Tags: Institutional | individual | outperform | market

Beware of the Market's Split Personality

By    |   Monday, 20 August 2012 12:25 PM

The economic news has been mostly bad.

The European debt crisis continues and periodically erupts into a major threat. Much of Europe is in a recession and is dragging the world economy down with it. The Chinese economy has been slowing even more than previously thought. Leading indicators in the U.S. economy have been turning lower. Meanwhile, uncertainty regarding the "fiscal cliff," the presidential election and the possibility of a military conflict with Iran looms in the near future.

But the market seems to love it.

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The Standard & Poor’s 500 Index has returned more than 14 percent for the year so far and about 11 percent just since early June. It seems that the market just shrugs off all these serious concerns and continues to forge higher anyway.

What's going on?

Positive forces beyond the headlines

While most of the news is bad, it isn't all bad. Stocks are still relatively cheap on a historical basis and corporate balance sheets are generally quite strong with tons of cash on the books. Meanwhile, with interest rates near historic lows, money has no place else to go besides stocks.

In addition, there is a general perception that if economies get weaker, central bank easing all over the world will prop up markets — at least in the near term. In other words, economic weakness makes central bank easing more likely. Since central bank easing is good for stock prices, bad economic news is also good for stock prices.

This thinking seems backward and misguided — because it is. But, this mentality is also propping up stock prices — for now.

But there is something else that makes the market dangerous in the near term.

The market has a short-term personality disorder

The market is being driven by institutional money, and the individual investor is largely not participating. The mutual fund money flow for the year has been overwhelmingly toward bonds and out of stocks. The trend has reversed somewhat very recently, but the flow of individual investor money so far this year has been decidedly toward bonds.

Much of the professional money currently driving the market invests with a different perspective than does the typical individual investor. While some individuals are short-term traders, most buy stocks with the intention of holding them for at least a year and possibly far longer.

But institutional money invests to "keep up with the Joneses."

Consider that a money manager who gets paid substantial fees for services needs to outperform the overall market to earn his keep. After all, why pay a money manager all those fees for expertise if you would have been better off simply buying the market index?

This motivation leads to different behavior and a different personality than that of the typical individual investor. To illustrate, a money manager may believe that the market will likely rally for the rest of the summer, and then things could get ugly. An individual facing that scenario would likely say 'no thanks' and stay out of the market.

But with a mandate to outperform the market, a money manager must be invested in the crucial last two weeks of the summer where he could pick up another few percentage points in gains. A move like this simply can't be missed if you need to outdo the market.

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But the motivation can reverse quickly, along with the perception of near-term market direction.

If a mutual fund manager believes that the direction of the market will be downward after Labor Day, he or she will be motivated to get out of stocks bigger and faster than the competition does and outperform the market on the downside. This mentality could snowball and send the market plunging fast.

While predicting the short-term gyrations of the market is always difficult, it is worth noting that there is substantial downside risk. Beware of the flip side of irrationality.

About the Author: Tom Hutchinson

Tom Hutchinson is a member of the Moneynews Financial Brain Trust.Click Here to read more of his articles. He is also the editor of The High Income Factor. Discover more by Clicking Here Now.

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Monday, 20 August 2012 12:25 PM
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