Why the Lousy Outlook is Good for Stocks in 2013

This article published with permission from InvestmentU.com.

USA Today recently ran a column reviewing the 2013 stock market forecasts of Wall Street’s leading firms. It was a tad underwhelming.

The most bullish stance comes from Citigroup, which sees the S&P 500 climbing 14%. The most bearish forecast came from Wells Fargo. It sees the S&P 500 dropping 2% in the year ahead.

That’s not terribly pessimistic. And it underscores the perpetual optimism of Wall Street, which needs clients and customers to buy stocks and do transactions.

The stock market could drop a lot more than 2% next year. However, if I were to hazard a guess I’d say it won’t. The market, if anything, may just do surprisingly well next year.

Why? Because things are just so darn bleak.

Investment legend John Templeton said bull markets are born on pessimism, grow on skepticism, peak on optimism and die on euphoria.

Do you know anyone feeling euphoric about the stock market right now? How about highly optimistic?

Me neither. And we have more than just anecdotal evidence.

Equity mutual funds have been hemorrhaging shareholder money not just for months but for years now. Stocks have more than doubled from the lows of March 2009 but this remains the most disrespected bull market in history. My friends in the brokerage industry say their good clients have mostly sat on their hands throughout this rally. The others cashed out near the bottom and never got back in.

You know what they’re thinking because the media saturates us all with it. The economy is weak. Washington is dysfunctional. Uncle Sam is drowning in red ink. The Eurozone is coming apart at the seams. Real estate — while no longer in a free fall — is mired in the muck. Consumers are overleveraged. Banks aren’t lending. Businesses aren’t hiring.

What these investors apparently don’t know is that a dismal outlook is almost always positive for stocks. Why? Because optimistic investors get complacent and overpay for stocks. Pessimistic investors are wary and leave stocks discounted.

That’s exactly what we find today. The S&P 500 currently sells for 14.5 times its companies’ operating profits vs. the average of 18.9 over the past quarter century.

And it’s not just that stocks are historically cheap. Interest rates are zero and the Fed is in an uber-accommodative mode. Inflation is M.I.A. Consumers are both saving and paying down debt. Economic output is now back where it was at its peak in 2007. Emerging markets — accounting for three quarters of the world’s land mass and nearly 85% of its population — are still growing at a 5% to 6% annual clip. Shale gas is creating a cheap, clean energy revolution. Corporate profits are at an all-time record. And so are corporate profit margins.

Of course, none of these factors make any difference to investors who — wittingly or not — are responding to fear, not reason. And, while it may be counterintuitive, this is exactly why stocks in 2013 may not just do better than Wall Street’s (admittedly tepid) worst-case scenario but better than it’s (admittedly tepid) best-case forecast.

In short, if bull markets die on euphoria, we can only conclude that stocks are still very much alive. It’s the typical investor who is out to pasture.

Alexander Green is the chief investment strategist at InvestmentU.com. See more articles by Alexander here.