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

Meanwhile, on Wall Street, analysts are slashing profit forecasts that still look way too high to me.

Already, high-profile investment firm Lehman Brothers (which, like some other brokers, closed its books May 31) plunged in value because the market anticipated a large loss for this quarter. It will be Lehman’s first loss in nearly 25 years – and more asset write-offs are likely. Lehman will fess-up on June 16…stay tuned.

Also, two leading banks just sacked their CEOs amid mounting sub-prime losses. Wachovia got rid of Ken Thompson, who had the misfortune of buying California lender Golden West Financial for US$25 billion…pretty much at the top of the sub-prime boom two years ago.

That acquisition turned out… badly, to say the least. Meanwhile, Washington Mutual’s Chairman will “step down” according to the bank.

These are just the latest casualties from the sub-prime credit crunch, but rest assured, more heads will roll before this financial reign-of-terror is over.

So what’s ahead for earnings this quarter?

Financial stocks are expected to fare the worst, once again this quarter (surprise, surprise). Consumer discretionary shares are next in line, with an earnings hit of -10% expected this period.

There is some good news however. Energy sector stocks should post 16% earnings gains, which is no surprise with sky-high oil and gas prices. Tech-sector profits are also expected to shine this quarter, which is a pleasant surprise to investors amid a slowing economy.

Technology stocks are enjoying a healthy export boom, due in part to the falling buck, but also from healthy demand from overseas markets. Also, tech companies just aren’t as impacted by soaring raw-material costs, like rising oil prices, which does impact so many other sectors of the economy.

The result is likely to be 15%-plus profit gains for technology shares this quarter. That’s a very nice showing amid the Wall Street gloom.

MIKE BURNICK, Senior Editor & Global Markets Analyst

EDITOR’S NOTE: Right now, Mike is researching several key ways to play the technology sector for a possible double or triple-digit gain in the coming months. Keep an eye on his Market Shock Trader alerts for more updates on these stellar plays.

Source: Why More Heads Will Roll Down Wall Street