'Buyers Strike' May Not Stop Market From More Gains

The second half of 2010 has proven something about Wall Street: Stocks not only don't need good news to rally, they don't need many real investors, either.

A trader at the New York Stock Exchange.
Photo: Oliver Quillia for CNBC.com
A trader at the New York Stock Exchange.

For the first time in at least 25 years, the market has staged a three-month rally of more than 10 percent without having a single week where equity mutual funds saw net inflows, according to data from the Investment Company Institute and LPL Financial.

The resilience of the stock marketin the face of weak economic trends and so much cash continuing to funnel into bonds has many market pros baffled. The Standard & Poor's 500 has gained nearly 14 percent in the second half despite having a rough day Tuesday.

"Perhaps it stems from a lack of confidence in the US stock market itself," Jeff Kleintop, LPL's chief market strategist, said in a research note. "While individuals may have overcome, to some degree, their distrust of the durability of the economy recovery and policymakers in Washington, they remain distrustful of the integrity of the US stock market."

Kleintop suggested that investor leeriness accelerated after the May 6 "Flash Crash," in which the Dow industrials plunged nearly 1,000 points at one juncture before paring losses. Regulators have blamed the crash on one firm's effortto hedge positions by flooding the market with plays that bet against the S&P 500, but those conclusions have been treated with skepticism in some quarters.

While he said investors shouldn't allow themselves to be dissuaded by a somewhat anomalous event, Kleintop said the trend is worrisome.

"[I]t would be unfortunate if this record-breaking buyers strike by individual investors is a precursor to a permanent boycott by individuals from investing in US stocks," he said. "Without the return of the individual investor to the US stock market, further gains in the rally may be hard to come by."

Others suggest that investors' aversion to stocks may not prevent a further rally.

"The individual investor has become a kind of minor, bit player in the drama of a stock market dominated by hedge funds, institutional money and the big investment banks all managed now as if they were hedge funds," said Walter Zimmerman, chief strategist at United-ICAP in New York.

Indeed, some $53 billion has left equities since the Flash Crash, with some finding its way back into zero-yielding money markets but most going to bond funds.

In the past quarter, equity fund outflows, excluding exchange-traded funds, saw net outflows of $27.3 billion, while taxable bond inflows have totaled $68 billion, according to Lipper data.

So why has the market risen?

There are a variety of factors, most of which revolve in some way, shape or form around the Federal Reserve. The latest market rally began in earnest shortly after the Fed's September meeting, after which the central bank released a statement largely interpreted as a backstopping of the US capital markets through aggressive measures.

Specifically, the Fed is expected to embark on a Treasury-buying program that should hit $500 billion or more.

At the same time, it continues to engage in its Permanent Open Market Operationsprogram in which the Fed periodically buys Treasurys to stimulate liquidity. Though the program itself is five years old, the Fed began using POMO to buy longer-dated Treasurys shortly after the March 2009 stock market lows. In August 2010, the Fed stepped up the program even more to include using payments from agency debt and agency mortgage-backed securities to buy longer-term Treasurys.

The Fed purchases the Treasurys usually from institutions that then are expected to leverage the money up by buying risk assets. That in turn generates market momentum, which is the mother's milk of the computerized high-frequency trading that has taken over more than half of all stock market activity.

"[T]he market has gone from fretting over how soon the Fed would begin to withdraw the extraordinary support they provided in the aftermath of the financial crisis, to looking forward to even more stimulus in the coming months," Kleintop said.

The main question now is how long a rally can continue with so many investors refusing to put money into the equity markets, especially without any improvement in housing or jobs to generate confidence.

"There are many things going on that give the individual investor zero confidence," Zimmerman said. "These things have a big impact. They see this huge disconnect between the stock market going higher and nothing else getting better."

Yet Zimmerman, despite how generally bearish he is on stocks, thinks the current rally can continue.

With the market heavily dependent on technical factors, he sees 1,190 as a critical point for the S&P 500. If the market can take out that level, the next resistance point would be 1,230, and if it breaks past there 1,350 to 1,380 could be in sight.

That's with our without participation from retail investors.

"While it's been a nice rally so far, in terms of absolute price technically it's not yet a breakout to the upside," Zimmerman said. "Viewed technically, it's missing the essential ingredients for a sustainable move. But that doesn't mean it can't sustain itself a little bit longer."