Psychological studies confirm that we all have biases. Yet we’re generally unaware of them.

When it comes to investing, few of them do more harm than “recency bias.” This is the tendency of investors to extrapolate recent events into the future indefinitely.

The Recency Bias Creates a “New Era” of Growth

When technology and Internet stocks were hot in the late 90s, for example, investors began talking of a “New Era” of limitless technological growth. The truth, of course, is that technological innovation does steadily increase. Alas, the same cannot be said of technology stocks.

Years of sharply rising prices lulled investors into a false sense of complacency. Investors didn’t just plan to hold Lucent (NYSE: ALU) and JDS Uniphase (Nasdaq: JDSU) long term. Many began calling them “legacy stocks,” companies that were so exceptional that they would pass them on to their children and grandchildren.

Yet someone less obsessed with recent performance and more familiar with the lessons of history might have recollected that behind every bull market is a growling bear market. From the peak in March 2000 to the bottom in October 2002, the Nasdaq (.IXIC) lost more than three quarters of its value.

Most of your children and grandchildren would have been better off with a passbook savings account or the use of a trailing stop.

Of course, recency bias works the other way, too. Last year the S&P 500 (.INX) dived 38%, its worst performance since 1931.

Now the galloping herd is convinced that stocks have nowhere to go but down. Mutual fund flow figures show investors yanked tens of billions of dollars out of equity funds in the fourth quarter alone.

Much of that money is piling into bank accounts and money market funds. Yes, they’re super safe, but they pay a national average of less than 1%.

The Recency Bias: Teaching Investors That Nothing Is Better Than Something

Still, recency bias convinces them that earning next to nothing is better than losing something.

Once again, they’re rationalizing. Sure, stocks may continue down for a while, but look beyond this week’s headlines and you may see opportunity and not just risk.

Today there is more money available to buy shares than at any time in almost two decades. The $8.85 trillion held in cash, bank deposits and money market funds is equal to 74% of the market value of U.S. companies, the highest ratio since 1990 according to the Federal Reserve.

What has happened in the past when cash reached these levels?

• In September 1974, cash on hand reached $604.5 billion, representing a record 1.21 times U.S. stock market capitalization. That preceded a 31% gain in equities between October 1974 and March 1975.
• In July 1982, just as a 20-month bear market was ending, cash as a percentage of the U.S. stock market’s value rose to 95%. The S&P 500 began a six-month, 36% advance.

According to Bloomberg, the eight previous times that cash peaked compared with the market’s capitalization the S&P 500 rose an average 24% in six months.

There are no guarantees, of course, but this is a very positive near-term signal for the market.

Smart investors – even bearish ones – understand the significance of high cash levels. For example, Leuthold Group, whose Grizzly Short Fund returned 83% in 2008 thanks to bets against equities, recently put out a bulletin calling stocks “one of the great buying opportunities of your lifetime.”

The report pointed out that the ratio of cash on hand to U.S. market capitalization jumped 86% in the first 11 months of last year. That’s the biggest increase since the Fed began keeping records in 1959.

When Will Investors Wake Up From This Recency Bias?

Some day soon, millions of investors will wake up to this recency bias and the fact that their cash is earning a negative return after taxes and inflation. And when they do, money will start migrating back to the market.

One good reason? In addition to capital gains potential, stocks currently yield three times as much as cash.

However, investors suffering from recency bias will not be persuaded by facts, figures, historical parallels or rational arguments. Unbeknownst to many of them, emotions are dictating their actions, not reason.

If history is any guide, they won’t leave the safety of cash until a rising market – and a whole new round of recency bias – convinces them that it’s safe to own equities again.

And they wonder why they don’t buy low and sell high.

Source: The Recency Bias: Why Your Subconscious Is Wreaking Havoc On Your Investment Portfolio

The Dow Jones Industrial Average (.DJI) and the Nasdaq (.IXIC) are skirting 5-year lows.

To date, the 10-year return of the S&P is -16%. If that performance holds until the end of the year, this could be the first 10-year period in which the market has lost money. Your broker’s marketing materials may require some significant edits.

In other news…

Jobless claims surged to a 16-year high, while leading economic indicators erased gains from September. Wall Street has keyed off a stream of seemingly endless negative information. And primetime Senate hearings for the auto industry haven’t helped.

The CEOs of General Motors (NYSE: GM), Ford (NYSE: F) and Chrysler failed to impress Capital Hill during their testimony. Executives were unable to gain the support they needed to get federal bailouts. All three companies could face bankruptcy without help.

Meanwhile, GMAC – the finance arm spin-off from General Motors – was looking for money, as well. GMAC is looking to become a bank holding company to qualify for federal bailout dollars.

Companies mentioned in this article: GM and F.

Source: S&P’s Back To The Future: 1997

The Daily Reckoning’s Chuck Butler has a less positive interpretation of the growth data, which he says is a blip on the downward path to recession. First, here are some more details from Forbes.com:

“The second quarter revision was well above the 2.7% average prediction from economists polled by Thomson Financial.

The faster-than-expected growth came off the back of rising exports, which were helped by the weak U.S. dollar, falling imports, more consumer spending and less inventory reduction than initially reported, the Commerce Department said.

“The increase in real GDP in the second quarter primarily reflected positive contributions from exports, personal consumption expenditures (PCE), federal government spending, nonresidential structures, and state and local government spending,” the department said in its report. Commerce also noted that imports, which subtract from GDP, were revised lower.”

Chuck wasn’t surprised by the elevated reading. A plunging dollar and the government’s stimulus checks are behind the upward revision. And neither will apply to data for Q3…

“Front and Center this morning I have to talk about the blip that we’re going to see that happened in the 2nd QTR due to the stimulus checks. It all goes back to the stimulus checks and the first sign of this came (besides Retail Sales) yesterday in the form of Industrial Production. Remember yesterday when I told you that Industrial Production is a second tier piece of data that gets ignored by the markets, but I think it’s important so I talk about it? Well… Just like last week, when I described the bratty spoiled child throwing a tantrum on the floor of the grocery store as being something you can’t avoid paying attention to… The growth in Industrial Production was the same…

Industrial Production for July came in strong, and rose 1.3% in the month and compared to expectations of a no change. The June increase was revised up to 1.3% from an initially estimated gain of 0.8%. And… The good news about this data is that the growth was led by non-defense spending! WOW! When was the last time that happened? Anyway…. The stimulus checks have their fingerprints all over this report…

And so too will they have their fingerprints all over the 2nd QTR print of GDP today. I told you Monday that to expect a blip up in GDP, which will stir the interest rate hike pot once again, and probably give the dollar some love. One thing to think about here, because the dolts in the media won’t even think about it, they’ll just drool all over the size of the GDP growth, is that I expect exports to have contributed to the 2nd QTR GDP by a sizeable margin, for what was happening to the dollar in the 2nd QTR? It was getting sold like funnel cakes at a State Fair, and getting weaker, and weaker, which just made exports look cheaper and cheaper, thus giving them a huge boost.

But what’s happened since the end of the 2nd QTR? The dollar has rallied, so don’t look for that boost to GDP in the 3rd QTR… And don’t look for the boost to GDP in the 3rd QTR from the stimulus checks… Those have already been spent! So… The 2nd QTR is going to end up being a blip on the recession chart when the historians look back on this period of time. But… That means, dollar strength, folks… Because, even though the markets normally are “forward looking” they will get so caught up in this 2nd QTR GDP growth that they will lose their focus.”

To read more of Chuck’s currency analysis today, click here.