Friday, May 17, 2013

We Are Prisoners of Our Past

Investors Have Their Eyes on the Past
Even though interest rates are at historic lows, and despite repeated warnings from economists and analysts that bond funds at today's yields are risky, investors continue to move money into fixed income.

According to Merrill Lynch, investors have poured more than $94 billion into bond funds so far in 2013.

Equity fund flows have picked up - last week a whopping $14 billion moved into stock funds - but more than half of the equity flows have been into exchange-traded funds (ETF's), which are typically trading vehicles rather than long-term investments.

What's going on here?

Jason Zweig had an excellent piece in the Wall Street Journal earlier this week about investor psychology. 

Zweig wrote that most investors who are active in the market today have never experienced a true bear market for bonds, which means they have a hard time  visualizing how one could lose money in fixed income investing:

Today’s bond investors have lived through more than three decades in which bonds almost never went down. So, even though everyone talks about the coming bear market in bonds, most people can’t imagine how painful it could be, warns David Allison, a partner at Allison Investment Management in Wrightsville Beach, N.C.

That’s true not just for individual investors but for professionals as well: The average age of a portfolio manager, according to the CFA Institute, is 43 – meaning that the last bear market in bonds ended when the typical portfolio manager was around 10 years old.

Meanwhile, unless you were active in stocks in the 1980's and 1990's, you probably have never experienced a true bull market for stocks:

For today’s stock investors, the reverse is true. The past 13 years have been gut-wrenching, with the Standard & Poor’s 500-stock index collapsing 38% between 2000 and 2002, then roaring up until 2007, then losing half its value between 2007 and 2009, then bouncing back again. No wonder nearly a third of investors think the stock market went down last year, even though the S&P 500 gained 16% in 2012.

Gillian Tett of the Financial Times wrote (another) bearish column on stocks in this morning's edition.

One of the most respected financial journalists in today's press, Ms. Tett typifies the widespread belief that stocks are floating on a air of undeserved optimism, and that bad times surely must be ahead:

Are the markets going mad?  That is a question many investors might have asked in recent weeks, as stocks in the UK, eurozone and the US have soared - even as bond yields decline.

Tett goes on to argue that because none of the "traditional" correlations have held true in recent times - that is, correlations that were correct in the bear market for stocks between 1997 and 2011 - all of the market's recent gains are only setting up for a larger fall somewhere down the road.

I suggest that Tett has become a prisoner of the recent past. 

She was more prescient than most in seeing the credit crisis of 2008, and wrote a best-selling book about the collapse of the derivatives market. Her argument that all of this is based on central bank easing is echoed by many, yet it ignores that fact that the S&P today stands no higher than it was in 1997 on inflation-adjusted basis.  

I am not saying that we may not suffer a correction at some point - based on history, we are long overdue - but the tendency to base investment decisions solely on recent history has rarely proved to be a successful strategy.