Retail Investor Buys The Dip Despite Bearish Sentiment

by Lance Roberts, RIA

It has been an interesting correction. The average retail investor was “buying the dip” despite having an extremely bearish outlook. This is an interesting point because, as shown, the retail investor used to be considered a “contrarian indicator” as they were prone to be driven by emotional behaviors that led them to “buy high and sell low.”

However, this isn’t the first time I have written about the retail investor’s transformation from panic selling corrections to buying them due to F.O.M.O.

“The “Fear Of Missing Out,” or “F.O.M.O.” is a centuries-old behavioral trait that began to get studied in 1996 by marketing strategist Dr. Dan Herman.

“Fear of missing out (FOMO) is the feeling of apprehension that one is either not in the know or missing out on information, events, experiences, or life decisions that could make one’s life better. The fear of missing out is also associated with a fear of regret. Such may lead to concerns that one might miss an opportunity. Whether for social interaction, a novel experience, a memorable event, or a profitable investment.” – Wikipedia

Over the last few years, the “fear of missing out” has gone mainstream. Young retail investors armed with a Robinhood app and a WallStreetBets membership have been chasing risk in the markets. But why wouldn’t they, given that the Federal Reserve has consistently backstopped market risk, creating a sense of “moral hazard” in the markets?

What exactly is the definition of “moral hazard.” 

Noun – The lack of incentive to guard against risk where one is protected from its consequences, e.g., by insurance.

After more than a decade of repeated rounds of monetary interventions, retail investors’ F.O.M.O. morphed from the “fear of missing out” to the “fear of missing the bottom.”

Such is why the markets are now parsing every word from the Federal Reserve. The massive Federal Reserve interventions provided a perverse incentive to take on extreme forms of risk, from speculative I.P.O.s, S.P.A.C.s, or Cryptocurrencies in 2021 to leveraged single-stock ETFs and zero-day options in 2024. Investors continue to expect the Fed to protect them from the consequences of risk. In other words, retail investors believe the Fed has effectively “insured them” against potential losses.

Therefore, the “fear of missing out” overrides the “need to get out.”

Such is the case we see currently in the markets.

I’m Terrified, But I’m Not Selling

Not surprisingly, investors were terrified when the market entered correction territory last week (a decline of ~10%). Our composite index of retail and institutional investors showed that fear was rampant. As shown, the standard deviation of net bullish sentiment was at the lowest level since the depths of the 2022 market correction and the “financial crisis.”

The fact that retail investors were so bearish after a minor market correction is something rarely witnessed in the markets. Such was a point made by Charles Rotblut of the American Association of Individual Investors.

But this is where it gets interesting.

You would expect that such extreme levels of bearishness would coincide with investors grossly reducing their exposure to equity risk. However, the reality is quite different. As shown below, the A.A.I.I. investor allocation to stocks and cash tells a very different story. Despite retail investor sentiment at deeply bearish levels, the allocation to equities remains very high with low cash holdings.

While investors are incredibly fearful of a market correction, they are unwilling to take any action to reduce risk significantly. In other words, they are reluctant to sell for the “fear of missing out.“ It is worth noting that during previous bear markets, equity allocations fell as investors fled to cash. Such is not the case today.

While the evidence is only anecdotal, I suspect that investors today are more afraid of missing the bottom should the Federal Reserve suddenly reverse course regarding monetary policy. Much like Pavlov’s dogs, after years of being trained to “buy the dip,” investors are awaiting the Fed to “ring the bell.“

You could even go as far as to say, “This time is different.”

Retail Sentiment Suggests A Bottom

Historically, watching the retail investor has been an excellent contrarian indicator. Whenever the retail investor was either extremely bullish or bearish, it was a good time to take the opposite side of the trade. We can see that by looking at the “smart” versus “dumb” money indicator compared to the market. As the chart from Sentimentrader.com shows, retail investors’ confidence in stocks is very low, while professional investors have a strong outlook. Such suggests that the recent correction is likely close to a bottom unless we enter into a deeper corrective cycle.

There is currently a large contingent of investors who have never seen an actual “bear market.” As noted above, their entire investing experience consists of continual interventions by the Federal Reserve. Therefore, it is unsurprising that despite the recent price decline, they aren’t selling out of the market. Wall Street also suffers from the same “fear of missing out” as they hope the Fed can engineer a soft landing.

The question, and the most significant risk to investors, is when the “fear of missing out” changes to the “fear of being in.”

However, that is not likely today, particularly with the elevated bearish sentiment. From a contrarian view, it is likely a good time to buy equities, at least for a reasonable trading opportunity. Excesses occur when everyone is on the same side of the trade. With everyone so bearish, a reflexive trade will be rapid when the shift in sentiment occurs.

The takeaway from this commentary is not to let media headlines impact the decision-making process in your portfolio strategy.

Our job as investors is to capitalize on available opportunities but avoid long-term risks.

There are plenty of reasons to be very concerned about the market over the next few months. However, markets can often defy logic in the short term despite the apparent weight of evidence to the contrary. As I noted previously:

“It is always important to never discount the unexpected turn of events that can undermine a strategy. While we continue to err on the side of caution momentarily, it does not mean we will remain wed to that view.”

The next few weeks and even the next few months will likely be frustrating. Markets will likely remain rangebound, with little progress made for the bulls or the bears. We are maintaining our exposures to higher-than-normal cash levels and underweight equities and bonds.

Predicting market outcomes has little value. The best we can do is recognize the environment for what it is, understand the associated risks, and navigate cautiously.

Leave being “bullish or bearish” to the media.

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