Cover Story: Fear Factor

Volume Outlook Bleak as Investors Shun Stocks

On Wall Street, risk is suddenly a four-letter word. Retail investors can’t stomach it. Pension plan sponsors are allocating away from it.

That’s bad news for stocks. Volume has been dropping almost nonstop for three years and shows no signs of improvement. The situation is worse than it was following the crash of 2000. It’s worse than it was after the crash of 1987. Fearful of the future and still wincing from 2008, investors are moving funds into bonds, commodities, cash, private equity, hedge funds and even foreign securities-anything but U.S. stocks.

"Our bread and butter is the retail investor," Scott Wren, a senior equity strategist at Wells Fargo Advisors, one of the country’s four largest retail brokerages, told Bloomberg Radio recently. "They’re not jumping into the market. They’re not chasing it. Those who have been around for a little bit have been probably burned twice here in the last 10 years or so. They’re definitely gun-shy. They’re not believers. I’m not sure what it’s going to take to get them back in the market."

See Chart: Down Escalator

Their financial advisers aren’t sanguine about the U.S. stock market, either. Only 44 percent of them plan to increase their clients’ allocations to U.S. stocks this year, according to a recent survey by Investment News. That’s down from 63 percent at the start of last year.

Retail investors own about half of all stocks, either directly or indirectly. Institutional investors, both foreign and domestic, own the other half. Both groups operate under different constraints, but both groups are searching for the same thing: a return on their investment.

For most of this century, stocks haven’t provided one. The S&P 500 Index registered a 10 percent loss (including dividends) in the first decade of the 21st century, the worst 10-year period ever. Add to that one recession and two financial crises-one in the U.S. and one in Europe-and the idea of risking one’s assets in the stock market loses its appeal.

Market Meltdown

Pension plans, which own about 20 percent of all U.S. equities, are following individual investors out the door. As a result of the stock market meltdown, both public and private defined benefit plans are underfunded, as their assets have fallen below their liabilities. And because they must earn a return regardless of stock market conditions in order to pay retiree benefits, they are as worried as retail investors.

Ford Motor Co., for instance, which manages about $60 billion in defined benefit plan assets, now allocates 22 percent to U.S. equities and 20 percent to foreign stocks. It plans to drive the combined figure down to 30 percent "over the next several years," according to its recent 10-K filing.

See Chart: Turning Passive

The big carmaker, whose pension plan is underfunded by $15 billion, plans to allocate more funds to fixed income securities and alternative investments, such as hedge funds and private equity. The goal is to "minimize the volatility of the value of our U.S. pension assets," Ford said in its filing.

Ford also plans to close its plan to new employees. The upshot of the changes, Ford contends, will be to decrease its risk. "This will reduce our balance sheet and cash flow volatility and, in turn, improve the risk profile of the company," chief financial officer Lewis Booth told analysts on the company’s recent earnings call.

Dumping Stocks

According to data published by the Federal Reserve, private defined benefit plans have been dumping stocks for the last five years-even before the crash. New rules from the federal government and the Financial Accounting Standards Board are also behind the slashing of stock allocations. The rule changes speed up loss recognition by the sponsors, which reduces reported earnings. That has made the corporate funds less inclined to endure the ups and downs of the stock market.

Public funds don’t have the same constraints. Still they have been net sellers of U.S equities, albeit to a much smaller degree. By and large, public funds have maintained their allocations at post-crash levels, although they are swapping positions in domestic stocks for those in foreign securities.

Federal Reserve data illustrates the diverging path of the two big investor groups. In 2003, stocks made up 60 percent of the total assets of both public and private defined benefit pensions plans. That figure is now 57 percent for public plans and 34 percent for private plans.

See Chart: Ups & Downs

Still, like their cousins in the corporate world, public funds are unsettled. According to a study released last year by the National Conference on Public Employee Retirement Systems in Washington, the 215 U.S. public pension funds had only 76 percent of the assets needed to meet their expected obligations.

For the California Public Employees Retirement System, or CalPERS, that figure is 70 percent. The plan sponsor manages $219 billion in assets and is dialing back on its risk by cutting its equities exposure. At the end of last year’s third quarter, CalPERS allocated about 46 percent of its assets to U.S. and foreign stocks.

That’s actually four percentage points below CalPERS’ strategic target. "We’re maintaining an equity underweight," the plan sponsor’s chief investment officer, Joe Dear, said on CNBC last fall. "The difference is in our absolute return strategies. We take a risk buffer and try to go with returns that aren’t going to lose us a lot of money."

Absolute return strategies are typically run by hedge funds, which aren’t bound by benchmarks and can short stock to hedge their bets. CalPERS had $5 billion invested in absolute return strategies at the end of the third quarter, according to its Web site, part of a trend under way of pension plans investing in hedge funds.

Dear noted there is less justification for taking equities risk these days. "With low interest rates and a relatively small equity risk premium, you are going to have a hard time getting that 7.75 percent," he said. "So you have to look at alternatives. You have to innovate if you’re going to get there." CalPERS’s growth target is 7.75 percent, slightly below the standard 8 percent pension plans expect to earn over the long haul.

Turnover Down

The decline in stock market volume isn’t solely related to the decline in allocations. Turnover is down as well. Turnover is a measure of how long a stock remains in a portfolio. It is calculated by dividing the value of all purchases or sales, whichever is lower, by the fund’s net asset value. A ratio of 100 percent, for example, implies the fund replaced all of its holdings during the period in question.

See Chart: Bursted Bubbles

Whether it’s cause or effect, turnover typically rises and declines along with changes in volume. As did volume, turnover peaked in 2009, and has fallen since. For mutual fund managers, according to data from the ICI, turnover hit 64 percent in 2009; falling back to 53 percent in 2010. For hedge fund managers, turnover hit 180 percent at the end of 2008, according to data from Goldman Sachs. It dropped to 132 percent by the end of 2010.

With both allocations and turnover down, traders have suffered. Volume in stocks and ETFs peaked at an average 12.3 billion shares per day in March 2009. In December of last year, volume was averaging 6.4 billion shares per day, a drop of 47 percent. Retail volume has fallen just as hard. Data from Thomson Transaction Analytics, taken from broker regulatory reports, shows retail volume has been cut in half since peaking in March 2009.

The share volume drought is worse than the periods following the crashes of 1987 and 2000. All three events produced tremendous volume during the crashes themselves and in the months that followed. Following the crash of 1987, volume peaked and then dropped sharply. It then leveled off for three years before turning up.Following the crash of 2000, volume spiked upwards and then remained roughly at its peak level for four years before turning up. This time is different. Trading in stocks (but not ETFs) has declined steadily for nearly three years, with the exceptions of a couple of European debt crisis-related spikes.

ETFs Flat

Exchange-traded funds haven’t fared as badly as stocks. ETF volume also peaked in March 2009 before crashing back down. But, in contrast to stocks, ETF volume has remained flat, with about 1.5 billion shares per day traded ever since. Volume in the SPDR S&P 500 ETF actually rose last year.

See Chart: Adios IBM

Assets managed by ETFs and traditional index funds are on the rise, while assets of actively managed mutual funds are not. The result is that the proportion of stock investments in index funds has hit an all-time high. At the end of last year, index funds held 28 percent of all stock mutual fund investments, according to the ICI, up from 19.5 percent at the end of 2007. Some investors consider index funds to be less risky than actively managed funds as they eliminate the risk that the manager will not beat his benchmark.

Some stocks are actually doing well. Volume in American Depository Receipts, for example, has been rising steadily since 2007. According to Citigroup, ADR volume passed half a billion shares per day on average last year. That’s up from about 170 million shares per day in 2006. The push into foreign stocks following the crash is borne out by Federal Reserve statistics as well.

Between 2009 and the third quarter of 2011, U.S. investors were net buyers of foreign stocks, including ADRs, by $273 billion. By contrast, U.S. investors were net sellers of domestic stocks during the period by $263 billion.

Profits Down

See Chart: High Road, Low Road

Despite the silver linings, the overall decline in volume has hit the industry hard. Profits are down and layoffs are up. Small institutional firms such as Ticonderoga Securities and WJB have closed their doors. Just about all of the larger firms are pruning their ranks. Still, the market was up 7 percent as Traders Magazine was going to press. Could allocations to equities soon follow?

See Chart: ADR Trading

"I don’t think I have a good crystal ball on that one," Richard Weil, chief executive officer of Janus Capital Group, a money manager prominent in U.S. equities, told analysts recently. "People have been afraid of equity markets and equity allocation. But I think if the equity markets remain strong through the first part of the year, there’s a good likelihood that institutions will return some asset allocation back into the equity market as their confidence grows. But I think that those decisions have yet to be made and they’re very hard to predict." 


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