As Sentiment Shifts, Pension Funds Could Soon Turn to Stocks

When pessimism was surging in the wake of the financial crisis, bond giant Pimco embarked on an outspoken publicity campaign that turned its "new normal" view into a household phrase. Stocks were likely to languish in the coming prolonged period of muted growth, Pimco CEO Mohamed El-Erian repeatedly said, going as far as to declare a last winter's stock market rally as a temporary "sugar high."

Of course, crowding into bonds despite their meager yields would make sense given the dangerous deflationary view prominent bearish pundits like El-Erian were pushing when sentiment was at its most dour.

Now, though, a growing chorus on Wall Street is forecasting major gains for stocks in the coming year. Even Pimco has abruptly changed its tune. The bond giant has aggressively ratcheted up its growth forecast for the U.S. GDP to 3.5%, citing political factors like President Obama's agreements with the Republican leadership in Congress on tax cuts. Here's another sign that the tide is taking a more hopeful turn: After two years of having investors pile in, Pimco's Total Return Fund saw its first outflows in November.

Woefully Underinvested

But beyond high-stakes political dealmaking, investors should also consider a simpler alternative explanation for the turn in sentiment: Pimco simply got it wrong and vastly underestimated the potential for stocks. And while individual investors have already started dipping back into stocks, the country's major pensions funds remain woefully underinvested by historical standards.

So, a recognition by the country's big pension fund managers -- some of whom control hundreds of billions in assets and are desperate for returns to match their ballooning liabilities -- that they need to raise their exposure to stocks could further boost equity prices.

The equity allocation of private U.S. pension plans nosedived following the financial crisis, according to a recent report by investment bank Credit Suisse (CS). Equity holdings fell to almost 30% of overall assets from a trend of about 45% over the last five decades.

Is Bullish Sentiment Bearish?

Along with El-Erian, other high-profile bears like Goldman Sachs (GS) Chief Economist Jan Hatzius have also backed away from their pessimistic outlooks recently. Safe-haven assets like government bonds have seen their value tumble around the world amid surging yields, and dealers are anticipating further rises in 2011.

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A sharp rise in bullish sentiment can sometimes signal market tops. After all, bull markets are often said to climb a "wall of worry." But as erstwhile pessimists shift their stance, they become the buyers that drive prices higher.

The thin equity holdings of pension funds, however, could make for an abundant source of new capital. As bearish pundits fold, pension fund managers no longer have the intellectual cover to pile into bonds with tiny yields even as stocks trade at reasonable valuations.

The bunker mentality encapsulated by the new normal view is fading fast. And stocks could get a nice boost as pension funds again shift their assets back to the old normal.

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