Manufacturing and Earnings Are Reviving Investors' Hunger for Stocks

Manufacturing Rebound, Earnings Boom Revive Investors' Hunger for Stocks
Manufacturing Rebound, Earnings Boom Revive Investors' Hunger for Stocks

It's easy for investors to become short-sighted in an era of frenetic markets and hyper-accelerated news cycles. At this moment, the consequences of big Republican victories in the midterm elections and the size of soon-to-be-revealed quantitative easing measures by the Federal Reserve seem to be holding center stage in the nation's financial theater.

But investors should look past Wall Street's latest headlines and distractions, and focus on the broader economic picture being painted by recent data: A robust manufacturing rebound seems to be taking shape across the world, and third-quarter earnings have been highly impressive.

These strong fundamentals are finally starting to get investor attention and could set the stage for a stock market rally that will last well beyond the immediate aftermaths of the elections and Fed moves.

Europe became the latest region to report a manufacturing renaissance. While manufacturing was already expanding in September, a key index showed an acceleration in October that was even faster than initial estimates.

The bullish European data comes in the wake of strong manufacturing expansions in the U.S., U.K., China and India. Moreover, the export sectors in key large economies continue to strengthen, thanks to demand driven by rapidly expanding emerging markets. This robust demand is being reflected on corporate balance sheets as well. As third-quarter earnings season winds down, the results have been very encouraging as companies breezed by strong expectations.

Ready to Bet on the Equity Risk Premium

Those fundamentals finally seem to be persuading individual investors who were battered by the financial crisis and have been understandably skittish about risky assets like stocks. Despite their meager yields, investors have piled into less-profitable assets like bonds that are seen as safe.

But with bond yields at a trickle even as corporate earnings boom, individual investors are becoming increasingly aware of the gap. The equity risk premium -- the amount of extra yield investors demand from riskier assets like stocks -- has now shot to a five-decade high, according to analysts at institutions such as JPMorgan Chase (JPM).

Big companies have been quick to take advantage of the situation. They have been selling the parts of their capital structure that are overvalued and buying back the parts that are undervalued. Bond issuance and stock buybacks have been on the rise.

That risk premium, though, is finally generating a revival in interest among retail investors. Asset allocation to stocks in portfolios is again starting to reach levels on par with historical norms, according to the American Association of Individual Investors. And U.S. mutual fund inflows have climbed to highs last seen in April, according to Investment Company Institute.

Hedge Funds and Individuals Return

"The evidence shows that global retail investors are finally warming up to stocks, having bought more over the past month than they bought year-to-date up to September," analysts at JPMorgan wrote in a note to clients this week. "Asset allocators have added and are on net overweight, but are well off the positions they hold during sustained bull markets."

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Hedge funds have also been buying aggressively over the last two months to bring their stock positions to near April highs but are well below the levels they held before the financial crisis, JPMorgan analysts note. "Adding up all investors in the world, we find that their equity holdings are just below their 20-year means versus bonds and cash," analysts wrote.

In other words, while the yields on stocks outshine those offered by bonds by the highest ratio in five decades, investor holdings are still only coming back to the levels where they've been during the past two. Meanwhile, based on 2011 forecasts, earnings for the S&P 500 companies are on pace to hit record highs next year.

So, as individual investors finally start to feel comfortable again with stocks, expect the market to pick up steam.

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