Stocks Shining as Bonds Lose Luster

By JONATHAN CHENG And TOM LAURICELLA

The U.S. stock market has powered back in the face of major global uncertainty. It may have bond investors to thank for that.

Money managers and advisers say there has been a steady undercurrent of cash heading out of bonds and into equities. While there remains unease about U.S. fiscal policy, with the Federal Reserve having pinned interest rates essentially at zero for so long, investors are capitulating and moving into stocks.

"We're in the early innings of a big asset allocation shift," says Jason DeSena Trennert, chief investment strategist at Strategas Research Partners.

That, some suggest, is what helped stocks rally last week despite spreading political turmoil in the Middle East, sustained higher oil prices, the ongoing nuclear crisis in Japan and looming problems for Portugal.

Analysts say investors, tired of earning nothing on their cash, are taking advantage of dips in the stock market to buy. Above, a trader works on the floor of the New York Stock Exchange last week.

 

"These kinds of events two years ago would have produced a significant de-risking" in which investors bail out of stocks, says Erin Browne, director of macro trading at Citigroup. "And we didn't see that."

Analysts say investors, tired of earning nothing on their cash, are taking advantage of dips in the stock market to buy. That sentiment has been largely missing since late 2008 amid the drubbing that was handed to many who tried to pick the bottom of that brutal bear market.

The recent inclination to buy the dips has been particularly strong among investors who missed the market's big rally since March 2009 because they were sitting in cash or gravitating toward bonds.

While the Dow Jones Industrial Average did decline in the first half of this month, losing 5% through March 16, it rallied back just as quickly and is now back where it started the month. On Friday, the Dow gained 50.03 points, or 0.4%, to close at 12220.59, its sixth gain in seven sessions.

After domestic stock funds registered outflows in the early part of March—to the tune of $5.6 billion, according to the Investment Company Institute—there is evidence that investors moved back into equity funds in recent days, according to global fund-flow tracker EPFR Global.

Driving this trend has been increased confidence that the U.S. economy, while still weak when it comes to housing and job growth, is well on its way to a self-sustaining recovery. And with the simple passage of time from the worst of the financial crisis in 2008, investors are less worried about protecting their money at all costs.

"You had a lot of people at the beginning of the year still not believers in the economy; I think more people are believers now," said Michael Strauss, chief economist and market strategist at Commonfund.

In one shift, some investors are less enthusiastic about the outlook for corporate and high-yield bonds than in the earlier stages of the recovery. The market value of the Barclays U.S. High Yield Index roughly doubled over the past 18 months to $968 billion, and few see similar gains ahead.
"The once-in-a-lifetime opportunity in credit is gone," said Leon Cooperman, chairman of hedge-fund manager Omega Advisors, at a conference sponsored by Strategas last week. And Treasurys "are screaming to be shorted," Mr. Cooperman added.

That leaves stocks. "At worst, stocks are the best house in a bad neighborhood," Mr. Cooperman said. If the U.S. can address its fiscal problems, "they could be the best house in a good neighborhood."

Making investors comfortable with stocks, even two years into a bull market, is that valuations aren't extreme by most measures. Stocks "are cheap relative to history, they're cheap relative to inflation and they're cheap relative to interest rates," Mr. Cooperman said.

Stocks are trading at a price equivalent to 13 times earnings, compared with the average of the past 10 years of about 17 times, according to FactSet.

A shift into stocks and out of bonds is exactly what the Federal Reserve had been hoping for when it started its second round of quantitative easing last year.

By pumping cash into the financial system, the Fed was aiming to force investors to move into riskier investments, such as stocks, that could eventually feed through into the broader economy.

"It's a desire of the Fed to push money out of shorter-term riskless instruments and into riskier things, like stocks," says G. Scott Clemons, chief investment strategist for Brown Brothers Harriman.

According to the ICI, the amount of money in money-market funds has come down steadily over the past four weeks, from $2.75 trillion at the beginning of March to $2.73 trillion last week. Much of that money is likely to be flowing into the equity markets, say those who watch fund flows.

After a 24% jump in the Dow between the end of August and mid-February, many investors were waiting for a pullback before jumping into stocks.

For some, that point came in mid-March and, in particular, on March 16, when the Dow fell by as much as 300 points amid fears of a nuclear meltdown in Japan. In the days since, the market has moved higher as investors bet the worst was over in Japan and the Middle East. They also figured those events would have relatively little impact on the U.S. economy.

As well, investors deemed the spike in oil prices a relatively minor drag on the economy.

"If you were worried about Japan or the Middle East or oil and sell stocks, what do you do with the proceeds?" Mr. Clemons says. "Put it in cash, where you earn nothing and are eroded by inflation? You could buy bonds, but yields are so low that the tradeoff of risk to yield isn't terribly attractive."
Write to Jonathan Cheng at jonathan.cheng@wsj.com and Tom Lauricella at tom.lauricella@wsj.com