Is This the Death Knell for the Bull Market?

This article published with permission from InvestmentU.com.

Well, it had to happen eventually. The average punter is finally returning to the stock market. (Or, as the little girl said in Poltergeist, “They’re baaa-aack.”)

We have more than just anecdotal evidence. TD Ameritrade, the Omaha-based online broker, registered an average 370,000 trades per day in January, up from 30,000 trades a day in December. And, according to data from TrimTabs Investment Research, investors funneled $55 billion into U.S. equity funds in January, the most ever for any month on record.

I have spoken to several brokers and money managers who also confirm that long-dormant clients are finally investing in stocks again.

“They sense that the fiscal cliff was overhyped,” one broker told me. “The euro zone is not coming apart. And they are sick and tired of earning nothing on their income investments.”

Of course, there’s another big reason average investors are finally warming up to stocks again…

They’ve been missing the boat.

Signaling a top?

Last week the Dow closed above 14,000 for the first time since the financial crisis hobbled the global economy. Small investors — having missed out on the last 7,500 points — don’t want to miss any more.

Some analysts say the return of the small investor is a signal that the bull market, already nearly four years old, may soon give up the ghost. They point to the Odd Lot Indicator.

An odd lot is an order for stock of less than 100 shares, or a round lot. Historically, small investors could not afford to buy a round lot so when odd lot orders started coming through, the pros recognized that smaller investors were buying into the market. That was viewed as the market top. Or as JFK’s father Joe Kennedy put it, when the shoeshine boy starts giving you stock tips it’s “time to get out.”

There is some evidence to back this view. For instance, a 25-year study published a few years ago in the Journal of Financial Economics found that if you had simply invested in the S&P 500 when equity fund flows were negative (redemptions exceeded new investments) and into 90-day Treasury bills when fund flows were positive (new investments exceeded redemptions) you would have substantially outperformed the market while spending nearly half the time in riskless T-bills.

Mutual fund flows just turned heavily toward equities. Does that mean the end is near?

Not likely…

History shows that small investors are only a good indicator at market extremes. They tend to be wildly optimistic at market tops and wholly pessimistic at market bottoms. For two perfect examples, think about how they felt about real estate as an investment at the top of the housing bubble and stocks as an investment at the bottom of the financial crisis. Their instincts — based on greed and fear — were dead wrong.

The Odd Lot Indicator only works as a sell signal when valuations are high and sentiment is euphoric. Neither is the case today. The market sells for less than its average P/E ratio of 16. And while investors may be feeling a bit more positive lately, it’s hard to sense anything like euphoria out there.

When we do, it will indeed be time to trim back stock positions. But that is still a ways in the future. In the meantime, we should welcome new stock market investors — and their influx of cash that is pushing our shares higher.

Alexander Green is the chief investment strategist at InvestmentU.com. See more articles by Alexander here.