Why Small Investors Lack An Appetite For Equities

The year 2017 has been one of the most benign years for equity investors in memory. With hardly a setback in the benchmark S&P 500 Index (SPX), large-cap stocks in particular have posted an admirable, if unexciting, performance. With so many stocks having made new all-time highs this summer, why then is there so little enthusiasm evident among individual investors? Sentiment polls for this group consistently show a decided lack of interest in active investing, and whatever participation is seen among this group has largely been passive (via ETFs). How can we reconcile the recent record highs in the SPX with the lackadaisical attitude of the retail investing crowd?

The best way I know of describing the lack of enthusiasm for equities – and the lack of active trading – is summarized in the following graph. This chart shows the performance of the Russell 2000 Small Cap Index (RUT) over the past year. As you can see, the Russell has been essentially flat during the last 12 months and has made no discernible progress. On a relative basis, it has under-performed the SPX and has been relegated to the proverbial dog house by money managers.

Why is the Russell 2000 so important to our discussion? Most small-time participants tend to lean toward small-cap stocks, and when the small caps as a group aren’t performing well, it naturally breeds indifference bordering on frustration among the average investor. As anyone in the financial advisory business can attest, nothing blunts the public’s interest in the stock market quite like an extended sideways trend. What’s more, trading ranges characterized by low volatility are the worst kind of sideways trends. One look at the Russell’s performance since last year and it’s easy to comprehend why the announcement of new highs in the major large-cap indices has been greeted by apathy among the public.

The problem with mainstream investor apathy is that a vigorous and voluble bull market requires heavy, active participation by the crowd. When the crowd isn’t heavily involved with the stock market via active trading and investing, the market tends to languish in those long, dull trading ranges we’ve all become accustomed to in recent years. A sideways trend in the major averages results in a temporary loss of forward momentum, and this can be quite dangerous if the market isn’t in the control of strong-handed institutional investors. Fortunately, the informed investors who have largely controlled this bull market have retained control of their stakes and have been unwilling to unload them on the public. In fact, it would be a very tall order for them to do so since the public has so little interest in buying individual stocks directly.

Bull markets of this magnitude end when the public enters a frenzied state and exhibit an insatiable desire to own stocks. The “smart money” investors who made the long-term bull market possible are all too happy to oblige the public by dumping their shares into its hands. Elevated and sustained levels of bullish sentiment among individual investors are an indicator which strongly suggests that the distribution phase of a bull market (which always precedes a bear market) is underway. We’ve yet to see signs that a major distribution phase is underway.

The biggest requirement for distribution is of course the average investor’s willingness to buy stocks. As the recent latest AAII investor sentiment polls show, however, the individual investor is still somewhat cold in his reception of the bull market. For the latest week, AAII bullish sentiment was a paltry 34 percent. Historically, a bullish percentage well above 50 – and on a sustained basis – is the requisite sign that the bull has reached its final exhaustion stage.

When equities get stuck in a sideways trend for several months, investor psychology goes through four basic stages of change: 1.) Initially they feel expectant that stock prices will quickly breakout of the newly formed range. 2.) When this fails to materialize, sentiment turns sour as stocks drop to the lower boundary of the range. 3.) As stocks continue bouncing from the top to the bottom of the range, investors begin to lose interest and eventually quit participating altogether with many selling their stock holdings. This is what forms the basis of a bullish accumulation pattern since “smart money” professional investors eagerly snap up the disgorged supply from disgruntled retail investors. 4.) Finally, as the range is nearing its final resolution, small investors who may, or may not, be invested are thoroughly frustrated at the lack of directional movement. This is where we are with respect to the movement of the Russell 2000 in recent months.

Since the smart money pros can’t unload their holdings among themselves, they need the public before concluding their long-term bull market campaign. Hence the reason for expecting that the frustrating trading range in small-cap stocks will eventually resolve in favor of the bulls. When small investors finally become convinced that stocks are emerging from the sideways trend, they’ll almost certainly be lured by the temptation to put more of their money to work where it gets the best treatment. And for the last few years that has been the U.S. equity market.

In the immediate-term (1-3 week), the stock market remains unsettled as evidenced by the preponderance of NYSE stocks making new 52-week lows. On Aug. 12, for instance, there were 158 stocks on the new 52-week lows list while only 17 made new highs. Obviously the hi-lo polarity must return to a positive number before the next immediate-term bottom is confirmed. As long as this negative polarity persists, the market remains vulnerable to selling pressure.

The dominant longer-term trend remains positive, however. In the final analysis, the weight of evidence still favors the stock market’s primary trend remaining up as long as it’s supported by the technical, fundamental, and investor sentiment indicators. It would therefore be premature to jump to a negative conclusion on the bull’s long-term health.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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