Overdue Analysis

Several things disturb me about the recent run up in stock prices.
1) The rally is concentrated in large cap and tech stocks. Small companies are lagging behind.

[First, an aside.... Stock prices are determined by what people will pay for them. Money must flow into (or out of stocks) for the price to change. These money flows are determined solely by fear and greed.]

The majority of investors today have been taught to pursue a buy and hold strategy. Overall, though discipline or ignorance these people refused to sell during the panic and thus set a floor under stock prices in March. Everyone who was inclined to panic, did.

These days the market is being driven by greed. Some people are worried they will miss out on the market rally. I consider these people unsophisticated speculators. For reasons I will lay out below, I believe the out-performance of large cap and tech stocks signifies a broad based lack of trust in the stock market. Buy and hold investors are not, by and large, buying.

In my unscientific analysis over the past two years, tech stocks seems to have exhibited more volatility than the overall market. They gained more on up days and lost more on down days. Therefore, day traders tend speculate in tech stocks because they are interested in making a quick, short term profit. The out-performance of tech stocks over every other market sector is worrying to me because I believe this sector is filled with speculators, looking for a quick buck. These money flows can reverse quickly and are not sustainable.

Unsophisticated speculators, tend to invest in companies that are readily recognizable. These tend to be large cap stocks like Google and Apple. The out-performance in large cap stocks worries me because it signifies that these stocks are being bid up due to the greed of unsophisticated investors. If greed was causing money to flow into lessor known stocks, it would signify a more broadly based participation in the form of disciplined buy and hold investors.

2) Finance stocks in the S&P 500 have not confirmed the rally over the last two weeks. They have been essentially flat since early May, and have stalled over the past week. The economy can not return to health until the banks do, and the banks are still in deep trouble, due to a combination of massive hidden losses on their balance sheets and sharply increasing defaults in their consumer loan portfolio due to rising unemployment. Perhaps even more worrying, the Regional Banks' stock prices have been falling since early May and are starting to approach their March lows.

3) The S&P 500 is approaching the psychologically important level of 1000 and is likely to encounter significant overhead resistance at this point. Around big fat numbers like 1000, people tend to start to worry they will overpay. Think of it like a candy bar. At 99 cents a candy bar seems like a good deal. At $1.10 you instantly feel ripped off. Even though 10 cents may be insignificant to you, you probably will chaff at the store owner for charging more than what you believe to be the fair price. There will be a moment of indecision where you wonder if you should wait till you come across another store, just to teach the store owner a lesson... or more accurately just to assert that you are not a rube.

While this is an extremely unfit analogy, (comparing a consumable to an investment) the principle nevertheless holds true. People will think the S&P 500 dear at 1001 points, realizing they could have gotten it cheaper in the weeks before. They will wait for a cheaper time to purchase it. In the most benign scenario they will wait to invest, stalling stock prices. In the most adverse scenario, the economy will continue to worsen during this period of indecision causing people to lose their nerve.

It is important finally to keep in that the exuberance of the stock market in the past week has been due to earnings being less bad than expected. They are still terrible. And as a final disclaimer, I follow the American Stock market only as an economic indicator. Under no circumstances would I put my money in there. See the post from December 6th 2008, titled "After the Gold Rush..." for details on my investments.