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Nope -- we're too gloomy
It's chic to be down on the market. But positive omens abound -- not the least of which is pessimism
December 17, 2005: 8:57 AM EST
By Andy Serwer, FORTUNE editor-at-large

NEW YORK (FORTUNE) - During the darkest days of October -- when the S&P 500 dropped below 1200 and became mired there -- life got a little scary for bulls like Tobias Levkovich.

"There were some anxious moments," acknowledges Citigroup's chief U.S. equity strategist, who had predicted that the markets would rise nicely in 2005, "but you ask yourself, 'Has anything really changed?' And if the answer is no, you stay the course." With the S&P 500 now returning a tidy 6 percent for the year as of presstime, it appears that staying the course was the right move.

Of course, to some nattering nabobs, the good news is actually the bad news. The higher stocks go, the handwringers argue, the further they must fall. Well, I'm not buying it. And Levkovich makes a pretty compelling case that it's best to keep the tiller steady again in 2006. For the record, he is calling for the S&P 500 to hit at least 1400 by the end of next year -- that would be an 11 percent gain from here.

Let the doom-and-gloom crowd cluck. I would simply point out that the economy is sailing right along. The latest GDP readings show us expanding at 4.3 percent. Job growth has rebounded despite the miserable hurricane season, and the unemployment rate hovers at a mere 5 percent. Interest rates and inflation remain relatively low. Meanwhile, corporate earnings are coming in according to plan.

Yes, there's terrorism, global warming and bird flu to worry about. But what's a market without fear to balance greed? Plus, there are plenty of potential catalysts for a rally in 2006. The Fed is expected to stop raising interest rates after the first quarter. And Levkovich also argues that energy prices could be lower in 2006 than in 2005.

But is the market overvalued, as Yale's Robert Shiller argues? Levkovich doesn't think so, Professor. "Stocks are, at worst, fairly valued," he says. "And probably they are attractively valued."

Let Levkovich -- who enjoys working some fairly esoteric models -- count the ways. Yes, the S&P 500 is trading about 17 times trailing earnings, which is above the historical norm. But when Levkovich adds the 4.5 percent yield of the ten-year Treasury bond to his 3.5 percent estimate of the risk premium (the return investors expect from stocks over Treasuries) and compares that 8 percent level with historical charts of the market's P/E, he concludes that the S&P 500 is 25 percent undervalued.

Stocks have been similarly undervalued by this measure 87 times, according to his charts. "And every time the market has gained over the next six months and 12 months

Levkovich is undeterred by the angst of the naysayers. In fact, he's encouraged by it. Consider his Citigroup Panic/Euphoria index, a contrarian indicator if there ever was one. It is a deep, dark, black box of eight measures of investor confidence including everything from Nasdaq daily volume as a percentage of NYSE volume and margin debt, to the put/call ratio and gasoline prices.

In early 2000, his contrarian index was go-go green euphoric, reaching peak levels. Right now it's signaling the brightest-red panic (it hit an eight-year low in October). To Levkovich this means there's a 95 percent chance the market will be higher a year from now.

Sure, investors were irrationally exuberant during the bubble years. And that's exactly why the shrewd market players today should be feeling confident. Look at it this way, says Levkovich: "Six years ago we could do no wrong, and everything was possible in the world. Today everything seems exceedingly challenging. We were wrong six years ago. And I think we could very well be wrong today."

On Wall Street, it most often pays not to follow the leader.

FORTUNE's Geoffrey Colvin say's we're still too exuberant.  Top of page

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