2004 redux?

Here's an interesting article posted by Dennis. It in it's mentions how the retail investor is returning to the market with Janurary showing the largest monthly increase into stock funds since early 2004 and the first positive monthly inflow since April 2010. Anyone with a bearish mindset would immediately point out this behavior as a bad sign for the market. After all, the last time monthly inflows were positive was just prior to the market correcting 15%. Admittedly, I would agree that the retail investor is terrible at market timing and this could be viewed as ST negative. However, I've always said the following when it comes to market sentiment: In bull markets bullish sentiment is to be expected and therefore can be tolerated for quite some time without having any bearish consequences (the same thinking goes with bearish sentiment in bear markets) We have seen this happen just recently with the sentiment surveys. They have been screaming "too bullish" since October and yet the market has pretty much ignored it (aside from small pullbacks) and continued climb a lot higher since then.

In the article it mentioned this

"For 23 consecutive weeks, surveys by the American Association of Individual Investors have shown a greater-than-average belief that stock prices will rise. The last time the surveys had such a long streak of bullish sentiment was in 2004"

I talked about this in early December. Here's what I said:

"Regarding sentiment. I looked back to see if there was ever a notable time when the market ignored the contrarian implications of excessive bullish sentiment for a long time. There was. It was in the summer of 2003. From the summer of 2003 until the end of the year, AAII sentiment averaged over 4:1 bulls vs bears, Investors Intelligence average 3:1 bulls vs bears and the VIX traded below 20 most of the time. Yet despite what appeared to be very excessive and chronic bullishness for months, never mind weeks, the market still trended higher with only minor dips closing out the year on the highs."

The high bullish sentiment I was talking about above also spilled over into early 2004, so to be more accurate I should have said it was in place until early 2004.

So, based upon the info provided in the article, current sentiment conditions are similar to that in early 2004 when you look at AAII sentiment and mutual fund investor behavior. Economically, there are also similiarities. In both periods, ST Interest rates were rock bottom even though the economy had clearly turned up from a recession well over a year ago with strong earnings growth for over a year as well. Jobs gains were picking up but were still volatile from month to month with strong months and weak months. However, towards the end of q1 and onward in 2004, the monthly job gains were consistent and large. Thus, the surge in bullish sentiment was justified back then because evidence was building that the economic upswing was sulf-sustaining. But ironically, March of 2004 marked an IT top as investors began to deal with the prospect of fed tightening which did end up occurring starting in June of 2004. That kept a lid on the market for many months as it basically went sideways with a downward tilt until October (If you want to see how the market traded in 2004 go back to a post I made in early January).

We could be at a similar cross-roads right here. Aside from serial top picking gone wrong, the relentless rally we've been seeing in the market could be the anticipation that jobs are going to be coming back in a big way proving strong evidence that the economic recovery self-sustaining. So, like in early 2004 the catalyst to mark a IT top could be the worry that the fed is behind the curve and that they will soon start "taking away the punch bowl" by raising rates and ending QE. I think there's a very good chance this worry is going to come to fruition. Leading indicators for growth such as ISM data and corporate profits have been yelling and screaming this for months. Employers have been slow to hire because the wounds of 2008 haven't fully healed. But it's just a matter of when not if they start hiring in a big way if you ask me.

If I'm right about what I just said, we could see a prolonged consolidation phase like in 2004 begin shortly (within the next month or 2) as investors start pricing in the normalization of rates and reversing QE. Now, I realize I'm looking ahead quite a bit here and I could be completely wrong....I'm just fleshing out a thesis here that think could  happen based upon evidence and experience. I also realize that when you have thesis you need to be careful not to be a victim of confirmation evidence bias. We'll just have to see what happens in the never ending soap opera known as the stock market.

I should also mention the consolidation phase in 2004 was fairly mild with respect to downside. The market had declined 10% from peak to bottom during a sideways phase that lasted about 6 months. During this phase, bears viewed the market as topping out....they ended up getting their asses handed to them in a big way as the bull market resumed course for another 3 years. And as far as retail investors returning to the market, those inflows in Januarary is just a drop in the bucket compared to all the money that was pulled out in 2008 and 2009. We have a long way to go before mutual fund inflows show any exuberance.