Investors Continue to Unload Stocks

Despite a gain in stock prices in recent months, investors continued to sell stocks..
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NEW YORK (TheStreet) -U.S. stocks, as measured by the S&P 500, are up 15% in the three-and-a- half months since the beginning of the second half of 2010.

Nonetheless, individual investors have remained net sellers during every week. In the past 25 years, there has never been a three-month gain in the S&P 500 of 10% or more that was not accompanied by net inflows into equity mutual funds and Exchange Traded Funds, according to Investment Company Institute data.

Why are individuals staying away from investing in the stock market?

Of course, risks remain but have shown some mitigation and prompted foreign and institutional investors to push stocks higher. Two key issues investors have been focusing on this year have taken a positive turn:

  • Some confidence has emerged that the economy will not enter a double-dip recession. The sluggish growth in the U.S. economy has stabilized in the last month or two and many key economic releases have been stronger than most predicted.
  • Policy actions are becoming more positive for the market. The mid-term elections herald a change likely to return political balance to Washington between the parties that may slow the pace of legislative change and result in the "gridlock" the market has historically favored. In addition, the market has gone from fretting over how soon the Fed would begin to withdrawal the extraordinary support they provided in the aftermath of the financial crisis to looking forward to even more stimulus in the coming months.

Individual investors have not been avoiding investing entirely. Interestingly, they have been putting money to work in foreign stocks and U.S. bonds, including more aggressive emerging market stocks and high-yield bonds, as they reallocate money from cash and U.S. stocks.

With this improving backdrop, why do individual investors continue to sell U.S. stocks? Perhaps it stems from a lack of confidence in the U.S. stock market itself. While individuals may have overcome to some degree their distrust of the durability of the economic recovery and policymakers in Washington, they remain distrustful of the integrity of the U.S. stock market.

A whopping $53 billion has come out of domestic equity mutual funds since the "flash crash" on the afternoon of May 6, 2010 in which major equity indices, down over 4% from their prior-day close, suddenly plummeted an additional 5% to 6%

in a matter of minutes before rebounding almost as quickly to "pre-crash" levels. During the "flash crash" the

Dow Jones Industrial Average

plunged about 600 points only to recover those losses within minutes. It was the biggest one-day point decline, 998.5 points, on an intraday basis in the 114-year history of the Dow Jones Industrial Average.

Against the backdrop of unusually high volatility and thinning liquidity, the trigger for the "flash crash" was a large mutual fund company initiating an automated computer sell program that had no regard for price or timing in order to sell a massive amount of S&P 500 futures contracts as a hedge to an existing equity position.

The Securities and Exchange Commission (SEC) investigation of the "flash crash" highlights that it was not merely the major averages that experienced wide swings, but the stocks of some large U.S. companies fell to a penny or spiked as high as $100,000 before the prices returned to "pre-crash" levels.

The SEC notes that "more than 300 securities were executed at prices more than 60% away from their values just moments before." While the SEC has taken actions intended to avoid a similar event in the future, it noted that under stressed market conditions, the automated execution of a large sell order could trigger extreme price movements.

The structure of the U.S. stock market has evolved significantly from the days it took place under the shade of a buttonwood tree on Wall Street. Today, most of the volume trades electronically, off the NYSE and

Nasdaq

.

That fragmentation, combined with millisecond trading, unbalanced transparency into real-time order flow, and electronic trading strategies that damage market integrity through the almost instantaneous creation and cancellation of millions of orders, has pushed the U.S. stock market to fray at the edges. When pushed too hard, it can have a temporary breakdown.

However, it would be unfortunate if this record-breaking buyers strike by individual investors is a precursor to a permanent boycott by individuals from investing in U.S. stocks. While these noted evolutionary shifts and potential for intra-day breakdowns of liquidity for stocks make regular trading of individual stocks challenging for an individual, they have had little to no effect on investing through mutual funds and ETFs for a time horizon that exceeds a single day.

Without the return of the individual investor to the U.S. stock market, further gains in the current rally may be hard to come by.