Will Investors Return to US Stocks?

Tuesday, December 14, 2010

Here’s an excellent question from a reader:

“If small investors did not jump back into equities at 20% or 40% less, why would one think they will jump into equities now or at any time in the near future? They may well leave bonds and bond funds if interest rates rise, but that does not mean they will move into equities.”

Here we are, with stocks up significantly over the past 21 months, yet individual investors continue to liquidate US stock mutual funds by the billions each week. Likewise, institutional investors are keeping most of their assets in anything but US stocks.

So, is this the “new normal” we read about?

No. Investors will return to US stocks. Here’s why…

Trends are meant to be broken

Every investment trend breaks. There are no exceptions.

Why? Because investors are human. We prefer surety to uncertainty, so we paint with black and white, not gray. As investors, we vacillate between loving and hating an investment. US stocks have been an alternating source of investor affection and revulsion for over 100 years and counting.

Are investors saying to US stocks, “I hate you! And this time I mean it!” Perhaps. But, if so, that’ll be a first.

Money is the root of all trend reversals

When a trend is firmly entrenched (in our portfolios and our minds), we view the rest of the world through that prism. We gain positive reinforcement from recent performance. We take it as a measure of correctness. However, it is simply the fallout of buying and selling.

What happens then? Values get out of whack. Favorites get bid up, and the discarded suffer price drops. Some investors, with a different prism, see the price moves, not as confirmation, but as valuation shifts. So, they begin to move their money from favored investments to the abandoned ones.

The initial results are hiccups (i.e., anti-trend price moves) – what the press initially calls “profit-taking” and “bargain hunting.” Only later, when the new trends are self-evident, will articles explain the wisdom of the shift and the folly of those who overstayed the now-derided past trend.

Misplaced faith

Trend followers (i.e., those who lose by missing out on trend changes), rely on what they read, see and feel. Their faith is in current conditions, built upon the latest results. They see uptrends as “good” and downtrends as “bad.” This moral judgment provides a sense of permanence.

Trend leaders (i.e., those trying to take advantage of the next trend and avoid overstaying the current one) rely on investing history. Their faith is in human nature’s ability to create recurring cycles of fear and greed. They see neither good nor bad – just money-making and money-losing prospects.

So… Not to be flip, the answer to the reader’s question is “because that’s investing.” US stock avoidance, a current trend, has created highly attractive valuations (see previous post, “The 2011 US Stock Market Outlook Look Bright”). These valuations offer opportunity (money!). Eventually, individual and institutional investors will be enticed by those rewards. Then – voila! – a new, favorite trend will be born and US stocks will have a home in investors’ portfolios once again.

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