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More individual investors are gone from the equity market than at any other time in decades, pushed out by poor returns, unfathomable volatility, and concern and disillusion with the political and economic environment. Instead, investors have turned to bonds, as they seek safety and the return of their capital ahead of investment returns. This search for safety will prove counterproductive and investors will get hurt down the road once the economy recovers. Their flight from stocks has made the equity market the place to be for the foreseeable future, although only those with some staying power will reap these benefits.

The flight to safety is demonstrated most clearly by the flow of investor funds into bond funds and bonds. IBM (NYSE:IBM) recently issued a $1.5 billion 3-year note to yield 1.0%, one-half the yield on its common stock. This contrast indicates in the starkest terms that many investors prefer that they get their capital back in three years, even if they earn almost nothing on that investment, rather than risk capital loss by buying the common stock. U.S. Treasury TIPs, which protect investors from inflation, yield zero in the 5-year maturity range. So, some investors are forgoing all return, if they can keep their capital inoculated against inflation over this term. Just as impressive is last week’s Johnson & Johnson (NYSE:JNJ) issue of 10-year notes at 3.15% in contrast with the 3.7% yield on its common. It is very likely that the stock investor will earn a return that is a multiple of the return earned on these bonds over a 10-year horizon.

This preference for bonds over stocks is not restricted to just high quality borrowers. High yield bond issuance so far this year has already exceeded $155 billion, versus a record $163.6 raised in calendar year 2009. So, last year’s record level of issuance will be exceeded by a considerable margin. August issuance is normally quite light, but $21.1 billion has already been brought to market. In fact, when we speak to bond dealers in our effort to buy bonds for our clients, finding attractive paper is hard and we have been forced to become very selective in our picks. In contrast, we can easily sell anything we own. We have also heard that bond funds have had to sacrifice their ability to be selective, because so much cash is pouring in, they must buy almost anything available to avoid sitting on mounds of uninvested cash. How did we arrive at this point?

Investors are clearly seeking safety. Their concerns may be motivated by fear that economic growth might lapse, that the Washington political process is so polarized that good policy is hard to win approval, while foreign policy is also fraught with unusual dangers. In truth, I can think of any period in my entire investment career when the outlook has ever been clear and there weren’t major concerns. Uncertainty has always been high.

The economic outlook is “unusually uncertain,” as suggested by Fed Chairman Bernanke, a rhetorical flourish that supports current apprehension. Looking back, I recall forecasts of a double dip recession in every single recovery I have lived through, even though not one ever flamed out. People are always nervous that bad times will come back. That history notwithstanding, a double dip recession forecast has become fashionable, once again.

However, the data suggest that growth has slowed in 2010, not that a second recession has started or is even likely. Companies have refinanced themselves with enormous volumes of debt and equity issuance. Public companies are sitting on about $1.7 trillion in cash, S&P 500 companies are sitting on about $1 trillion, profit margins have widened very sharply and profits and cash flow are quite robust. Analysts have been caught up in this atmosphere of caution and companies keep exceeding and raising their profit forecasts above that of analysts. The typical company has too much cash and needs to figure out how to use this asset more productively than earning a few basis points. Companies have been investing in new equipment and technology in their effort to improve competitiveness, but despite this sizeable rise in capital investment, retained profits exceed investment, so the cash hoard keeps getting larger. So, acquisition activity has picked up and most firms have used cash to finance these deals. It is hard to see the basis for a significant retrenchment in the corporate sector under these conditions.

The health of the banking system is also greatly improved. Late in 2008 and early in 2009, there were reasons to fear that the entire financial system might unravel, severely damaging the overall economy. After the failure or near failure of Lehman, Bear Stearns, AIG, Fannie Mae and Freddie Mac (OTCQB:FMCC), a financial collapse was not a farfetched possibility. Instead, the banking system was recapitalized, bad loans were written off, and government loans have been largely repaid. Yes, borrowers are not borrowing, but this has as much to do with the flush condition of the corporate sector as it does with the caution of bankers to lend. Good projects can get financing, as is easily demonstrated by the extraordinary low rates available in the bond market.

Job growth, the ultimate indicator of the health of the economy, remains disappointing. In 2010, we have averaged just 90,000 net new hires monthly, when we should be creating twice, or even three times as many new jobs. Thus it is absolutely clear that the pace of the recovery is anemic. But the job growth, as weak as it is, is distinctly positive and a far cry from the hundreds of thousands of jobs lost monthly during the recession. And as other circumstances improve, the pace of hiring should also pick up. For example, the pay down of household debt takes time. But the savings rate has surged above 6%, which will enable consumers to improve their balance sheets and resume spending, which will increase demand and require more hiring.

The housing market remains a focal point for bulls and bears, but most of the weakness lies in the recent past. New construction activity is barely above 500,000 units at an annual rate, dramatically below the underlying rate of household formation of about 1.5 million. So, inventory is being absorbed far faster than is commonly recognized. This underlying improvement in housing fundamentals explains the gradual rise in housing prices over the past several months, a key element in the data that is impossible to reconcile with forecasts of impending worsening conditions in housing. Sooner rather than later, population pressures will force up new construction activity and new hiring in this sector.

Politics has become highly contentious. It is often described as more combative and less collegial than ever, a claim that is demonstrably untrue. Having recently gone on a kick of reading several books about our Founding Fathers and the early stages of the formation of the United States, I must conclude we are truly myopic and forget the past very easily. It is remarkable that John Adams and Thomas Jefferson ever worked together on the Declaration of Independence, since they were in severe conflict on almost everything else and it took years for Adams to forgive Jefferson for his behind the scenes efforts to undermine Adams and destroy his reputation. Nor was their adversarial political relationship atypical. By the time of his retirement from public office, George Washington, who was held in the utmost of regard by his compatriots, was fed up with politics. And, of course, politics spilled over into civil war upon the election of Abraham Lincoln. Politics has always been extremely combative, even vicious, in our history.

The general unease of the investing public, for the reasons given above and more, is the very reason stocks are so cheap and bonds are so dramatically overvalued today. Such swings in sentiment are actually also common historically. Investors went entirely overboard in the opposite direction in 1997 through 2000, driving up stock valuations to absurd levels for tech companies. That piper was paid from 2000 to 2003 when tech valuations crashed and stocks became outrageously cheap. Stocks were priced for a possible depression in March 2009 and valuations are not dramatically better now. Given some time, equity investors will do quite well, in our judgment, at least those who have the fortitude to remain in equities. But it isn’t easy now. And, in fact, it has never been easy. It has always seemed easy with hindsight.

Disclosure: No positions

Source: Fear and the Flight of the Individual Investor