A Long Retreat from U.S. Equities is Continuing

In the last 25 years, Americans have steadfastly increased their exposure the U.S. equities, as the mutual fund industry matured and the cost of investing directly into stocks dropped. In 1980, only 6% of households held mutual funds, rising to 25% in 1990 to about 50% today. And far more people trade individual equities now than in the early-1980s.

That's the type of accumulation of an asset class that limits future returns, because there's less "money on the sidelines" available to drive demand for equities much beyond supply.

This trends are reflected in the following long-term P/E chart (below), which, toward the far right, shows valuations rising sharply from 1981 through 2001 (as investors raised their exposure to the asset class), and then retreating somewhat since then, and still not near a classic bear-market bottom by any means:


For a decade already, many of the world's savviest and nimble investors have owned far less U.S. equities as a percentage of total assets than the typical recommendation of 40-80% advocated for Americans saving for retirement, as referenced here for example. Lately, more of the largest and slower-moving institutional investors are shifting away from U.S. equities, as covered by Pension Risk Matters:

• [D]efined benefit plans are moving assets away from equity to alternatives and fixed income. In "CalPERS to shift $44 billion" (December 24, 2007), Pensions & Investments reporter Raquel Pichardo describes the giant retirement plan's move into international equity, real estate, private equity and a "new inflation-linked asset class." On April 17, 2008, New York Times reporter Mary Williams Walsh offers insight into what some of American's biggest plan sponsors are doing to manage market volatility. Referring to a new study by Evaluation Associates in "Market Turmoil Has Taken a Toll on Big Pension Funds," Walsh writes that General Motors, Ford, Boeing and Deere are a few of the large plans to turn from equities.

Retail investors, usually the last to move en masse, have also begun (but only just begun in the past year or two) to diversify away from U.S. equities, according to the latest fund flow data, and judging from the amount of money being injected into global, commodity and other new ETF varieties.

This process could have a ways to go before U.S. equities bottom, from a long-term perspective. Barclays Treasurer John Porter, being interviewed in Inside the House of Money, says:

• From a financial markets point of view, we're in a range type of stock market with a downward bias. People will become quite disillusioned with the financial markets. At some point, people are going to look to other things, like public service, the Peace Corps, or that type of thing, as opposed to getting an MBA or going into investment banking. These things tend to go in waves."
  

The process of moving toward this notion of a market bottom sounds painful for portfolios. But economic and financial dynamism will prevent a washout. In other words, we think investors will still make money in U.S. equity indices in the next five (+) years, but the trends we discuss above -- and other risks we discuss in previous posts -- will probably keep U.S. index returns in the low-single-digits.

We're overweight cash now, and gradually adding funds to a broad array of asset classes when each of them dips. In the last two months, we've added a bit to Developed Europe equities, Emerging Markets equities, Frontier Markets equities, municipal bonds, and environmental trend-driven equities (rather than high-yielding "real assets," as of yet). We're watching for entry points in Real Estate, U.S. Treasuries and TIPS (Treasury Inflation Protection Securities), and we're hunting for a top-performing and uncorrelated market-neutral equity fund and private equity fund.