After the first 30 or so responses, the established pattern was simply magnified, so we are comfortable about the statistical validity of our sample. Most of the responses were from the U.S., but we also had multiple advisors respond from at least four other countries.  Let’s get down to an analysis of the data! Note: You can click on any of the charts to enlarge them.

Despite strong U.S. equity market returns in early 2012 that sent the Dow back above 13,000 by the end of February, indications are that many Americans remain investment spectators, reluctant to participate in the equity market rally, a Franklin Templeton global poll has found.

Investor skepticism appears to be tied to the extreme volatility witnessed in 2011, in which the Dow Jones Industrial Average had 104 days of triple-digit swings-representing a significant portion of the 252 total trading days last year. Indeed, when asked about the importance of various market scenarios when deciding to purchase an equity investment, market stability was most frequently identified by U.S. respondents as an important factor.

“The market volatility that has persisted since 2008 is keeping many investors on the sidelines, and their ability to view positive equity market performance constructively has been thwarted by the market ups and downs that are at odds with the stability they are seeking,” John Greer, executive vice president of corporate marketing and advertising at Franklin Templeton Investments, said in a statement. “But the reality is that investors who have been waiting for ‘the right time’ to get back into the equity market have been missing out on the market rally we’ve witnessed over the past few years.”

This is sadly typical of retail investors.  Volatility tends to be greatest at market bottoms, and volatility tends to be what investors most avoid.  As a result, investors often avoid returns as well!

This period strikes me as psychologically reminiscent of the late 1970s, when Business Week famously published a cover announcing the death of equities.  Consider what investors had been through: in the late 1960s, the speculative names had gotten torched.  By 1973-74 even the bluest of the blue chips had gotten ripped.  By the late 1970s, 20% annual corrections were the norm.  The economy was a mess and investors simply opted out.  The Business Week cover just reflected the spirit of the time.

The late 1970s are not so different from now.  The speculative names collapsed in 2000-2002, followed by a bear market in 2008-2009 that got everything.  The last couple of summers have been punctuated by scary 15-20% corrections.  The economy is still a mess.  Psychologically, investors are in the same spot they were when the original cover came out.  Based on fund flows, “anything but stocks” seems to be the battle cry.

Yet, consider how things unfolded subsequently.  Only a few years later both the market and the economy were booming.  (High relative strength stocks began to perform very well several years ahead of the 1982 bottom, by the way.)  The Business Week cover is now famous as a contrary indicator.  It wouldn’t shock me if the current investor disdain for stocks has a similar outcome down the road.

Business Week: the famous "Death of Equities" cover

via The Big Picture  (click on image to enlarge)

You can see that relative strength did not crack the top ten.  On the bigger chart, which you can see in the article, relative strength came in at #11.  Of course, there are many formulations of relative strength, so even that ranking probably covers a lot of different methods.

A number of the popular factors are value-related and some are based on profitability.  All of these factors ultimately interact in complicated ways, but you don’t have to worry about a crowded trade in relative strength.

Value, quality, and risk-related factors are all much more popular than relative strength.

via The Big Picture     (click on image to enlarge)

This particular article appeared August 17, 2010.  The market had just gone through a near 20% decline, as well as the flash crash a few months before.  Here is the front end of the article:

Yes, it’s going to get worse, a whole lot worse … Bill Gross warns this is the “New Normal. Forget 10% returns. Think 5%”. … Economist Larry Kotlikoff, author of The Coming Generational Storm, warns: “Let’s get real. The U.S. is bankrupt. Neither spending nor taxing will help the country pay its bills” … Economist Peter Morici warns: “Unemployment is stuck near 10%. Deflation coming. Stock market threatens collapse. The Federal Reserve and Barack Obama are out of bullets. Near zero federal funds rates, central bank purchases, a $1.6 trillion deficit have failed to revive the economy.” … Simon Johnson, co-author of 13 Bankers, warns: “We came close to another Great Depression, next time we may not be so lucky.” Why? Because Wall Street’s already well into the next bubble/bust cycle — the “doom cycle.”

The doom cycle sounds pretty bad and we are warned that things are going to get a whole lot worse.  I’m not exaggerating.  The whole paragraph was in heavy bold type.

Since then, we’ve gone through another 20% correction.  And the market is more than 25% higher.  Yes, higher.

Before you smirk and think you are immune from getting carried away, think again.  We are all susceptible to emotion—it’s just part of our wiring.  And it’s not just on the downside.  It’s equally easy to get carried away with “new era” thinking on the upside.

Sentiment swings, I think, demonstrate one of the very best reasons to use a systematic investment process.  Our happens to be an adaptive one driven by relative strength, but I’m sure other styles could also be successful.  The important thing is to define a profitable process and then stick to it through thick and thin.

After the first 30 or so responses, the established pattern was simply magnified, so we are comfortable about the statistical validity of our sample. Most of the responses were from the U.S., but we also had multiple advisors respond from at least three other countries.  Let’s get down to an analysis of the data! Note: You can click on any of the charts to enlarge them.

Source: The Leuthold Group

Without an investment process that systematically allocates to where the action is, investors may be psychologically incapable of making much money for years to come.

“There’s a big shift in terms of how plan sponsors are defining risk,” said Michael Thomas, chief investment officer for the institutional business in the Americas at Russell. “During the last 10 years, our industry has developed an unhealthy obsession with tracking error, but managing tracking error isn’t managing risk.”

He’s right—tracking error is not the same thing as risk.  Nor is volatility the same thing as risk, I might add.  Volatility management is just another unhealthy obsession.  Besides, the source of all of the evil volatility is readily apparent.

So far, most of the target volatility asset allocation strategies focus on equity exposure, which is, “by far, the biggest contributor of [portfolio] volatility,” Russell’s Mr. Thomas said.

Equity exposure = volatility.  To reduce it, just add some Treasury bills or bonds to the portfolio.  Duh.  That seems like a simpler solution if you really are concerned about reducing volatility.

I don’t think that investors are going to be any more successful targeting volatility than they are trying to target returns. We have no idea year to year what returns are going to be, even though we know exactly what they have been historically.  We can’t forecast it or target it–we just put up with whatever returns we get.  I don’t think volatility is going to be any more tractable.

It remains my contention that it will take relatively large losses in bond funds to bring back the individual investor into equities. But this is likely coming — it almost always occurs coincident with higher stock prices — and when it does, one of the greatest reallocations out of bonds and into equities will commence.

Mr. Kass discusses also the flow of funds and many factors that he believes are impacting prices.  It’s a nice piece because it hits most of the talking points that clients ask about.