Not Necessarily the Greatest Fools

As someone who has been studying markets for more than two decades and who has a natural predilection for betting against the crowd, I have some sympathy for the popular view that share prices don't hit their peak until the individual investor is "all in."

That said, the assumption that this is a necessary prerequisite for a contrarian reversal of fortunes probably owes much to the fact that we have lived through one of the greatest long-term bull markets of all time.

During that span, the percentage of Americans who own equities, either directly or indirectly, has jumped from 13 percent in 1980 to 46 percent as of 2008, a nearly three-fold increase which helps explain why the perspectives and actions of the little guy (or gal) have come to mean a lot.

But as the past three years or so has taught us, history does not just include the most recent decade or the golden era that began in the early-1980s. Before then, as Charles Hugh Smith, publisher of the Of Two Minds blog notes in "When Belief in the System Fades, Stock Market Version," there were times when individual investors were not necessarily the greatest fools of their day:

"When belief in the system fades" the Great Middle Middle Class opts out: in this case, of the fraudulent, manipulated stock market.

Astute reader John M. recently offered this commentary on the news that Americans pulled money out of stock mutual funds in 2009, despite the glorious "nascent recovery rally" engineered by the Fed and Wall Street. That item can be found in (March 19, 2010).

According to this article, How Greed and Fear Kill Returns (NY Times), American investors put an estimated $506 billion into mutual funds in the past year, of which $409 billion went into bond funds. My guess is the balance went into overseas funds, currency/FX (foreign exchange) funds or commodity (oil, gold, etc.) funds.

The writer concluded, "The point is to recognize that, in aggregate, investors tend to be very bad at timing the market." Or in other words, avoiding stocks is simple the result of "dumb money/investors" doing the opposite of what they should have done to profit handsomely.

John M. offers a historical perspective on the issue:

I enjoyed your recent article about redemptions from equity mutual funds. I thought I'd provide a couple of historical examples where Americans redeemed more from funds than they put in, and significant bear markets followed shortly afterward.

At the top of the Dow's bull market in fall 1976 (the Dow had rallied 75% from the 1974 lows), Americans were pulling money out of equity mutual funds at a record rate. This was followed by a 27% drop in the Dow in 1977-78. Here's a news article about it from '76:

archive article 1.

Here's another example, from 1972. Americans pulled more money out of equity funds in '72 than they put in, and this was followed by a 50% bear market in 1973-74:

archive article 2.

Actually, starting in 1972, there were more outflows than inflows in equity mutual funds throughout the 70s, and the Dow went nowhere between 1972 and 1982.

A counter-example would be 1988, when Americans pulled more out of equity funds than they put in due to jitters from the '87 crash, but the market continued to do well in 1989-99.

So it's not really a definitive indicator, but it's interesting that a similar pattern was developing in the early 70s with mutual fund inflows/outflows as the public slowly became disenchanted with stocks after the go-go 50s and 60s, and the market went sideways for 10 years from '72-'82.

Thank you, John, for a timely reminder about the last "Lost Decade." Maybe retail investors weren't so dumb after all.

Within the context of the Survival+ analysis, I think the investing public's distrust of the stock market is merely one manifestation of a much larger and more powerful cultural trend that I call When Belief in the System Fades (March 12, 2008):

In a way, a belief in the value, transparency, trust and reciprocity of the System is like a religious belief. The converts, the true believers, are the ones who work like crazy for the company, or the Force or the firm. And when the veil of illusion is tugged from their eyes, then the Believer does a reversal, and becomes a devout non-believer in the System. He or she drops out, moves to a lower position, or "retires" to some lower level of employment.

The belief that the stock market is trustworthy and transparent is also like a religious faith. Americans have lost that "religion"--and their faith in the trustworthiness of the entire fraudulent doomed carcass of American finance.

Hapless investors saw trillions of dollars of their hard-earned wealth destroyed in the dot-com meltdown, and they came to learn that insiders had distributed their shares during the run-up, leaving the investing public as bagholders when that bubble collapsed.

Their faith in the system was only shaken, however, and they dutifully piled back into stocks in the 2003-2007 time period, as the "smart money" bet on a collapse of the housing/credit bubble and on the fall of all the Wall Street firms which had profited from selling the fraudulent MBS and derivatives generated by the housing bubble.

Twice burned, trice shy. Now that American retail investors lost 40+% of their wealth in the 2008 stock meltdown ("global financial crisis"), they finally "get it:" Wall Street is a machine run on embezzlement, fraud, willful obscurity in service to information asymmetry, extreme leverage, predation, disinformation and malignant malinvestments in parastic speculations with no value except transactional churn.

Yes, investing in long-term bonds sure looks like a bad bet, as interest rates are sure to rise, despite the prognostications of Fed Chairman Ben Bernanke ("Away, tides! I speak for the mighty Federal Reserve!"). But "belief in the system has faded" and it won't return until the system is cleaned out of scum, fraud, obscurity and all the structural rot at the very heart of a predatory American financial system (and by extension, its political system as well).

This aligns with the public's reluctant grasp of the political and financial rot at the center of the U.S. Empire in the 1970s. Watergate was simply a bungled offshoot of an entire political and financial system built on disinformation, propaganda, manipulation, and criminal activities pursued in the name of "national security."

A new "improved" credit bubble took hold in 1982, and that expansionary-credit-based prosperity based on cheap oil lasted a good 25 years (1982-2007). But now the bubbles have all been blown and the bubble-blowing elixir (exponential expansion of credit) has lost its magic. To cover up the endgame, the Powers That Be are reduced to manipulation and propaganda. The public senses that the manipulations are not sustainable or credible, and so they once again reluctantly conclude that the predatory system does not serve their best interests.

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Comments

[Anon Omous]

Let it burn!
This system is not worth saving.

[R Man J]

Here's one average middle class American who sold 90% of equity related investments in late 2008 and never got back in. I guess that makes me one of those "'dumb money/investors' doing the opposite of what they should have done to profit handsomely." I may be dumb, but I am not a fool. Even if it means living a simpler life, I'm never going back in. I won't get fooled again. Paper...let it burn!

[gordon]

PERCENTAGE (48% in 2008) of Americans owning stocks is NOT THE ***MEDIAN AMOUNT$ PER INVESTOR***! That would be around $3500.00! The CNBC hypesters just keep up the PROPAGANDA. This market is controlled by PPT, we all know it. Nasdaq up 17 days in a row NEVER BEFORE IN HISTORY! 19 of 21 days. Stocks are AT LEAST 30% OVERVALUED, that's if you believe S&P OPERATING P/Es at 23. I submit OPERATING has never been the historical benchmark, REPORTED GAAP is. What's that number?

[Small Town Gal]

Now there is an analysis I can believe in. A productive, market-based society needs a couple of things to thrive, at a minimum: a high level of mutual trust and a strong "rule of law" underpinning that can mediate conflicts and enforce agreements/rules when private attempts fail. The past decade has been all about undermining both -- but the breakdown of the trust component has been really achieved in the past three years.

And it's not coming back any time soon. I'm not in the market, and I'm not coming back into the market. Know your counter-parties is my new motto.

[Dave Narby]

I like Swenlin for P/E ratios (he also includes Hussman's calculation. http://www.decisionpoint.com/TAC/SWENLIN.html

The DJIA is at 17 (not so bad) but the S&P is at...

93!

[Namazu]

Many financial (ahem) commentators take things one step further: stocks can't fall until the individual investor is heavily invested. Of course, if this were true, there would never be periods of "revulsion" like the market of the '70s, when John Lynch could find bargain stocks walking around the mall. If memory serves, this follows from the intermediate value theorem.

[gordon]

Small Town- thx for the Swenlin link, he is good. It says "fair value" for the S&P (p/e 15) is currently 892. I remember reading Swenlin on financialsense and came to the conclusion the S&P is 30% OVERVALUED, based on $SPX 1165. Of course, this
is all speculation driven by ZeroInterestRatePolicy (ZIRP) to
reflate the stock market, using the Primary Dealers HFT trading desks, because Bernanke thinks the stock market controls the economy.
Here is an excellent blog comment from zerohedge explaining it(hat tip to Mr. Krasting):

by Bruce Krasting
on Sun, 03/28/2010 - 09:16
#278628
So stocks are up 60-70% in a year. And we still have ZIRP. And we will have ZIRP (or something very close to "0") for a long time to come.
So does Benny not believe in this idea that stocks = economy? If so, you would have thought he would have backed off of ZIRP by now.
ZIRP is TARP in slow motion. The banks are earning a ton from their book of assets. This income allows them to absorb losses from crappy assets.
We have a 15T banking system. Because of ZIRP they are earning 2-3% on this book today. That comes to $500b of "extra" income every year. So ZIRP is just a subsidy for the banks.
Who pays for ZIRP? Savers of course. They get nothing for their money. So they buy stocks.
I can't imagine how this crazy imbalance can be brought back into balance without a very big bang at some point.