Why Contrarians are Itching to Buy Stocks – But Should Not

The last twelve months have been one of the toughest times to be an investor I’ve ever seen.

It wasn’t long ago we waded through the panic stricken days when a currency crisis enveloped the Asian Tigers. Then Russia’s debt default spooked global markets again. Then the tech bubble burst.

You could put all of those “crises” together and they still wouldn’t compare to what the markets have gone through in just the past few months. The Dow is off 36% in the past year. Broader indices like the S&P 500 and the Nasdaq are off 44% and 46% respectively.

Even Warren Buffett, who lives the contrarian credo of “be fearful when others are greedy and be greedy when others are fearful,” has taken a few swings in misses in this market. Despite how unwarranted, Berkshire Hathaway (NYSE:BRK-A) have been down as much as 40% for the year.

Yet, there still hasn’t been a true panic. The long sell-off has been relatively controlled considering the extensive drop. As a result, many investors are hoping to catch the bottom.

Stocks are cheaper than they were a week, month, or a year ago. And the opportunity to buy a stock you liked three months ago now at 75% less, has a lot of investors very interested. But that doesn’t mean we’ve hit bottom yet.

Up to now, we’ve only seen 4 of the 5 Signs of a Market Bottom (we’re still missing the market going up when news isn’t “as bad” as expected).

Also, we’ve still got two more big things to happen before it’s time to aggressively start buying stocks.

First, all the sellers must have to be weeded. Every rally there is plenty of sellers just waiting to sell more shares. There can only be a sustained rally when there’s no one left to sell. Second, most investors have to quit caring and hoping for a bottom. Let me explain.

Running for Cover

As we noted a few months ago, the amount of mutual fund and hedge fund redemptions are soaring. And as the markets continue to slide, they will continue to do so. Most importantly, this would be a good sign.

It would be good because the average investor is not average. In most cases, average investors are downright terrible. They buy at the top and sell at the bottom. Watching a record number of investors scream “get me out now,” would be a good thing. It would go a long way to proving we’ve reached the point of maximum pessimism.

Here’s the thing I see most pundits missing, the selling has to stop first.

We watched the first major wave of redemptions in July. Then they dropped off a bit in August. Then September came around and the markets really started to tank and more than $30 billion was yanked out of equity mutual funds.

The redemptions didn’t stop there. TrimTabs Investment Research found investors pulled out $68 billion in October. The research firm also notes $70 billion has been pulled out of mutual funds in November (the months is not even over!). This all works out to about 3.3% of total assets held in mutual funds.

When you compare this sell-off to the amount of mutual fund redemptions after the tech bubble burst, there could be more redemptions on the way. While the Nasdaq was dropping 80% and the Dow was falling 30%, investors pulled out 4.3% of total assets held in mutual funds.

Clearly, we haven’t seen the end of investors dumping their mutual funds. When we do reach that point, we’ll have to wait for one more thing to happen before aggressively buying into the market: investors giving up.

When Everyone Throws in the Towel

The daily ups and downs of 5%, 6% or more can be absolutely gut-wrenching. The last half hour of the trading day can shake the nerves of even the most experienced traders. Eventually, these huge moves will make most investors throw in the towel. And that’s the key sign to wait for.

After all, bull markets emerge when no one is watching. Right now, the investor community is watching as closely as ever.

According to web traffic data at Quantcast.com, the number of visitors to Bloomberg.com rocketed up 50% last month. About eight million visitors stopped by the Bloomberg web site from June through September. In October, about 12 million different people visited the Bloomberg website. The Wall Street Journal states the number of visitors to its web sites has more than doubled in October.

Investors aren’t just turning to the web for information either. They’re turning to printed financial newspapers as well. The Financial Times says its global subscriber base increased 5% in October. The one-month growth spurt completely offset a 4.5% decline in subscribers over the entire previous year.

Finally, despite every reason not to do it, more and more investors are tuning to CNBC to watch every history-making market day. CNBC reports viewership increased by 26% in October.

The Good News

Clearly, investors haven’t thrown in the towel yet. On the good side of things, all of these mutual fund redemptions have left hundreds of billions of dollars waiting on the sidelines. That money will come back into the markets – eventually.

The bottom will come when everyone quits looking for it. Continue to learn from history. Remember the tech bubble? It took almost two years for the markets to start to turn. Given the size and length of this crisis, it could take even longer than that.

But as long as the average investor is watching a few more hours of CNBC a month, chooses to wake up with the Financial Times on the doorstep, and checks Bloomberg.com and the Wall Street Journal throughout the day, no sustainable rally will emerge.

I realize, many of us are itching to buy stocks right now. They’re beaten down, cheap relative to past prices, and P/E ratios on some very solid companies have dropped to 3 or 4 (those low numbers are based on past earnings though, and will be much different going forward). There are a lot of good deals out there, but they will probably be there for quite some time to come.

There has not been a more critical time to remain prudent, avoid chasing anything, and develop a plan. There are going to be more wild up and down moves in the markets. If you can make the right moves using the right investment strategies, over the next year or two, you’ll have a truly life-altering fortune to show for it.

By Andrew Mickey

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