Investors Bolting Out Of Equities?

Andrew Ross Sorkin of the NYT reports, Why Are Investors Fleeing Equities? Hint: It’s Not the Computers:

Let’s stop with the excuses.

You’ve no doubt been reading a lot about a “crisis of confidence” on Wall Street in recent days after software problems at a big trading firm sent the stock market, briefly, into a tizzy.

Everyone is hyperventilating at the errant trades at the Knight Capital Group — suggesting, in the words of Arthur Levitt, that these malfunctions “have scared the hell out of investors.” The problems at the firm were immediately lumped together with Facebook’s glitch-filled initial public offering, the flash crash of 2010 and the rescinded public offering of BATS Global Markets, among others.

Apparently — if the experts are to be believed — these computer errors are the reason “investors are fleeing the markets like never before,” Dennis Kelleher, president of Better Markets, told The Los Angeles Times. Dozens of articles about the trading blunder included some form of that contention, using statistics showing that $130 billion or more had been withdrawn from mutual funds over the last year or so.

Let me offer a more straightforward explanation of why investors have left the stock market: it has been a losing proposition. An entire generation of investors hasn’t made a buck.

“The cult of equity is dying,” Bill Gross, the founder of Pimco, wrote in his monthly letter last week.

“Like a once bright green aspen turning to subtle shades of yellow then red in the Colorado fall, investors’ impressions of ‘stocks for the long run’ or any run have mellowed as well,” Mr. Gross wrote. His letter came after he had sent a Twitter post that read: “Boomers can’t take risk. Gen X and Y believe in Facebook but not its stock. Gen Z has no money.”

(Mr. Gross, who manages the largest bond fund in the world, started a stock fund several years ago, too, so he has a vested interest in seeing stocks succeed for his clients.)

This is not to say that Knight Capital’s software debacle is helping instill confidence in investors. But it’s doubtful it would make a Top 10 list of reasons for investors to flee.

So why are so many investors sitting on their hands? The unemployment crisis, the European debt crisis and the looming fiscal-cliff crisis, to name just a few reasons. Economic growth is slowing, not just in the United States but in China, too.

Those are the same reasons that chief executives and boards of American companies are sitting on $2 trillion in cash and not investing in their own businesses. They are scared, rightly or wrongly, about the future. (It should be noted that some of the most skilled investors recommend staying in the game during such times. Warren Buffett famously advised that investors “should try to be fearful when others are greedy and greedy only when others are fearful.” But it doesn’t seem like that advice is being followed.)

Even the hedge fund titan Louis M. Bacon has been so humbled by the stock market that he returned $2 billion to his investors last week rather than risk losing it.

None of these fundamental issues have anything to do with a computer that ran amok or a trade order mistakenly entered by a fat finger.

Blaming computers is not a new phenomenon. In 1988, months after the 1987 crash, The New York Times explained that small investors shared a “fear of being whip-sawed by program trading.”

“I think everybody is concerned about the flight of the small investor — the S.E.C., the exchanges, everyone,” Howard L. Kramer, assistant director of the Securities and Exchange Commission’s division of market regulation, said in another article, also in 1988.

Here are the numbers today: About $171 billion has flowed out of mutual funds over the last year, according to the Investment Company Institute, which tracks mutual fund data. Where has all that money gone?

Bonds. About $208 billion has flowed into the bond market over the same period, according to numbers from the I.C.I.

The fact that so few long-term investors are in the stock market has only worsened the volatility, since it often seems as if the only people who are trading stocks are the professionals.

Which brings us back to the “crisis of confidence.” This does exist among investors, but they are not focused on how computers are making the markets go haywire. Rather, they are concerned about the future of the economy and, yes, trust.

Individuals are worried that it’s hard to make the right bet and worried that the market is rigged against them. Much of this is an outgrowth of woes of Wall Street’s own making, like insider trading cases or market manipulation scandals. Those situations are partly why individual investors don’t believe they stand a chance against the professionals.

Consider this: Of 878 students at 18 high schools across 11 different states surveyed by the Financial Literacy Group, three-quarters of them said they agreed with this statement: “The stock market is rigged mostly to benefit greedy Wall Street bankers.”

So for now, it seems, trading firms don’t just need to throw out their electronic trading systems or bring in more regulators to oversee their stock executions. They need the country to get a shot in the arm to address its economic problems, and they need the public to have faith in the long term.

Instead of pointing the blame at one incident or another, look at the fundamentals.

I agree that it's silly to blame computer glitches for the weakness in equities. Sorkin is right to report on the general loss of faith in stocks as individual investors realize that these rigged markets only benefit the financial elite.

In short, the Knightmare on Wall Street isn't what caused America's 401(k) nightmare. Trading glitches don't help instill confidence but over the long-term, they're irrelevant. And if like most people you're invested in mutual funds, you needed be worried about computers run amok.

Nonetheless, while I understand why investors are fleeing equities, I'm afraid that they will miss another historic opportunity to make serious money in stocks. I agree with Vanguard's founder, John Bogle, avoiding stocks now is a big mistake:

If you don't have money in the stock market (^GSPC) and you hope to retire someday, the founder of The Vanguard Group says you're making a big mistake.

John 'Jack' Bogle tells us if you're investing for the long-term don't get spooked by events of late. "Knight Capital is meaningless for anyone in the market for the long haul," he says. "In fact, you're probably in a mutual fund and you can pat yourself on the back for being smart."

In other words, for most individual investors the risk from Knight Capital is non-existent because most individuals hold a basket of stocks and the diversity of the basket hedges out the single stock risk.

And he takes issue with commentary from Bill Gross who believes "the cult of equity is dying."

"Like a once bright green aspen turning to subtle shades of yellow then red in the Colorado fall, investors' impressions of 'stocks for the long run' or any run have mellowed as well," Gross says.

The analogy of stock investing to autumn may be poetic, but it's not accurate and never will be, according to Bogle. "Equities offer higher risk and will therefore always generate higher reward," he argues. Therefore, "The cult of equity is never going to be over."

Bogle goes on to remind us that in 1979 BusinessWeek made the same argument.

The article came out right before the beginning of one of the greatest bull markets of the 20^th century, Bogle insists. "It's always a question of balance but anyone who is out of stocks right now is making a big mistake.

I'm not ready to claim that we're about to enter another great bull market in stocks but if you read my weekend comments, I do think it's time that investors take a deep breath and exhale as the summer surprise may very well be stocks that soar to new highs.

Of course, skeptics aren't buying any of this. This could very well be the most hated stock market rally in history. According to Dan Geller, the curator of the Money Market Index economic barometer, the stock market rally worth about 300 points on the Dow over the past three sessions is "totally irrational":

In particular, investor enthusiasm over Friday's monthly jobs report from the government is misplaced because a large portion of the 163,000 new non-farm jobs reported are temporarily and likely to vanish soon, says Dan Geller, chief research officer of the index.

"The rally on Friday after the release of the employment figures and the consumer confidence index really has no economic merit," Geller says. "It's totally irrational."

Like the surge in food service and other hospitality positions, the market surge will prove temporary as well, he says.

Looking inside the government's figures, which also showed the unemployment rate climbing to 8.3 percent, many of the gains came from industries that generally benefit from summer vacation season.

Food and drinking establishments boosted hiring by 29,000, while temp services jobs increased by 14,000. Moreover, education and health care added 38,000, after falling 6,000 in the previous month, a move Geller attributes to the Supreme Court validating the national health care reform law. He deems those jobs to be "on shaky grounds."

Information services jobs related to motion picture and sound studios grew 11,000 "due to the increase in election-related activities. These jobs will disappear after the elections," Geller says.

When formulating the Money Market Index, Geller looks to more lasting attributes.

Specifically, he places a large weight on Personal Consumer Expenditures, which have been flat for two months. Another measure in the index, gross domestic product registered an anemic 1.5 percent grow in the second quarter.

The index also factors in spending and saving numbers. Recent government data showed spending is flat while saving appears to be increasing.

The index is registering a 2012 high of 92.0 that, while lower than the same period last year, is indicative of worsening conditions.

"If we are going to continue on the path are are now on we are likely to see a recession by the end of the year," Geller says. "Unless something drastic happens to increase consumer confidence or reduce the level of anxiety, we will see a recession."

Despite what Geller sees as a shaky foundation, investors continued to buy the stock market Monday, indicating at least a short-term rise in confidence that has generated a 9 percent rally over the past two months.

"Markets are cycles. The problem is everybody pins markets to economic cycles. That's not the case," says Nadav Baum, executive vice president at BPU Investment Management in Pittsburgh. "Markets are just long-term cycles, and we haven't had a good stock market since 1998. At some point the market's going to do better."

Baum advises clients with a high level of anxiety to stick to what works - dividend-paying blue chips that are going to weather stormy markets.

"Once you get past the noise the whoever's going to be elected in the election and once you get past the euro, at least you own something that you know," he says. "If something happens to Coke (KO) and Johnson & Johnson (JNJ) and Kraft (KFT) and Heinz (HNZ), then the whole thing's bad anyway."

Indeed, it's been the market stalwarts that have led the way this summer.

The average Standard & Poor's 500 (^GSPC) stock gained just 0.2 percent in July, but the largest 50 stocks in the group rose on average 1.46 percent. Dividend-payers rose 1.15 percent for the month and are up about 7 percent year-to-date.

"Everybody's complaining about the market zigging and zagging. My clients aren't zig-zagging," Baum says. "I own the AT&Ts (T), the Verizons (VZ), the Philip Morrises (PM). I'm having a great year because those companies are doing well."

I think the economic recovery in the US is picking up steam. As housing recovers, financials will do well, confidence will creep in and risk assets will rise in sympathy.

And while I have nothing against large caps paying nice dividends, Michael Gayed is right to point out small caps have reached a pre-'Melt-up' extreme:

Price is sending a message, and that message is bullish.

In my last article titled " The most important charts in the world ", I noted that the performances of bear trade sectors relative to the Dow Jones Industrial Average were across the board rolling over from extreme high levels last hit before the “Fall Melt-Up of 2011” took place.

I made a big point about this on CNBC in the face of "disappointment" over no actual monetary policy changes by the Fed and the European Central Bank. Market internals have continued to improve in favor of bullish sentiment even amid the gloom and doom.

Despite tremendous fear expressed following Draghi's speech last Thursday, stocks closed the week positive holding gains made the week prior. Our own ATAC (Accelerated Time And Capital) models used for managing client accounts got even more aggressive in equity positioning as a result.

I maintain the idea that the “Summer Surprise” will be an end to the end of the world trade , as the "great reallocation" out of bonds and into stocks seems ever more likely now.

Money has been afraid to take risk because of the memory of 2008, pushing bond yields to illogical levels below rates of inflation. “Dividendsanity” has resulted in low beta/dividend sectors being vastly overpriced on a valuation basis. Dividendsanity and the love for bonds may be on the verge of a meaningful turn.

As I argued in a bull/bear debate on Bloomberg last week , the negative narrative is too priced in to be right.

I have been arguing since the market low of June 4 that another melt-up similar to the Fall Melt-Up of 2011 was likely based on intermarket relationships and reasonings that led me to the belief last year that such a move would occur ( October 3, 2011: From Summer Crash to Fall Melt-Up? ). Aside from the emerging weakness in utilities XLU -0.24% , consumer staples XLP -0.06% , health care XLV +0.03% and bonds TLT -1.03% relative to the S&P 500 IVV +0.24% , one additional piece of data is worth exploring to assess the potential for a melt-up redux.

Take a look below at the price ratio of the small-cap Russell 2000 ETF IWM +1.01% relative to the large-cap S&P 500. As a reminder, a rising price ratio means the numerator/IWM is outperforming (up more/down less) the denominator/IVV. A falling ratio means the opposite. For a larger chart, visit here .

Small-cap stocks tend to outperform when money is comfortable taking risk given that these companies tend to have higher beta, and thus more sensitivity to market movement.

They also tend to be less liquid and have more breadth than large-cap names. Notice the severity of the underperformance that occurred in July, dramatically underperforming in a way not seen since the Summer Crash of 2011. The level the ratio is now reaching is the same extreme level hit right before the October 3 low and ensuing Fall Melt-Up of 2011.

I suspect a strong bounce can soon occur as small-caps themselves begin to rally in August at a faster pace than the S&P 500. Given that August is the strongest month of the year during an election year, historically, leadership here combined with a continuation in weakness in the bear trade and easing of dividendsanity, alongside rising inflation expectations, all equates to a potent environment for equities.

If Gayed is right, a rally in small caps will be a welcome relief for the overall market and for Long/ Short equity funds which tend to be long small caps/ short large caps (this has changed somewhat in recent years).

My own reading of the markets is much simpler. Markets are ruled by fear and greed. There has been way too much fear mongering over the last few years and yet stocks keep climbing the wall of worry. This is extremely bullish and I think it sets us up for a pleasant summer surprise. In fact, I see stocks "bolting" ahead of all other asset classes (focus on high beta stocks).

Below, ICAP Corporates Managing Director Kenny Polcari and Pension Partners Chief Investment Strategist Michael Gayed debate the direction of the markets. They speak with Adam Johnson on Bloomberg Television's "Street Smart."

And scores of Jamaicans turned up in Half Way Tree, St. Andrew to watch the 100m final in which Usain Bolt won in an Olympic record time of 9.63 seconds. His compatriot Yohan Blake finished second in a time of 9.75 seconds. Happy Birthday Jamaica!