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A bull market's third year differs significantly from the first two, both in temperament and magnitude. Typically, large-cap stocks take leadership from small- and midcap stocks, and the gains are more muted.
"Things get more challenging," said Sam Stovall, the chief investment strategist at Standard & Poor's Equity Research. "The first two years, all sectors typically advance," he said. "Cyclical stocks do better than defensives, and it's a nice party."
But in the bull's third year, the dynamics of the market change, Stovall said. "Investors are less willing to throw caution to the wind."
Clearly, risk-taking has been amply rewarded since the market's low on March 9, 2009. The Standard & Poor's 500 Index ($INX) has almost doubled since then, after hitting a 12-year low. And the Dow Jones Industrial Average ($INDU) has done nearly as well, climbing back above 12,000 from its March 9, 2009, close of 6,547. It's still 14% below its all-time high in October 2007.
Retail investors enjoyed little of the rally after being big sellers of U.S. stock mutual funds through most of 2009 and 2010. Since the beginning of the year, however, investors have put $24.2 billion into U.S. stock mutual funds, according to the Investment Company Institute, a fund-industry trade group.
It would appear that many retail investors -- and more than a few fund managers -- are afraid of missing the next leg of the bull run. Indeed, two of every three U.S. stock fund managers who attempt to top the S&P 500 fell short in the past year, while three of four midcap stock funds failed against their benchmark, according to Standard & Poor's.
"We remain concerned that too many investors are chasing stocks higher for the sake of performance," Brian Belski, the chief investment strategist at Oppenheimer Asset Management, noted in a recent report to clients.
"Stocks lead the economy," Belski said. "Unless economic and employment growth substantially improve over the next few months, we believe there is a very good chance that stocks have already priced in the majority of the economy's recovery."
'Extreme' optimism a warning sign
Investor sentiment has been buoyed by healthier portfolios and the improving economy, although bullishness has softened a bit as oil prices jumped in the wake of political uprisings in the Middle East and North Africa.
"There's extreme optimism," said Ed Clissold, a senior global analyst at Ned Davis Research. "That is a warning sign, but optimism can stay at elevated levels for a while."
Investors getting back into stocks now may be disappointed. While seven of the 10 bull markets since 1949 have marked their third anniversary, the S&P 500's average gain in the third year of a bull market is just 5%; it's 19% in a rally's second year.
