Investing to Wealth

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):

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.