Investors Beware: Return to Stocks May Be Too Late

This article was originally published by the Fiscal Times on Monday, March 7, 2011.

By Katherine Reynolds Lewis

Investors are worried about the federal deficit, still-high unemployment and rising oil prices, which are raising the specter of inflation. But they’re buying stocks, afraid of being left out as major indexes rise to their highest levels in nearly three years. They may be too late.

Individuals tend to sell out of the market near the bottom and buy back close to the top — realizing their losses and missing out on potential gains, experts say. After the flash crash in May 2010, massive amounts of money flowed out of stock mutual funds: $82.3 billion in the eight following months, according to Chicago-based research firm Morningstar. The Standard & Poor’s 500 index went on to double from its low in March 2009, the fastest such increase in the index's history.

The financial crisis and Great Recession shook Americans' confidence in the markets, and investors withdrew $216 billion from stock mutual funds from 2007 through 2010, according to Morningstar. "This was fundamentally different from past bear markets," said Morningstar analyst Kevin McDevitt. "There are a lot of people who felt they didn’t want to play this game anymore and felt the whole system was rigged against them." The S&P is still down about 5 percent from the start of 2007.

Sentiment started to change this January, when $15.8 billion flowed into U.S. equity funds, the biggest January since 2004, though small relative to the $3.5 trillion in overall assets held in the funds. A new Wells Fargo-Gallup poll found that retail investors remain wary of investing in stocks, but the market's climb is pulling many back in. The federal budget deficit — tied with unemployment — is the top worry of individual investors, a concern for 71 percent of those surveyed.

"It's shocking to me that the federal budget deficit would rank ahead of energy prices, ahead of access to credit, ahead of the questions that have dominated the media," said David M. Carroll, a senior executive vice president at Wells Fargo. "It's food for thought for our representatives in Washington."

The poll adds to recent evidence of growing consumer confidence. Despite the $1.6 trillion federal deficit and stubbornly high unemployment, the Gallup Investor Optimism Index rose to 42 in February, up from an all-time low of negative 64 in February 2009, though still far below the prerecession score of 90 in February 2007. The Conference Board’s Consumer Confidence Index rose to a three-year high in February, although it also remains below the level that signals a healthy economy.

At times like these — when many are feeling optimistic — experts often predict a market drop. It's been 130 days since stocks declined 5 percent. Since 1928, stocks have seen a 5 percent correction every 84 days on average, Carroll noted. "Corrections math would suggest inevitably we're going to have a pullback," he said. He advises anyone interested in investing new money in stocks to do so gradually, over at least six months.

The poll found that 61 percent of working investors have little or "some" confidence in the stock market for their nest eggs, compared with 59 percent of already retired investors. The phone survey of people with at least $10,000 of investable assets was conducted between Feb. 1 and Feb. 8, and was said to represent the wealthiest third of Americans.

In addition to those who said the deficit and unemployment are hurting the investment climate "a lot," 60 percent cited energy prices and 58 percent "the financial position of state and local government." Of those surveyed, 51 percent saw danger from "a politically divided federal government," 46 percent worried about home values and only 38 percent cited availability of credit as a concern.

The level of federal debt has the potential to hobble America's economy, unless the government tackles Medicare and Social Security reform more seriously, said David Rempe, 44, a physician in Rochester, N.Y. "I don't have as much confidence in stocks as I did a few years ago, I don't see the glory years of the '90s returning. You have to have certain lower expectations."

Still, he continued to invest his 401(k) plan in stocks during the recession, even as many friends pulled their retirement funds out at the depths of the market, even paying penalties. "I'm sure they're not happy now," he noted.

During the recession, "people were basically saying, 'Get me out, I don't care the price.' Now you've started to see a trickle of capital into equity funds for the first time in nearly three years," said Paul Larson, equities strategist for Morningstar. "For better or worse, a lot of retail investors tend to chase performance, which is not a good thing."

People look at the most recent information available in an attempt to understand a situation, said Hersh Shefrin, a professor of behavioral finance at Santa Clara University. "You have to be prepared psychologically and financially to ride out periods of substantial volatility," Shefrin advised. "You want to have a prudent component of your investment strategy so you can ride out those periods without starving to death or panicking."

Investors' concern about federal debt levels and the budget deficit reflects their new understanding of the dangers debt can pose, Carroll said. "Businesses were the first to begin deleveraging. Consumers have begun to deleverage. Now the governments are having to do the same thing," he said.

There's also the reality that between wage cuts and real estate losses, people have $1 trillion less income each year, said Charles Biderman, chief executive officer of TrimTabs Investment Research. "That's less money for investments." He argues that federal intervention is the only major force holding up market values. "I don't think the market is going to keep going up; individuals who think it will are probably going to be disappointed."