For market to rally, sell your stocks

Matt Thompson used to trade stock options, trying to make a little money on the side. He would chart price movements and read newsletters. But after his portfolio headed south last year, he pulled out from options and took up the guitar instead. "I just totally unplugged from the whole thing," says the Grafton, Ill., resident.

There's just one thing: He's holding his remaining tech stocks. Yes, he's discouraged from buying more, but "I'm not discouraged enough to sell." Like many investors, he hasn't given up completely on the stock market.

Strange as it may seem, that may be bad news for those expecting a recovery. According to a popular contrarian view on Wall Street, investor sentiment has to really sour before stock prices can stage a large, sustainable rally. The more gloom, the more investors sell, and the further stock prices fall. At some point, the theory goes, prices reach such ridiculous lows that they set the stage for a frenzy of buying and the next strong rally.

Yet so far, despite new lows set by blue-chip and technology stocks this week, investors' outlook remains a little too upbeat, analysts say.

For those who believe in the predictive power of investor sentiment – and not everyone does – that suggests more depressing times ahead. "The last four years, we've seen a lot of optimism where people basically want to be bullish," says Michael Burke, editor of Investors Intelligence, a biweekly newsletter in New Rochelle, N.Y., which tracks the sentiment of stock newsletter writers. Its latest reading shows bulls still outnumbering the bears, 42.2 percent to 34.5 percent. "They're still not readings that say everybody is worried," says Mr. Burke.

Other surveys show much the same: discouragement but not enough for investors to throw in the towel.

In July, for example, the index of investor optimism hit a record low – 46 – down from a relatively buoyant 121 in March. That decline closely tracked the new lows the market indexes were setting at the time. But as soon as the markets rebounded in August, so did optimism, according to UBS and the Gallup Organization, which created the measure. With a big spurt in the Dow Jones Industrial Average, the optimism index rose to 52. And this month, even though the markets plunged again, the index registered another small gain, to 60.

The poll took place before this week, however, when bad earnings reports and uncertainties about Iraq helped send the Dow to a four-year low. Also this week, the Nasdaq, which lists many technology-related stocks, reached a six-year low. "Many investors are still not convinced that the economy has hit bottom," UBS/Gallup concluded. While 45 percent thought it had, a slightly larger group, 52 percent, believed it hadn't.

With the market bouncing back a bit on Wednesday, these kinds of halfway sentiments are not the signal that market-watchers are looking for. They want full-blown, rock-bottom pessimism – the kind that pervaded the markets in 1974, the last time Wall Street endured such a nasty, long-term downturn.

Even though stocks were cheap back then, with low price-earnings (or p/e) ratios, investors held back. "In '74, you couldn't find a p/e above 10, and people didn't want to buy them," recalls Burke of Investors Intelligence. But that extremely bearish outlook set the stage for a strong rebound that lasted for the rest of the decade.

This time around, "you don't [have] enough people hating the market yet where they get the prices down," says Burke. In July, his bearish sentiment index reached 42 percent. Although that's a high not seen since April of last year and, before that, 1998, the index has to breach 55 percent to signal really bearish times, he says.

Of course, there's no guarantee that even if such a point were reached, the markets would then enter a rally.

Moreover, the markets' decline has already taken its toll on other aspects of investor confidence. Better than three-quarters say they have less trust in analysts' recommendations than they used to, according to a survey released Wednesday by Standard & Poor's and BusinessWeek. The survey, conducted in August, found that recent stock scandals and earnings restatements have caused nearly half of investors to change their investment strategy.

"People are gravitating toward conservatism and fixed-income investments as opposed to thinking the market will spring back," says Craig LaMaster, a financial planner here in St. Louis. Until the downturn this month, many of his clients were reluctant to diversify: Instead of spreading their money into bonds and other less volatile investments, they insisted on keeping it in stocks.

"It has been such a struggle to get people from where they shouldn't have been to begin with," he says. "Now, we're getting much more response."

The response varies, however, depending on the type of investor, according to the UBS/Gallup survey. Those under age 40 have become significantly more optimistic since last September in the wake of the terrorist attacks, while older people remain just about at last September's lows.

Some analysts say that the latest market downturn may be the blow that finally pushes some investors to throw in the towel. "It's a discipline – kind of like a fighter," Mr. LaMaster says. "People have been in the ring and constantly getting punched by depressed prices. They finally get their wind and think things are going to get better. Then they get punched again."

Many quit as a result. That's the wrong response in his view, but these days, quite understandable.