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Case for contrarians: Fearful investors flock to sidelines

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It’s amazing how the 24/7 media bombardment of random noise and sound bites on the economy and markets has investors continuously on tenterhooks. It seems Armageddon is always lurking around the corner.

Investors have also been conditioned to attach special significance to stock market milestones, like the Dow Jones industrial average flirting with 17,000 (vs. 6547 at the bottom on March 9, 2009). As a result, we’re frequently asked whether the Dow at 17,000 means stocks will continue to move higher, or if they’re in for a painful fall.

Unfortunately, we can’t (nor can anybody else) say for sure whether the Dow’s next 1,000-point milestone will be 18,000 or 16,000. However, we think there are a number of positives for stocks.

The Leading Economic Indicators point to an economy gaining momentum, recovering from a weak first quarter of 2014 caused in large part by the brutal winter. Short-term interest rates remain close to 0 percent and longer-term rates have defied expectations of an increase caused by the Fed’s “tapering.”

Contrary to popular misperception, the federal deficit is shrinking rapidly. The overall stock market is fairly valued, even after the surge off of the bottom. Investor sentiment is far from ebullient.

This is not to say we see smooth sailing ahead. The stock market can encounter severe turbulence at any time and for any reason. However, we believe in Warren Buffett’s advice to “be fearful when others are greedy and greedy when others are fearful.”

Investors are certainly behaving as if they’re fearful.

The S&P 500 returned about 16 percent in 2012 and 32 percent in 2013. Yet according to an article published on June 9 by The New York Times, a new study by asset manager/custodian behemoth State Street’s Center for Applied Research showed U.S. retail investor cash allocations increasing from 26 percent to 36 percent between 2012 and 2014. Thus, contrary to what you might expect, investors are actually jumping off the bandwagon as stocks reach new highs.

Interestingly, the jump was the same for “Millennials,” those under 33 and just starting their investing lives and having the longest time horizons, as for “baby boomers,” those 49-67 and starting to liquidate investments for retirement and having far shorter time horizons. State Street said, “The crisis of 2008 is burned into their memories.” Further, “when you find consensus across age cohorts, you realize it’s not for liquidity needs but lack of trust across all age and wealth levels.”

This phenomenon can also be seen in U.S. stock mutual fund flows. According to data from the Investment Company Institute, investors sold a net $159 billion of U.S. stock funds in 2012. Flows turned slightly positive in 2013, with net purchases of $18 billion. However, since stocks began their run of new record highs in late April, investors have been net sellers of U.S. stock funds every week, to the tune of $19.7 billion from the week ending April 30 to the week ending June 25.

Regarding sentiment, legendary investor Sir John Templeton said, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” While it’s unrealistic to expect gains of the magnitude experienced in 2012-2013 going forward, we think investors are still skeptical and stocks remain on solid fundamental ground.

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