Dec 07, 2010

The Big News Everyone Missed

By Andrew Mickey, Q1 Publishing

It’s hardly a surprise anymore that the financial media, and by association most investors, miss out on the most important news.

Over the last week your editor has been on the road again (using “road” loosely).

A little over a week ago we traded in our comfy confines in central Arizona for an 8,000 mile trek halfway across the world.

The 36-hour journey plunged us into the Philippine jungle exploring a unique low-risk/high reward gold investment strategy for Prudent Investors. Despite the off-road trucks bouncing across roads only the locals could see and a rickety wooden boat which after hopping on you reflexively count the life vests and after engine fires up you look for oars that you’ll likely need at some point, it was nice to get away from the daily crises of the markets.

It helps to get a clear head and time away from the market swings always serves as a solid reminder that a 5% move – either with you or against you – isn’t much to get worried about in the big picture of investing successfully.

But now that most of the deep-in-the-woods work is over, we’re back in a downtown Manila hotel. It’s about 100 degrees. The heat and humidity makes the Christmas music blaring in the mall across the street a bit odd, but nice. It’s almost two o’clock in the morning and there’s still enough traffic even to frustrate an L.A. commuter. But we’re back to civilization and we were kind of excited to log onto the well-traveled laptop to see the major news for the last few days.

Of course, the “big” news didn’t have too many surprises. Unemployment hung steady around 10%. The tax compromise, which was essentially a done deal after Election Day, is now nearly finalized. As for the markets, everything that was going up continued to go up.

Not much to worry about really. But then I came across something incredibly important. Of course, there was significant news that most of the investment world simply passed over. And it explains what’s going on in the markets, where the opportunities lie, and what to do now.

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The One Thing That Truly Matters

Every little bit of news isn’t really news at all. The markets are mostly random. But the financial press and punditry can’t really say that. They have to analyze and dissect every little move and create reasons why GE is up 30 cents or why Wal-Mart is down 20 cents.

That’s great for them, but it distracts from the real fundamentals which drive markets. Usually, that’s earnings, the economy, technology, and competition. Today, however, that’s low rates and investors natural response to them.

Last week the American Association of Individual Investors (AAII) released its latest survey and didn’t create much buzz with taxes and unemployment on everyone’s minds.

The results of the survey though reveal almost everything about why the markets are doing what they’re doing and where they’re headed next.

The Survey Says…

The AAII’s monthly asset allocation survey shows where individual investors, the majority that makes up “the herd” who are prone to make the worst moves at the worst times, are actually putting their money.

As we’ve suspected since this rally began, they’ve been doing exactly what they are being induced to do, whether it’s good for them or not over the long run.

It found investors have been riding the stock wave. Stock and stock funds now make up 62.4% of investors portfolios. This is the largest allocation to stock and stock funds in 11 months and is slightly above the 23-year average allocation of 60%.

The survey found they continue to love bonds. The average allocation for bonds and bond funds totaled 21.8%. That’s significantly higher than 23-year average allocation of 15%.

With both of the primary asset classes most investors focus on taking up disproportionately large portions of their portfolios, there can’t be much cash left on the sidelines. The survey found individual investors have allocated a mere 15.9% of their portfolios to cash. That’s well below the 23-year average allocation of 25%.

Of course, we have to discount a lot of the upward moves in stocks due simply to the run-up in stocks across the board. But with that in mind, these shifts in allocation are incredibly important.

What’s an Investor to Do?

The allocation shifts signal a lot about what’s going on in the markets today.

First, they signal everyone is responding to the Federal Reserve’s policies. The low rate policy virtually forces investors to hunt returns anywhere they can find them. With cash and money markets paying below a half percent per year, investors gladly walk up the risk scale to earn greater returns.

It also adds why every asset class largely moves up and down together. If oil’s up, gold’s up, and stocks are too. If stocks take a hit, oil, and gold go down with them. Everything is in lockstep and the fundamentals matter less and less.

Perhaps most tragically of all though, it shows most investors are making some very bad moves. Increased exposure to stocks is the last thing most investors should be doing. Remember, Baby Boomers make up most of U.S. investors’ assets. And since they’re nearing retirement, a higher allocation of stocks is a very risky move. Also, the risk/reward on bonds is absolutely terrible. A year or two of interest can, has, and will again be wiped away in a matter of days.

Also, with stocks just above their long-run average, it shows there is still some upside potential if the bubble continues to example. Bonds, meanwhile, get another warning sign.

But in the end there’s not much any of us can do about it over the short-term. The best bet is to simply go along for the ride.

So buy stocks. Buy what has the best risk/reward profile you can find. History has proven rallies tend to last far longer and go far higher than most everyone expects.

Most importantly though, keep stop losses in place. Be psychologically prepared to sell and live without getting out at the exact top (odds are about 1,000-to-1 that neither you nor I were going to anyways) and losing just a little bit after the party’s over. Because when the Fed’s starts hiking rates or the bond vigilantes start driving rates higher beyond the Fed’s control, the music will stop and there will be even less chairs to grab than there was in 2008.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

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