Taking stock for a few dollars more

Fund Strategy - 26 Sep 2011 | By Vanessa Drucker

The king is in his counting house

American mattresses are cushioned with plenty of dollars. Investors are still licking their wounds, after suffering two bear markets since 2000, the May 2010 flash crash that wiped 583 points off the Dow, a raft of ugly geopolitical news and a deep-rooted suspicion that capital markets are rigged. Money market funds and equivalents yield near-zero returns.

Notwithstanding, emotionally scarred investors have fled equity markets since 2008, and show little enthusiasm to return. How long can they crouch in cash, holding out for the all-clear signal?

It could take a long while. According to data from JPMorgan Asset Management, domestic equity flows have been negative for several years, comprising $48 billion [£31 billion] in 2007, $152 billion in 2008, $39 billion in 2009 and $96 billion in 2010. Inflows into global equities over those years, albeit positive at $145 billion, did not make up the shortfall.

”Typical investors lack good advice and are more likely to be subject to psychological whims”

A long retrenchment from stocks has historical precedent. In 1948, years after the Wall Street Crash and the Great Depression, the Federal Reserve conducted a survey of 3,500 investors, asking where they considered the safest place for their money - a bank, real estate, savings bonds or common stock. Among respondents, 26% considered stocks “not safe” or a “gamble”, with only 4% saying they were “satisfactory.”

Those paralysed souls demonstrate that the public can resist investing in equities for decades. Contrarians argue that markets only reach bottoms after an entire generation has forsworn stocks indefinitely, a bitter lesson that Mrs Watanabe in Japan has learned. (Stateside continues below)

Demographics are destiny

The year 1948, just after the second world war, may seem like a different era. In fact, alternative yields from fixed income of 60 years ago were comparably meagre. The prime rate then, at 2% in August 1948, was lower than it is today, at 3.25%.

Or one might argue that the structure of American retirement investment funds has radically altered, shifting from corporate pension plans toward self-directed 401(k) vehicles and Individual Retirement Accounts. Do these contemporary structures manoeuvre savers
into stocks?

The opposite is more likely. These 401(k)s offer employees a menu of choices, including equities, bonds and money market funds. Investors can choose for themselves, thereby controlling their own cash positions, unlike the traditional pension plans of 30 years ago.

Mutual fund managers, by contrast, rarely keep more than a modest percentage in cash. John Longo, a finance professor at Rutgers Business School and chief investment officer of the MDE Group wealth management firm, says: “These investors, who generally have no financial training, are still responsible for managing their retirements. Typical investors lack good advice and are more likely to be subject to psychological whims. That means they get nervous when the market goes down and sell.”

Demographic pressures build as a generation is turning 65. Every day, for the next 19 years, 10,000 baby boomers will cross the retirement age threshold. Kent Croft, who manages the Croft Value fund from Baltimore, Maryland, marvels at how so many have ratcheted down their equity exposure since 2007. “They will need the income returns through retirement, which will push them into dividend paying stocks.”

On the other hand, it can be more terrifying for an older person to see their capital ebb away in stockmarket volatility. According to Croft many people bail out at a certain level that represents where they can survive. It may leave them strapped, but “it’s a natural primitive reaction”.

When the tide turns

Sooner or later, investors must stop hoarding cash, but what could tip the balance?

On the bright side, a perceived recovery in either stock prices or the economy itself will gradually restore confidence. Longo suggests that a meaningful drop in unemployment, below about 8% would make an impact, but that would probably take until 2012 or 2013. Croft, however, is optimistic that investors will be willing to venture into stocks, “if the economic news is not as bad as feared”.

He points out a disconnect between macro fears and corporate fundamentals: balance sheets are healthy, with companies demonstrating earnings resiliency and ­prepared even to weather another recession. Croft saw his own clients return to stocks in early 2010, rebalancing ­portfolios from a retreat of about 50% in equities, to
70% levels.

The 2012 elections could prove a watershed. As that date approaches, rhetoric and emotions are bound to run high, with candidates predicting disaster scenarios if their opponents get elected. Meanwhile, the debt ceiling stand-off has merely been postponed, and seemingly intractable problems in euroland make for chilling headlines.

On a sober note, James Dailey, a portfolio manager at Team Asset Strategy in Harrisburg, Pennsylvania, warns that we are still fighting the last post-Lehman war. He expects an eventual crisis in the dollar will be the spur to push investors by default into stocks. In normal times, people might reduce equity holdings as a rational response to an overleveraged culture.

But, he says, policymakers are willing to sacrifice the currency to prevent that outcome. A massive battle is brewing, between the forces of deflation and insolvency - when cash should normally be king - and policymakers willing to erode the value of fiat money (inconvertible paper money made legal tender by a government decree). If that occurs, investors will rush to relinquish greenbacks, flocking to blue-chip multinationals and commodities in general.

It would be disingenuous to try to pinpoint a date for that frenzy to spend devalued cash. So many potential factors are operating to undermine paper money. As snow gathers, a small noise can set off an avalanche. Only then, late to the party, investors may rapidly open their wallets.

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