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What If Wall St. Threw A Party, And Nobody Came? at Trader’s Narrative

While we all like to think of ourselves as rational beings, making decisions based on sound judgment, the truth of the matter is much more unsettling. We are, for the most part, rather peculiar creatures, prone to irrational and emotional biases. What makes this even more disturbing is that the edifice of our economic and financial system is built on the foundation of a rational, utility maximizing individual.

The most recent sentiment overview shows an amazing turn of events. Even as the stock market has gone on to rise almost 60% from its dark depth 8 months ago, a moderate correction was enough to plunge the majority of retail investors into a new state of capitulation.

Even more curious, instead of investing more as the stock market recovered, which is the norm, the US retail investor has completely given up on equities. Here is an updated chart which I originally shared two months ago (Equity Mutual Fund Outflows):
US mutual fund flows equity bond ICI data Oct 2009

If anything, the exodus of US retail investors (mutual fund owners) has intensified. The data for the full month of September shows redemptions of almost $13 billion - the most since February, just before the spring rally started. And to make it even more bizarre, the frenzy of bond buying is getting even more frenetic with net purchases of $55 billion (in September).

The data for the latest data (3 weeks in October shown in darker colors) promises a continuation of the same trend, if not a new record. So far, October had net equity redemptions of $11.5 billion.

Almost the same can be seen from insiders trading activity. These more ‘in the know’ individuals have continued to sell shares of their company’s stock almost as fast as they could. While there are many reasons for an insider to sell (diversification, divorce, etc.) the fact that we aren’t seeing an uptick in purchases is telling.

So why is there so much pessimism around this latest stock market rally?

Loss Aversion
A concept from behavioural finance offers a possible explanation for the bizarre fund flows pattern, bearish investor sentiment and insider selling. “Loss aversion” is a concept from prospect theory which explains that people prefer to avoid losing, rather than take a proportional risk to receive a gain.

Think of it this way. Given an event which triggers either a loss or a gain of the same amount, for some strange reason, we prefer to avoid a loss, rather than receive a gain. In other words, we prefer to keep what we have (not lose some or all of it), rather than add to what we already have. For most people, losing is much more painful than gaining is pleasurable.

Having experienced such scorching losses, the average US investor has a very clear idea of the kind of risks that exist in the equity market. They are intimately acquainted with them - most would say too intimately by now. So the possibility of further losses is also very real. In contrast, fixed income offers a cool balm - the perception of less risk and slow, steady returns.

A Real Bull Market
The retail investors and insiders are not showing up at the party, there is an unmistakable ‘wall of worry’ and prices have an uncanny way of climbing higher, against all seeming logic. It could very well be that Wall Street has thrown a party. That’s what one of the most respected technical analysts thinks.

Paul Desmond, the 2009 Technical Analyst of the Year (awarded by Technical Analyst magazine in the UK), thought the rise off the March lows to be merely a bear market counter rally and scoffed at the idea of a new bull move as late as June: This is No Bull Market. But then surprisingly, Lowry Research turned bullish in in August: Intermediate Buy Signal.

While Lowry missed a good portion of the stock market gains from the spring bottom, you won’t hear many of their clients complaining as they were saved untold anguish and loss by being told to exit the market in July 2007 - three months before the bear market top.

Now, Desmond’s firm believes that we are in the midst of a bull market that will last another 3 years. He bases this on Lowry’s proprietary analysis of demand and supply in the stock market as well as the four year stock market cycle.

The Importance of Being High
If you are skittish, Desmond suggests you keep an eye on the new 52 week high list. Since major market tops are made slowly, as leadership is lost, the number of new highs tapers off months before indexes themselves makes a top. According to studies of market history, if you find that 11% or less of the NYSE shares are making new 52 week highs, watch out! But that sort of pattern is not evident right now.

Last month, on the NYSE there was an average of 149 stocks a day reaching new highs. In October, that average was 173 daily new highs. Based on this strong showing, Desmond says, “The patterns we see here are very similar to those that preceded previous major market bottoms”.

Even if there is a party in full swing on Wall Street, in the short term, it is prudent to be cautious. The percentage of S&P 500 constituent stocks trading above their 10 day moving average was 73% on Friday. And with a strong showing on Monday that could jump to mid 80’s, leaving little overhead room for further advancement the rest of this week.

But then again, Paul Desmond says that these sort of breadth rules do not apply in the early stages of a multi-year bull market as “overbought” tends to be the norm.

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6 Responses to “What If Wall St. Threw A Party, And Nobody Came?”  

  1. 1 david

    Not sure the data is a good contrarian indicator. In the second half of 2007 at the top of the last bull market investors were selling US equity funds too. That was not a bad decision.

  2. 2 Babak

    David, yes, others have mentioned that. I wanted to present the bullish arguments. Next I’ll cover the bearish ones which includes the point you raise and much more.

  3. 3 dacian

    Babak, for the bullish arguments (or why the retailers aren’t showing up like before), here is a simple explanation: they have no money; demand for everything - look at credit - will be lower, stocks included. Maybe they are dumb people and Wall Stret is waiting for them to appear at the party so that they can dump the garbage, but is these retail people who are giving money to professionals and fund managers to invest.

    Regarding bond market inflows, look who funded Japan’s public debt over the last 20 years ;-)

  4. 4 dacian

    Another thing: the stupid retail guy, like me, isn’t showing up because it probably had enough of buying Wall Street stories within the last 10 years. The dumb retail investor needs to repair its balance sheet and make a living; he also refuses to buy on margin - credit is contracting for the 8th consecutive month, the biggest contraction since 1943. What if this thing will finish in a pro-bloodbath?

  5. 5 Senta

    Great article. The wall of worry really is the dry powder on the sidelines. It is really stupid to overweight bonds right now - interest rates cannot go any lower and have to go higher - that means bond prices will go down.
    Slowly but surely the equity market will suck up the money now in bonds and cash.

  6. 6 wayne

    A couple of comments.

    1) First on Sentiment.

    As far as sentiment is concerned, if P then Q does not mean if Q then P. The majority of market tops have occurred when sentiment was high, but if sentiment is high, it does not necessarily mean a market top. Sentiment can go to high levels and stay at high levels for a long period. This is a common technician mistake when using indicators that are range bound between say 0 and 1 vs a market that is not. The underlying indicator can approach it’s maximum level and stay there as the internals rotate. A recent example of such, taking new highs vs (new highs plus new lows). As we pointed out here,, this indicator went to 1 several months ago, certainly as high as it can go, but that didn’t mean the market couldn’t go higher as only 5% of stocks were making new highs at that time and that number can theoretically continue to rise. But back to sentiment, I think the important measures in sentiment are the smart money vs the money with not such a stellar track record, and as the studies on retail investing and the work by Jim Stack at Investtech suggest, those measures are still fairly constructive.

    2) Bond yields.

    I’ve heard a lot of people in the last 12 months, state that they are not going to own bonds because interest rates are at zero and can’t lower. I’m not predicting such, and don’t mean to be contrare, but consider for a moment the possibility that short term interest rates go up a couple of points over the next couple of years without much change in the bond rates. For example, throughout history the average spread between 30 yr bonds and Tbills is around 1.5-2% (I did this study many yrs ago and would have to look it up to get the exact #). Right now, there is a very wide 4-4.25% spread or yield curve. And of course there have been a few occasions where the yield curve actually inverts (which has usually been an ominous sign for equities). A 4% spread is on the very high end of the historical yield curve and suggest there is much room for contraction, which one would have to figure will come from higher short term rates Again, this started out as a comment and has turned into a study for my todo list. But my intention was to not make a prediction for bond yields, but to simply provide food for thought. It is certainly a possibility that at some point in the future, that short term rates go up, stocks go down and substantial amounts of the cash coming out of equities finds its way into the longer end of the yield curve.

    Does this make any sense?

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