Don’t confuse a rising tide with competence

David MoonBlog

In 1929, Walter Miles published a paper in Scientific American Magazine titled “Sleeping with the Eyes Open,” in which he described a phenomenon we now refer to as “highway hypnosis.” During a period of relative and unchanging calm, we have a tendency to stare at something simple and almost meaningless, lulling us into a state of environmental unawareness.

That is, we are asleep at the wheel.

A related condition is velocitation, where, in the absence of impediments, we exceed an otherwise normal, safe speed.

Both are happening today in the stock market.

And like a 19-year-old boy in a 1967 Camero, hypnotized investors today won’t have a clue of the danger they are courting—until they are upside down in a ditch.

That’s what happens when the stock market doubles in five years. Investors become effectively hypnotized, ignoring risks simply because they haven’t recently materialized.

Consultant Aon Hewitt tells us that 67 percent of employees’ new 401(k) contributions are now going into stocks, a 20 percent increase from the market low in March 2009. But it was only after the S&P 500 increased 32 percent last year that investors began to make any meaningful moves back into stocks.

This is the highest level of individuals’ stock exposure – and the lowest level of cash exposure – since the stock market last peaked in October 2007.

It is no coincidence that this new record exposure to stocks is occurring as the US indices reach new highs.

These new highs are also causing people to ignore quality. In 2012 and 2013, the stock prices of the companies with the weakest balance sheets increased twice as much as the entire S&P 500.

That reminds me of 1998, when the collective prices of the unprofitable companies listed on the New York Stock Exchange increased, compared to a decline in the prices of the companies that actually made money.

Investors—well, speculators—are pouring money into penny stocks at a new record, finally eclipsing the record set during the bubble of the late 1990s. People are leaving their real jobs to enter the investment advice business or become day traders.

A recent Wall Street Journal article featured Steve Templeton, a full-time day trader concentrating in medical marijuana stocks trading at less than a penny per share.

Steve explained that buying stocks with prices that low limits his downside. After all, once a stock has dropped to a penny, how much lower can it go?

Answer: to zero.

Steve doesn’t realize it, but the return on a stock that drops to zero is negative 100 percent, whether the starting point is $50 or 50 cents.

I am not predicting an impending market top or collapse. Not at all.

But for investors whose expectations about the future are predicated on the extraordinarily positive returns in 2013, I am predicting disappointment.

People confuse a rising tide with skill and competence. But, as Warren Buffett reminds us, it’s only when the tide goes out do we find who’s been swimming naked.