Are Average Investors Getting Too Optimistic About Stocks?

Wall Street's first test of the new year and decade could well be whether investors are following each other over a cliff.

Traders at the New York Stock Exchange.
Photo: Oliver Quillia for

Following a year that featured a violent stock rally led mainly by institutional investors and traders, 2010 begins with new signs that retail investors are beginning to buy into a better future for stocks.

While on the surface positive trends might be seen as a good thing for markets, sharp spikes in investor sentiment are often seen as contrarian indicators that the rally has begun to lose steam and the market is headed in the other direction.

"That's why we've been bullish for a while—we haven't seen a lot of optimism on this rally," said Ryan Detrick, analyst at Schaeffer's Investment Research in Cincinnati. "Longer term we think this market is going higher, but in the short term we wouldn't be surprised if we see a bit of a pullback."

Two contrarian indicators screamed out at the end of December: A sharp increase in the amount of money directed toward stock funds, and a big jump in bullish sentiment in one of the leading investors polls. Strategists believe that strong bullish sentiment indicates a rally is beginning to run its course and stocks are approaching overbought levels.

Inflows to stock funds soared in the week ending Dec. 22 to $3.1 billion, from $226 million the previous week. Just two weeks before that, equity funds had seen outflows of $2.3 billion, according to data from the Investment Company Institute.

The biggest gains came to foreign equity funds, which saw net inflow of $2.3 billion.

Bond fund flows slipped, dropping to $8.1 billion from $9.8 billion the previous week.

"Seeing a big move into equity funds and much less into bonds does raise some red flags in the very near term," Detrick said.

The rise in equity fund flows comes as investor sentiment surveys show a much more positive mood about the state of the market.

According to the latest numbers, 49.2 percent of investors consider themselves bullish on the markets, a rise of 11.5 points from the previous week, according to the American Association of Individual Investors. Bearish sentiment comes in at 23 percent, down 14.7 points, while 28 percent of investors consider themselves neutral on the market, up 3.2 points. The AAII numbers are for the week ending Dec. 30.

"Investor sentiment is a little ahead of itself," said Michael Bapis, managing director at HighTower Advisors in New York. "It's interesting how quickly we forget a year and a half ago."

Bapis thinks investors should be cautious in an environment where optimism seems to be getting a little frothy and stick to strong dividend-paying stocks in the energy and pharmaceutical spaces.

"People don't want to do anything to rock the boat," he said. "That may be why you're seeing an inflow of capital into equity funds into January. There was such a shift because people are now going to start managing their portfolios again."

The result of that process could well be rebalancing that gets more retail investors off the sidelines and back into the markets.

The larger question, then, is whether the market, which jumped out of the 2010 gate Monday and posted gains in excess of 1 percent, will stay true to the "January effect" where the first month dictates the rest of the year's pace.

In 2009, the opposite was the case after the S&P 500 in January lost 8.6 percent but finished up more than 23 percent. After such a harrowing year, some investment pros would welcome a return to a more normalized trend.

"People tend to rebalance and they were probably underweight equities most of last year. They're getting back to more normal allocations," said William Quinn, chairman of American Beacon Advisors in Fort Worth, Texas. "Looking at some of the long-term trends, there's been a 10- and 20-year secular rally in bonds, and stocks for the last decade have seen zero returns. Contrarians would (also) say this has got to be a time when equities should do better than bonds."

Quinn said he's not doing anything out of the ordinary in terms of making adjustments outside of increasing some allocation toward emerging markets.

In the meantime, investors are preparing to turn their gaze to several key signposts ahead.

Predictions '10 - See Complete Coverage

The latest monthly unemployment numbers are due out Friday, and some economists expect that the economy may have returned to job-creation mode after a brutal run-up in claims over the past two years.

At the same time, earnings season kicks off officially on Jan. 11 when Dow component Alcoa continues its traditional role as the first major company to report.

For the moment, investors remain positive, at least gauged by their most recent behavior, that the market remains relatively undervalued and poised for growth through the year.

"There are still a lot of questions out there," Quinn said. "I think the (economic recovery) is going to be somewhat more muted than historically (is the case), but it probably starts to move in the right direction."