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What If Retail Investors Are Smart To Ignore This Rally? at Trader’s Narrative

At the start of the week we contrasted the strange pessimism that has gripped the US retail investor to the levitation act of Wall Street. It is almost as if Wall Street threw a party and other than institutional investors, a few day traders and algo quant jocks jamming high frequency trades, no one else showed up. If you ask Paul Desmond, of Lowry Research, this is a real bull market that will last another 3 years.

With all due respect to Desmond, today I wanted to entertain some bearish counter arguments to temper that cheery outlook and delve a little deeper into the market condition both in the short and longer term.

While considering the same ICI fund flow data, it is conceivable to come to bearish conclusions. Take for instance the fact that domestic equity funds have attracted less than $8 billion of fresh capital since the lows in March. Had this rally provoked the same pattern of retail investor participation as previous ones, we should have seen $150 billion flow to equity mutual funds, according to TrimTabs.

Maxims ad Nauseum
While it has become an accepted maxim repeated ad nauseum that a bull market likes to climb a “wall of worry”, the historical evidence is otherwise. The stock market actually tends to float higher on gradually increasing levels of optimism - until that optimism reaches a crescendo and then the whole thing unwinds. And we start all over again. So generally speaking, the stock market performs better following periods where there are net inflows of funds.

Whether retail investors are acting intelligently by avoiding this rally or more accurately, by selling this rally, is something that only history can answer. It isn’t hard to imagine though, the possibility that they are reacting emotionally. Think of it. Having first experienced severe loss in their portfolios and watching Wall St. insiders ride on a cushion of bonuses, insult is added to injury when they have to fend for themselves in a new harsh economy.

What if we are seeing the rejection of the great “equity culture” and the almost religious belief in “buy and hold”? What if the record inflows to bond funds are being driven by a traumatized populace seeking the one shelter of income investing?
ICI record inflows to bond funds long term chart

So far, this has been so relentless that it has pushed the fixed income share of US household wealth above 6% once again. But if you notice, the last time there was a similar increase happened during one of the strongest bull markets in equities:

bond share of US household wealth

However, what is undeniable is that if the US retail investor doesn’t return to equities eventually, what we could see is another lost decade; where markets flop around like a dead fish, but don’t really go anywhere. This is what happened before the great super-bull market was launched in 1982.

The completely stark scenario is one where retail investors continue to ratchet up their sales of equities and push the stock market lower as a cascade effect takes place where gloomy sentiment and fear feeds on itself. Think of it as the great unwinding; or the negative wealth effect.

Technical Weakness
Returning to more present and short term matters, the market came perilously close to the invisible 20% distance from its long term moving average. Yesterday I mentioned that stocks have little room to the upside and while I’m not surprised to see the weakness today, it by no means guarantees that we won’t see a final push to 1120.

On Monday 94% of the S&P 500 stocks closed above their 10 day moving average. That’s the highest since mid July. Since then this measure of breadth has backed off slightly but is still hovering above 90%. Other negative technical considerations are that prices are pressing against the downtrend line at 1100 - from the top of the bear market (in October 2007). And that other major market indexes like the Nasdaq, Russell 2000, the Philadelphia Banking Index (BKX) and the Semiconductors (SOX) are still below their previous swing highs. Finally, volume continues to be anemic as it has been for most of this whole trip.

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6 Responses to “What If Retail Investors Are Smart To Ignore This Rally?”  

  1. 1 alfagetti

    re: the inflows to bond funds.. is there any breakdown, i.e. are these mainly corporate bond funds, i.e. a diltuted play on equities? or are they bona fide government bond funds? thanks

  2. 2 Babak

    alfagetti, most of it is ‘taxable’ which would be regular T-bonds and corporates. Munis make up about 20-25% of total bonds. You can get the data here and see for yourself.

  3. 3 dacian

    Babak, all good questions; I don’t know if the stupid retailer Wall Steet likes to fool and take their money will be right or wrong, but does that matter in the end? What’s sure is that the demand for everything goes down! Stocks included! So yes, Wall Street can have parties, well, good for them. But the stupid Jim doesn’t bite this time; yes my friend, this is the sad truth. And it’s not because they are stupid or feel insulted, but because they simply don’t have enough income to participate! It’s as simple as that imo…

  4. 4 Investorsconundrum

    Babak, you said Paul Desmond expects a 3 year bull market?. I’m a Lowry’s subscriber and I don’t read nothing like this. Are tou refering to any Paul public interview?

  5. 5 Babak

    yes, this was in a recent interview

  6. 6 dacian

    there is another problem I see here with this rally; what would be in the public’s eyes another “bad guess” from Wall Street? I mean these people in Wall Street are working hard to make us believe this is a recovery, right? (the market knows in advance, it anticipates). Now how the american public will deal with another bad move from Wall Street? That’s why they need to keep this rally on, it’s a lie but they need to perpetrate it; they have no choice.

    In general, it doesn’t worth playing such moves, although this one was exceptional and worth the price capturing part of it. One need to keep in mind that the pool of greater fools is not unlimited; some participants know this, most don’t so be maximum prudence is required; going full long after such a move it might hurt (yes, we can move 50% above 200DMA or make another 60% move up from here, but the odds are rather slim imo). The best strategy here imo is to be hedged; we’ll see how this plays out…

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