One Reason to Stay Long Equities

By Alex Daley, Casey’s Extraordinary Technology

There are a lot of troubling signs with the equity markets these days, with valuation ratios at multi-year highs despite looming troubles in the EU and continued joblessness. To make matters worse, it seems there are fewer and fewer bears in the mainstream financial media, with all sides bullish on all markets.

As a contrarian at heart, I’d normally be the first to call investors’ attention to the dangerous trends building in equity markets and recommend taking some hedges if not reducing exposure. And in some really overheated markets like China, that might be the right move today. After all, markets crash the hardest when no one is paying attention to the potential downside, as seems to be the case today again after a brief stint of the skeptics occupying equal airtime the past few years.

But I do see at least one compelling reason to stay net long in equities right now: The wheels are coming off the bond market.

And that means money is flowing into equities in a major way. Excess liquidity, especially in the sheer proportions now flowing into the stock markets, tends to drive up asset prices. And the stock markets are seeing liquidity at levels not seen in years.

Ever since the big liquidity crunch that sunk the markets in 2008, investors big and small have been pouring into income assets, especially bonds. Since the beginning of 2009, the net inflows to bond funds have been more than 11x (!) the inflows into stock funds. But as you can see from this graph, that trend is deteriorating rapidly:

(Source: Credit Suisse)

It’s such an about face that, bond inflows have gone negative for the first time since the crash (and at that time they were only negative because every asset class saw massive withdrawals). Despite new money still flowing into markets globally, investors are now leaving bonds net. With rates remaining low and alternative markets (i.e., stocks) calm for the moment, there is little reason to believe that trend will reverse anytime soon. But all of this money not heading into bonds and now even leaving bonds needs somewhere to go. Thus, the inflows into equities are rapidly rising back to some of the highest levels seen since the heady days before the housing-related crash:

All of these investors chasing stocks are after the kinds of gains the equity markets have been posting recently – the Dow Jones Industrial Average is up 9.36% in the last year, the S&P 500 is up 12.58%, and the NASDAQ Composite is up a whopping 20.57% (shameless plug for Casey’s Extraordinary Technology: we’ve been handily outpacing the NASDAQ over the past year, and with a much safer net cash position than any index fund).

You simply cannot find that kind of yield in bonds these days, with the average yield across all categories just shy of 4%, and the most risky bond categories still only in the high single digits. With bond prices now at record highs, investors have wrung the speculative gains out of the paper, and yield is the only thing the category can provide. And if interest rates rise, falling prices are sure to follow. The result: investors in search of capital appreciation are moving away from bonds and back into equities.

What may look like a short-term trend has plenty of potential fuel. U.S. pension funds now hold only 33% of assets in equities, the lowest level on record dating back to 1960. U.S. households are still holding smaller equity stakes than they have in the past 20 years, at just 47%. And property & casualty insurance companies, another major source of institutional dollars, are now holding about 15% equities, right above the low-water marks set in 2008 and 1977:

In 2009, investors flooded the income markets, pushing every type of income asset higher, including driving the High Yield Corporate (or “junk”) Bond index up over 57% last year. Now, with yields in that high-risk subcategory averaging just below 8% after historic defaults – and who can expect defaults to stay that low after such a big influx of new money? – income investors are left longing for the returns of the equity markets.

So, money is shifting direction back to stocks in search of that increased return and as a result of the collective calm that rising indices seem to bring to investors’ worries about the long-term economy. If that trend continues to accelerate at its current rate, and is even half as strong as what happened with bonds since the crash, you can expect equities to post a strong showing in the next few months at least.

This trend is not enough on its own to justify a heavy long equities stance, of course. But it is one trend that may put some tailwinds behind the market and is worth considering as you evaluate your portfolio allocation.

A Quick Kindle Comment

Earlier I mentioned that I see book stores as DDW businesses. I am reaffirmed in that opinion by the latest Kindle application – a free application for smartphones that allows you to automatically sync up with your Kindle library and go straight to the last page you were reading on a Kindle device. I downloaded it yesterday, then found myself with a bit of time on my hands and so gave it a live test – and sure enough, with a few taps I was using my iPhone to read the book I’m currently reading on the Kindle on my nightstand.

Think of it. Next time you are stuck in a line at the post office or don’t want to take your Kindle on the plane, or whatever – you are now able to seamlessly use your smartphone to continue reading where you last left off on your Kindle.

Of course, specialty book stores – featuring art books and such – will be around for a long time (until they are replaced by some future variation of the e-book that allows for HD graphics and multidimensional interactivity)… but run-of-the-mill book stores simply have to follow the video rental stores into oblivion as they serve almost no real purpose at this point. If you own shares in Barnes and Noble, don’t.

Since we’re talking books – I’ll mention that I’m currently reading the Kindle version of The Book of the Dead: Lives of the Justly Famous and the Undeservedly Obscure by John Mitchinson and John Lloyd. It’s a fast-reading and very interesting collection of short biographies of a large number of remarkable individuals – with a special focus on character quirks that shed insights into their extraordinary lives. If you like biographies, you’ll enjoy this book.

That’s It for Today!