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Retail Investors Should Lower Expectations: Santoli

Michael Santoli
Daily Ticker
Retail Investors Should Lower Expectations: Santoli

Where else are you going to go?

This is the question individual investors are asking themselves and their financial advisors as some of the past decade’s most tightly embraced trends in financial markets have been upended.

The vaunted “commodity supercycle” -- driven by emerging countries' voracious appetite for resources -- has waned as growth in China and elsewhere has slowed. As The Daily Ticker's Lauren Lyster notes in the attached video, money has fled commodity funds and assets under management in the sector have fallen by more than 20% from their 2012 peak to $350 billion.

The recent surge in interest rates in anticipation of the Federal Reserve’s eventual curtailment of its $85 billion monthly bond-buying pace has spooked fixed-income investors, leading to a record net outflow ($50 billion) from bond funds in July.

Retail investors are pivoting toward stocks almost by default. Equity mutual funds have taken in about $30 billion since the beginning of June according to Goldman Sachs, which notes that the firm’s “rotation index” -- which measures investors’ tilt toward stocks -- has reached its highest level since 2008.

True to form, the public has warmed to stocks just as the Standard & Poor’s 500 Index (GSPC) has gained some 150% over four-plus years. Retail investors as a group have not participated in this enormous, if sometimes jagged rally, withholding their cash from a market that has appeared vulnerable to global shocks, shadowed by a slow-growth, debt-hampered economy and overly dependent on central-bank generosity.

Stocks are among the few goods that individuals would rather buy more of when they are expensive than when they’re on sale, a trait rooted in natural risk-aversion and herding instincts. According to the Leuthold Group, when stock mutual funds have net inflows the S&P 500 trades on average at a “normalized” price-to-earnings multiple (based on the past decade’s corporate profits) of 20, a market trend since 1980. The normalized P/E during months of net outflows was below 17.

Just because the public is late to the game doesn’t necessarily mean the bull market is at a top. No market relationships play out quite so tidily. In the past the small investor has participated in the final up leg of a bull market, at least, often driving a fully valued stock market to overvalued levels.

Most technical measures of market health confirm the power of the upward trend, for the moment at least. A rush of money chasing new highs in the indexes could produce a classic “overshoot” phase, occurring after most of the likely profit growth has been realized. Corporate profit margins, remember, are near historic highs, and companies as well-run as Google Inc. (GOOG), McDonald’s Corp. (MCD) and United Parcel Service Inc. (UPS) have recently faltered in their efforts to meet market earnings targets.

So what’s a careful investor to do, if the commodity-boom story has been refuted, bond funds have surrendered their reputation for safety and stock prices are already near all-time highs?

As a start, folks should lower their expectations for the long-term return potential of nearly all asset classes. When global interest rates are anchored so close to zero, as they are now, they drag the expected future returns of every sort of investment down. The value-focused institutional asset management firm GMO publishes a seven-year return forecast for all investible markets, from developed and emerging stocks and bonds to timber.

Its last report predicted that over the next seven years every single category would return less, after inflation, than the historical 6.5% average real return on U.S. stocks -- and that was before stocks had run up to current levels.

This doesn’t mean people should hide in cash. It makes sense to spread money broadly across all markets, perhaps taking advantage of the weakness in emerging-market stocks and even commodities to gain exposure there. Just don’t bank on the markets to do your saving for you.

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