Oxstones Investment Club™By Doug Kass, The Street,
Today’s dominant investor classes — individual investors, hedge funds and pension funds — have de-risked and are relatively uncommitted to equities.
A re-allocation into stocks (and out of bonds) represents an underappreciated and potentially massive (and latent) demand that could easily be the catalyst for a move to all-time highs in the S&P 500 in 2012.
Individual Investors
According to the Investment Company Institute, in 2011 retail investors liquidated $130 billion of domestic equity mutual funds, accumulated $1.7 billion of international stock mutual funds, purchased $120 billion of bond funds and bought $8.4 billion of high-yield funds. Since the beginning of 2007 (through 2011), retail investors liquidated over $450 billion of domestic equity funds, accumulated $130 billion of international stock mutual funds and purchased $930 billion of bond funds. The near-$1.4-trillion swing out of domestic equity mutual funds and into bond mutual funds is unprecedented.
Since 2001, as measured by stock holdings as a percentage of total financial assets, individual investors’ share of stocks has declined from 25% to only 18%. In the same time frame, stock mutual funds have dipped from 79% of total mutual fund assets (excluding money market funds) to only 65% at year-end 2011.
Hedge Fund Investors
After Wednesday’s close the ISI Hedge Fund Survey, which is based on the actual exposure at 36 long/short funds, which have approximately $90 billion in assets, indicated that net hedge fund exposure moved down to 44.3% (while gross exposure dipped to 49.7%). This is close to the lowest level of long exposure in four years and equivalent to the low exposure at the generational low in March 2009.
Large Pension Fund Investors
There are less official data on pension funds than on retail investors and hedge funds, but it is commonly recognized that pension funds are disproportionately exposed to fixed income over equities. This important asset class remains fearful of stocks, preferring the haven of safety available in low- or virtually non-yielding bonds (which provide returns well below actuarial assumptions).
Watch What They Do, Not What They Say
As most subscribers know by now, I prefer to watch what investors do, not what they say. That is why I am dismissive of many of the sentiment surveys (AAII, Investors Intelligence, etc.) as well as put/call ratios (which are further rendered relatively meaningless, owing to the proliferation of leveraged ETFs).
The aforementioned de-risking and flight to safety in bonds by all three dominant investor classes help to explain the last five years of action in domestic equities and the contraction in P/E ratios in 2011.
I expect the recent trend of large outflows over the last year (and last five years) to be reversed in 2012. Not only are interest rates at generational lows but many high-quality companies are yielding (at 2.5% or even better) well above the yield on the 10-year U.S. note.
At first, similar to the past two weeks, in which under $1.5 billion has come into stock mutual funds, the pace of inflows will be slow. As it becomes clearer that the domestic economy is self-sustaining, that the European debt crisis is showing continued evidence of stability, that a Republican presidential win in November grows more likely and that corporate profit (and margin) expectations will be achieved, I expect the rotation out of bonds and into stocks to accelerate.
Tactically, I favor the asset management stocks such as Och-Ziff Capital Management (OZM_), T. Rowe Price (TROW_), Waddell & Reed (WDR_) and Legg Mason (LM_) and the discount brokerage stocks such as E*Trade (ETFC_) and Schwab (SCHW_) as direct beneficiaries of the expected rotation out of bonds and into stocks in 2012.
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