The state of the Individual Investor

Smaller investors have come across as so confident that even at times they appear arrogant.  This is of course off putting to anyone who specializes in risk controlled strategies because when smaller investors are overly confident that means they don’t care about risk control at all.

Recently, however, I have come to question observations I have made about smaller investors being overconfident and arrogant.  I have my finger on the relative pulse of the smaller investor; I have been writing articles and providing risk controlled trading strategies to smaller investors for over 20 years, and I keep a close eye on the general sentiment of this group.

Thankfully, many of my clients are also fund managers, and that helps me understand both sides of the sentiment spectrum, but at times it does appear as if the lines cross.  When looking specifically at individual investors, I have found them to be overly confident at first glance, but when we add in other variables I recognize that my assessment could be wrong.

One of my hedge fund clients brought up a point that helps clarify this issue.  He said that the recent AAII report on investor sentiment was actually down 5.4% to 32.4% bullish.  If smaller investors are as arrogant as I thought they were, I had to ask myself why that report showed that so few in the survey were actually bullish.

That made it clear that another important variable needed to come into play.  It has been evidenced recently through the media that the smaller investor has been investing money into the stock market at a pace that is about 10 times faster than any other time in recent history.  Smaller investors have been pouring money into the market, and although many market professionals consider that to be a red flag, it also plays a role in my reconsideration of my initial observation of smaller investors.

Think about those two variables for a minute.  They are not bullish, but they are investing at a pace that is 10 times faster.  Something seems amiss.

What I once thought was arrogance may actually be something completely different.  Smaller investors may be pouring money into the market even though they perceive tremendous amounts of risk, and so the sentiment that I initially observed might instead of being arrogance actually turned out to be an observation of those smaller investors doing something that they feel they should not be doing.

Smaller investors maybe pouring money into the stock market even though they perceive risk and even though they don’t feel as if it is the best thing to do, they just don’t want to miss another rally like many seemed to have missed in 2013.  The smaller investor may be buying stocks aggressively even though they perceive risks to be extremely high and that makes them appear to me as if they are arrogant, but they may not be arrogant at all.

I will be specific with two Dow stocks that have recently reported earnings.  Both General Electric and Honeywell are important Dow components, and each trade with PE multiples at very high levels.

However, the EPS growth rate for these companies does not warrant the PE multiple levied on the stocks. 

Of course, with every fundamental observation must come a technical observation, and that is where smaller investors took issue with my work.  When I pointed out where longer term resistance levels were and told them that these stocks could fall hard when resistance levels were tested given the associated valuation risks defined by the EPS growth charts, they seemed to all be saying ‘there’s no way that can happen’ in unison.

Their response was that I was a fool to believe that these companies would ever fall in price because management was so good and management expected positive results in the future.

Anyone who was in this market for the past 20 years has heard that before, and initially that appears to be an arrogant point of view, but it could instead be a sign that smaller investors have simply thrown in the towel and they’re buying and convincing themselves that stocks will go up forever even though they perceive a tremendous amount of risk.

Either way, these are red flags.  Whenever smaller investors become this active it is a concern, but they may not be bullish, instead they may just be buyers.

Author: Thomas H. Kee is a Stock Trading Analyst and editor of Stock Traders Daily.