Without wanting to be accused of being melodramatic, I did want to put this type of title into our current market outlook piece, as much to highlight what has been going on in stock markets for over a decade now as well as to try to look objectively beyond the current rhetoric and see if this could really be setting up as one of the better buying opportunities for stocks of the past few decades.  Stocks have not been so far out of favour for half a century. Many declare the “cult of the equity” dead.  With equity returns virtually flat for more than a decade, the incentive for investors to take risks has declined –  which has lead to a huge flow of public and private funds out of stocks and into bonds.  Two bear markets in ten years and a near collapse of the global financial system have served to undermine the confidence of investors across the globe.  Add to that the increase in fraud (Bernie Madoff), financial time bombs (recent JP Morgan $2 billion trading losses), failures of the trading system (May 6, 2010, rout known as the ‘Flash Crash’ erased $862 billion in less than 20 minutes) and pure, unadulterated greed (the Facebook IPO) and we can see further evidence of why trust in the system has broken down.

Retail investors’ conservatism has also driven money out of collective investment funds. In the US, inflows to bond funds have exceeded equity inflows every year since 2007, with outright net redemptions from equity funds in each of the past five years.  A net $1.4 trillion swing in money flow from stock to bond mutual funds has occurred over this five-year period.  U.S. households held about $8.1 trillion in corporate equities at the end of 2011, about 16 percent less than the $9.6 trillion they held in 2007, according to Federal Reserve data.  Some retail investors still haven’t moved off the sidelines after pulling out of the market during the 2008-09 financial crisis. The S&P500 Index has made no progress in more than a decade, currently trading at levels first seen in 1999 following two bear markets that wiped out about 50 percent from the index.

This is stunning in light of overwhelming evidence that, in the long run, equities outperform all other major asset classes.  From 1900 to 2010, stocks beat inflation by 6.3 per cent a year in the US, according to a widely used benchmark maintained by London Business School, compared with only 1.8 per cent for bonds.  In the US and the UK, public pension funds had allocations to equities as high as 70 per cent only 10 years ago. They are now down to 40 per cent in the UK, and 52 per cent in the US.  Insurance firm Allianz Capital, with over US$2.0 trillion under management, has only 6 per cent of its insurance portfolio in equities, while 90 per cent is in bonds. A decade ago, 20 per cent was in equities.  It is far from alone: institutional investors, from pension funds to mutual funds sold directly to the public, have slashed holdings in the past decade.

One of the constant complaints of investors is that ‘markets have become too volatile for the average investor’ and ‘playing field is not level’ for everyone.  While we can’t quantify the latter point, the former one about volatility is absolutely true as shown in the chart below which shows the volatility of stock returns over rolling 4-year periods for the 30 years ended December 31, 2010.  While the data points would always narrow over longer periods of time (more ‘averaging’ of the data), the spread over recent years is substantially more pronounced.  While the spread between the top and bottom returns over 30 years is only 4 percentage points (high is 12.7%, low is 8.7% and the average is 10.2%), that spread widens to 16.7% over the last 10 years, 29.7% over the last 5 years, 40.4% over the last 3 years and a whopping 126% over the year ended December 2010.  So if investors feel like stocks have become much more volatile over the past few years, they’re absolutely right!  Whether this is the influence of trading systems, too much information or the constant impact of real-time analysis and opinion changes on television (is CNBC becoming the ultimate ‘market-maker’?) is less relevant than the fact that it has chased investors away from stocks since they view them as ‘too risky’ an asset class.

Volatility on the (long term) rise

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