Can investor sentiment get any worse?

Another day, another big drop. When will the market finally turn around for real?

If anyone could accurately predict the exact date, he or she would already be a trillionaire. I don’t know any trillionaires.

But whatever the short term brings, the longer turn is looking much brighter, regardless of recession, credit crisis or bank failures. Why? Because the biggest bull markets spring from extreme pessimism. Investors were down in the dumps in 1982. I’m sure they were depressed in 1932 (we don’t have any good investor sentiment data from back then). Today, they’re as negative as they’ve ever been, far more so than in 1990 or 2003. On top of that, stock valuations are, by many measures, the cheapest they’ve been in decades, maybe ever. Cheap stocks and extreme bearishness—what could be a more bullish combination?

Merrill Lynch just completed one of their investor surveys. This firm's outlook is often cited as one of the best contrarian indicators: When Merrill is buying, you should sell; when Merrill sells, you should be buying. (I wonder if we’ll still be able to use the Merrill indicator once they’re absorbed into Bank of America?)

Currently, Merrill—and the fund managers they survey—are selling... everything. “Right now they hate almost everything except cash.” Even hedge funds are moving to cash. (One hedge fund manager says the best position to be in right now is CASH and FETAL.) Individuals are going so far as to take money out of banks and put the cash in safes (apparently, safe sales are up 50% this month). No one wants a whiff of risk. And no one seems to think anything will change anytime soon.

Which probably means it will.

Someone asked me today, “When will individual investors put their money back into stocks?” My answer: when they usually do, well after the market has recovered, and after the “smart money” has already made 30% or more by being invested when the rebound began. Since you don’t know when that will be, you’ve got to be prepared ahead of time, even if that means withstanding some huge price swings.

Stocks are historically cheap. Investors are terrified. Everyone thinks we’re on the cusp of another Great Depression. They buying opportunity of a lifetime? I think so.

Volatility works both ways

Today was another one for the record books, and thankfully it was on the upside! The Dow Jones average had a record point gain (though not a record percentage rise) of +936 points. That’s bigger by nearly 200 points than any of the large one-day drops we’ve had recently. The percentage gains were impressive as well: +11.1% for the Dow, +11.6% for the S&P 500 (now up +19.5% from it’s low last Friday), +15.9% for the EAFE (developed foreign markets), and +22.8% for emerging markets. Some individual stock gains were enormous: Morgan Stanley was up +87%. Today’s huge one-day move illustrates that volatility can work going up as well as going down. Expect to see a lot more big moves over the next few weeks, both up and down.

What propelled today’s jump, and will the rally continue? In other words, have we finally seen the bottom of this ferocious bear?

Answering either question requires some speculation, but it seems clear that worldwide government action over the weekend contributed to the turnaround. I won’t go into detail here on everything that transpired, but the message sent by governments everywhere was that they are committed to real action, and proved it by putting some unprecedented programs into place. One positive that didn’t involve direct government intervention was that the deal by Mitsubishi UFJ Bank to buy 21% of Morgan Stanley went through, albeit on somewhat less generous terms than initially proposed 2 weeks ago.

Since this is a market dominated by fear, anything that calms investors down and/or reduces uncertainty is likely to spur buying. But there are other factors at play that may conspire to create a very rapid recovery of the recent large losses. These include the cessation of margin calls, a massive short squeeze, and the settlement of the Lehman Bros. credit default swaps. All three of these are powerful, though arcane, influences on market prices.

I was going to explain each of these, but this post was getting too long. For now, suffice it to say that in addition to fear and the desire by many investors to own only the safest assets, internal market forces that contributed to the big drops of the last 2 weeks are now in decline. And they may continue to wane over the coming weeks, which is obviously a good thing.

So are we out of the woods yet? One day does not a bull market make, and we’ll almost certainly have some more chilling drops over the next few weeks as fear periodically resurfaces. Yet while it’s still too early to say with conviction that last Friday’s panic lows represent the ultimate bottom for this bear market, a number of factors are finally coming together that make this more likely than not. I also think it’s again safe to start buying stocks; even if you don’t catch the lows, you’re getting in at incredibly cheap prices.

As painful as the past year—and especially the past 2 weeks—has been, I believe that we’ll look back on October 2008 as one of the great buying opportunities of the 21st century. Those who purchased stocks this month—or didn’t throw in the towel on their existing stockholdings as so many other investors did—should enjoy returns well above average over the next decade or more.

Now more than ever, it’s crucial to focus on the long term. Today’s wild swings seem huge in comparison to what we’re used to, but in the long run, they’ll be just blips on a chart.

Mr. Market's Wildest Ride

Today’s violent mood swings capped one of the worst weeks in stock market history. (It’s not always fun to be part of history in the making.) Fortunately, stocks recovered sharply in the late afternoon, so that the averages were down 1% or less today (a few were even positive). At one point, the Dow Jones average soared over 1,000 points from its low in just 30 minutes. Talk about volatility!

This weekend, the G-7 ministers are meeting in DC, and all eyes are on them. I suggest you forget about this. Also forget about whether or note the economy will suffer a long and deep recession. Forget about the credit crisis. None of these have anything to do with stock prices any longer. At this point, it’s all about perception.

Over the past couple of weeks, as the averages tumbled at rates rarely seen, there have been 2 primary types of sellers:

1. Those selling because the want to, mainly out of abject fear (usually accompanied by some seemingly rational explanation, which is just cover for the underlying panic); and

2. Those selling because they have to, mainly hedge funds and other leveraged institutions that have been receiving margin calls (demands for cash) at a rapid rate.

Virtually none of the selling has come from a cold analysis of the facts. Because if you take a step back (and a big breath), you’ll see that stocks are cheaper by almost any measure than they have been in our lifetimes. Cheaper than 2002. Cheaper than 1990. Cheaper than 1982. We’re talking 1949 and 1932 cheap. It all makes no sense.

Here’s something to keep in mind: During the Great Depression, US stocks bottomed in July 1932, just after FDR was nominated. Over the next 18 months, they rallied +187%, starting a full 9 months before the economy began to grow again (after shrinking 30% over the prior 3 years). By the end of 1936, stocks had risen +368% (that’s 4.7 times) from their lows.

There’s only one question you need to ask yourself when deciding whether to stick with stocks (or even buy more): Is the world about to end? If the answer is “Yes,” sell everything (not just your stocks), buy gold and diamonds, lots of canned food and ammunition, and hole up in a bunker. If the answer is “No,” then stocks are now the best place to be.