Friday, May 25, 2012

Investors Flee the Stock Market

In a piece titled "Out of Stock" in yesterday's Financial Times, co-authors John Authers and Kate Burgess wrote the following:

Indeed, equities have not been so cheap relative to bonds since 1956, which turned out to be one of the best moments in history to have bought stocks.

By any number of measures, the relative attractiveness of stocks relative to bonds should be evident to most investors.

Interest rates on government bonds in the U.S. and Western Europe are below the rates of inflation. 

Indeed, earlier this week the German government successfully auctioned notes maturing in two years that will pay investors no interest.

The period of "financial repression" that we are experiencing is robbing savers of a reasonable rate of interest. Government policies around the world are all targeting low interest rates, which allows fiscal deficits to move ever higher without a corresponding rise in interest expense.

And why should this change?  Some serious observers of the financial markets suggest that we are actually experiencing a shortage of bonds.  They suggest that low interest rates reflect the huge demand for income and safety from an aging population.

Regardless of why interest rates are low, however, it still is puzzling why bonds continue to be favored over stocks by investors.

Authors Authers and Burgess note fixed income allocations continue to ratchet higher among not only individuals but also managers of pension and endowment funds despite the fact that: the long run, equities outperform.  From 1900 to 2010, they beat inflation by 6.3 per cent in the U.S., according to a widely used benchmark maintained by London Business School, compared with only 1.8 per cent for bonds.

And yet:

In the U.S. and U.K., public pension funds had allocations to equities as high as 70 per cent only 10 years ago.  They are now down to 40 per cent in the U.K., and 52 per cent in the U.S.

Ponder this for a moment:  a pension fund, by definition, should have a very long term time horizon when it comes to investment policy.  Investing in assets like stocks that have proven over very long periods of time offer superior inflation-adjusted returns should be automatic.

But that's not what is happening.

Some of this behavior is not as irrational as it might seem, by the way.  Government regulations have been enforced on pension plans that make their managers very risk adverse. 

Bonds may offer meager returns today, but their strong relative performance over the past decade relative to bonds makes it easy for plan sponsors to justify high bond allocation.

Yet with interest rates at generational lows - Merrill Lynch writes this morning  that Dutch bond yields are at 500-year lows - it doesn't take much thinking to envision a scenario of interest rates rising and declining bond values.

Before loading up on equities, however, it is worth remembering the words John Maynard Keynes wrote long ago:

Markets can stay irrational longer than you can stay solvent.

Stocks, in my opinion, offer the best opportunity for investors to earn reasonable real returns, yet the ride will not be smooth.