Successful investing is similar to good comedy. They both depend on accurate timing.
Over a 30-plus year career as an investment analyst and investor, there is one observation I've found useful: major investment trends last longer than are justified by the facts.
Remember Housing: This was true of the relentless rise in housing prices during the turn of this century. Housing values shattered all accepted historical housing valuation metrics, i.e., house values-to-income ratios, loan-to-value ratio, replacement costs, etc. Any investor that recognized this abnormality early-on and took the other side of the trade "lost his shirt."
New Tragedy Developing: This misfortune is now being reenacted in the fixed-income markets. Historical metrics suggest a severe overvaluation of fixed-income securities. This would be based on relative equity yields and historical inflation projections following periods of easy money. The "call" for a massive shift of capital from fixed-income to equities is a defensible argument. So, why isn't it occurring?
Urban Myths: Like urban myths, there are investor myths. When the myth becomes so pervasive it becomes a self-fulfilling prophecy. And changing that widespread perception becomes the equivalent of turning around a supertanker-long and arduous.
The housing crisis was based on the investor myth that "housing prices don't go down." Our pending crisis is based on the investor myth that "fixed-income investments provide safety" in uncertain times. (One should explain this to the private investors in Greek sovereign debt.)
Follow the Money: The recent rise in the S&P 500 index has been on low volume. This means the equity markets are vulnerable to downdraft in investors' sentiment-as there are few current buyers available to "sop-up" the volume of the sellers. This has been some of the source of recent market volatility.
Sources of Investor Demand: Investment companies (mutual funds, ETF's, closed-end funds and UITs) at the end of 2010 held $12.1 trillion of investable securities. About 27% of domestic U.S. corporate equities are held by investment companies.
Mutual funds represent 90% of investment companies' investable funds. They offer a good proxy for investor sentiment. The adjacent chart compares the mutual fund flows for equity ("blue") and fixed-income ("red") versus the S&P 500 ("green") on a weekly basis since the beginning of the year.
Where's the Love? Year-to-date ("YTD"), the S&P is up approximately 10%, yet there has been $15 billion of domestic equity mutual funds flow leaking from this sector during the period. (This is in addition to the $134 billion funds outflow of 2011). In contrast, total aggregate fixed-income money flows YTD is up $87.1 billion.
These numbers provide little evidence that investors are gravitating towards equities. In fact, they're relentlessly pouring money into fixed-income funds. We may be witnessing the greatest investment catastrophe of our lifetimes: the popping of the fixed-income valuation bubble.
Pundits May be Right, but Not Correct: So, for all the pundits predicting a shift from fixed-income to equity, for all the right reasons-for which we are proponents-there is not much funds flow data to support this contention from an important investment source, i.e., mutual funds.
Our previous analysis doesn't support the proposition that mutual funds' flow is a contra indicator. According to the ICI 2011 Fact Book, "Net flows to equity funds tend to rise with stock prices and the opposite tends to occur when the stock prices fall." The question is which comes first?
What Would Change Our Mind: We are in the camp that equities are currently more attractive than fixed-income on a longer-term basis. However, investors, managers and families need visibility regarding fiscal, monetary and economic policies that allow for planning for both business and personal affairs. Investors' sentiments regarding recommitting to equities will unlikely change until this fog lifts.
Here what we're looking for in terms of events to cause us to commit additional funds to equities:
- Sustained Increase in Stock Prices with Increasing Volume Coupled with a Nascent, Steady Decline in Bond Prices. However, if there is a disastrous revaluation of fixed-income securities, investors may become paralyzed and sit on their hands or buy gold and other commodities.
- A Viable Attempt at Resolution of the Fiscal Crisis. Any reasonable attempt at deficit reduction would provide comfort to investors that we're "back in control" of our destiny. As we've seen previous, any whiff of a bi-partisan settlement would thrill the markets.
- A New Tax Regime: While related to the point above, America is long overdue for a serious overhaul of its tax code. A simpler, fair attempt at raising revenues is needed to replace the current tax system that has been over-lobbied and contorted. We find Simpson Bowles a good place to start.
- Rationale of Entitlements: The country lacks the resources to fulfill every citizen's want let alone all legitimate needs. Social Security and Medicare need to restructure along a private health care system solution with regulatory oversight.
Higher Taxes, Yes: We do anticipate higher taxes on dividends. The more important question is: will it be higher than those on capital gains? If it is, we expect corporations to lower their rates of distribution. We expect such excess cash flow will be reinvested in the businesses and likely result in higher share prices. This excess share price appreciation will be harvested on a regular basis as capital gains in lieu of a distribution generating comparable or greater cash flow.