Investors Are Flocking To Stocks In Droves

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
February 28, 2006

IN THIS ISSUE:

1. Investors Flocking To Stocks This Year

2. So Where Is The New Money Going?

3. Why The Rush Into Equities Now?

4. The Surge Into International Funds

5. Market Volatility Expected To Remain High

6. Revisiting Third Day Advisors

Introduction

All of a sudden, investors are pouring near-record amounts of money into the stock markets. As I will discuss below, individual investors are moving into the stock markets at a stronger pace than seen in years. Money flowing into stock mutual funds rose to a near record amount last month. Likewise, the number of stock trades at discount brokers rose substantially in January.

So, what’s up? Did someone ring a bell? Why are investors suddenly pouring money into the equity markets? Is it because the major stock indices have moved to the highest levels in nearly five years? Is there somehow a renewed level of confidence in the economy, despite the disappointing 4Q GDP report? Do investors believe the new Fed chairman will stop raising rates?

The truth is, we don’t know exactly why investors are all of a sudden deciding to join the party. But the money certainly rolled in last month, and early reports suggest more of the same this month.

Interestingly, most of the new money pouring into the markets is going into international mutual funds, which outperformed most domestic funds last year. This is an interesting development for several reasons that I will discuss below. This week, I’ll give you my analysis and opinions on these new trends.

Also in this issue, week we will revisit one of the more successful money managers I’ve run across. In January of last year, I introduced readers to Third Day Advisors, a money manager that focuses on short-term trends in the stock market. Third Day has turned in another stellar year for clients, and I will update you in the pages which follow. (Past results are not necessarily indicative of future results.)

Investors Flocking To Stocks

An article in the Wall Street Journal last week noted that, “Individual investors are moving into the market at a stronger clip than seen in years.” And in fact, there was a strong surge of new investor money going into stocks and mutual funds in January. We have seen a similar trend at my company. Calls from prospective investors are up, and even our existing clients are adding to their accounts and opening new ones.

At Fidelity Investments, the nation’s largest mutual fund family, net flows of money going into stock mutual funds soared to $5.6 billion in January, up from only $400 million a year ago. Fidelity said the large inflow represented new money coming in and the redeployment of money that was sitting in cash in brokerage accounts and money market funds.

Charles Schwab Corporation, for example, saw $4.5 billion flow into its stock mutual funds last month, the highest amount since February 2000, when net investments hit $4.7 billion. February 2000 was, by the way, the top of the long bull market.

At Citi-Group, the Smith Barney Consulting Group division, which provides fee-based managed accounts, says investment flows into stocks so far this year are “substantially” higher than they were in 2005 and 2004. St. Louis-based brokerage firm Edward Jones saw new account openings in January rise 11% from a year ago, and says February growth is also strong.

The number of trades by individual investors at discount brokerage firms has risen substantially in recent months and jumped an estimated 30% to 40% in January from December. The discount firms, which offer lower-priced trades, also report that money flowing into stock mutual funds last month was at a near record level.

Equity fund inflows in January alone were a whopping $29 billion, according to AMG Data Services (Arcata, CA), compared to $38 billion for the entire 4Q. I could go on with such numbers, but it is clear that investors are flocking into the equity markets this year.

Interestingly, new assets going into money market funds were up only $4.1 billion in January, compared with average January inflows of over $33 billion over the last 10 years, according to iMoneyNet.com. This suggests that much of the money moving into stocks today is coming from the sidelines.

So Where Is The New Money Going?

A surprisingly large chunk of the recent inflows went into international mutual funds. The international equity fund sector normally only amounts to around 15% of total assets of all stock mutual funds. However, according to AMG, international funds captured about 80% of the huge inflows in January. 80% - wow!

According to AMG, four of the five mutual funds that saw the largest inflows last month were international funds, including Fidelity Diversified International, American Funds’ Capital World Growth and Income Fund (Class A shares), Dodge & Cox International Stock, and the JP Morgan International Equity Fund (Select shares). [Note: I am not endorsing these funds, just giving you the stats.]

Is the latest stampede into international funds and foreign stocks another example of investors chasing the latest “hot” returns? The Morgan Stanley Capital International EAFE Index, a broad measure of stocks in Europe, Australia and the more-developed parts of Asia, gained 26% in 2005 in local-currency terms (or 11% when converted into U.S. dollars), outpacing the S&P 500 Index’s 4.9% rise last year.

Investing in international funds has long been a good way to diversify one’s portfolio. Yet in looking at the latest rush into such funds, it seems clear that some investors are loading the boat with foreign funds. I would bet that many do not fully understand the volatility they may experience or the sudden movements that can and do occur in currency exchange rates, which affect international funds’ returns.

In addition to international funds, a lot of new money is going into domestic equity funds. In particular, investors are flocking to so-called “asset allocation funds” which diversify one’s investment by holding multiple types of investments and asset classes within one fund. AIM Investments, one of the huge mutual fund families, says that sales of its asset allocation funds are up 50% this year.

Why The Rush Into Equities Now?

There are numerous reasons why investors are flocking back into the equity markets. Clearly, the fact that the equity markets have been rising since last fall has piqued the interest of more and more investors. Many investors have been waiting to see if the Dow could get over 11,000 and stay there, which it has. They may be viewing this as a buying signal.

Next, where else can investors go? Rising interest rates are having a negative effect on both the bond markets and real estate, where a huge amount of money has been invested. With the Fed expected to raise interest rates at least two more times, investors may be deciding that it’s time to leave the bond market. Ditto for real estate.

Next, aging Baby Boomers may finally be realizing that they have to save more for retirement. Having been on the sidelines for several years following the bear market of 2000-2002, and seeing the market move to new highs recently, maybe now they’ve decided to jump back in. Many of the Boomers who have been on the sidelines since the bear market might be seeing that they have to be in the market to ever hope to reach their retirement goals.

Or, Boomers may now be realizing that they’ve left a LOT of money on the table since bailing out in late 2002 and early 2003 when the S&P 500 bottomed out around 800. Today, the S&P 500 is near 1300. That’s a cumulative return of over 60%. Greed is finally overtaking fear, apparently.

If they had taken my advice back in early 2003 to get back in the market before the war in Iraq started, and when the S&P 500 was near its lows, they would have enjoyed this nice ride.

I suspect that the renewed interest in stocks and mutual funds is the result of all the reasons outlined above, not to mention New Year’s resolutions to save and invest more.

The Surge Into International Funds

As noted above, AMG reports that apprx. 80% of the new money flowing into stocks in January went into international mutual funds. I must say that this number seems high to me, and I would not be surprised to see it revised lower once all the data are in. Yet even if it was 50%, that’s still huge.

Also as noted above, the Morgan Stanley Capital International EAFE Index rose 26% last year versus the Dow Jones, which was down fractionally (-0.61%) in 2005. However, when that 26% is converted to US dollars, the net return is only 11%. Still, that’s pretty good compared to the Dow and the S&P 500 last year. In 2004, international stocks were second only to US small cap stocks. No doubt, this superior performance in the last couple of years is drawing investors to the international funds.

I wonder how many investors saw the 26% return last year but did not see the 11% net return after currency conversion?

Currency volatility is another real risk investors face when buying foreign stocks or international funds. While foreign stocks may go up (or down), the currency they are denominated in can fluctuate, often significantly. So, investors rushing into international funds now face not only the price risk of the shares going down (some analysts feel the international markets are overpriced today), but also the currency risk that goes along with these foreign companies.

Perhaps another reason for the surge in international investing is the constant negative reporting on the economy in the US. The media constantly downplay the good economic news and emphasize the negative stories. The result is a public that doesn’t believe the US economy is as solid as it really is. Polls continue to show that Americans have a more negative opinion of the economy than is merited by the actual numbers (+3.5% GDP growth in 2005).

Another factor that may be affecting investors’ desire for international stocks could be the realization that the Fed may continue to hike short-term rates, and the growing potential for an inverted yield curve. Maybe investors are buying into the gloom-and-doom crowd’s hype that we’re headed into a severe recession in the second half of this year.

Again the question is, are investors just chasing the latest “hot” performance? Time will tell, of course, but studies have shown that investors are frequently disappointed with their returns when they try to be in the latest hot sector - in this case, international funds. For many years, I have written about the Dalbar studies which show that investors who chase the latest hot markets often find that they go cold just as quickly.

It remains to be seen if this is the typical scenario where the smart money gets into an asset class that is undervalued; the value then goes up and gains the attention of the investment public; investors rush in, thus driving prices to over-valued levels; at which time the smart money moves out; and a decline follows. Time will tell. My main concern, however, is that many of these new investors may have put all or most of their portfolio in international funds recently.

We haven’t seen any statistics regarding the investment activities of institutional investors or large hedge funds in the area of international stocks so far this year. It will be interesting to see what these sophisticated investors do after this mass influx of money into international funds.

Finally, do not read the above discussion and conclude that I do not like international funds. In fact, I am a huge fan of international funds, if selected carefully. I absolutely believe that international stocks or funds deserve a place in a well-diversified portfolio.

Volatility Is Expected To Remain High

As I have noted in previous issues, The Bank Credit Analyst forecasts stocks to remain in a broad trading range with a modest upward bias, and with continued high volatility. Put differently, we could be in for another generally “sideways” market this year. My impression is that when I talk about sideways markets, some readers envision a rather flat graph line with just a slight upward tilt. Nothing could be further from the truth.

Even though 2004 and 2005 were generally regarded as sideways markets, we saw extensive volatility in both directions. The major stock indices shoot higher for a time, only to plunge lower later on. In 2004, for example, the S&P 500 was all over the board, but mostly lower, until the last two months of the year when prices soared. The S&P 500 Index ended the year with a gain of 10.7%, but I suspect many investors bailed out due to the high volatility. 2005 was a similar year, with high volatility for most of the year and a year-end rally for a modest return of 4.9%.

BCA believes we will see another high volatility year in 2006, as do plenty of other market analysts. This is true not only for US stocks, but also for international stocks. A January press release from Mercer Human Resource Consulting noted that global investment managers in all regions they surveyed expect high market volatility during 2006.

This year has started out somewhat differently. The major market indices broke out to new recent highs in January, with the Dow above 11,000 and the S&P near 1300 for the first time in almost five years. Then in late January and earlier this month, prices fell sharply, then reversed upward and then fell sharply again. Last week, the indices rallied back to near the highs.

Will the new high hold? Is this just the starting point for even better performance? Or will new concerns about the yield curve, the economy and oil prices cause the market to give back all or most of the recent gains? Unfortunately, none of us know the answers to these questions, but I think it is fair to assume that the market’s volatility will continue to be high in the months ahead.

As you have seen in recent weeks, the market’s activity so far this year is not a smooth line, but rather more like a roller coaster. In fact, a roller coaster is a good analogy for the kind of sideways markets we have experienced over the last couple of years. Investors experience impressive gains, only to plunge down the other side, giving up the gains and sometimes even dipping into loss territory. At the end of the ride, they are back at the loading ramp, essentially ending up about where they started. Unfortunately, many investors can’t take the high volatility and end up selling during the low points. The Dalbar studies certainly seem to indicate that.

Third Day Advisors – Taking Advantage Of Volatility

In January of last year, I introduced you to Ken Whitley, founder of Third Day Advisors. Ken has developed an investment strategy that not only doesn’t mind market volatility, but actually uses it to attempt to generate investment gains. While space does not permit me to do a complete explanation of Ken’s program, I encourage you to read my January 18, 2005 E-Letter which describes Ken’s investment strategy in detail.

Since my recommendation of Third Day last year, I have had many readers write in to ask how this program has done, especially in light of the sideways direction of the overall market. I’m pleased to report that for the 12 months ended January, Third Day gained 14.7%, handily outpacing the S&P 500 Index’s performance. Third Day’s average annual return from inception and through January of this year is 20.7%, net of all fees and expenses, with a worst drawdown of –12.18%.

Third Day Advisors Data

PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. BE SURE TO READ THE IMPORTANT NOTES AND DISCLOSURES BELOW.

How has Third Day achieved this impressive performance record, even in a generally sideways market? Ken Whitley’s system focuses primarily on short-term market trends that can lead to gains if you know when to get in the markets and when to get out. He has developed a proprietary system that produces the key buy and sell signals that are the backbone of his strategy.

It is important to note that Third Day’s system trades both long and short in the market, giving investors the potential to make money even when the trend in the market is down. Because Third Day’s program does short-term trading and will short the market from time to time, it is an aggressive strategy that is not suitable for all investors.

If you read about the Third Day program in my January 18, 2005 E-Letter and have been waiting around to see how it did over the last year, I think you have your answer. If you are a sophisticated investor, I encourage you to check out the Third Day Advisors program.

To invest with Third Day, simply give us a call, and we will send you all of the account paperwork. Investors open accounts with the Rydex family of funds, and Third Day is given a power of attorney to make the trades in your account. The minimum account size is $50,000 and the annual management fee is 2.5%. Third Day shares a portion of the management fee with my company for introducing clients.

You could bypass my company and invest with Third Day on your own, but the management fee is the same 2.5% either way. By investing through my company, you gain several benefits. First, we monitor every Advisor we recommend on a daily basis to see that they continue to perform acceptably. Second, we are in frequent touch with all of the Advisors we recommend. Third, we will not hesitate to rescind our recommendation of an Advisor if performance is not acceptable, or if they materially change their program or strategy.

In addition, as one of my clients, you will have access to all of the money managers we recommend. We are constantly searching for new Advisors with successful performance records, and you will be among the first to know about them. We will also let you know about the other investment programs we recommend. And you will also receive my monthly newsletter free of charge.

While no system is perfect, Third Day’s has certainly resulted in gains for our clients who got in when I first made my recommendation in January of 2005. It is important to note, however, that while we have been very pleased with Third Day’s performance, past results are not necessarily indicative of future performance. In addition, you should read the important disclosures below.

Finally, you should also know that I have a chunk of my own money invested with Third Day. I have my own money invested in every investment program we recommend.

If you would like to get Third Day on your team, give us a call at 800-348-3601 or CLICK HERE for an online request form. If Third Day’s program is too aggressive for you, we have several other professionally managed programs that may fit your investment objectives and risk tolerance.

Wishing you profits,

Gary D. Halbert

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IMPORTANT DISCLOSURES: ProFutures Capital Management Inc. (PCM), Third Day Advisors, LLC, and Purcell Advisory Services, LLC are Investment Advisors registered with the SEC and/or their respective states. Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed. Any opinions stated are intended as general observations, not specific or personal investment advice. This publication is not intended as personal investment advice. Please consult a competent professional and the appropriate disclosure documents before making any investment decisions. There is no foolproof way of selecting an Investment Advisor. Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors. PCM receives compensation from the Advisors in exchange for introducing client accounts to the Advisors. For more information on PCM or any other Advisor mentioned, please consult PCM Form ADV II, available at no charge upon request. Officers, employees, and affiliates of PCM may have investments managed by the Advisors discussed herein or others.

As a benchmark for comparison, the Standard & Poor’s 500 Stock Index (which includes dividends) represents an unmanaged, passive buy-and-hold approach. The volatility and investment characteristics of the S&P 500 or other benchmarks cited may differ materially (more or less) from that of the Advisors. Historical performance data represents actual accounts in a program named Third Day Aggressive Plan, custodied at Rydex Series Trust, and verified by Theta Investment Research, LLC. Purcell Advisory Services utilitzes research signals purchased from Third Day Advisors, an unaffiliated investment advisor. The signals are generated by the use of a proprietary model developed by Third Day Advisors. In all cases, performance histories reflect a limited time period and may not reflect results in different economic or market cycles. Statistics for “Worst Drawdown” are calculated as of month-end. Drawdowns within a month may have been greater. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Investment returns and principal will fluctuate so that an investor’s account, when redeemed, may be worth more or less than the original cost. Any investment in a mutual fund carries the risk of loss. Mutual funds carry their own expenses which are outlined in the fund’s prospectus. An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.

Returns illustrated are net of the maximum management fees, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees. They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. Individual account results may vary based on each investor's unique situation. No adjustment has been made for income tax liability. Performance for other programs offered may differ materially (more or less) from the program illustrated. Money market funds are not bank accounts, do not carry deposit insurance, and do involve risk of loss. The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.