These statistics relate to mutual funds and their retail investors. While not necessarily the same for institutions, they are indicative of trends in investor psychology. In other words, the disaffection with stocks is continuing, and the withdrawn capital and much more is flowing to bonds. (It must be noted, however, as Tom Petruno of the Los Angeles Times pointed out on August 21, that gross inflows to equity mutual funds are still very substantial – and larger than those into bond funds – although exceeded in this period by outflows.)
The first question I want to tackle is "why these trends?" The answer with regard to stocks is simple. They were over-hyped in the 1990s; they disappointed in the 2000s; and investors are extrapolating the poor performance (even at lower prices) just like they previously extrapolated good performance (at higher prices). This tendency to expect trends to continue is typical of investor behavior, especially with regard to phenomena that should instead be expected to regress toward the mean.
In the late 1990s, when stocks were performing so well and universally expected to far exceed most investors' return needs, no one saw a reason to hold fixed income instruments with their modest yields. Now stocks have performed poorly for a decade and expectations have been cut back. Equities are no longer considered the sure thing they were. The other day The New York Times ran an article entitled "In Striking Shift, Investors Flee Stock Market":
Renewed economic uncertainty is testing American's generation-long love affair with the stock market. . . . Small investors are "losing their appetite for risk." . . . "Like everyone else, I lost" during the recent market declines [an individual investor] said. I needed to have a more conservative allocation." . . . Investors pulled $19.1 billion from domestic equity funds in May, the largest outflow since the height of the financial crisis in October 2008. (August 22, 2010)
Turning conservative after a crisis smacks of closing the barn door after the horse has left, but it's a regular feature of investor psychology.
Of course, there has to be a fundamental rationale for investor behavior, and the current low opinion of stocks is based on the spreading belief that the recovery will be anemic and there could be a double dip. Also behind it may be the expectation that tax rates on dividends and long-term capital gains will rise relative to the rates on ordinary income.
And why is so much capital flowing to bonds? The analogy to hemlines serves well in this regard. Take a long-established style, stir in changed circumstances, and add a significant swing in psychology. Bonds became passé over a long period of time, and stocks caught everyone's attention. When these trends had gone as far as they could, and the error of the fashion extreme ultimately was exposed, bonds came back into style.
Bonds used to constitute the majority of portfolios; then a 70:30 equity/bond mix became the norm; and then bonds went further out of style. And then, when bond allocations got as small as they could, the style mavens began to call for more, instead. Of course it helped that bonds outperformed during and after the crisis.
So few people held bonds going into the crisis, and in such small amounts, that the attractions of bonds must seem like a sudden revelation: They're senior in the capitalization to equities, of course, so they're less subject to fundamental risk. Then there's what I call the "power of the coupon." In addition to redemption at maturity, most bonds provide an interest check every six months. Not only are these cash flows spendable and investable, but they also serve to stabilize bond prices, restraining volatility. Sounds like a great deal. So why, people now wonder, did we hold so few? Take historically small allocations, add in newly discovered merits, and you get a buying trend and rising prices.
The fundamental underpinnings for the buying trend in bonds are the converse of those compelling equity reductions: concern about economic sluggishness, the chance for a double dip, and even the distant possibility of deflation. Under any of these circumstances, companies are likely to do poorly, so you'd rather own senior securities (debt) with the promise of positive returns if held to maturity, rather than junior ones (equities), to which just about anything can happen.
And if inflation is declining – taking interest rates with it – you'd rather secure a fixed rate of return with a bond than hold a totally variable instrument like a stock. With inflation at zero or negative, the thinking goes, locking in today's interest rates will prove to have been a godsend.
Finally, if we get back into another crisis, wouldn't we rather hold bonds? Look how well they did during the last one.
At What Price?
That question – at what price? – isn't just the right question to ask about bonds versus stocks today. It's the right question regarding every investment at every point in time.
I try every chance I get to convince people that in investing, there's no such thing as a good idea . . . or a bad idea. Anything can be a good idea at one price and time, and a bad one at another. Here's how I've put it in the past:
It has been demonstrated time and time again that no asset is so good that it can't become a bad investment if bought at too high a price. And there are few assets so bad that they can't be a good investment when bought cheap enough. . . No asset class or investment has the birthright of a high return. It's only attractive if it's priced right. ("The Most Important Thing," July 1, 2003)
Investment success doesn't come primarily from "buying good things," but rather from "buying things well" (and the difference isn't just grammatical). ("The Realist's Creed," May 31, 2002)
The thing to think about isn't whether you'd rather have junior or senior securities in a recession, or fixed rate securities versus variable ones in deflation. The question is which securities are priced right for the future possibilities: which ones are priced to give good returns if things work out as expected and not lose a lot if they don't? You mustn't fixate on a security's intrinsic merits, but rather on how it's priced relative to those merits.
So, for example, it's not enough to say "We want fixed rate securities in deflationary times." You'll be glad to be holding 2'/2% ten-year Treasurys if deflation materializes, but how will you feel if it doesn't? And what's the probability of each outcome?
If bonds are ideal for deflation and stocks will bear the brunt of the associated economic weakness, is that all that matters? Would you rather buy overpriced bonds than underpriced stocks? Is there an objective standard for overpriced and underpriced? And, for example, if the ten-year note will pay 2'/2% regardless of the environment, and stocks will return 15% if deflation is avoided and lose 10% if it's not, doesn't deflation have to have a likelihood exceeding 50% for bonds to be preferred? (Check the math.)
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