October 2009 |
|---|
While the Federal Reserve’s ZERO rate monetary policy and the government’s fiscal policies have stimulated a rapid recovery in the stock and bond markets, they have had a much more muted effect on the economy so far. And while investors are obviously relieved to see such a large rally off the bottom, there seems to be a lingering sense of doubt among many people that this rally is for real and sustainable in light of the economic challenges ahead of us. This has caused them to reassess the amount of risk they are willing to accept in their portfolios.
One would think that after having watched the powerful rally in the stock market over the last six months investors would be looking for opportunities to put more money into stocks. After all, the Great Recession was proclaimed to be over by Federal Reserve Chairman Bernanke.
In fact the opposite has been happening. Investors have been using this market rally to scale back on their exposure to stocks and putting more of their savings into bonds.
The flow of funds for mutual funds data provided by the Investment Company Institute shows that bond mutual funds have taken in about $220 billion in the first eight months of this year. That is more than twice as much as last year and almost quadruples the year-to-date average over the past ten years.
In comparison, total stock mutual funds have attracted a little over $12 billion through August this year. While that is a relatively small amount compared to bond funds it is much better than the $69 billion outflow from stock funds in the first eight months of 2008.
This data helps explain one aspect of this market rally that has been different and troubling for those market strategists that want to proclaim this as a new secular bull market. The trading volume in the stock market has been lower than in past starts to new bull markets and has been declining as the market has been rising.
With short-term interest rates just above ZERO it is not surprising that money has been flowing out of money market funds at a fairly rapid rate. Through August these funds have seen an outflow of over $291 billion compared to an inflow of $340 billion in the comparable period in 2008.
Despite these outflows there is still about $3.5 trillion in money market mutual funds. However, before you get too excited about the stock buying potential of that amount of money, only about $1.1 trillion is in “retail” money market funds for individual brokerage accounts.
To give that amount of money market funds some perspective, it represents about 11% of the Wilshire 5000 Stock Market Index. Historically, the amount invested in retail money market funds has averaged about 9% of the index and has gotten as low as about 7% near stock market peaks. At the March low in the market, these money market funds were as high as 18% of the Index. We believe the amount of cash that is targeted for future equity purchases is much less than the “trillions” of dollars that we have read about.
So the flow of funds data and the returns in the stock and bond markets are showing that the Federal Reserve’s monetary policy is at least having the desired result in the financial markets. Zero percent money market rates and quantitative easing (the Fed’s purchasing of Treasury and agency securities) have helped push U.S. Treasury bond yields down to low single digit rates. Those intended results are forcing investors to take more risk with their savings in an effort to at least keep up with inflation and to recoup some of the losses from the past.
But while this policy has had the desired affect in the financial markets and brought some relief to investors, we are very concerned that it has caused stocks and bonds to be valued at higher prices than the current economic fundamentals would suggest are warranted.
While U.S. Treasury bond yields were actually even lower at the beginning of the year (10-year bonds at 2.2% versus 3.2% now), yields on corporate bonds are substantially lower. The additional yield spread over Treasury bonds that investors can now get for accepting the credit risk of default from corporate bonds is much lower than a few months ago and is still declining as investors reach for higher returns.
Three months ago low investment grade (BBB rated) corporate bonds were offered at yields that were over three percentage points higher than Treasury securities with similar maturities. Today the offerings are much less attractive with yields of about 1½-percentage points higher. In a low interest rate environment like we have today that is not much absolute return for the risks involved.
The ZERO rate policy has undoubtedly forced money into the stock market. It is very difficult for portfolio managers of equity mutual funds or institutional equity accounts for pension plans and foundations to have a lot of cash in their portfolios earning nothing, especially in a rising market. The pressure to get the cash invested in the stock market is intense.
The stock market is now at valuation levels that are discounting a more normal economic recovery than we think is possible. While the various government stimulus programs have created some economic activity, we question the sustainability of this activity and are concerned about the long-term consequences of the deficit spending.
At Front Street Investment Management we do not believe that investing in risky assets such as stocks should be a default decision, i.e., because “what else can we do with the money?” We need to be confident that the downside risk is limited by a margin of safety provided by low prices in case the economy and corporate earnings do not meet current expectations. The flow of funds data shows us that some other people feel the same way.
