BARRON'S COVER
Caution Rules
By LESLIE P. NORTON
Chastened investors have new priorities, such as safety and simplicity. How to get the most bang for your hard-earned buck -- without losing sleep.
AFTER SECOND-QUARTER MUTUAL-FUND PERFORMANCE turned positive -- the first good showing since the economic crisis started -- financial planner Nancy Anderson expected a flood of inquiries about buying stocks. None came. "I was surprised," says Anderson, who works for Financial Finesse, which advises 401(k) clients like Aetna and General Motors. "I'm a certified financial planner. But calls about foreclosures and hardship withdrawals were up," as well as questions about budgeting and debt payment. So much for animal spirits.
Following the series of shocks that started nearly two years ago -- from a 30% decline in the Dow to the collapse of Bear Stearns, Lehman Brothers and AIG to the revelations about Bernard Madoff's $65 billion Ponzi scheme -- individual investors have changed. They've understandably grown cautious, as was evident again last week when new data showed mutual-fund investors put an estimated $43 billion into bonds and withdrew $1.7 billion in stocks in August, even as the Dow was charging from its March low of 6,547 on its way to last week's 9,820. Cash now stands at $3.5 trillion, above where it stood at the height of the financial crisis.
So if he or she isn't jumping into equities, what does this new investor want and how will these altered desires change the market and the economy? In brief, they want more safety, preservation of capital, lower fees and more transparent products. These desires will push them toward fixed-income investments and other offerings that provide consistent returns and those that are easy to understand like indexes and exchange-traded funds. Although a few stock plays will benefit, the market itself will have to rely on professional buyers for support. The economy will have to soldier on without a key source of investment.
"The investment industry is knocked about and pessimistic," says Jim McCaughan, president of global asset management for Principal Financial Group, which sponsored a major study of investor expectations post-crisis. "People were seared by the last decade, which has seen two of the worst four bear markets in the last century," he adds. "A fair number of people expect as many as two [more] crises in the next decade. Both investor behavior and regulatory behavior will be measured to avoid these crises. Whether this caution is generational in the sense of the Great Depression -- where one never lost the [desire for] thrift -- is questionable. But it could be quite long term."
IT'S LITTLE WONDER THAT WE GOT to this gloomy point. Despite recent gains, American portfolios are decimated -- even as the big retirement wave looms. Says Richard Hughes, co-president of Portfolio Management Consultants, which advises pension managers: "People who were one to three years from retirement have lost 40% to 50% of the value of their portfolio; they can't possibly face another November 2007 to March of 2009 time frame." In a low-rate environment, expectations also are falling. Says Anderson: "Once people thought rates of return of 8% were realistic. Now, they're doubting 4% is attainable."
Plunging real-estate values and job insecurity are also affecting investors' view of the world. (Witness Eli Lilly's move to cut 5,500 workers last week.) In New York City, for example, high-end residential property resale prices are off by a third, while the number of finance jobs fell by 40,000 last year. That experience is more or less replicated in most of the country's urban centers.
This uncertainty is further stirred by concern about the outcomes of the political debate on items like Medicare and Medicaid, and worries about the stability of corporate and public pension plans.
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As Mohamed El-Erian, co-chief investment officer at bond powerhouse Pimco, sees it, the market offers "equity risk, default risk, liquidity risk, inflation risk, and now, in this brave new world, public-policy risk." He likens stocks' recent advance to "a sugar high," and has 30% of his major funds in global equities -- just half the benchmark -- on the theory that companies will fail to deliver sustainable growth next year. (See his model portfolio nearby.) In its Total Return fund, Pimco has 44% in U.S. Treasuries, up from 25% in July.
"Nothing I see on the horizon will get us back to what we've always expected," says Stephen Leeb, a money manager, author and the publisher of a newsletter called the Complete Investor. "Our sun is setting, and that's anxiety-provoking to a lot of people."
BONDS WILL SURELY BE POPULAR with the new investor, both institutional and individual, who needs to offset his or her liabilities. In the flight to safety in 2008, U.S. Treasuries outperformed every other fixed-income security, and people still want a return of their principal. With governments of developed countries issuing so much debt, Pimco has constructed a new bond index that more heavily weights attractive bonds from emerging markets. In this environment, says Pimco's Ramin Toloui, "emerging-markets bonds are an attractive alternative," including Brazil's 10% bond due 2012, yielding 11.35%, and Mexico's 7.75% bond due in 2017, yielding 8%.
Corporate bonds also look cheap, yielding more than their historic averages both on investment grade and high yield. And despite their run-up, there are still plenty of municipal bonds with high yields and low prices, says Ellen Baber, who, with her mother and sister, runs an investment advisory practice for Wells Fargo Advisors, in Princeton, N.J. They work with professors and other generally conservative types of investors.
The newfound popularity of bonds is evident in recommended model portfolios that Wall Street firms assemble for their clients (for a sampling of changes in both model and actual portfolios see the chart below). As well-regarded strategist David Rosenberg of Gluskin Sheff said in last week's Barron's, investors have more downside protection in corporate bonds today than in equities, and he favors investment-grade securities in the A-rated universe yielding 6%. In a deflationary atmosphere, the real yield could be much higher than on stocks. Two of his picks: Goldman Sachs 7.50% due 2019 and Philip Morris 9.25%, also due in 2019.
And for newly budget-conscious Americans, cash will be another big draw. Consider Stacy Halpern.
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Halpern, 47, lives in Chicago with her husband, who works in the financial-services business, and two youngsters who are in private school. She says that her husband, previously generous to a fault, recently "took a highlighter to the Visa bill," pointing out unnecessary expenses. And as for her son's bar mitzvah, "the big party is off; it might be the water park instead." With Halpern's third child, a daughter, at Wesleyan and bound for med school, the family watches its cash and assesses its risks more closely. "Our return expectations are lower, and we're more selective than we've ever been," she says.
Richard Marr, a financial advisor with Shottland/Marr Group, an affiliate of Wells Fargo Advisors, in Maplewood, N.J., says, post-financial crisis, he's become "more patient, and more analytical." He spends less time dialed into CNBC and, when an investment moves sharply, he's more likely to sell and sit on the cash. In the meantime, he's become even more enamored of dividends.
Rising savings rates could squeeze money available for stock investment, as people build cash cushions equivalent to living expenses ranging from six months to two years. "Cash is now a legitimate asset class," says Jack Ablin, chief investment officer of Harris Private Bank. The savings rate ranged from 8% to 10% from the 1950s to the 1980s, and then plummeted, falling to 1% by 2005. It's recently rebounded to 5%, according to the Bureau of Economic Analysis. Some predict it will hit 10%.
This budget consciousness also will affect the fees that investors are willing to pay and the value they place on liquidity. According to the Principal study, more than 40% of retail investors now seek "better liquidity," while more than 35% are looking for a "value-for-money fee structure." That means that cheaper, easier-to-understand products like index and exchange-traded funds will become more important to investors. Within 401(k)s, target-date funds are expected to grow in popularity. Employees, though cautious, may actually be more willing to boost their contributions to savings plans like 401(k)s.
In turn, at least for individual investors, products like private-equity funds will lose allure. Says Harris' Ablin: "Investors aren't going to trust these opaque investment products as much as they did in the past. That may mean avoiding vehicles with lockups, and without full transparency and disclosure. Anything like private equity that salts away money for extended periods of time could be a problem. Structured notes were supposed to protect on the downside, but there was a lot of credit risk there."
Instead, investors will demand more investments that offer guarantees or protection. Pimco recently rolled out a fund that seeks to limit risk in ways that diversification wasn't able to in the recent round of across-the-board declines. The Pimco Global Multi-Asset Fund (ticker: PGMAX) attempts to cap declines and uses a technique that identifies worst-case scenarios. And in an unstable world, Pimco increasingly uses indexes that don't rely on data from the past.
Annuities could also be more popular as well as TIPS -- Treasury Inflation Protected Securities -- and commodities that provide protection against inflation. Some companies, including Putnam, are introducing funds that seek to achieve specific, absolute target returns over Treasuries, reports Strategic Insight, a consulting firm.
As the recent rally demonstrates, there will be opportunities within the stock market to play this new theme. One group that may benefit is online brokerages catering to independent advisors and individual investors. These advisors could see an inflow of cash because they offer such a wide variety of investments at low fees.
Among the favored stock picks are Charles Schwab (SCHW) and TD Ameritrade Holding (AMTD). Jim Tierney, portfolio manager of the W.P. Stewart Growth Fund (WPSGX), is a fan of Schwab, citing its competitive costs and ability to cause disruption in the brokerage community. Schwab is forecasting 8%-10% organic growth in assets, and Tierney sees the stock "easily" getting to the mid-20s from 17.61 last week. Brian Angerame, a portfolio manager at ClearBridge Advisors, is also a fan of Schwab and TD, on the thesis that investor behavior is changing. "It will be generational. Have I started changing? Everyone has."
Other plays would include banking survivors like JPMorgan Chase (JPM) and Wells Fargo (WFC) and well-positioned asset managers such as BlackRock (BLK) and State Street (STT).
Some experts foresee Americans -- despite their new caution -- venturing overseas more often as they become more comfortable with foreign investing and, possibly, more skeptical about their own country's ability to lead global growth. Says El-Erian of his model portfolio: "The first message [of the model] is to make sure you have truly global international exposure. Don't be blinded by excessive home bias."
IS THERE ECONOMIC DOWNSIDE to the new investor's caution? Yes. The worst case would be a replay of the experience in Japan, where the stock market is still 75% below its 1989 peak, and what was once the world's strongest economy is now the world's most sluggish. As Japan's bear market wound through the 1990s, retail investors began plowing money into post-office savings accounts. These accelerated as Japan's population aged faster than any other nation's. Though younger investors put money into Chinese, Indian, Thai and Vietnamese stocks, and into high-yielding Australian deposits -- buying every market except their own -- they sustained huge losses in 2007. These younger investors don't have a lot of wealth, either; many are "flexible" hires, unlike their older counterparts in the Japanese labor market. The government has tried to shore up the market, without success. As a result, Japan has an astounding $13 trillion in bank deposits.
"It really did turn out to be generational in Japan," says Principal's McCaughan. "To the extent they invest in anything, they're risk-averse."
A survey conducted during the second quarter of 2009 by academic Amin Rajan, CEO of U.K.-based Create Research and funded by Citigroup and Principal Global, found that 34% of asset managers believe this scenario will unfold -- that clients' investment choices over the medium term will be driven largely by capital-protection considerations. Rajan's study surveyed 225 asset managers from 30 countries who oversee a total of $18.2 trillion of assets.
Wrote Rajan: "Big losses and changing demographics risk driving out a whole generation of clients, as has happened in Japan." Of course, he says, a V-shaped recovery in the U.S. could restoke greed. Nevertheless, "Chances are slim. Four standard-deviation events have burnt a big hole. Its pain may well endure beyond the recovery."
To be sure, many experts don't think we'll have a Japanese-type decline. The U.S. economy is much more flexible than Japan's, with fewer regulations; the population is also younger.
REGARDLESS OF THE EXACT EXTENT, the shocks of the past two years will limit investors' appetite for risk -- the question is really for how long. This caution is hardwired into us, according to Joy Hirsch, the director for the Program for Imaging and Cognitive Sciences at Columbia University. When not fielding questions from grad students at her office, Hirsch is running a series of experiments, including one that determines how likely people are to gamble if they feel stress. You could take $10 now, or wait a couple of weeks for the high probability of winning $20. So far, says Hirsch, people are more likely to take the $10, and gamble only if they feel they have some say in the decision.
Put another way, in blackjack, you are dealt two cards adding up to 16 and the dealer deals himself a seven. You assume there's a face card underneath, or at least a 10. Until recently, that suggested you take a card. "What we see today is investors much more happy sticking with 16," says Hughes of Portfolio Management Consultants. "If the dealer has 17 or higher, so be it. Nobody wants to experience regret from actions that they've taken."
"How afraid are you of a loss? That influences your risk-taking nature," says Columbia's Hirsch. "The basic tenet of economics is that investors are rational. But risk is uncertainty, and uncertainty is about emotion. Investors are more averse to loss than motivated by gain. Under conditions of high emotional arousal, you take less -- the $10 -- to get it immediately."
The trouble is that periods of high emotional arousal have chemical effects on the brain, ending up reorienting it. The recent crisis, Hirsch continues, is a "traumatic brain injury of an economic variety." And that could take a while to recover from, perhaps a generation.
Eventually, people will venture back to equities, once they build a cash cushion that makes them feel secure -- whether that's six months' living expenses or two years. That could boost the savings rate closer to 10% than zero. In fact, muses McCaughan of Principal, that could be the way some damaging global imbalances get fixed. The trade deficit could even close in on zero at some point, which might mean a stronger dollar. But that's another story.
Richard Marr, a financial advisor with Shottland/Marr Group, an affiliate of Wells Fargo Advisors, in Maplewood, N.J., says, post-financial crisis, he's become "more patient, and more analytical." He spends less time dialed into CNBC and, when an investment moves sharply, he's more likely to sell and sit on the cash. In the meantime, he's become even more enamored of dividends.
Rising savings rates could squeeze money available for stock investment, as people build cash cushions equivalent to living expenses ranging from six months to two years. "Cash is now a legitimate asset class," says Jack Ablin, chief investment officer of Harris Private Bank. The savings rate ranged from 8% to 10% from the 1950s to the 1980s, and then plummeted, falling to 1% by 2005. It's recently rebounded to 5%, according to the Bureau of Economic Analysis. Some predict it will hit 10%.
This budget consciousness also will affect the fees that investors are willing to pay and the value they place on liquidity. According to the Principal study, more than 40% of retail investors now seek "better liquidity," while more than 35% are looking for a "value-for-money fee structure." That means that cheaper, easier-to-understand products like index and exchange-traded funds will become more important to investors. Within 401(k)s, target-date funds are expected to grow in popularity. Employees, though cautious, may actually be more willing to boost their contributions to savings plans like 401(k)s.
In turn, at least for individual investors, products like private-equity funds will lose allure. Says Harris' Ablin: "Investors aren't going to trust these opaque investment products as much as they did in the past. That may mean avoiding vehicles with lockups, and without full transparency and disclosure. Anything like private equity that salts away money for extended periods of time could be a problem. Structured notes were supposed to protect on the downside, but there was a lot of credit risk there."
Instead, investors will demand more investments that offer guarantees or protection. Pimco recently rolled out a fund that seeks to limit risk in ways that diversification wasn't able to in the recent round of across-the-board declines. The Pimco Global Multi-Asset Fund (ticker: PGMAX) attempts to cap declines and uses a technique that identifies worst-case scenarios. And in an unstable world, Pimco increasingly uses indexes that don't rely on data from the past.
Annuities could also be more popular as well as TIPS -- Treasury Inflation Protected Securities -- and commodities that provide protection against inflation. Some companies, including Putnam, are introducing funds that seek to achieve specific, absolute target returns over Treasuries, reports Strategic Insight, a consulting firm.
As the recent rally demonstrates, there will be opportunities within the stock market to play this new theme. One group that may benefit is online brokerages catering to independent advisors and individual investors. These advisors could see an inflow of cash because they offer such a wide variety of investments at low fees.
Among the favored stock picks are Charles Schwab (SCHW) and TD Ameritrade Holding (AMTD). Jim Tierney, portfolio manager of the W.P. Stewart Growth Fund (WPSGX), is a fan of Schwab, citing its competitive costs and ability to cause disruption in the brokerage community. Schwab is forecasting 8%-10% organic growth in assets, and Tierney sees the stock "easily" getting to the mid-20s from 17.61 last week. Brian Angerame, a portfolio manager at ClearBridge Advisors, is also a fan of Schwab and TD, on the thesis that investor behavior is changing. "It will be generational. Have I started changing? Everyone has."
Other plays would include banking survivors like JPMorgan Chase (JPM) and Wells Fargo (WFC) and well-positioned asset managers such as BlackRock (BLK) and State Street (STT).
Some experts foresee Americans -- despite their new caution -- venturing overseas more often as they become more comfortable with foreign investing and, possibly, more skeptical about their own country's ability to lead global growth. Says El-Erian of his model portfolio: "The first message [of the model] is to make sure you have truly global international exposure. Don't be blinded by excessive home bias."
IS THERE ECONOMIC DOWNSIDE to the new investor's caution? Yes. The worst case would be a replay of the experience in Japan, where the stock market is still 75% below its 1989 peak, and what was once the world's strongest economy is now the world's most sluggish. As Japan's bear market wound through the 1990s, retail investors began plowing money into post-office savings accounts. These accelerated as Japan's population aged faster than any other nation's. Though younger investors put money into Chinese, Indian, Thai and Vietnamese stocks, and into high-yielding Australian deposits -- buying every market except their own -- they sustained huge losses in 2007. These younger investors don't have a lot of wealth, either; many are "flexible" hires, unlike their older counterparts in the Japanese labor market. The government has tried to shore up the market, without success. As a result, Japan has an astounding $13 trillion in bank deposits.
"It really did turn out to be generational in Japan," says Principal's McCaughan. "To the extent they invest in anything, they're risk-averse."
A survey conducted during the second quarter of 2009 by academic Amin Rajan, CEO of U.K.-based Create Research and funded by Citigroup and Principal Global, found that 34% of asset managers believe this scenario will unfold -- that clients' investment choices over the medium term will be driven largely by capital-protection considerations. Rajan's study surveyed 225 asset managers from 30 countries who oversee a total of $18.2 trillion of assets.
Wrote Rajan: "Big losses and changing demographics risk driving out a whole generation of clients, as has happened in Japan." Of course, he says, a V-shaped recovery in the U.S. could restoke greed. Nevertheless, "Chances are slim. Four standard-deviation events have burnt a big hole. Its pain may well endure beyond the recovery."
To be sure, many experts don't think we'll have a Japanese-type decline. The U.S. economy is much more flexible than Japan's, with fewer regulations; the population is also younger.
REGARDLESS OF THE EXACT EXTENT, the shocks of the past two years will limit investors' appetite for risk -- the question is really for how long. This caution is hardwired into us, according to Joy Hirsch, the director for the Program for Imaging and Cognitive Sciences at Columbia University. When not fielding questions from grad students at her office, Hirsch is running a series of experiments, including one that determines how likely people are to gamble if they feel stress. You could take $10 now, or wait a couple of weeks for the high probability of winning $20. So far, says Hirsch, people are more likely to take the $10, and gamble only if they feel they have some say in the decision.
Put another way, in blackjack, you are dealt two cards adding up to 16 and the dealer deals himself a seven. You assume there's a face card underneath, or at least a 10. Until recently, that suggested you take a card. "What we see today is investors much more happy sticking with 16," says Hughes of Portfolio Management Consultants. "If the dealer has 17 or higher, so be it. Nobody wants to experience regret from actions that they've taken."
"How afraid are you of a loss? That influences your risk-taking nature," says Columbia's Hirsch. "The basic tenet of economics is that investors are rational. But risk is uncertainty, and uncertainty is about emotion. Investors are more averse to loss than motivated by gain. Under conditions of high emotional arousal, you take less -- the $10 -- to get it immediately."
The trouble is that periods of high emotional arousal have chemical effects on the brain, ending up reorienting it. The recent crisis, Hirsch continues, is a "traumatic brain injury of an economic variety." And that could take a while to recover from, perhaps a generation.
Eventually, people will venture back to equities, once they build a cash cushion that makes them feel secure -- whether that's six months' living expenses or two years. That could boost the savings rate closer to 10% than zero. In fact, muses McCaughan of Principal, that could be the way some damaging global imbalances get fixed. The trade deficit could even close in on zero at some point, which might mean a stronger dollar. But that's another story.
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