Spooked by the challenging economic picture and with memories of the financial crash still fresh, U.S. investors appear almost oblivious to the fact that the stock market is on a tear.
Even though the S&P 500 is up more than 115% since it bottomed out in March 2009 — and its Friday closing price of 1,460.15 is well within striking distance of its all-time high of 1,565.15 — investors continue to run from U.S. stock mutual funds.
Altogether, investors yanked $300 billion more from actively managed U.S. equity stock funds than they put in over the three-year period through July 31, according to Morningstar Inc. While the net $140 billion that investors dumped into passively managed funds and ETFs over that period offset those withdrawals, it still leaves a net $160 billion on the sidelines.
To be sure, that is a drop in the bucket when compared with the $3 trillion-plus that is invested in equity mutual funds and ETFs. But with the prospects for returns across all assets looking dim at best, investors can't afford to continue ignoring U.S. stocks forever.
For baby boomers facing longer retirements than ever before, there is a very real chance that they could run out of money, thanks to a combination of inflation and painfully low interest rates.
“We've long hoped people would stop chasing returns, but in some ways, this actually seems worse,” said Russel Kinnel, director of mutual fund research at Morningstar Inc.
“Five years ago, we thought investors were overweight equities and we were talking about fixed income. Now there is such a hangover from the 2008 market that investors are too conservative,” said David McSpadden, Franklin Templeton Investments' senior vice president of global advisory services.
NEW APPROACHES
“We're not saying people should go barreling into equities, just that they should be having meaningful conversations with financial advisers,” he said. “The degree of the 2008 correction certainly caught everyone by surprise, but given the stock market rally, we would have anticipated more of a balanced flow back into equities.”
Advisers know that clients want their help, but they realize the need for new approaches.
“People have been generationally beat up to the point where investors are now like the children of the Depression, who became consummate savers,” said Sam Jones, president of All Season Financial Advisors Inc., which has $110 million under management. “I think it will take an entire generation for investors to become wildly bullish again.”
The disconnect reflects investors' unwillingness to dip their toes back into equities — even though staying out of the market or investing too heavily in bonds could prove more damaging to their portfolios.
“At some point, people are going to have to accept the fact that the economy has moved forward,” said Lee Munson, principal at Portfolio LLC.
Maybe so. Although many economic indicators are improving, they aren't improving as fast as most people would like.
The unemployment rate, for example, has fallen to 8.3%, from a high of 10.1% in October 2009; new housing starts have risen to 754,000, from a low of 478,000 in April 2009; and new homes sold totaled 372,000 in July, up from a low of 273,000 in February 2011.
There are a number of theories to explain why investors haven't come back yet. Some say that the scars of 2008-09 are still too fresh.
“The upside isn't high enough to take on the risk of losing half your money,” said Janet Briaud, chief investment officer of Briaud Financial Advisors Inc., who is keeping her clients' exposure to stocks low because she doesn't feel that the risk is worth the reward.
Others blame the 24-hour news cycle for keeping the crises front and center, and still others think that investors have simply come to the conclusion that the stock market is rigged and want no part of it.
Liz Ann Sonders, chief investment officer of Charles Schwab & Co. Inc., said that investors are intent on avoiding the stock market altogether.
“More than one client has brought up that the Fed is just manipulating the market for the benefit of the few rather than the many,” she said.
After all, the Federal Reserve has intervened three times, four if you count “Operation Twist,” to try to steer investors toward riskier assets, Ms. Sonders said.
So far, investors haven't bitten.
But to paraphrase Bruce Springsteen, stocks aren't a beauty, but they're all right, at least when compared with bonds.
The Fed's latest intervention is to purchase $40 billion of mortgage-backed securities a month until the unemployment picture gets better. It also said that it will keep rates at near zero until at least the middle of 2015, which spells big problems for bonds, the biggest beneficiary of the aversion to stocks.
Bond funds took in a startling $734 billion over the three-year period through July. The total amount of assets in the intermediate-term-bond fund category at Morningstar has doubled to more than $2.1 trillion since the financial crisis.
The average allocation to bonds is up to 25%, from its 20-year median of 16.9%, according to The Vanguard Group Inc.
Meanwhile, the Fed's near-zero rate puts bonds in a precarious position when it comes to protecting purchasing power. At current yields, the 10-year Treasury is hovering around 1.8% and it won't even take historically average inflation to chip away at the value of a bond investment today.
“A lot of investors are locking in negative real returns and they're OK with that,” Ms. Sonders said. “The problem is when rates go up enough that they actually start to look at losses, period.”
NO CUSHION
The Barclays Aggregate Bond Index, the most widely used proxy for U.S. investment-grade bonds, has an average duration of between four and five years. A rate rise of just 1% would cause it to lose 5% of its principal.
In ordinary times, that wouldn't be so bad, but with the index yielding just under 3%, there is no cushion to soften the fall.
That threat of loss could be what it takes to get investors to flip-flop on U.S. equities, assuming that the market doesn't fall off the fiscal cliff, Ms. Sonders said.
“It's going to take a combination of a push out of bonds and a pull into equities,” she said.
Some advisers are moving to protect their clients' nest eggs by persuading them to buy stocks, even if it requires more than a little nudge.
“Clients are getting squeezed on every side,” said Margaret McDowell, founder of Arbor Wealth Management LLC. “Their heels are dragging in the dirt as they're going, but they know stocks are the only way to have something to come home to.”
Senior reporter Jeff Benjamin contributed to this article.
jkephart@investmentnews.com Twitter: @jasonkephart
