Should You Buy Stocks Now? Most Investors Run for the Exits

“Investors repeatedly jump ship on a good strategy just because it hasn’t worked so well lately, and, almost invariably, abandon it at precisely the wrong time.”

That’s what David Dreman wrote back in 1980.

The S&P 500 was sitting around 100, and the Dow was trading under 1,000 after a decade of big ups and bigger downs.

No one wanted stocks — no one except for Dreman, that is.

And he turned out to be fantastically right.

Stocks entered a multi-decade bull market. Relatively small investments of a few thousand dollars at the time are now worth hundreds of thousands of dollars.

But a lot has changed since then...

Here’s how to apply the same rules now.

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Some Things Never Change

Regrettably, we’re not at an obvious long-term bottom.

Stocks aren’t paying 6% to 9% dividends. P/E ratios haven’t fallen to five across the entire market.

That’s how the eventual rock bottom will look when the mega-debt-financial-government bubble has not deflated. And quite frankly, the Fed and policy makers have ways of keeping this going for another 5, 10, or 20 years.

We’re stuck in the middle right now. Stocks are neither cheap nor expensive. Bonds are very expensive, but will only get more expensive if the economy continues to limp along.

Times like these are more challenging, but they don’t have to be any less profitable.

The market volatility over the past few weeks is the perfect example...

Bad Decisions and Worse Timing

The winding road the markets has been on has been a painful one. Many investors are down, frustrated, and throwing in the towel.

Consider this: Mutual fund investors are, as a whole, the worst investors in the world.

I mean, who would give their money over to managers who consistently underperform the markets and pay them 1% to 3% of their assets each year to do it?

But that’s not what makes them the worst.

What makes them the worst is they always buy and sell at the worst possible times. It never fails.

Barton Biggs, hedge fund manager and author, stated in his book Hedgehogging:

The big flood of money comes in after instead of before a fund has done well, and then redeems after it has done poorly and usually just before it’s about to do relatively well again.

Billions of dollars poured into tech funds in 1999 and 2000 when the Nasdaq was toward 5,000. In fact something like 80% of all the public money that was invested in mutual funds at the height of the bubble in the spring of 200 went into tech funds.

Over the next three years, as the Nasdaq raggedly sank to 1,000, investors lost 60% to 80% of their money. Redemptions were heavy in 2002 and 2003 just before the Nasdaq doubled again.

Mutual fund investors continued to buy and sell at the worst possible time the next time the markets sunk. In 2008, they pulled more money out of mutual funds at the height of the credit crisis than they did at any other time in history.

Recently, they’ve ramped up their selling of stock mutual funds once again. On net, they’ve been pulling money out since April. And in July, investors pulled out more money than they have since the end of 2008.

Mutual fund investors are getting scared. They’re almost panicking.

By itself, this is a relatively good sign. But there’s more...

Hedge Funds Betting Big

The latest correction hasn’t just spooked the mutual fund investing crowd; the big money has been taking precautions, too.

The chart below shows hedge funds net short and long positions on S&P 500 futures contracts over the past year:

Hedge fund managers are making the biggest bets against the S&P 500 of the past year.

And to put the size of this bet in perspective, it is currently at 80% the size of the bet they made right after Lehman Brothers collapsed in 2008.

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Taking the Easy Way Out

Combine the actions of mutual fund investors and big money hedge funds, and it's clear to see everyone is scared...

We all see the daily news. We all see the negative trends forming. And most everyone is preparing (or has already prepared) for the worst.

Of course, that’s usually the time when everything starts to turn around.

The best thing to do right now is still what is always best to do: Find what is cheap, carries the least risk and greatest reward, or the next big growth stories to catch Mr. Market's fancy (or some combination of all three).

Then buy up as much as you can.

David Dreman is a fitting example.

Your editor had the chance to spend some time talking with Dreman one-on-one in late February 2009. The situation now is similar to what it was then: Stocks are down. Investors have lost. They’re getting scared. And they’re selling.

Dreman told me at the time:

I would probably want to buy companies that could rebound sharply. I’m buying banks, for example.

They will come back at some point; it’s essential to the economy.

We need a banking system we’re confident in. We can’t work without a banking system. We can patch it up for a while, and the government will probably take some stake in a lot of these banks they already had, but we need a banking system.

When financials come back, I think they could double or triple.

He was completely right because he didn’t worry about the short-term news. There were long-term trends the markets would have to come back to...

They did. And he was there to sell to them at sizeable profits.

Now is the time, when everyone is looking to “jump ship” and "abandon it at precisely the wrong time," you can buy assets far cheaper than you could have just a few weeks ago.

Have a good weekend,

Andrew Mickey

Editor, Wealth Daily