The Bears Haven’t Surrendered Yet

Markets have reached new highs, yet equity ownership has fallen to the lowest level in more than a half-century. Markets have reached new highs, yet equity ownership has fallen to the lowest level in more than a half-century.

Last year, we noted that there was a “Bubble in Bubble Calling.” News media bubble chatter was the rage, whether it was tech initial public offerings or stocks or bonds -- all caused by “a global central bank QE bubble.”

Here we are two quarters later, with the central bank reducing quantitative easing by scaling back its asset purchases. Markets have reached new highs, which is a highly bullish sign. The jobs lost in the great recession have been recovered, and economic data continues to trend positive.

Despite this, we still hear bubble chatter. Yet when we look at what individuals are doing with their investments, their behavior is definitely bearish. According to a study published in the Financial Analysts Journal, equity ownership has fallen to the lowest level in more than a half-century. In 2012, investors held a mere 37.7 percent of their portfolios in equities. That was out of a grand total of $90.6 trillion in investable assets around the world.

Over the past three decades, U.S. investors’ portfolio equity exposure has run at a historical average of about 60 percent. Think of this as the classic 60/40 stock-bond allocation.

In the early 1980s, investors reduced their equity exposure to just 45 percent. In the late 1990s, it rose to 75 percent and higher. A 15 percentage-point swing in either direction is an indication of extreme sentiment. Savvy contrarians can make a bet in the opposite direction with a high degree of confidence.

Today, the equity allocation is a modestly elevated 65.3 percent among the 150,000 members of the American Association of Individual Investor, which tracks individual investor behavior. Given last year's 30 percent gain in the Standard & Poor's 500 Index, it is reasonable to guess that much of this increase was from price appreciation in existing equity holdings, and not due to a newfound love of stocks. Meaning, we are not seeing the sorts of sentiment moves that indicate a bubble.

This is confirmed by other data sources. As of May 2014, investors’ cash allocations had risen to an eight-month high while equity exposure had actually fallen to a six-month low, according to AAII. And, the survey data is confirmed by other data from the quantitative team at Bank of America Merrill Lynch, which tracks the money flow of the firm’s clients. Their clients have been net sellers of equities during the last few months.

None of these data points are supportive of an extreme in positive market sentiment. Indeed, most of the data suggests that individual investors have left the building. If history holds, the top will not be formed until they belatedly come running back to equities, embracing stocks with enthusiasm. Once the last suckers have thrown in the towel and bought stocks again, goes the contrarian thesis, who will be left to drive them higher?

Why do investors behave this way? There are lots of explanations involving cognitive issues and behavioral economics, but my pet thesis relies on how humans experience time. There is a tension between how people live their everyday lives -- more or less in the here and now -- versus the time frame over which portfolios exist. In other words, investors don't quite comprehend the life cycle of their portfolios relative to how they experience the elapsing of time. We live our lives over the short term, but our portfolio’s lives are over the long term. And rarely does short-term decision making accrue to the benefit of long-term investing.

Where does that leave us in the markets today? From a valuation perspective, we have elevated equity prices in the U.S., but cheaper ones in Europe and emerging markets. Average investors seem to be not very enthusiastic about the U.S., but they are even less optimistic about equities abroad.

My preferred definition of a bubble remains that offered by hedge-fund manager Clifford Asness, who classifies an asset bubble as “a price that no reasonable future outcome can justify.”

It isn't too difficult to foresee a modest acceleration in global economic activity that leads to a further increases in corporate profits. This not only reduces the bubble thesis, it potentially supports the equity market rally.

If you want to get really bullish, consider the positions of strategists such as Altaira’s Ralph Acampora or Raymond James’s Jeff Saut, who view the current environment as a new secular bull market. And folks such as Laszlo Birinyi note that the final phase of a bull market can't occur until the public joins in.

Hence, we see individual investors not buying equities the way they have in the past. Until that changes, the odds are against a major market top forming.

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