Is now the time for stocks?

The markets are dominated by a hidden powerful force; one that decides whether you’ll retire wealthy or work until you’re 75. Now I’m not talking about a cabal of central bankers here. Or sharks at the big investment banks.

It all comes down to that very human condition of herding. Once understood, it has big implications for the way you invest…

City folk are easily frightened

The first herding issue is a psychological one. As humans, we have a primitive instinct to follow what everyone else is doing. We feel comfortable in the crowd, especially when it comes to investments.

As I mentioned on Wednesday, one area where investors are certainly huddling up is in government bonds.

Insurers and pension funds control the lion’s share of UK assets. And they’re all filling up on bonds like there’s no tomorrow. For some it’s a regulatory issue – they’re compelled to do it. But others wilfully follow the crowd. Insurers hold massive investment portfolios – and over the last ten years or so, it’s become increasingly unfashionable to hold equities.

I’ve read a number of company reports boasting about how they’ve dumped equities and de-risked their (or should I say shareholders’) portfolios.

Many of the massive defined benefit pension schemes have skewed their portfolios towards bonds too. They just can’t stand the heat: first the millennium crash, then the 2008/09 financial crisis.

Well, as it happens, this strategy has served them well. Bonds have had a fantastic run. In fact, in my opinion, they’re getting close to bubble territory at this point.

That said, there’s likely to be a bit of life in the market yet. Because there’s another side to herding…

How boomers bust a market

Recent research out of the San Francisco Fed shows that the stock market closely follows demographics. Basically, markets get more expensive (price/earnings ratios go up) as the proportion of middle-aged workers in the workforce increases. Of course, that makes perfect sense. As the baby boomers hit their earnings peak during the ’80s and ’90s, they pumped a load of savings into stocks – prices went up.

But times have changed. Today the boomers are in drawdown mode. They’re selling stocks and prices are heading down. You may think that this isn’t such a big problem. I mean, the tide moved slowly in, and now it’s moving slowly out. Unfortunately not…

Yes, the boomers gradually built up equity over the last 30, 40 or even 50 years – and that provided a decent tailwind behind the stock market.

But the big problem is that when it comes to drawdown, the whole lot is usually sold in one fell swoop. The equity portion is axed – a quarter of a fund can be taken as a cash (tax-free) lump sum, while the remainder usually goes into an annuity policy. This policy promises an income for life – and they’re mostly invested in government bonds.

So now everyone and their dog are buying bonds. I mean, let’s not forget the Bank of England and their quantative easing too.

Bonds are becoming fantastically expensive. In comparison, equities look like a fantastic buy. But what’s to stop this situation getting even worse?

Just consider the number of affluent boomers set to drawdown equity holdings over the coming years. 

Who’s going to take up the slack? Not the young – they’re mostly riddled with debt. And anyway, many of them are increasingly disillusioned with pensions.

Turning their back on stocks

Which brings us full circle back to the primary herding instinct. Many of today’s savers reckon pensions are useless. Many are saving pensions via the property route, or just not saving at all.

Well, that’s up to them. But it’s kind of ironic that just as the stock markets are heading towards some semblance of value… nobody’s interested! Though, because of pent-up demographics, the situation may well get worse.

But at some point, the tide will turn.

There’s not much we can do to change demographics. But we can alter our own behaviour. When markets become too crowded we can take our profits off the table and shift to another, more compelling investment. And when markets become unloved, then it may soon be time to consider jumping aboard.

For the moment, patience is the order of the day. If I were young and just starting out, I’d be drip-feeding cash into equities today. But seeing as I’m not, I’m going to stay defensive.

Sitting on a decent slug of cash should offer me the means and the courage to snap up equities, if they head into extreme undervalued territory. The wind has changed direction for the stock market. Cheap stocks can always get cheaper. Just be ready to buy if Mr Market offers an extreme bargain.

• This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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