by Kelly Evans
Individual investors are wading back into the U.S. stock market. That ought to make über-bulls think twice.
Positive forces including strong corporate earnings, improving economic data and more bond buying by the Federal Reserve have fueled a 17% rally in the Standard & Poor's 500-stock index since late August. The market has now punched through its prior 2010 highs, set in April, to reach levels last seen in 2008 before the collapse of Lehman Brothers.
Predictably, that has also triggered a rebound in bullish sentiment and helped coax investors back into the market. The American Association of Individual Investors finds 48% of investors surveyed are bullish on stocks as of last week—the highest level since February 2007. Bearish sentiment, at 27%, is at its lowest since January 2006.
And it appears their money is following suit. Roughly a quarter of recent flows into U.S. equity funds, including exchange-traded funds, have come from individual investors, according to EPFR Global. Since early September, such retail investors have poured about $2 billion into these funds, which have taken in about $8.4 billion. That is a marked turnaround from the $23 billion yanked out of equity funds in August, when double-dip fears raged.
For now, this support could help the market extend its recent run. Yet it may also mean it is late in the rally game. Retail investors are usually a lagging indicator, reacting to past performance rather than predicting future gains. Their flows, says Harvard University lecturer Owen Lamont, can create "a short-term lift" but it rarely lasts beyond a few months. He and Andrea Frazzini of AQR Capital Management have written a series of papers together on this "dumb money" phenomenon.
Admittedly, the flow of money from individual investors back into the market has been more a trickle than a flood—from January 2009 through August, individuals pulled around $162 billion from equity funds.
Even so, a return of retail investors argues for caution. The prior high in sentiment this year came in late spring, just as the market was headed for a bruising selloff. It may not be wise to fight the Fed, but it can be just as ill-advised to follow the crowd.