When Will the Retail Investor Return to the Stock Market?

I've been attending "The Asset Gathering Conference" being held here in Boston.

Sponsored by the brokerage firm UBS, the conference features speakers from such large asset managers as Franklin Resources; Fidelity; MFS; and State Street Global Advisors.  In addition, several consulting firms are making presentations, including Boston Consulting Group and McKinsey & Co.

UBS has held this conference annually for the past several years, and I've always found them to be informative.

The mood at this year's conference is relatively somber, in my opinion.

All of the companies are struggling to offer products that will attract new investments.  However, most investors are fairly discouraged by the meager returns from the stock market over the past decade, and are mostly focused on income and safety.

Last year 80% of the mutual fund inflows went to just three companies:  Vanguard; Pimco; and Fidelity.  Moreover, the vast majority of these inflows went to just five mutual funds.

Investors are interested in either index funds (Vanguard) or fixed income (Pimco);  actively managed equity funds, especially those investing in the US, continue to see outflows, regardless of their relative performance.

According to the speakers that I have heard so far, investors are more interested in guidance than relative investment performance.  Target funds - where fund complexes offer funds that adjust asset allocation as a selected target date approaches - are the third most popular product offering, after bond funds and emerging market equity funds.

So the question is: When will the retail investor return to the US stock market?

Unfortunately - and this may explain the somber mood of the audience - history suggests that the average investor may shun stocks for longer than anyone would like.

In the 1970's, for example, the market took a steep dive in 1974, but then gradually recovered for the rest of the decade.  According to data from the Investment Company Institute (ICI), inflows into equity mutual funds did not turn positive until 1982, or nearly 8 years after the market had hit its lows.

http://www.ici.org/pdf/per02-02.pdf

However, I would argue that today's low interest rates makes avoiding stocks altogether a fairly expensive way to invest your savings.  Inflation is low, but is still running at around 2% or so, meaning that you need to earn more than money market rates to keep up with inflation.

In addition, unlike the 1970's, nearly all workers have been forced to save for their own retirement - pension plans have largely disappeared for all but the public sector.

However, the ICI released data yesterday that indicated an acceleration in outflows from domestic equity funds, despite the more bullish commentary emanating from Wall Street.

The average investor just ain't buying into this rally.

Investment Lessons from Andrew Carnegie

A little more than a century ago, in 1901, Andrew Carnegie sold his family's interests in its steel enterprises to a group led by J.P. Morgan and Charles Schwab (no relation to the brokerage).

The consortium - which was retitled the United States Steel Company - immediately became the largest corporation in the world, with a market capitalization of over $1 billion.

The sales price was 12x annual earnings (interestingly, about where the S&P 500 is trading today). The total value of the transaction was $480 million, or about $13.7 billion in today's dollars (according to Wikipedia, by way of Gale Virtual Reference Library).

Carnegie's personal share of the transaction was slightly more than $225 million, which was paid to Carnegie in the form of 5%, 50-year gold bonds. According to Wikipedia:

The bonds were to be delivered within two weeks to the Hudson Trust Company of Hoboken, New Jersey, in trust to Robert A. Franks, Carnegie's business secretary. There, a special vault was built to house the physical bulk of nearly $230,000,000 worth of bonds. It was said that "...Carnegie never wanted to see or touch these bonds that represented the fruition of his business career. It was as if he feared that if he looked upon them they might vanish like the gossamer gold of the leprechaun. Let them lie safe in a vault in New Jersey, safe from the New York tax assessors, until he was ready to dispose of them..."

http://en.wikipedia.org/wiki/Andrew_carnegie

What made me think about Carnegie's transaction was how, in some ways, the world is still struggling to find the right combination of safety and yield.

In Carnegie's day, there was no Federal Reserve (which was actually started in 1912). Deposit insurance was unheard of, and bank failures were not uncommon. Government bonds were relatively scarce, and even if they were, the creditworthiness of the United States was not perceived as strong as other countries like Britain or Germany.

So it would make sense for someone looking to preserve great wealth to look for two key characteristics: first, it had to offer an attractive yield (5% sounds pretty good today!); and, second, it had to be absolutely secure (hence the gold backing).

Unfortunately there are no 5% gold-backed bonds available today. Moreover, the only place that investors can find any sort of relatively safe yield is in dividend-paying common stocks.

Bloomberg had an interesting article this morning noting that while dividend yields are attractive, there is plenty of reason to believe that corporate America can raise payouts significantly in the coming years, especially if stock market returns remain subdued:

Pressure is building for higher dividends as U.S. companies from Google Inc. (GOOG) to Valero Energy Corp. (VLO) sit on record cash stockpiles and payouts remain at three- year lows.

Standard & Poor’s 500 Index companies paid 27 percent of earnings in dividends in the second quarter, down from 30 percent in 2008 and below a 30-year average of 41 percent, according to Wells Fargo & Co. Company cash, equivalents and short-term marketable securities jumped 63 percent to $2.77 trillion in the same period, according to Bloomberg data.

http://www.bloomberg.com/news/2011-10-05/dividends-at-three-year-low-mean-pressure-builds-as-cash-rises.html

The article goes on to quote several investment professionals noting the extremely high cash levels that many corporations have stockpiled for fear of a repeat of the credit crisis of 2008.

Put another way, stock buybacks and hoarding cash are in some ways a bull market strategy. Investors have no problem not receiving cash directly from their investments so long as their stock investments are rising in value.

However, with the S&P down more than -17% over the past 5 years, and the papers full of recession talk, it seems logical to expect more pressure on company managements to return more cash to shareholders.

Unless we can convince someone to issue 5% 50 year gold backed bonds.