Investors are finally inching back into the stock market. But are they too late?
While millions sought refuge in traditionally stable bonds over the past two years, they missed a more than 90 percent rally in stocks. Suddenly bonds don't look so safe, and some of the $11 trillion that Americans have parked in mutual funds is shifting back to stocks.
After putting more than $570 billion into bonds over the past two years, mutual fund investors reversed course last fall, worried that the prospect of rising interest rates and the growing deficits of state and local governments were bringing bond prices down.
In the last two months of 2010, investors withdrew a net $23 billion from bond funds, according to industry consultant Strategic Insight.
At the same time, corporate bottom lines are improving. So investors are finally starting to take another look at stocks after being burned in the 2008 financial crisis and scared by the market's "flash crash" single-day plunge in May.
"Most investors have been in a capital-preservation mentality, because they saw so much of their net worth destroyed in the bear market," says Chris Jones, chief investment officer with J.P. Morgan Asset Management.
Few have fully recovered since the stock market began sliding from its historic peak in October 2007. The Standard & Poor's 500 index is 17 percent shy of that level, despite recent gains.
The momentum has shifted, and now, with a couple of years of solid market performance, many risk-averse investors may be ready to get back in. But there are cautionary voices.
The economic recovery is still fragile in the eyes of Tom Roseen, an analyst with fund-tracker Lipper Inc.
"I wouldn't be surprised if we have a little bit of a pullback over the next couple months, as people re-evaluate their portfolios and take a look at how much the market has gained," he says.
Until recently, investors got a decent return from their play-it-safe strategy. Diversified bond funds gained an average of 10.8 percent last year, beating their average annual gain of 6.2 percent over the past five years, according to Morningstar.
Still, nearly all types of bonds lost money in the fourth quarter, with government bonds taking the biggest hit.
This downturn helped fuel a shift into stocks — most notably abroad. Mutual funds buying overseas stocks took in a net $72 billion last year, while investors pulled a net $49 billion out of funds buying American stocks.
There are signs that U.S. stocks are becoming more attractive to mutual fund investors. For one week last month, domestic stock funds took in more money than investors pulled out. The last time that had happened was in April. And the pace of withdrawals is slowing.
Market optimism is also improving. For 19 consecutive weeks, surveys by the American Association of Individual Investors have shown a greater-than-average belief that stock prices will rise. The last time the surveys had such a long streak of bullish sentiment was in late 2004.
Yet the movement of money because of troubles with municipal bonds offers a reminder of how important it is for investors to remain even-keeled.
"You simply have got to put aside the emotion and believe in what you are taught, to buy low and sell high," says Carol Clemens, a 64-year-old retiree from Edmond, Okla.
She scored big when she snapped up shares of Ford for around $2 when it appeared U.S. automakers might go under a couple of years ago. The stock now trades above $18, thanks to smart moves by Ford's management and a strengthening economy.
Clemens' portfolio is about two-thirds stocks and one-third bonds, and she's recently been trimming her stake in bonds.
"If you put money into bonds, there is a nice cushion when the stock market goes down," Clemens says. "But I'm retired, and we're looking for an income stream. We're not getting it from bonds," she says, calling current yields "abysmal."
Belief that the economic recovery is on track has recently driven up long-term interest rates from record lows. This has led investors to pull out of low-yielding Treasurys. Rising rates also are making it costlier for state and local governments to borrow. Fear of further rate increases also is causing prices for many previously issued bonds to drop. That's because investors will be able to buy newly issued bonds paying higher interest.
So as bond prices decline, investors like Clemens will be looking for income from stocks that pay solid dividends. And as other investors step back into stocks, they may be questioning whether they're making the classic mistake of buying in at the market's peak.
The S&P 500 is up 23 percent since Sept. 1, and at its highest point since August 2008. It finished 2010 with a return of 15 percent including dividends, more than twice the gain for a comparable bond index.
J.P. Morgan's Jones expects further stock gains in 2011, with a breakout year for growth stocks of companies whose earnings rapidly appreciate — think Amazon.com, whose stock price has tripled since March 2009. But Jones doesn't think many investors are willing to get back into those richly priced stocks.
"Investors are incredibly shell-shocked," Jones says, "and they're not willing to pay for growth until they see it."
Yet many market pros are predicting another year of double-digit gains. They point to an abundance of positive economic indicators: factories cranking up production, hiring activity picking up, growing corporate investment in technology. Consumers also are more confident, thanks in part to the recent extension of the Bush-era tax cuts and a new cut in the Social Security payroll tax.
Sooner or later, investors will put their money where it's gaining the most, predicts Bob Doll, chief stock strategist at BlackRock, the world's biggest money management company. Investors tend to chase rather than anticipate returns. He expects investors will embrace stock funds over bonds, ending what he calls an era of fear.
Stocks may post their third year of double-digit percentage gains in a row, Doll says. That hasn't happened since the late 1990s.
And if the market behaves like it has coming out of previous recessions, the S&P 500 could rise nearly 12 percent this year. That's the average gain the index made in the one year immediately following this point in the economic cycle, a year and a half after the end of a recession. The analysis by Birinyi Associates examined market gains coming out of seven prior recessions.
Another positive: Corporate earnings are rising. Around mid-year, Doll expects profits of S&P 500 companies will top the record high they reached in June 2007, noting that more companies have recently been boosting their earnings projections than scaling them back.
Yet many believe investor conservatism still runs deep, in part because of demographics. Baby boomers are beginning to retire in droves, and they're drawn to the steady income and returns that bonds typically generate.
Indeed, not everyone is declaring that investors have given up on bonds. Strategic Insight expects demand for bond funds will rebound in the first half of this year.
A key reason is that bond yields still look pretty good compared with the current near-zero returns from cash investments such as money-market funds.
"The numbers suggest a slow rebound for investor confidence in stocks," says Strategic Insight's Avi Nachmany. "But they'll continue to buy bonds for the same reasons they bought them before: There's an insatiable interest in income, and people are still scared."
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