stock you essentially "borrow" the stock through a broker and then sell it, expecting its price to fall when you can then buy it back and return the "borrowed shares" keeping the profit. This activity is rarely undertaken by individuals and resides mostly in the domain of more sophisticated market participants, including many hedge funds. Currently, some measures show the overall short base in the market at its highest levels in well over three decades.

In a sense, the amount of short interest reflects the sentiment of at least a segment of professional investors. (However, other institutional measures of sentiment are at extreme bullish levels like individual sentiment.) But more important than what it says about sentiment, elevated levels of shorting means a reservoir of future demand for stocks, since every share of stock sold short has to eventually be bought back. Moreover, given that shorting a stock has limited potential gain (a stock can only fall to zero), but unlimited potential risk (in theory there is no limit on how high a stock can rise), there are the ingredients for what is called a "short squeeze." A short-squeeze occurs when a stock with a large amount of short interest starts climbing in price and as a result a number of the short sellers try to exit their positions (i.e., buy back the stock) all at once. But as this wave of buy-backs gets underway, the stock price can move sharply higher thus "squeezing" the shorts. If the market continues to ascend, it’s likely we’ll see more "short squeezes" and another strong source of buying power as the shorts look to buy back their positions.

A Respite For The Dollar?
In recent weeks, the declining dollar has been a hot topic in the financial press, as various finance officials from around the globe have talked about the vulnerability of the U.S. dollar. The leading reasons for a weaker dollar remain the same: a large and increasing trade deficit and a large and potentially increasing federal deficit. Also, given that the U.S. doesn’t quite have the same arsenal of fiscal and monetary tools to stimulate the economy as they have had in recent years, it makes sense that a weaker dollar can help a slowing economy if it can stimulate export growth. And in that light, U.S. officials have made it clear they would welcome a lower greenback. In this case, we are not outside of the consensus as we remain believers in a weaker dollar in the coming years and we have positioned portfolios accordingly.

That said, at this point, we are not willing to press our bets. Pessimism on the dollar is indeed extreme at present, which as outlined in the sentiment discussion above, makes us more positive on the dollar in the near-term. Also, seasonals tend to be supportive as the dollar typically has its best performance of the year in the first quarter. Also, the Fed is likely to raise short-term rates another quarter point in December. If so, that would make U.S. short term interest rates higher than the average nominal short-term rates of other leading foreign countries. Lastly, other countries that depend on exports to the U.S. instead of domestic demand to maintain their own economies (i.e., China, Japan and, to a lessor extent, European countries) have a strong vested interest in keeping the dollar strong relative to their currencies (or at least only losing ground at a very gradual pace). In sum, we think the dollar’s bear market needs to take a breather before it makes another significant extension lower.

Preparing for 2005
As we get ready to close the books on another successful year in 2004, I want to thank you for your continued confidence and I encourage you to review your financial situation and talk with your personal KIM Account Manager about any changes that might suggest a change in the way we manage your portfolio for the year ahead. Our goal is to always strive to serve you better and as always, please let us know what you think.

If you are happy with our service, we are accepting new clients for 2005, so if you know someone that might benefit from our management, please let your Account Manager know. And if you are unhappy with us, please let us know that, too. That’s the best

Wishing you happy holidays and a profitable new year!