Small Investors Get It Wrong (Again)

There is a widely held belief, which is backed by significant research, that small investors are usually wrong, meaning they buy when they should sell and sell when they should buy. This usually occurs because, at times when stocks are usually the most attractively priced, conditions are very scary: the economy is weak, corporate earnings are down, there is a lot of uncertainty, etc.

At times like these, small investors are not comfortable taking risk, so they typically sell. When times are good — corporate profits are strong, the economy is doing well, there is less uncertainty, etc. — small investors feel good about things, so they buy. Unfortunately when times are good, stock prices are usually high — not the ideal time to buy. In short, small investors consistently get it wrong, when it comes to investing in stocks (and pretty much in anything else, too).

The fact that small investors typically make bad investment decisions supports the need for professional money managers who are experienced, disciplined, rigorous and skilled at making appropriate investment decisions — taking their personal emotions out of the equation, and taking advantage of opportunities to buy and sell at the right time. While these professionals are not always right, in general, they are right a lot more often than small investors.

Small investors caused considerable damage to their portfolios during the stock market crash and subsequent recession, which started in 2008. Panic selling near market lows by small investors “managing” their own assets, particularly in retirement accounts such as IRAs and 401(k)s, took these investors out of the market at or near multiyear lows. The vast majority of these investors failed to get back into stock investments before the stock market rebounded significantly, placing these investors in a difficult position: do they bite the bullet and buy back in at substantially higher prices, or do they wait and hope for the market to correct back down close to where they sold? For many, buying back in at the higher prices so soon after they had sold was too painful, resulting in a wait-and-see stance.

For many who sold in the 2008-2009 time period, the wait was very long. A check of 401(k) cash balances showed massive cash accumulation all the way through to the end of 2012. The “fiscal cliff” debate, which began to gain steam in the collective consciousness of investors around the end of summer, caused uncertainty to build in the minds of small investors. As a result, stocks performed poorly from the end of summer through the end of the year. In fact, the Standard & Poor’s 500lost about 1 percent over the course of the fourth quarter. Although the S&P 500 gained 13.4 percent during 2012, the vast majority of those gains came in the first quarter, during which time the index gained 12 percent. For the remainder of the year, or over the following nine months, the S&P 500 gained only an additional 1.4 percent.

Once the government made a decision on the fiscal cliff, (even though it was really just a Band-Aid “solution”), investors were relieved, feeling that a lot of the uncertainty had been removed. They reacted to this reduction of uncertainty by throwing cash into stocks. In fact, during last week alone we saw $18 billion flow into stock mutual funds and ETFs, according to Bank of America. By comparison, the biggest week in 2012 was $11.4 billion and the net for the entire year was just $3 billion. The S&P 500, since the end of 2012, has gained 3.2 percent as a result, driving the index to a five-year high.

Unfortunately for these small investors, their enthusiasm is likely misplaced, and it is highly likely that they are once again playing the role of the typical small investor, that is, buying when they should be selling.

Last week was the start of earnings season for the fourth quarter of 2012. Over the coming several weeks we will see earnings for the majority of companies. Given the challenges to consumer spending during the fourth quarter, largely as a result of the uncertainties surrounding the fiscal cliff, it is likely that corporate profits are going to disappoint. With stocks at five-year highs, they have a lot of room to fall. We also have the pending (real) debate for the fiscal cliff as well as the debt ceiling. The combination of these two major issues will certainly result in a contentious battle in Congress. There is no guarantee that they will find a solution before the spending cuts from the fiscal cliff, which are set to go into effect at the beginning of March (unless Congress agrees to postpone or eliminate them), and before we run out of money (we actually hit the debt ceiling at the end of December and are operating the government on gimmicks to avoid a shutdown of operations, but there is a limit to how long these gimmicks will work).

Economic growth is slow even without any spending cuts taking effect. Economists expect only 2 percent GDP growth in 2013. This is probably optimistic. Once Congress addresses the fiscal cliff, it is highly probable that we will have at least some spending cuts, which will certainly reduce economic growth. We also have a very serious flu blanketing the country, which some experts believe could reduce GDP from the current 2 percent estimate to only 0.5 percent (without including any negative impact from spending cuts due to the fiscal cliff). One noted economist,Gary Shilling, a longtime Forbes columnist, and the author of The Age of Deleveraging, is looking for the S&P 500 to drop 42 percent this year. He provides a simple calculation to justify this decline: he assumes that S&P 500 earnings will be $80 and that with slower growth, the price-to-earnings ratio (P/E) should therefore only be 10X. His target for the S&P 500 therefore would be 800 (10X$80). From current levels, a fall to 800 would represent a 42 percent drop.

A lot can happen over the coming few weeks. Corporate profits could surprise to the upside and Congress and President Barack Obama could quickly agree to a plan for addressing the fiscal cliff and debt ceiling that achieves our dual goals of reducing the budget deficit and national debt while preserving economic growth. It is more likely, however, that we will not have a perfect storm of good outcomes. If this is the case, stocks are at risk of a substantial decline, and, once again, the small investor will be proven wrong.

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