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Pro Forecasters Stink, but Individuals Are Worse

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This morning, I want to direct your attention to a Bloomberg News article titled Individuals Pile Into Stocks as Pros Say Bull Is Spent. It is a worthwhile read, but a bit of context is required.

The article notes that Main Street and Wall Street are allocating money in diametrically opposed ways:

Individual investors are plowing money back into the U.S. stock market just as professional strategists say gains for this year are over. About $100 billion has been added to equity mutual funds and exchange-traded funds in the past year, 10 times more than the previous 12 months, according to data compiled by Bloomberg and the Investment Company Institute.

At the same time, various big-name forecasters are predicting the “stock market will be stagnant.” They further observe “valuations are at four-year highs.”

Individuals pile into equities while the pros pull out? The knee-jerk response is to run for the hills, or Treasuries, or whatever your favored disaster trade might be.

Unfortunately, it is never quite that simple. A little bit of context explains why neither of these indicators is of much significance.

Let’s begin with the forecasting portion of our discussion. The abilities of strategists and economists to foresee the future run from merely horrible to embarrassingly foolish. Someone gets it right each year more or less at random, but there is little reason to put much faith in the predictions of the pros. As we discussed last week, expert forecasts are statistically indistinguishable from random guesses. And, there is little or no penalty for being wildly inaccurate.

The joke on trading desks was that the World Cup predictions from investment banks were meant to make their analysts’ calls look prescient.

Recall none of the pros forecasted last year’s 30-percent-plus rally in the Standard & Poor’s 500 Index. In the beginning of this year, all 72 economists surveyed by Bloomberg predicted higher rates and falling bonds. Treasuries have rallied about 10% so far this year as yields fell.

Now that we are reminded how awful the pros are in forecasting markets, are the individual investors any better? As it turns out, they are even worse. First, they chase performance, not value. At best, they are a lagging, not leading, indicator. Secondly, individuals don’t move the needle very much. Money flows into equities have been negative for almost the entire rally since the March 2009 lows.

If we can’t rely on strategists’ or economists’ forecasts, and individuals’ trading is of no value as an indicator, what should we be looking at? I would suggest two areas worthy of your attention: Institutional flows and extremes in sentiment.

 The day-to-day flows into retirement accounts, exchange-traded funds, pension funds and 401(k)s have been creating a fairly steady demand for equities. If and when that reverses, it will be much closer to the end of the bull cycle than the beginning. Second, once individuals become enthusiastic equity investors once again, that will also be near the top. It would be the opposite of the capitulation we saw in March 2009, and would represent a buying climax. Be forewarned: It takes more than a few months of stock buying for that full-on exuberance to make an appearance. When former Federal Reserve Chairman Alan Greenspan described the “irrational exuberance” of stocks investors in 1996, it took almost four more years until that climax was reached. If we even go half as long, we might see another year or two before small investors become too bullish.

Today, they are barely putting their toes back into the water. Draw your own conclusions.

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