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Average Investors Return to Stocks, But Will It Matter?

Tuesday, 4 Jan 2011 | 11:46 AM ET

With bullish projections abounding and money starting to flow out of bonds and into US equity funds, retail investors finally might start finding their way back into the stock market.

Mom-and-pop investors have been only marginal players in the market rally of the past 21 months. High-frequency traders and large financial institutions have come to control most trading, with retail players likely only one-quarter or so of actual market volume.

So with indications now that the so-called "average" investor is ready to come in from the cold, the question is whether it will even make a difference in the market's direction.

"Inflows are starting to come, with the retail crowd slowly starting to dip their toes back in," says Ryan Detrick, senior analyst at Schaeffer's Investment Research in Cincinnati. "We just got over 33 straight weeks of domestic mutual fund outflows. It's a step in the right direction, but there's still a ways to go."

US equity funds did in fact snap their eight-month losing streak last week, posting a meager $335 million inflowthat nonetheless provided some indication the tide was turning.

Measuring how much an impact retail fund flows back into the market could have is difficult, but some basic figures suggest it's less than overwhelming.

US equity funds redeemed $39 billion in 2010 while some $271 billion went into bond and exchange-traded funds, according to TrimTabs. Measured against a stock market with a $14.6 trillion market capitalization, those numbers don't seem to add up to much, even if retail investors run full-bore from bonds.

But while the dollar amount might seem insignificant, the psychological impact could be greater. Investors already are showing an overwhelmingly bullish mood in polls, but have been much slower to turn that sentiment into action.

Should the inflows continue, that could provide another signal to buy for larger players.

"It gets hard to measure," says Kathy Boyle, president of Chapin Hill Advisors in New York. "Billions, trillions, market cap—does $270 billion really move the market? It's both a chicken-or-the-egg thing and a domino effect."

Nonetheless, individual investors are showing increasing willingness to take a shot at the market.

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"We're struggling to explain to the average investor that there's still a lot of risk in this market. They just don't see it," Boyle says. "They say, 'I'm worried about the country, but my 401(k) keeps going up.' There's this disconnect going on."

Indeed, 2011 could be the year when fund managers try to make up for last time, regardless of the various risk factors in the marketplace and the economy.

The previous year was a disaster for the industry—the worst ever, in fact—with just one in five fund managers beating their benchmarks, according to Bank of America Merrill Lynch Global Research. Strong correlation of movements between various asset classes and the outperformance of small-caps and high beta, or risky stocks, made it difficult for managers to hedge and diversify, despite the fairly robust gains of the market overall.

"We believe that stock pickers could make a comeback in 2011," Savita Subramanian, BofAML quantitative strategist, said in a research note for clients. "Clustered performance has begun to abate as clarity has improved on the macro front, and performance spreads appear to be bottoming, suggesting a better environment for stock pickers."

Whether that makes life easier for individual investors is unclear.

High-frequency traders aren't going anywhere, and market distortions from Federal Reserve liquidity programs are likely to remain as well while the central bank continues with its quantitative easing policy.

"If the money to boost the US stock market capitalization by almost $9 trillion from the March 2009 lows did not come from the traditional players, it had to come from somewhere. We believe that place is the Fed," TrimTabs analysts said in a research note. "By funneling trillions of dollars in cash to the primary (bond) dealers in exchange for debt, the Fed has given Wall Street lots of firepower to ramp up the prices of risk assets, including equities."

Whether that is sustainable and leads to an influx of money from retail investors remains to be seen. TrimTabs predicts the market bubble will burst once the Fed turns off the money spigot.

With the events of the past two years still fairly fresh in investors' minds, that could once again chase retail players from the market, though such an event does not appear imminent.

"You have a perfect storm, with the high-frequency desks continuing, the pension funds throwing money in, the new 401(k) allocations coming in. So you do have free cash flow," Boyle says. "That's part of it. But I feel it's a fool's game at this point."

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