Rational Optimism, Not Irrational Exuberance

Bull markets die one of two ways: Atop the wall of worry, when stocks' reality can't meet euphoric investors' lofty expectations, or with a wallop-a powerful negative surprise erasing trillions worth of economic activity. Since the last bull market was killed in late 2007 by a wallop (FAS 157 and the schizophrenic government actions that followed), 15 years have passed since we really saw equity market euphoria. As a result, one camp of investors sees today's budding optimism and a six-year old bull market that ranks as history's third oldest and fifth strongest and worry we sit atop the wall now-and stocks will soon fall. But in our view, this overlooks sentiment's gradual and typical evolution during bull markets. Past market cycles show a natural evolution of sentiment, and current signs are consistent with maturing phases of bull markets, not the end of them.

Sir John Templeton arguably described the trip up the wall best, saying bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria. Sentiment is at its worst when bull markets begin, gradually improves as stocks rise, and reaches euphoric levels as bull markets end. Some fear we've already made that journey and presently sit at or near a peak. As evidence, they cite above-average valuations and the bull's above-average duration and magnitude. They fear "complacent" investors are overlooking risks like surging bond yields, China , Greece and Fed rate hikes.

Ironically, all those fears are signs skepticism remains. There is just less of it, and we're well past 2009's deep pessimism. Back then, as the bull market began, sentiment was abysmal. Many believed the economic downturn was the beginning of a depression. Some feared banks were insolvent. Many thought the market would go even lower due to rising unemployment and cratering corporate profits. Pessimism persisted in 2010, with investors largely believing a "double dip" loomed. Most saw good news as fleeting or soon to morph into catastrophe. In 2011, a divide grew between those who'd bought into this bull and the staunch pessimists who kept their guard up. The year was a tug-of-war, with pessimists arguing slow global growth, the US debt ceiling fight and related downgrade, Europe's continuing debt saga and Japan's tsunami would do stocks in. By 2012, sentiment had warmed further, although deep skepticism about the slow global expansion remained, and fears occasionally dominated-like the moveable molehill known as the US "Fiscal Cliff." But dire pessimism mostly gave way to skepticism. Skepticism remained in 2013, tied to the still-slow global economy, with many suggesting the tapering of US quantitative easing was a looming threat.

Last year folks warmed further, although professional forecasts remained muted-few were willing to embrace optimism wholeheartedly. The fearful reaction to Q1's "polar vortex"-induced US GDP dip showed skepticism was alive. Contrast that with the mostly optimistic takes on this year's Q1 GDP contraction (or slow initial read), which evoked fairly rational responses. With a few exceptions for things like buybacks and M&A, most media coverage isn't spinning positive news negatively.

Sentiment in 2015 stands in stark contrast with 2009, to be sure, but that doesn't make it euphoric-just not totally bleak. This is following a similar sentiment path as prior bull markets, and we haven't reached euphoric peaks' typical giddiness. Yet memories of true euphoria seem to have faded-perhaps because we didn't get there last time. When stocks peaked in October 2007, sentiment was still in a skepticism/optimism tug of war. Emerging Markets' swift growth buoyed sentiment, yet fear persisted. Folks fretted "tapped-out" consumers and negative savings rates in America. Two-speed growth in Europe. Too-tight monetary policy in the US. Inflation. Housing. Investors didn't get the chance to work through that skepticism and reach a truly happy place before the implementation of mark-to-market accounting that autumn forced markets to begin pricing in the vicious circle of asset firesales and writedowns that ultimately destroyed banks' capital ratios and collateral, leading to the government's haphazard crisis management-and investors' sheer panic-in Fall 2008. FAS 157's wallop truncated the sentiment cycle.

To see a full sentiment cycle, revisit the 1990s. Even as stocks surged, fear ruled most of the decade. Early, it was banks and European recession. Then Fed rate hikes. In the mid-1990s, folks fretted US government shutdowns and gridlock. Then came the Asian Contagion, Russian default and Long-Term Capital Management's failure. Some fears remained even as late as mid-1999-remember Y2K? It wasn't until after years of climbing the worry wall that investors reached euphoria in 2000 and bought into a myth-that the technology-driven "new economy" would usher in an era of neverending widespread prosperity, with folks so convinced boom and bust were passé that they ignored an inverted yield curve and falling Leading Economic Index. Boom. Euphoria. Bang. Bear market.

Absent a wallop, bull markets end when sky-high expectations exceed reality. None today argue we've reached perpetual boom. Heck, few investors or pundits refer to our economy as "booming" at all^[i]-the expansion is still commonly called a "recovery"-a subtle remembrance of the big recession in 2008-2009. No one we can find is arguing the economy has systematically eliminated recession through some great new development. False fears are still present, if less common. Market strategists haven't shifted forecasts to anticipate hugely bullish returns or S&P 500 earnings. Expectations are tame, not out-of-this-world high. While we've seen a few bears being poked fun at, most still get respect-unlikely when investors are euphoric. Unless we get another wallop-and we don't currently see anything anywhere near this big, bad and ugly-the wall of worry, and the bull market, appear alive and well.