The comments below were provided by Kevin Lane of Fusion IQ.

Stock price direction is a function of several factors, namely valuation, future expectations, sentiment and liquidity. We believe the last component may be the most important since buying power or lack thereof ultimately determines whether stocks go up or down. Typically liquidity is strongest when expectations are the most dismal and weakest when expectations are most optimistic. Stated another way, at market tops investors tend to have exhausted all their liquidity and go “all out” because their expectations for the future are optimistic. However, by the time investors go “all out”, economically things are about as bullish as they are going to get and valuations typically are stretched. With investors “all out” in the aggregate there is no buying power left to push stocks higher (since everyone is fully invested) and stocks come down.

The polar opposite occurs at market bottoms as investors become so pessimistic about the future they move large amounts of cash to the sidelines. Additionally, at this point valuations have contracted significantly as well and are now attractive. With large sums of cash moved to the sidelines, valuations attractive and selling pressure removed from the markets vis-à-vis investors selling in concert, liquidity, i.e. future buying power, is then put in place to push stocks higher.

The chart below looks at how far above or below the 21-year average allocation of 60% invested in stocks individual investors are at present. As seen above, when stock allocations drop 15% or more below that 22-year mean (red circles), which has occurred only three times in the last 22 years (1990, 2002 and late 2008/early2009), it has equated to significantly higher stock prices three to six months up to several years later.

We are using this chart to show that even with the current rally investors are still 6% below the mean allocation to stocks and significantly below fully invested levels of 10-15% above the mean. What does this mean now? It means sideline liquidity remains strong, investors are still not fully invested and thus dips should remain fairly contained (5-10% corrections), and over time the stock market can still work higher. Anecdotal sentiment also echoes the underinvested theory as most investors expect (no, demand) a correction and refuse to invest as the market melts up. Typically investors talk their positioning and underinvestment breeds statements of caution.


Source: Kevin Lane, Fusion IQ, September 11, 2009.

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