By James Mackintosh 

The rarified air of the Swiss Alps helped reveal a scary truth to investors attending the Davos forum last year: The elite gathered in Switzerland were wildly optimistic about the economy and markets. The catchphrase was "synchronized global recovery," and it appeared the market bears had been vanquished.

The confident mood was impossible to miss -- and it offered a perfect sell signal for those paying attention.

Optimism has since turned to pessimism. But investors and economists are nowhere near as pessimistic now as they were optimistic then. As a result, this year's meeting isn't likely to justify a contrarian move to buy. This year, fundamental economics matter more than mood.

Investor sentiment is most important when it is extreme. When investors are deeply negative, even a hint of good news can offer a pleasant surprise. Equally, when investors are complacent and piling on risk, they can be shocked if the news isn't uniformly perfect.

This time last year, investors were clearly complacent about the global economy, following a surprisingly good 2017. Measures of mood aren't scientific, but one of the longest-running gauges, from Investors Intelligence, showed bearishness at an all-time low among writers of finance newsletters. The proportion of self-reported bulls minus bears in the American Association of Individual Investors was the highest since 2010 in the weeks before Davos. More than 80% of analysts' profit forecasts for S&P 500 companies were upgrades, too, the biggest proportion in IBES data back to 1985.

This optimism was obvious in markets. Demand for put options to protect against falling U.S. stock prices was the lowest in three years relative to demand for call options, which gain from rising stocks. The S&P hit its highest valuation -- using Wall Street's favored ratio of price to estimated operating earnings for the next 12 months -- in 15 years.

Investor optimism was mirrored by high levels of confidence in economic growth around the world, confidence that proved sadly misplaced.

The U.S. economy did well, but as the rest of the world slowed, investors eventually turned gloomy.

They are not deeply pessimistic, however. There is still an expectation that what's coming is weaker growth, not recession. Sentiment measures remain higher than those seen in the postcrisis scares of 2010, 2013 or early 2016. Sure, investors have lost their complacency. There was even a whiff of fear at the end of the year, as stocks fell hard. But investors haven't panicked -- yet -- the way they often have in the past.

So was that it? Is the bear market done?

Bullish sentiment isn't so depressed as to make an equity rebound especially likely. Instead, much rests on the fundamentals of the global economy, which in turn depend to a big extent on the U.S.-China trade war and on central banks.

If Donald Trump and Xi Jinping can mend their differences before the next round of U.S. tariff hikes threatened for March, investors will be delighted. But Mr. Trump has canceled his Davos visit after shutting down the U.S. government in his fight with Congress, and Mr. Xi isn't due to attend. So trade negotiations aren't likely to be advanced behind the scenes in Switzerland.

Meanwhile, decisions by central bankers could be as important to markets as progress in trade talks. Federal Reserve policy makers have been making dovish noises since U.S. stocks briefly fell into a bear market on Christmas Eve, and investors have been hypersensitive to their comments. Easy money is generally good for investors, all else being equal. But Fed policy makers and Chairman Jerome Powell emphasize that they are "data dependent." That sounds dovish when the data have been disappointing and politics hurts growth. But if no more shots are fired in the trade war and the global economy starts to pick up again, that same data could put the Fed back on a tightening path.

Investors are probably right to think the Fed is ready to help if things get worse. But if things look better and markets get tanked up, the Fed will be taking away the drinks.

Even on this best-case outcome, those attending Davos parties should be prepared to accept sober equity returns -- and plenty of wild lurches before they get there.

Mr. Mackintosh is a columnist for The Wall Street Journal in London. He can be reached at Iames.mackintosh@wsj.com.

 

(END) Dow Jones Newswires

January 21, 2019 10:35 ET (15:35 GMT)

Copyright (c) 2019 Dow Jones & Company, Inc.