By: Larry MacDonald

Legg Mason’s renowned market strategist, Michael J. Mauboussin, has published a new study, The Sociology of Markets. In this thought-provoking piece, Mauboussin says it’s important to know the sociology of financial markets – i.e. the main participants and their objectives, modus operandi, risk preferences, etc.

For example, the growth of mutual funds and pension funds over the 1980s and 1990 is credited with reversing the premium observed on small caps over large caps in previous decades. How so? As investment decisions shifted from individuals to professional managers during the 1980s and 1990s demand went up for large caps owing to their greater liquidity.

Looking ahead, Mauboussin sees Asian and petrodollar countries increasingly becoming sources of funds for U.S. stocks via direct channels (e.g. central banks) and through agents such as sovereign wealth funds (SWF) and hedge funds. Both regions will have ever-growing mountains of U.S. dollar reserves to invest and Mauboussin sees evidence that they are beginning to diversify those reserves away from U.S. government bonds into stocks and alternative assets (e.g. SWFs recent investments in U.S. bank stocks).

“This lower risk aversion, in turn, serves to dampen equity risk premiums and ultimately increase valuation multiples,’ writes Mauboussin. “Note that, if true, this analysis suggests an upward re-pricing to gain a new equilibrium [for stocks].” In short, a flood of liquidity from Asian and petrocurrency countries could buoy the U.S. stock market and perhaps over time help lift it out of the current malaise triggered by the housing and financial crisis. Here is the link to his report.