Retail investors dive into stocks as pros exit

The greater fool theory on Wall Street is well known. After all, "buy low and sell high" implicitly requires that the dumb money buys from the smart money at the top.  

For many regular Americans tasked with managing their portfolios, amid day jobs and family demands, the primary concern isn't maximizing returns so much as not being that greater fool. You don't want to be the guy that bought Pets.com at the top or plunged into Miami condos in 2006.

Unfortunately, there are signs that the greater fool theory is at work again right now.

With the memory of the tech and housing bubbles fresh, and with an aging baby boomer cohort looking to reduce their risk exposures as they near retirement age, the last seven years have seen retail investors pour money into bond mutual funds whilst steadily pulling cash out of stocks. The activity was most intense between 2009 and 2012 according to data from the Investment Company Institute, with a total of $1.1 trillion flowing into bond funds as $327 billion was pulled out of equity funds.

But amid the great stock market melt up of 2013, the dynamic reversed. For the first time since 2006, as interest rates drifted higher and bond prices fell, Main Street pulled out of bonds and moved into stocks with $75 billion coming out of bonds and nearly $160 billion going into stocks.

Here's the kicker: As retail piles in, a growing share of Wall Street professionals are getting out, raising cash, and are generally nervous about what 2014 will bring.

You can see this in the way a number of prominent value oriented investors have greatly increased the share of cash holdings as valuations rise and earnings growth stagnates, resulting in fewer and fewer attractive opportunities for new purchases.

According to Jason Goepfert of SentimenTrader, the level of stock market exposure in five mutual funds that have tended to beat the market, have a long track record, and aren't afraid to raise cash levels is sitting at lows that far exceed what was seen in 1999 and 2007. (Funds include the Yacktman Fund, Weitz Value Fund, Pinnacle Value Fund, Fairholme Fund, and Tweedy Browne Value Fund.) 

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Well known money managers are also sounding a cautious note. Warren Buffett recently said that stocks are "more or less fairly priced now" and that he's "having a hard time finding things to buy." George Soros is sounding the alarm over the troubles brewing in China, as the country battles to cut runaway credit growth while also reorienting their economy away from an export and fixed-asset investment dependence.

And in the short-term, the options market suggests small time traders are far too excited. Small trader options market activity -- the ratio of call purchases to put purchases -- suggests a level of bullishness not seen since early 2011.

Then, as now, the market was coming off of a long, low volatility uptrend fueled by cheap money from the Federal Reserve. What followed were months of choppiness before the United States was hit with a credit rating downgrade and a harrowing stock market plunge.

For now, I continue to recommend my clients maintain a cautious stance, with a focus on the weakness in emerging market economies. Highlights include leveraged short ETF plays such as the UltraShort China (FXP), which is in my Edge Letter Sample Portfolio and is up more than 13 percent so far this month as Chinese shares come under pressure.

Disclosure: Anthony has recommended FXP to his clients.

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.