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Market Bubble? Retail Investor Behavior Is Not Even Close to 'Bubbly'

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Wild, speculative enthusiasm isn't even on the radar.

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Summertime and the livin' is easy...
 
That famous line from the Gershwin opera Porgy & Bess sums up my feelings about our current environment, but also brings to mind some sage advice from Bernard Baruch that I always try to remember: "Become more humble as the market goes your way."

Global stock and bond markets all seem to be acting in a manner that's almost exactly the opposite of what you'd expect if you were paying attention to the media. Every article, talking head, and investor letter has been preaching caution for the past six to 12 or more months. However, the flow of money continues to be toward investing, not saving. It isn't the same as 2006 or 1999, where all you heard was cheerleading and exuberance toward anything and everything rising. Currently, we all recall the burn marks from 2008, which seems to be keeping a lid on the enthusiasm. And to all those who think the Fed policy of almost 0% interest rates over several years hasn't really made a difference, I'd say it might not be pushing blazing inflation in the broader economy, but it certainly has taken away every opportunity for investment dollars other than equities. (This is not necessarily good, but it is reality.)

Investor behavior looks to be mimicking that of general society: "I know what's best for you, so you need to be cautious and do what I say... I'm smart enough to get out of the way when things go awry; I'll just stay over here."

There are no big, flashy warning signs that we saw prior to the last big falls -- probably because there are still so many things wrong economically and politically around the globe to forestall such overconfidence -- but I still have this nagging concern in the back of my head. Although, what's much more concerning to me than the current level of the equity markets is the continued chasing of the bond market as investors desperately reach for yield "safely."

One of my favorite indicators, the flow of mutual funds, shows that after a brief and minimal outflow in 2013 (after massive inflows the previous four years), taxable bond funds have once again collected more net money year-to-date than domestic equities. Unbelievable at these levels...

As with everybody else who works in the financial markets, I don't know when the Fed will once again raise interest rates, but I do know that the next move will be up. The other thing I know for sure is that bond mutual funds, unlike actual bonds, never mature, making them much more dangerous to your financial well-being than most folks appear to realize. And as we all know, the managers running those funds can only buy what is available in the current market; there is no "special window" where professional managers can buy bonds at rates above the market, especially when cash is being shoveled in the door like coal into a furnace.

Worse yet, most of these funds are actually run for "current income" not capital appreciation. (Read your prospectus.)  That means they care about paying as much of an income stream (current yield) as is legitimately possible, which likely involves paying out a sliver of principal to enhance that stream, thereby adding to the downside when interest rates eventually go against them. (See any government bond fund in 1994 to view what downside volatility really looks like in a high-quality -- and long-duration -- fund.)

What does this all mean, or what does it say about what the public is doing? It tells me that the general investor on the retail side is not even close to acting "bubbly" in terms of the equity markets. Looking at the mutual fund flow data going back 15 years, bond funds have never really seen massive outflows, which I believe is likely related to the demographics of American investors -- most investors are aging. However before each great fall, equity funds have shown massive inflows for multiple years. We've barely cracked positive over the past 18 months; wild, speculative enthusiasm isn't even on the radar.

So why is everything grinding onward and upward, making everyone feel as if things are overdone and sliding imminently toward the abyss? My belief is that it is a continuation of the politically driven emotions I dubbed "The Malaise" in one of these notes penned back in August of 2010. Politics and the divisive emotions surrounding politics have continued to grow more volatile, further away from consensus; and with the death of truly "fair and balanced" media outlets (at least any that are widely read or heard), public opinion continues toward the negative on both sides.

We used to only see political mudslinging in the run-up to elections (as much as people hate them, negative ads work), but now our only sound bites are attacks from both sides of the aisle. Neither political party stands "for" anything other than, "We're not them!"

It's as if the entire country has been split into two equally insulated groups that could each possibly be heard to utter the famous quote attributed to Pauline Kael, "I can't believe (insert right wing or left-wing politician's name here) won! I don't know anyone who voted for him!"

All "news" media have become profit centers for their respective owners out of economic necessity, therefore they work very hard to cultivate their audience, and nowadays their audience isn't seemingly interested in hearing, as Paul Harvey would say, "The rest of the story..."

In my work I have a lot of conversations and email exchanges all across the country with people both in and outside of my business. Invariably, if the conversation turns to economics and politics, many times I can tell on which side of the aisle someone sits simply by listening to whom they quote or whose commentary they send to me via email. I understand, everyone is busy, and in my mind it's not truly the fault of the viewer/reader to pick one outlet and stick with it. Rather, it's the fault of the outlet for choosing to be the house organ for one party or the other instead of telling Mark Twain's three-sided story: "Your side, my side, and the truth."

As also discussed in these notes over the past few years, I clearly have biases and blind sides like everyone else, although I do try to be somewhat self-reflective as I'm not selling my writing per se, I'm selling my thought process and brains to my advisory clients. Therefore I tend to be an equal opportunity disparager toward both extremes -- at least that's my intent. And the toxicity of politics across the globe and especially here at home are what concern me more than any economic or monetary piece of the puzzle at this point.

What do I think is to come in the second half of 2014?
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No positions in stocks mentioned.
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