The Dow Jones Industrials (^DJI -1.81%) closed up almost 42 points on Friday, limiting the Dow's losses for the week to about 150 points. Yet, what's surprising about the stock market is how quickly investors have become pessimistic, with two straight triple-digit declines for the Dow making many people think that a correction is imminent, even though the two-day drop barely added up to 1%. By contrast, the Dow remains just 225 points below the 17,000 mark, and all it would take is a minor push forward for the stock market to eclipse that level and potentially send investors into a bullish frenzy all over again. Let's take a look at the inflection point that investors face right now.
Source: Wikimedia Commons. Courtesy Walters Art Museum.
The bull-bear tug of war
In past bull markets, the Dow Jones Industrials followed a relatively similar pattern. In the early stages of an emerging bull market, most ordinary investors were still shell-shocked from losses they had suffered during the preceding bear market. As a result, they were typically slow to get back into the market, often missing out on a huge share of the initial run-up in the Dow. Eventually, performance-chasing mainstream investors regained confidence in the market's ability to produce solid returns, and they therefore invested in the market. In some cases, the wholesale adoption of stock market investing by even novice investors provided a contrarian indicator for more sophisticated investors to back out of their stock positions, leaving the market vulnerable to a further pullback.
This time around, though, there's a new dynamic that's changing the supply-and-demand equation for stocks. During the financial crisis, even the largest companies suffered from liquidity problems. Goldman Sachs (GS -1.81%), General Electric (GE -0.12%), and Bank of America (BAC -1.61%) were just a few of the major companies that went to extraordinary lengths to get the financing they needed, tapping both private-sector funds and government sources provided by bailout legislation. That experience taught companies the value of cash, and in the ensuing recovery, cash has reigned as king, once again.
But as the economy has improved, many companies have too much cash, and they've been looking for ways to deploy it. One of the most common methods has been stock repurchase programs, which, in many cases, have reduced outstanding share counts of popular stocks, and left investors chasing fewer available shares. As it happens, company buybacks also have a checkered history of being ill-timed, as they usually come when businesses are flush with cash and, therefore, when stock prices are especially high.
The major question is whether individual investors will side with corporate buybacks or with institutional investors, which have been the primary owners of the shares that companies have bought back. If the Dow Jones Industrials and the broader stock market start to fall in earnest, then institutions could redouble their efforts, and eventually woo individuals to the bearish cause. But if the Dow keeps rising, underperforming institutional investors will feel even more pressure to get back into the market to avoid missing out even further -- and potentially feed a bull market to Dow 17,000 and beyond.
