It was just over 4 years ago that global stock markets were at one of their lowest points, figuratively and literally, in years.   The global financial crisis had decimated economic growth, with the U.S. economy sinking at a 6% annual rate in the fourth quarter of 2008, corporate profits had seen their worst decline since the depression in the 1930’s and investor sentiment had reached its most extreme levels of pessimism.  Worldwide, stocks were demolished, falling about 40% on average in 2008, less than eight years after the bursting of the ‘tech bubble’ had also lead to one of the worst bear markets in decades.  Investors weren’t just ‘gun shy’, many were in shock!  They had seen the last ten years of savings eroded and many were totally rethinking whatever retirement plans they may have had.  As is typical in stock markets, though, it is ‘always darkest before the dawn’ and those conditions did end up giving rise to a recovery in stock prices of more than 100% since then.  It didn’t hurt that central banks all over the world, particularly the U.S. Federal Reserve, basically ‘opened the spigots’ and provided massive levels of liquidity to fund this recovery, driving interest rates to their lowest level on record.  Governments also went on a spending spree, with infrastructure programs all over the world breaking ground, and debt levels rising in the process.  U.S. federal debt ballooned from about US$6 trillion to a projected level of almost US$15 trillion this year.  Gold prices more than doubled along the way as investors worried about the continued depreciation of paper currencies everywhere.

While stocks have done well since the lows, the recovery has not matched that of prior cycles, and we have had additional bumps along the way, including the economic crisis in Europe (Greece could be looked at as the sequel to the U.S. housing market in the way that a single sector ignited problems elsewhere with a domino effect).  Moreover, the type of stocks that have lead the rally, particularly in the past two years, are not the typical leaders in that they have been the defensive, dividend paying companies as opposed to the cyclical and growth stocks that typically lead any recovery.  Clearly even equity investors have remained defensive, opting for REITs and utilities in addition to extensive bond holdings.

Despite the big move, stocks are still cheap on a historical basis, particularly since so many sectors did not participate in the rally.  The table below outlines some of the specific metrics of the U.S. stock market.  While prices have more than doubled off the lows, corporate profits have shown an even larger gain, leaving stock valuations still well below the average of the past 22 years.  On top of that, corporations are in better financial shape than they have been in a long time, with net debt of the S&P500 companies at only 34% of their equity valuation, much better than the 69% level at the peak of the crisis in 2009 and also below the long-term average of about 49%.  Finally, given that stock valuations are impacted to a large degree by the level of interest rates, the fact that the ten-year government bond is yielding only 2% compares well to 2.8% level at the market’s low point and the average rate of 5.2%.  Clearly there continue to be supports for stock prices.

Stocks below long-term values

Now we are finally starting to see a greater shift in asset mix towards stocks.  After four years of extraordinarily defensive investing, the nation’s largest wealth-management firms are growing wary of bonds and more upbeat on stocks.  On average, the wealth managers are recommending that investors put 29% of their money in fixed income, down from 34% a year ago.  The managers and their clients are increasingly worried that interest rates will start to rise, a development that would hurt bond values.  At the same time, wealth managers are recommending an average allocation to stocks of 48%, up from 45%, reflecting increased optimism about the U.S. and beyond.  Many expect to step up their equity allocations still further as the year progresses. The shift could put the wealth-management industry at the forefront of “the great rotation” — a long-awaited move by investors out of bonds and into stocks. Data on mutual-fund flows so far in 2013 suggest that the rotation is starting to happen, with net inflows into stock funds running at a vigorous $29.5 billion a month.  Wealthy investors appear to be heeding their managers’ advice, which itself is a big change. In the past few years, portfolio managers have periodically urged their clients to become more risk-tolerant and more open to equities, but their clients wouldn’t budge. Still rattled by the recession of 2008, they resolutely ignored their bankers’ advice.  In addition to cutting back on bonds, many wealth managers in our survey are sharply reducing their holdings of cash. LPL Financial, a large federation of some 13,000 independent advisors, has whacked its recommended cash position in half since last year, to 10%. HSBC Private Bank took cash from 6% to 1%.  Barclays has upped alternative assets to 28% of its model portfolio from 23% last year. Brown Advisory of Baltimore now has 27%, an increase of eight percentage points.  It’s not that wealth managers are ignoring the big risks posed by Europe’s banks, the U.S. debt crisis, and tensions in the Middle East. They remain keenly aware of the dangers but have subtly changed their point of view.

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