Don’t Trust the Market? You’re Not Alone, For Good Reason

Gold settled at its lowest level since February 2011 and the major indices were off more than 1% on Monday in a lack of confidence after the Dow and S&P 500 hit their highest levels ever last week, evidence that enthusiasm for stocks on Main Street remains muted at best.

Oh sure, there are plenty of stories about retail investors “rushing” back into the market but such analysis fails to put the recent trend into perspective.

In the first quarter, inflows into equity mutual funds totaled $62.5 billion, according to Lipper. If this pace keeps up, 2013 inflows would be the highest since 2000, according to CNN Money.

By comparison, approximately $445 billion came out of equity mutual funds from 2007 to 2012. And after a very strong start in January, inflows dried up in February suggesting investors will be quick to head for the exits at the first sign of trouble.

Indeed, Monday’s stock selloff and rout in gold are almost certain to test any recent excitement for investing.

Many reasons have been proffered for investors’ reticence to embrace the rally, notably: a still sluggish economy, high unemployment, falling median household income, fresh scars from the Great Recession, as well as bad memories of the bursting of the Dot.com and housing bubbles.

Another factor, one not easy to measure, may be the biggest contributor of all: Trust, or lack thereof.

In sum, investors don’t have faith in the rally because they don’t have faith in the market itself. According to the Chicago Booth/Kellogg School Financial Trust Index, more than half of Americans (58%) think it's likely that the stock market will drop by more than 30% in the next 12 months while only 22% say they trust the financial system.

Wall Street Scandals: The Beat Goes On

Last week brought more fodder that the game is rigged.

First, a former KPMG partner, Scott London, admitted to passing on insider information about two of his top clients, Herbalife and Skechers USA. Government authorities believe London may have also passed along insider information about Deckers Outdoor as well as pending acquisitions of RSC Holdings and Pacific Capital Bancorp.

This was a pretty classic insider trading violation and done in a ham-handed way, suggesting both a lack of sophistication among the participants and little fear of getting caught.

In recent years, the government prosecuted one-time hedge fund giant Raj Rajaratnam and his alleged tipsters, including former Goldman board member Rajat Gupta for insider trading. This year, the Fed is targeting SAC Capital’s Steven Cohen, one of the world’s most successful (and wealthy) hedge fund managers.

Such investigations are, in part, designed to send a message to investors that the Wall Street “cops” are on the beat and will restore faith in the market, similar to the “perp walks” of the early 2000s after the scandals at Enron, Worldcom, Adelphia and others.

Still, I suspect one the takeaway from the London-KPMG case is that “run of the mill” sharing of insider info remains alive and well. In related news, reports last week that former Enron CEO Jeff Skilling may get an early release from prison – and that “rogue trader” Nick Leeson is out of jail and back working in finance – aren’t going to change a perception the system is rigged, or at least badly broken.

Second, the minutes of the FOMC’s March meeting were accidentally released last Tuesday about 19 hours early. More tellingly, they were released early to approximately 150 individuals, including congressional staff members and lobbyists for some of the biggest Wall Street firms, including Goldman Sachs, Citigroup, Barclays Capital and Carlyle Group.

Apparently, it’s standard operating procedure for Fed minutes – along with other sensitive data – to be sent to such individuals on an embargoed basis.

“I wonder why this information is offered to anybody outside of even the president,” Jon Najarian declared on Breakout, prompting my colleague Jeff Macke to note that information about Oscar winners are treated with greater security than the Fed minutes.

The “Fed Flub” is certain to reinforce a notion there’s a Washington-Wall Street cabal running the country exclusively for the benefit of a select few.

Right or wrong, President Obama’s meeting last Thursday with the CEOs of Goldman Sachs, JPMorgan, Bank of America, Citigroup, Morgan Stanley, Wells Fargo and AIG adds further fuel to such perceptions. And while President Obama has a reputation for being anti-Wall Street, his actions have never matched the “Fat Cat” rhetoric, as I’ve long argued.

As you’ll see in the accompanying video, Henry Blodget believes the real reason investors remain wary of the market are memories of two 50% declines since 2000. In addition, he believes individual investors are better off sticking to index funds vs. competing with pros who have an asymmetric information advantage – even without resorting to illegal activities.

Academic research suggests Henry is 100% right about index investing. My point is the continued revelations about insider information and other illegal activity at the highest levels are scaring a lot of investors from even doing the basics.

Aaron Task is the host of The Daily Ticker and Editor-in-Chief of Yahoo! Finance. You can follow him on Twitter at @aarontask or email him ataltask@yahoo.com