When Will This Rally End?

It’s the question on every investors’ mind…when will this rally end?

There’s no easy answer here. There is a way to tell though. But you probably won’t find it in the mainstream media.

The Times in the U.K. proclaims:

“Optimism Races Through Markets After Show of Harmony at G20 Summit.”

Forbes ponders whether:

We can catch a glimpse of an economic “Light at the End of the Tunnel…”

The New York Times prominently warns:

“U.S. Bank Rally Looks Fragile” and goes on to add, “Operating earnings are going to have a hard time outrunning credit losses, making the massive rally in bank shares look ready to be marked down.”

Any help?

Didn’t think so. There is actually a much better way to get a sense of when this rally will end. Here’s how.

Buying High

The herd mentality of the markets never changes. When some sector heats up, the herd buys big.

When oil is at $100, everyone is talking about and buying oil. No one wants it at $40 a barrel, but they can’t get enough at $100. Even though the upside potential and downside risks are completely in your favor at $40 and against you at $100.

Also, when corn and wheat prices started to make the headlines, everyone wanted in. ETF’s were created to make it easier to buy into agriculture commodities (remember, ETF sponsors make money by providing products investors want rather than those that will necessarily be good investments at the time). Fertilizer stocks were heating up. The eventual impact of “Peak Soil” was being priced into agriculture immediately.

Again, when I first wrote about the best way to make money in ethanol back in 2006, only a few people cared. When Jim Cramer was touting fertilizer stocks and the Wall Street Journal had feature stories on a global land grab for farms, everyone cared.

The herd mentality never changes. They love to buy high and sell low. It’s almost like they want to be more entertained than to make money. But to each his own.

For my investment dollars though, I’d much rather look to see what “the herd” is up to when it comes to this rally. Of course, there is no perfect indicator of the herd. There’s no way to tell exactly when the last buyer buys. If there was, we’d all be retired and never have to work again. That’s just not the case though. So to follow the herd, I like to keep a close eye on what they’ve been doing with their money.

Given the strength on consistency of this rally so far, what the majority of investors are doing with their money may surprise you.

Waiting Patiently

Last September, when most investors got a crash course in investment terminology including “forced selling” and “margin call”, we were keeping a close eye on where investment dollars are flowing.

When you see new money flowing into equity funds, bond funds, or sticking on the sidelines in money market funds, you can get a good idea of how much money is left to flow into different financial markets. You can see how long it will take to get there and how much money is left to flow in.

An average investor with cash in a money market fund is like a teenager with a car full of gas. They want to get somewhere quickly, they’re not sure how to get there or where they’re going, but they’re not going to wait around.

Our research for September’s, What to do During a “Market Adjustment”, uncovered:

As a whole, mutual fund investors put money in and pull it back out at the worst possible time. The tech bubble is the perfect example. In 1999 and 2000, money flowed into technology-focused mutual funds. At the peak of the tech bubble in March of 2000, about 80% of all money in mutual funds was in the technology funds. All of that new money pushed the NASDAQ to a peak of more than 5,000.

When the downturn came, which it always does, the leading technology mutual funds lost 60% to 80% of their value as the NASDAQ plummeted back to 1,000. And most mutual fund investors weren’t selling out along the way.

Mutual fund investors waited and waited for a rebound to come. In typical fashion, most were unwilling to give up hope and take a loss at first. However, after the NASDAQ slid lower and lower each day over the next two years, they began to sell out.

As usual, they were selling at the worst possible time. In 2002 and 2003 when the major market indices were bottoming, mutual fund outflows were at their peaks.

Now, we’re seeing this cycle happen all over again – only in real time.

Selling Low

As you can see in the chart below, retail investors just haven’t gotten their risk appetites back…yet. The chart shows net outflows stock starting last June and continuing through February. Meanwhile, mutual fund investors sought the safety and reliability of quality bond funds in January and February:

This means most investors haven’t jumped back into stocks yet this year. Very few mutual fund investors are believers in this rally so far.

The trend continued into March. According to TrimTabs, a firm which monitors mutual fund inflows and outflows, mutual fund investors pulled out more than $45 billion out of stock mutual funds in March. Meanwhile, they pumped $12 billion into bond mutual funds in March.

Despite the 20%+ upturn in March, investors still primarily stuck to the sidelines. Stefane Marion, chief economist and strategist at National Bank Financial Group, points out:

“Stock funds now account for only 34% of the total assets of mutual funds, the lowest proportion since 1992. As shown, money market funds (which yield nothing currently) account for about 43% of total net assets, the highest share since 1991.”

Basically, that means there is still a lot of money left on the sidelines. And that means this rally could climb much higher in the weeks ahead.

The Panic Stage of a Rally

In the end, stock prices move due to supply and demand. Stocks go up when there are more buyers than sellers. Stocks go down when there are more sellers than buyers. When you consider the massive amount of money still left on the sidelines (on a percentage basis, the most is sitting in money market funds since 1991!), there is plenty of more cash out there which could easily come back to the market.

For now, we still haven’t seen anything close to “panic buying”. Panic buying is the inverse of panic selling. Panicked sellers dump stocks at any price because they think they’re all going much lower. Panic buying, on the other hand, is when investors rush back in because they’re afraid they’ll miss the rest of the rally (the dot-com bubble is the perfect example of this). If that starts, watch out. Dow 10,000 or 11,000 – followed by a sharp downturn – will shortly follow.

For now, the best thing to do is stick to your plan. Stick to shares in high quality companies where the upside potential far outweighs the downside risks when it comes to buying stocks. And don’t hesitate to eliminate a position that goes against you.

That strategy performs well in any market. At the Prosperity Dispatch, we’ve found that if you are able to stick to it and avoid all the mistakes of the “buy high/sell low” herd, you’ll be a much more successful investor.

By Andrew Mickey

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