Friday, June 29, 2012

How Can You Invest In Stocks When You Don't Trust the System?

"You Want a Friend, Get a Dog"
Professor Brad DeLong of the University of California at Berkeley wrote an excellent essay last month discussing why investors continue to flee stocks in favor of bonds. 

First, he sets out the incredible valuation difference between stocks and US Treasury Inflation-Protected Securities (TIPS):

The S&P stock index now yields a 7% real (inflation-adjusted) return. By contrast, the annual real interest rate on the five-year United States Treasury Inflation-Protected Security (TIPS) is -1.02%. Yes, there is a “minus” sign in front of that: if you buy the five-year TIPS, each year over the next five years the US Treasury will pay you in interest the past year’s consumer inflation rate minus 1.02%.

So, just doing the math, an investor who puts $10,000 into a S&P 500 index fund today has a reasonable chance of having roughly $14,200 five years from now.

Buying a intermediate maturity TIP, on the other hand, locks in a loss.  In five years, $10,000 in a TIP will be worth around $9,500 - guaranteed.

So why would anyone prefer a certain loss to an investment with a pretty high probability of gain?

Dr. DeLong cites many several reasons - economic uncertainty; memories of the "lost decade" in stocks; Europe, etc. - but he also mentions something that really hadn't registered with me until I read it.

Namely, that most investors have lost faith in our financial institutions.

There's something to this, I believe.  Just think of the three events in the past few weeks:

  • A month after dismissing questions as "a tempest in a teapot", JP Morgan is now facing the possibility of a $9 billion trading loss in Morgan's London office. Morgan CEO Jamie Dimon, meanwhile, continues to rail at the thought of any new regulations;

  • Barclays Bank faces huge legal and financial sanctions after regulators uncovered widespread manipulation of the LIBOR benchmark by some of its internal traders in order to generate trading profits;

  • Facebook comes to market with much hoopla, and prices its IPO at $38 a share after initially indicating a price of $28 per share.  Meanwhile, Facebook management quietly lets major institutional investors that recent trends in its business have slowed, and that Facebook shares are probably overpriced.
Stories like these coming so soon after the taxpayers had to bail out Wall Street and the banking sector leave a bad taste in everyone's mouth.

And so is it any surprise that investors continue to pull money out of the stock market?