We recently came across an article posted on ZeroHedge (Retail Investors Ignore “Generational” Opportunity To Buy Stocks One More Week) that presented the latest weekly data on Domestic Equity Mutual Fund Flows and subsequently challenged the concept that retail investors are coming back to the market anytime soon. A graphic depiction of weekly domestic equity flows suggests that the lack of retail investors back into the market will weigh heavily on future returns and a major market correction is on hand. While the correlation between domestic equity flows and market returns seems logically proportional, we interpret the data as in fact illuminating a disproportionate relationship between the two.
The chart below, which is taken from the article but depicts instead monthly domestic equity fund flows, best explains our understanding of the market dynamic as one that accounts for investor psychology as much as it does for company fundamentals. Sophisticated investors and professionals usually lead market rallies, aptly buying at the inception of an upward trend when fear permeates the market psychology and the market is generally considered oversold. Once retail investors become privy to any one company’s success it is usually at a much higher premium from what savvy, risk-taking investors paid. The exchange at elevated price levels from professionals to retail investors has led many market participants and observers to deem the market a ‘casino’ or better yet a ‘Ponzi Scheme’.
If that is going too far, it is at least worth referencing Warren Buffett’s description of the market as a poker game: “If you’ve been in the [poker] game for 30 minutes and you don’t know who the patsy is, you’re the patsy.” The market patsy is the one buying at the top when savvy investors are getting out. The chart illustrates such a pattern on 5 occasions since 2010; most notably, April 2010, March 2011, August 2011. In the first two instances, the upward market trend reversed only after retail investors came back into the market. In the third case, the downward trend in the market reversed when retail investor selling was at its maximum. Contrary to conventional wisdom, what we can extrapolate from this pattern is that the current upward market trend continues to have legs (also for fundamental, political reasons) and an influx of retail investors back into the market will in fact be a warning sign that a trend reversal might be at hand. In this current turbulent investing environment, simple ‘patsy psychology’ goes a long way.