Regret wrecks people’s finances like no other emotion. Nothing feels worse than missing out on a rally, except buying what turns out to be a top.

Retail investors were burned badly in 2000 and 2008. “Buy and hold” blew up in their faces. While stock prices lifted in step with the Fed’s balance sheet post-crash, the traumatized little guys sat out the stock market rise until the last year.

But now small investors are piling in again, and they’re investing like it’s 1999. “I could see it going up maybe 50% at a minimum, just being conservative,” a 35-year old computer programmer told the Wall Street Journal, talking about the stock price of a small biotech company he was pouring his 401(k) money into.

More money flowed into mutual funds and exchange-traded funds last year than ever before. Even more than in 2000, the tech bubble year. 2013 was the first year investors took money out of fixed-income funds after three straight years of dumping it into them.

The stock market is one giant roller coaster of regret for retail investors. Regret for not getting in… regret for getting in too late… regret for being left holding the bag.

Behavioral economics pioneer and Nobel Prize winner Daniel Kahneman quotes two Dutch psychologists about regret in his bestseller Thinking, Fast and Slow. They noted regret is “accompanied by feelings that one should have known better, by a sinking feeling, by thoughts about the mistake one has made and the opportunities lost, by a tendency to kick oneself and to correct one’s mistake, and by wanting to undo the event and to get a second chance.”

Studies of investor brains during experiments simulating stock market investing show the variable that most drove behavior in the investment game, in all markets, was the “r-word.”

Regret was a big factor when subjects changed their investments and also “showed up as an extremely strong neural signal in a reward-decision-making region of the brain, the ventral putamen, the same site where reward-prediction error signals appear,” writes neuroscientist Dr. Read Montague. Thus, the brain treats counterfactual experience the same as it does real experience.

Regret, in this case, is the difference between the value of what is and the value of what could have been. Dr. Montague offers what he calls a pseudo-equation: “Terry Malloy’s Regret equals (value of being a contender minusvalue of being a bum). Why this is important is something called dopamine, a chemical in the brain that helps humans decide how to take actions that will result in rewards at the right time.”

As investors pile into high-flying stocks, they receive a dopamine kick to their brains similar to the sensation a drug addict receives when getting high, or the response our brains receive during sex.

The sensation occurs in anticipation of the great returns. Getting what we expect doesn’t provide a dopamine rush, only unexpected gains do. The same way an addict needs larger doses, market investors crave more risk.

As the market continues to surge ahead, bad memories have faded and individual investors are chasing higher highs—literally.

When the investments crash, the pain of regret will be that much greater. Are investors about to plunge into another deep valley of regret?

This week Elliott Wave International’s Robert Prechter gives us some perspective on how far the market has soared in investor sentiment since the dark days of five years ago. The financial press’s rationalizations cloud our senses to the continued irrational investment ebullience.

Mr. Prechter brings us back to earth below—plus he has an offer just for Casey readers:  get two free weeks of EWI’s Financial Forecast Service to help you navigate these troubled times.

Enjoy,

Doug French, Contributing Editor

Capitulation of the Bears

Robert R. Prechter, Jr.

In the back-to-back weeks of December 4 and 11, Investors Intelligence reported that only 14.3% of stock market advisory services are bearish. This is the lowest percentage in over a quarter-century. It is lower than at the highs of 2000 and 2007. The last time numbers were lower was before the 1987 crash.

The flood of revisions of formerly bearish advisors’ market opinions started around November 15. It has been strong enough to prompt journalists to write articles about the shift. In half the cases, former bears said they were tired of being bearish and were turning 180 degrees to become outright bulls. In the other half of the cases, the few remaining super-bears say they still think the stock market is in a bubble, but it isn’t peaking now. It will first undergo a “melt-up,” “blow-off,” or “parabolic rise.”

A “Melt-Up”?

The idea that the stock market will end its rally with a near-vertical advance is appearing in articles, interviews, newsletters, web posts, and even emails to EWI. It is especially popular among super-bears who have long recognized that the market is in a bubble.

The problem with this idea is that the Dow and S&P have never blown off. The stock market as a whole has never accelerated upward at a market top. It often accelerates off bottoms, and it always accelerates in the center of a third wave; but it has always lost momentum in a fifth wave relative to the third wave. Predictions for a blow-off defy history.

Commodities are the exception, as Frost and I pointed out in 1978 in Elliott Wave Principle (see text, p.173). In fifth waves of Primary and higher degree, commodities often accelerate upward before reversing. Recent examples include oil in 2008 and silver in 2011. The reason for the difference is that commodities peak on fear, whereas stocks peak on complacency.

Some people are arguing that the stock market has become “commoditized,” and that’s why it’s about to go into a parabolic rise. While we cannot say such an event is outright impossible, it’s never happened. One thing that does happen repeatedly in the stock market is for investors to raise their upside forecasts dramatically at a top. In 1999-2000, at the market’s true peak, books came out calling for Dow 36,000, Dow 40,000 and Dow 100,000. Today’s calls for a melt-up, then, are probably just capitulation to the bullish imperative, a rationalization of optimism. By this means, bears have switched from predicting a collapse to predicting soaring prices. In other words, “Sure, it’s a bubble; but it’s not topping now. In fact, it’s going to start going up faster!” These melt-up predictions are yet another indication that the market is close to a peak in the biggest B wave in recorded history.

This type of capitulation to the trend is different from panic, because it occurs at the opposite end of the psychological spectrum. There is no single word for it. Some people say things such as, “Investors are going to panic into stocks.” But the only people who can buy in panic are those who are short, and they typically constitute a very small percentage of investors. The stock market as a whole does not panic up. But it does occasionally experience a sudden crystallization of optimism. Usually it happens without much near-term price movement; it is the result of a long period of past price movement. We might call this event a cynap, the opposite of panic. When investors’ synapses snap, their opinions become aligned like particles in a magnet. That’s what we have today.

Meanwhile, the stock market has been losing upside momentum for seven months. This is how market tops have always formed, not with a rocket blast but with a subtly slowing ascent. Even in 1929 the market did not blow off; the rise that year was slower than the market’s rise in the second half of 1928. Is this time different? Well, so far it’s exactly the same in that people are saying it will be different.

One or two bears agree with us in being more vocal than ever about the risk in today’s market. Jean-Pierre Louvet of the SafeWealth Group reports on US insolvency, bank woes, deflation, and what “cash” means: David Stockman knows it’s a bubble and pulls no punches in saying how it will end.

Conviction Among the Bulls

The Daily Sentiment Index (trade-futures.com) reported 93% bulls twice, on November 15 and 22. Two readings this high are a rarity. The weekly Investors Intelligence poll on December 11 and 18 showed over 80% bulls amongcommitted advisors (i.e., bulls/(bulls+bears), omitting those expecting a correction), the highest reading since 1987. Such extreme readings in conjunction are even rarer.

The Rydex family-of-funds data afford good sentiment indicators. Recent figures show a record low investment in conservative money-market funds, meaning nearly everyone is invested in stocks and bonds. At the same time, the ratio of money in bullish stock funds vs. bearish stock funds is over 5:1, and per SentimenTrader.com the ratio of money in leveraged bull vs. bear funds (see below) is 10:1! This reading leaves past extremes in the dust. If you study the chart, you will notice that the biggest rush has come in the past six months, which is precisely the time that stocks’ ascent has been slowing! In other words, optimism is soaring while upside momentum is waning. Once this epic complacency melts, I doubt we will see such a ratio again in our lifetimes.

Interviews with money managers and Wall Street strategists reveal extremely lopsided optimism. Journalists seem unable to find subjects who will make a bearish case. On December 16, a major national newspaper reported on the opinions of its roundtable of five forecasters. All five of them are bullish. Their major themes are:

1. Investors must display wild-eyed euphoria before the market can turn down.
2. The weak recovery is keeping investors from being bullish enough for a top.
3. The possibility of a “short and shallow … 5% correction” is not “outlandish.”
4. If the market corrects, it will be a blessing.
5. But don’t wait for a correction, because you’ll just miss the boat.
6. If the Fed tapers, it won’t hurt the market…
7. because the economy is getting healthier and will soon be in a stronger expansion.
8. Interest rates probably won’t rise very much…
9. …but if they do, it won’t hurt the market.
10. We have lots of sector picks and stock picks.

Can you imagine advisors showing this much confidence and unanimity at a truly good buying opportunity? In March 2009, the Daily Sentiment Index (trade-futures.com) recorded an all-time low of 2% bulls, meaning that 98% of S&P traders thought the market would go lower. Money managers who are bullish today will tell you that March 2009 was an “obvious” buying opportunity. But most of them never got out at the previous top so they could put cash to work, and when the time arrived they were cautious, if not scared stiff. Now they are devoid of fear. They won’t raise cash at this top, either.

We don’t know if the S&P will go up another 100 points before it reverses. But one thing we can count on is that all of the sentiment extremes we have observed will lead to their opposite.

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