The Looming Correction Blues

With bonds and cash barely showing a pulse when it comes to interest rates, investors may be timidly strolling back down Wall Street, trying to eke out returns on their money. With shaking hands, many are once again gambling on equities, keeping the bear back in his den and allowing the bull a run out into the ring.

“There is an old adage the market climbs a wall of worry, ” says Brian Sullivan, president and chief investment officer of Regions Investment Management.

Since the market’s 2008 plunge of 53 percent, a long and steady rally has brought prices back to historic highs. Yet, during the whole march upwards, people have been buying stocks with furrowed brows. Investors who abandoned the stock market are reluctant to return, fearing that they have waited too long.

“Investors are putting too much emphasis on what is coming out of Washington in terms of politics. While the NSA and IRS scandals are not economic problems, they are becoming a negative drum beat, ” says Sullivan.

The rally is fueled by investors converting cash and money market funds into stocks in an attempt to pump up their returns, according to Sullivan. Many predicted that bond market buyers, suffering from nearly negative returns, would turn to the stock market. However, that transition has failed to happen.

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Though many experts anticipate that investors will switch from bonds to stocks, “the Great Rotation has not begun in earnest, ” says RSA’s Marc Green.

Photo by David Bundy

“The Great Rotation [bonds to stocks] has not begun in earnest, ” says Marc Green, chief investment officer for the Retirement Systems of Alabama and a chartered financial analyst (CFA).

Historically, bonds have served as a defensive position, a good steady cash cow.  However, with low interest rates, that defensive position has vanished, according to Thomas Leavell, president and CEO of Leavell Investment Management in Mobile.

A much larger market, the bond market has taken well-publicized hits, including the largest municipal bankruptcy in U.S. history, Jefferson County. While just a blip on the bond screen, Jefferson County still represents, especially in Alabama, what can go sour in bond buying. Leaders traded the people’s welfare for Broadway play tickets, watches, spa treatments and $1, 000 suits, says Leavell.

Investor psyche gets pummeled by stories such as the Jefferson County bankruptcy and the looming Detroit bond debacle, which is predicted to be even worse. Once the bond market is tainted, it leaves few places for investors to put their money, leading them back to Wall Street, according to Leavell.

“There is essentially nothing left but equity investments, ” says Leavell.

Still, investors court stocks with caution. Jitters can be seen in investors every time the Federal Reserve calls a news conference. With the central bank pumping $85 billion a month into bonds, any indication of cutting back a few billion can send shock waves through the market, according to Sullivan.

“The market will certainly react to the end of the Sugar Daddy era, ” says Sullivan.

When the money stops flowing from the feds, who will be left to buy? The prediction is that stocks will drop to lower prices, deepening distrust among investors, according to John Steiner, CFA, managing director and portfolio manager of AlaTrust Inc. in Montgomery.

With the Fed using its deep pockets to prop up investments, interest rates are suppressed at unnaturally low levels, keeping investors guessing at the real economic picture. Anytime you take an economic system and force artificial restraints on it, you do not have a market built on simple capital systems such as profit and loss, says Leavell. “You don’t get a true reading on what is going on.”

Investors fear what the economy will really look like when the federal mask is pulled off its face. The quantitative easing that the Federal Reserve has created by buying up trillions in bonds could lead to a giant plunge once it stops. With computer trading, one negative comment about a federal pullout could drive down the market by 300 points, according to Tommy Smith, CFA, principal, portfolio manager with Birmingham Capital Management.

“Investors could get spooked by the feds, ” says Smith.

A naturally occurring market should self-adjust every two or three years, and with the federal prop, no adjustment has been allowed. The typical five to 10 percent drop returns prices to realistic levels. It takes a 20 percent drop to switch to a bear market. It is long overdue, according to Sullivan.

The low interest rates are maintained to encourage business investment. However, business spending is not the problem, according to Smith. With government spending 15 percent of the Gross Domestic Product, and business spending another 15 percent of GDP, the lion’s share goes to consumers at a whopping 70 percent.

“Investor confidence is very high, it is consumer spending that has not bounced back, ” says Smith.

The 92 percent who are employed still worry about job security. Many see their largest investment, their home, either underwater or not worth what it was just a few years ago. Heavy debt also keeps many away from the stores, according to Smith.

He cites the Thomson Reuters/ University of Michigan Sentiment Index, which showed consumer confidence at a high of 105 in 2004. It plummeted below 60 in 2008 and has only risen to 82 as of June 2013. As long as people are not shopping, new people will not be hired, says Smith.

In fact, fewer people are being hired than anticipated at this point in the recovery. Employers continue to dodge potential wage inflation by continuing to do more with less, according to Green.

“The productivity gains means they have squeezed a lot of blood out of that turnip, ” Green says.

Sensitivity to changes in the new healthcare bill may also be suppressing hiring. Any change to tax policy or business expenses could send a shiver through the system, according to Hart Johnson, financial advisor with Wells Fargo in Montgomery.

A rise in interest rates could also impact indebted Americans and their indebted government. Interest rates have no place to go but up, but Leavell worries that just a 1 percent rise could add $170 billion in interest charges to the federal debt.

“Everything will get hit, ” says Leavell.

The problem is, many of today’s investors can’t afford the hit. The biggest investment group is the baby boomers. Now nearing retirement, these cash-laden retirees are looking for investments to sustain them through the golden years, according to Johnson.

“There is a strong desire for stocks with a yield. We have a push for income producing securities, ” says Johnson.

If boomers lose, they lack sufficient time to rebuild their assets. More than ever, people need to know how much they can afford to lose, says Steiner.

Many investors are seeing their absolute income dropping by 20 percent, and their buying power is worse, says Sullivan. These investors are being forced back into riskier investments in high dividend stocks to avoid seeing an income drop year after year.

Even in these nervous times, there are real stocks with real sales and real earnings turning profits for savvy investors. Smith, who worries about a big drop after the feds taper off, advises his clients to invest in businesses with products people need, such as toothpaste or tires.

“We are not looking for companies that have to convince you to buy their product, ” says Smith.

Companies he recommends also exercise significant control over their costs, such as labor and equipment. He rejects companies such as airlines, which have no control over fuel and unionized labor costs. Government regulation is also a turnoff, as few can successfully fight the legal system, according to Smith.

He prefers mature companies that have survived a few ups and downs. Sailing through a bad time reveals the strength of management and product demand. Most of his stock recommendations include leaders in an industry, as weaker companies are more likely to fold, Smith says.

“It is time for some of those boring companies to do well, ” says Sullivan. Purchasing the stock of a company you can recognize and understand what it does eases investor nerves, even if the stock goes down. Good companies can be impacted by circumstances, but generally come back, he says.

Prices on some of these company stocks are inflated, to some extent because of their scarcity. Some companies are buying back their own stock, contracting the amount of stock available. This policy could result in a good but explosive effect, according to Leavell.

As the economy continues to improve, investors appear to be regaining their taste for the riskier lure of the stock market. While experts ponder and predict, Wall Street continues to lurch forward, and occasionally backward, without much respect for opinions on what should or shouldn’t happen.

“The stock market can turn on a dime for no real reason. Sometimes, we just don’t know why, ” says Steiner.

Short of a reliable crystal ball, investing remains a gamble for the bold buyers dipping their toes into the water.

Verna Gates is a freelance writer for Business Alabama. She lives in Birmingham.

Text by Verna Gates

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