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1 Reason to Be Nervous About the Market's New Highs

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With the stock market having had a great year in 2012 and having started off the new year on much the same bullish tone, most investors aren't even thinking about the possibility that the nearly four-year-old bull market could come to an end. Yet even as many market measures have hit all-time highs and others are at levels not seen since well before the worst of the financial crisis, one sign points toward caution: the possible return of ordinary investors to stocks.

When scared investors finally get greedy
For years, millions of investors have avoided stocks. After the 2008-2009 market meltdown that sent stocks plunging as much as 60% from their highs just a year or two previously, investors fled to the relative stability of bonds and cash, accepting losses in exchange for predictability at all costs. Despite the fairly strong performance that bonds have had in those years, investors who replaced stocks with bonds at the stock market's bottom ended up missing out on some huge returns, as both the Dow Jones Industrials and the S&P 500 have more than doubled from their lowest levels.

Even as recently as last year, investors pulled almost $120 billion out of actively managed stock mutual funds. Exchange-traded funds saw massive inflows of more than $150 billion in 2012, but only about $30 billion of that money went to stock ETFs. Much more of the money went into bond ETFs, many of which again posted attractive returns in 2012 thanks to falling interest rates and capital gains on bonds.

But now -- after the market's amazing bull run -- ordinary investors have finally started putting money back into the stock market. During the first weeks of January, massive amounts of new money have gone into both stock ETFs and actively managed stock mutual funds, with a total of $18.3 billion coming in during the first week of January alone.

Buying high?
The problem with getting back into the market now is that expectations are much higher for the future of stocks than they were back in 2008 and 2009. During the worst of the financial crisis, all it took to send the market soaring was anything better than the worst-case scenario. When Ford (NYSE: F  ) was priced at less than $2 per share, everyone expected that it would follow General Motors and Chrysler into bankruptcy. When it didn't, the stock quickly tripled in price. Since mid-2009, the company has made substantial progress and the stock has doubled again -- but the best returns were earned when sentiment went from hopeless to average.

Now, though, more stocks are priced for the good times to continue. Homebuilding companies Pulte (NYSE: PHM  ) and Hovnanian (NYSE: HOV  ) scored big gains in 2012 as the housing market apparently hit bottom and orders started to pick up. Yet with shares now well off their lows, both companies need to actually deliver on the promise that investors see in them, or else shareholders will see that the stocks have gotten ahead of themselves and send the shares down again.

The lesser of two evils
On the other hand, as uncomfortable as it may be to see investors buying stocks for the first time at current levels, the alternatives don't seem much better. Buying 10-year Treasuries yielding less than 2% essentially guarantees returns poorer than inflation unless you're fortunate enough to be able to sell them at a gain before maturity, and that relies on seeing interest rates move lower still. Emerging-market bond ETF iShares JPMorgan Emerging Bond (NYSEMKT: EMB  ) and corporate bond ETF iShares iBoxx Investment Grade (NYSEMKT: LQD  ) offer somewhat higher yields, but they've also seen substantial gains recently.

Whenever the investing herd appears to be moving en masse into the market, it's reasonable to start wondering if it's time to look to the exit. Yet after years of eschewing stocks, ordinary investors could have a long way to go before they get even close to fully invested, suggesting that the market may have further to run before it hits a new top.

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  • Report this Comment On January 23, 2013, at 11:54 AM, BigFatBEAR wrote:

    I'm not plowing any more money into stocks at the moment. But with 13% annualized returns, my Lendingclub account is looking pretty juicy vs. the market....

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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