The room's getting crowded, the party's been going on a while but more people could arrive. Just beware fair weather friends and a sign it could be time to think about leaving...
For U.S. stocks, 2013 saw the best return in 15 years, the value of world markets increased by over $6 trillion and the amount of money investors ploughed into equity funds hit record levels. While optimism has bred yet more optimism, this is what you should be asking:
1. How crowded is the room?
In a survey of Fund Managers by Bank of America Merrill Lynch, accounting for $655 billion in total: 54 percent of Fund Managers are overweight stocks in their portfolios; 48 percent have a higher allocation to the shares of technology companies than a broad equity index, the second highest amount in a decade.
The risk of owning something many other people own is the difficulty encountered when there is a widespread will to sell. When everyone's rushing for the door, you need someone to offer you a way out or you could be in trouble. This can turn a minor inconvenience into a full-fledged panic. In terms of investments, people sell at lower and lower prices; snowballing into a rapid and steep fall in value.
2. How long has the party been going on for?
It has been over 2.5 years since the last 'correction', defined as a fall of 10 percent or more, and last year it avoided stumbling by more than 5 percent. Whilst similar has happened twice before in the last 25 years, the concern is that both ended in severe and devastating falling share prices. The stock market, over the longer term, is not a one-way bet.
3. And how are the guests feeling?
However, investors seem to be worryingly complacent. Expectations for how much the stock market will swing in value are at a near 7 year low. Indeed stock markets continued to rise in the face of a government shutdown and, at certain points during the year, weaker than expected jobs data. Nevertheless, as government support winds down, investors will be less able to shrug off bad news or continue to look through 'beer-goggles'.
4. Any more guests to arrive?
The good news is that not all investors have been complacent and fully invested in the stock market. Individual investors, investing with their own money rather than a company's or clients', still have a large amount of money in 'cash-like' funds. This could make its way into the stock market if confidence were to continue to grow.
5. How committed are they to keeping the party going?
As more cautious investors, they are also more likely to race to the door at the first sign of trouble and perpetuate rather than offset widespread selling.
Conventional wisdom on Wall Street argues that these investors can be 'late to the party'. Needing more convincing, they may watch share prices rise for too long before buying. This has been challenged since markets can continue to rally for many years after they invest. However, knowing there to be fewer guests left to arrive can provide valuable caution.
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