Picture du Jour: Why stock markets haven’t corrected yet

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The comments below were provided by Kevin Lane of Fusion IQ.

Stock price direction is a function of several factors, namely valuation, future expectations, sentiment and liquidity. We believe the last component may be the most important since buying power or lack thereof ultimately determines whether stocks go up or down. Typically liquidity is strongest when expectations are the most dismal and weakest when expectations are most optimistic. Stated another way, at market tops investors tend to have exhausted all their liquidity and go “all out” because their expectations for the future are optimistic. However, by the time investors go “all out”, economically things are about as bullish as they are going to get and valuations typically are stretched. With investors “all out” in the aggregate there is no buying power left to push stocks higher (since everyone is fully invested) and stocks come down.

The polar opposite occurs at market bottoms as investors become so pessimistic about the future they move large amounts of cash to the sidelines. Additionally, at this point valuations have contracted significantly as well and are now attractive. With large sums of cash moved to the sidelines, valuations attractive and selling pressure removed from the markets vis-à-vis investors selling in concert, liquidity, i.e. future buying power, is then put in place to push stocks higher.

The chart below looks at how far above or below the 21-year average allocation of 60% invested in stocks individual investors are at present. As seen above, when stock allocations drop 15% or more below that 22-year mean (red circles), which has occurred only three times in the last 22 years (1990, 2002 and late 2008/early2009), it has equated to significantly higher stock prices three to six months up to several years later.

We are using this chart to show that even with the current rally investors are still 6% below the mean allocation to stocks and significantly below fully invested levels of 10-15% above the mean. What does this mean now? It means sideline liquidity remains strong, investors are still not fully invested and thus dips should remain fairly contained (5-10% corrections), and over time the stock market can still work higher. Anecdotal sentiment also echoes the underinvested theory as most investors expect (no, demand) a correction and refuse to invest as the market melts up. Typically investors talk their positioning and underinvestment breeds statements of caution.

fusion

Source: Kevin Lane, Fusion IQ, September 11, 2009.

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2 comments to Picture du Jour: Why stock markets haven’t corrected yet

  • Paul C Sandison

    The ‘too big to fail’ US banks are about to try to fail again, US exports are down again, Alt-A and Prime mortgage resets are about to hit, US unemployment is now over 16 million and in Europe it is approaching 10%, world trade is down much lower than in 1930 and China is going all out blowing up both a housing and credit bubble.

    The next 9 weeks will be fascinating. I think the irrational exuberance can only continue for another week from now. Thereafter:
    1 Market goes bizarre or spiky up or down from Tuesday 22nd September.
    2 Serious imbalances occur either way on afternoon of Friday 25th September and Monday 28th September. Most likely a correction downwards.
    3 The coup de grace on Friday 23rd October and Monday 26th October. A free fall ensues. The bulls fall off their ledge.
    4 New low on 18th November. Blood on the floor. All bulls are dead. Time to get into the market. Worst case scenario: the down continues into December, but I personally think it very unlikely.

    Enjoy!

  • Ray S.

    The commercial property meltdown is coming like another freight train out of the darkness and will decimate commercial banks. Many home mortgage lenders are forestalling foreclosures to keep the debt off the books, especially in depressed areas like Phoenix, where I live. (One lady we know has been out of her home since January and the lender has not yet foreclosed.) Banking Fiasco II is just around the corner.

    While interest rates are currently low, the policies coming out of D.C. all point toward an increase in taxes for business, especially struggling small business, many of whom are hanging on by their fingernails.

    Add to that the ever-climbing unemployment numbers and I think the future trends could most certainly be downside.

    To stop this spiral downward, a friend is trying to get some stimulus money set aside for a 40-year, 4% home mortgage plan (4-40 For Freedom). It will help keep people in their homes who can qualify. It will also help eliminate the estimated 7-9 year supply of used homes on the market as people turn to real estate for long-term investing. The multiplier effect of this program will put hundreds of billions back into the economy at a time when it is sorely needed. Right now, it is the only stimulus plan that injects cash right into the economy to help the taxpayer.

    Home real estate drives this economy. Until the Congress resolves this issue, the economy is in free fall.

    The amount of wealth that will be lost in higher-end homes alone if nothing is done amounts to billions in the Phoenix market alone. That capital will be lost for business formation and employment opportunities forever.

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