What U.S. Markets Sorely Lack: Investors' Faith

lost confidence among investors
lost confidence among investors

Have American investors lost faith in the nation's financial markets? Statistics from mutual fund trade group Investment Company Institute suggest the answer is yes. Investors have been pulling their money out of U.S. equities for 24 straight weeks, last week withdrawing $623 million from U.S. stock funds and investing $1.45 billion in overseas equity funds instead.

Mutual funds that invest solely in U.S. stocks have reported a massive $92 billion outflow as Americans give up on the stock market, despite its huge run-up from the lows of March 2009. The numbers offer a more accurate indicator of investor sentiment than polls that survey a tiny percentage of investors. Institutional money managers and individual investors alike have been voting with their feet and abandoning the market for both equity funds and mortgage-backed securities.

Twice Shy

With stocks and corporate profits rising, and pundits reporting that U.S. corporations have huge amounts of cash, why aren't investors jumping into the bull market?

For one thing, U.S. stocks have crashed twice in less than nine years -- between 2000 and 2002 and between 2008 and 2009 -- handing investors 40% to 80% in losses. As the old adage goes: "Once bitten, twice shy." Stock investors have been bitten twice.

On top of that history, investors may no longer trust the transparency of the nation's financial markets. First of all, Wall Street has become dominated by short-term traders who can instantly react to news. As Peter Cohan recently reported on DailyFinance, 70% of the trades on U.S. exchanges are held for an average of only 11 seconds, and that makes long-term investors vulnerable.

Follow the Money

Then there's all the insider selling, which by some accounts has reached the breathtakingly bearish ratio of 1,169 to 1, meaning insiders are selling 1,169 shares for every one they're buying. Insiders are presumed to have the best information about their own companies' prospects. So, if they're selling, what does that suggest about rosy forecasts for future profits? What do you believe: What insiders say, or what they do with their own money? Understandably, investors seem to be more influenced by the latter.

In addition, much of what passes for facts in the financial news doesn't pass the "sniff test": As blogger Mish Shedlock recently reported, many stories about corporations sitting on vast stashes of cash neglected to look at the other side of the balance sheet: liabilities. While the top 50 market-cap companies in the country collectively report $3.7 trillion of cash on hand, they also owe a total debt of $4.45 trillion, bringing the net cash balance to negative $749.6 billion, according to Shedlock. All together, corporate debt has skyrocketed to $7 trillion.

Meanwhile, the mortgage market hasn't proven that it deserves any more trust than the stock market. As Richard Bowen, former senior vice president of CitiMortgage, testified before the Financial Crisis Inquiry Commission in April, his company "continued to purchase and sell to investors even larger volumes of mortgages through 2007," even though defective mortgages increased rapidly in 2007.

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"This is not just errors and omissions," testified Joshua Rosner, managing director at independent research consultancy Graham Fisher. "This appears to be a massive fraud perpetrated on the investing public on a scale never before seen."

So, it's no wonder that the market for mortgage securities that aren't government guaranteed is dead in the water. From a peak of $2.3 trillion in mortgage-backed securities that weren't issued by Fannie Mae or Freddie Mac in June 2007, according to Bloomberg, only $15 billion were backed by banks and other private firms last year, while 99%, or $1.5 trillion, of mortgage securities came from government-backed loans.

It's clear that institutional money managers don't think mortgages are worth much at this point: Many of the mortgage-backed securities sold as low-risk AAA-rated investments are now trading for pennies on the dollar, and even the top deals are selling for just 50 cents on the dollar.

Seeking Shelter

With the stock market dominated by opaque high-frequency trading that's inaccessible to average investors, and a mortgage market still struggling to recover from a history of fraud and misrepresentation of risk, investors' loss of faith in American financial markets is hardly a mystery.

Until the markets are restored to trustworthy transparency and insider trading and fraud are vigorously prosecuted, it might be wise for investors to pull their money out and keep it safe.