U.S. Investors Who Missed Four-Year Rally Could Be Ready to Return to Market

NEW YORK and LONDON, March 28, 2013 — The return of U.S. investors to equities markets and more aggressive investing by non-U.S. investors could drive stock prices higher, even after a four-year rally that has more than doubled prices, according to a recent white paper from the BNY Mellon Investment Strategy & Solutions Group (ISSG).

U.S. investors could be reaching an inflection point where they begin returning to equities after years of seeking safer assets and missing the rally that began in March 2009, according to the paper: What if Something Goes Right? Equity Market Risk Signals and the Great Rotation.

The report also notes that the non-U.S. investors who have been fueling the bull market have enough buying power to send the prices of stocks in general and growth stocks in particular higher. These non-U.S. equities investors have been concentrating their investments primarily in defensive stocks, the report said.

"While stocks have rallied sharply, the gains have been built on a foundation of worry and risk aversion," said Robert Jaeger, senior investment strategist for ISSG and co-author of the report.  "These worries are reflected by the valuation premiums that defensive sectors command over growth-oriented sectors.  This combination of investor sentiment and valuations could indicate that investors in the U.S. and abroad have substantial potential buying power to acquire growth stocks, even after the big move that we've had."

Various sources of concern such as the U.S. fiscal cliff, the possible breakup of the eurozone and slowing growth in China did not stop the rise of equities during late 2012 and early 2013, according to the ISSG report.   Still, U.S. investors tended to overweight defensive and dividend-growing sectors while avoiding growth stocks, even when they did move to stocks, the report said.

"They are more focused on what can go wrong than what can go right," said Jaeger.   "But if things go right, too many investors could miss any continuation of the rally if it develops."

A familiar risk is that everyone could move to growth at the same time, creating a bubble and then a possible correction, according to the report.

However, this time there appears to be a supply of equities that could come on the market as defined benefit pension plans sell stocks as they rise to higher prices, the report said.  These plans are more interested in buying bonds to insulate their portfolios against further market volatility, said ISSG.

"These plans typically are more concerned about hedging their liabilities under the accounting rules governing pension plans, which means they will need to own long-term bonds," said Jaeger.  "That is more important to this group of investors than maximizing their returns by staying invested in equities."

Despite the sharp rise in stock prices since 2009, U.S. mutual fund investors continued to flee stocks over the last three calendar years to buy bonds, according to the Investment Company Institute.  These investors have been moving to safer assets since the onset of the financial crisis in 2007.

"So, while U.S. investors were avoiding U.S. stocks, non-U.S. investors were buying them right through the current rally," said Jaeger.  "Many U.S. investors continued to buy bonds even while government bond yields in the U.S., Japan, and Germany are at historic lows as investors willingly accepted artificially low interest rates created by the easing monetary policies of central banks."

The positions taken by options traders also indicates that investors are more concerned with avoiding a falling equities market than taking advantage of a possible rise in the markets, the report said.

"While we can't predict the direction of the equities markets over the next six months, we need to ask if the current strength in equities has some staying power," said Jaeger.  "If it does, we could be seeing a growing number of investors regaining their risk appetite at the same time defined benefit pension plans are selling equities for non-economic reasons.  This could create a slow, upward movement for stocks that would not feel like a bull market, or a bubble."

BNY Mellon's Investment Strategy and Solutions Group is a division of The Bank of New York Mellon.  In Asia, Europe, the Middle East and Africa, the ISSG offers products and services, including investment strategies that are developed by affiliated BNY Mellon Investment Management investment advisory firms, to clients through BNY Mellon Asset Management International Limited. In the US, ISSG is part of The Bank of New York Mellon.

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