Stocks Still Get No Respect

Have investors fooled themselves again? Despite strong returns since 2009, investors are more interested in bonds because they keep eyeing the stock market's past volatility.

Like Rodney Dangerfield, stocks don’t get no respect from average investors, despite strong returns since 2009, says Jonathan M. Bergman, vice president of Palisades Hudson Financial Group. Instead, bonds thrill them, he says.

Investors pulled money from U.S. stock mutual funds each of the last five years, including $100 billion in 2011. They’ve poured money into bond funds each of the last six years, including $110 billion in last year, says Bergman, a certified financial planner whose firm manages $1 billion.

Investor behavior is paradoxical. It’s mathematically impossible for bonds to keep appreciating anything like they have over the past several years, he says, citing financial guru Jeremy Siegel.

“If valuations returned to the norm, the S&P 500 would be 25% to 30% higher,” Bergman says.

Corporate profits have increased 125% since 2009.

“Corporations now run leaner than they did a few years ago and will benefit greatly from any economic tailwind,” he says.

Why the Great Paradox in investor behavior? Bergman says most investors follow the crowd. Looking at bonds’ once-in-a-millennium boom and the stock market’s recent volatility, they assume the future will mirror the past.

“While it’s smart to glance in the rearview mirror sometimes, looking only backwards will inevitably lead to messy smash-ups,” Bergman says. “Fundamentals matter. Investors have fooled themselves again.”

Many people are buying bonds very high and selling stocks low by historic standards. Treasury bonds have even outperformed stocks over the last 30 years, but they were a far more compelling buy in 1982, when the 10-year note paid around 14%, not 2%.

“There’s no reason for the excessive pessimism that investors seem to apply only to stocks,” he says.

How and where to invest now

Bergman isn’t knocking all bonds. He says most people need some in their portfolio, and the proper allocation varies greatly.

“But don’t overdo it, and invest mostly in short-term bonds to minimize your risk,” he says.

Invest the remaining 35% abroad, spreading it among developed and developing nations. The mix should include regional funds and single-country funds such as Australia, Japan and Canada, he advises.

“With rates at record lows, there’s no place for long-term bond prices to go but down,” Bergman says.The math is different for equities. The price-to-earnings ratio of the S&P 500 is less than 13 times the 2012 earnings forecast, compared to the average historical ratio of 16.4.Bergman recommends putting 40% of your equities in large-cap index ETFs. Put 10% in small-cap funds and 7.5% each in natural resources funds and REIT funds, for a total of 65% in the U.S. market.