Small investors 'throwing in the towel'

Timothy McIntosh, a Tampa financial planner, has always been able to soothe his customers after a rough patch in the stock market. Until now.

"They are just throwing in the towel," McIntosh says.

And it's not just McIntosh's customers. Investors have yanked $249 billion from stock mutual funds since January 2007 — an estimated $60 billion this year alone.

If you can't understand why small investors are getting out of the stock market, you haven't been watching it lately. The average stock mutual fund shed 17.4% in the third quarter, vs. a 13.9% loss for the Standard and Poor's 500-stock index, according to Lipper, which tracks the funds.

But it's not just the losses, which investors used to take in stride. Political turmoil over the budget is taking its toll on some investors. The debt problems in Europe are making other investors nervous. Flash trading by hedge funds and others makes the stock market seem rigged.

"You have better odds in a casino these days," says Raj Nijjer, 33, director of product development at Godaddy.com in Scottsdale, Ariz. "At least with roulette, you know what you're betting on — black or red," Nijjer says. "The market isn't geared to the small investor."

Institutional investors have long thought that peak pessimism is a buy signal, since the small investor is often on the wrong side of the market. But periods like the past 10 years can leave deep scars that last decades longer.

Cutting and running

Mutual fund investors typically follow the money: They add more to their accounts in bull markets, and sell in bear markets. From 2004 through 2006, bull market years, investors poured $473 billion into stock funds, according to the Investment Company Institute, the funds' trade group.

But investors didn't give much love to the bull market that began in March 2009, yanking a net $9 billion in 2009 and another $37 billion in 2010, the ICI says. Instead, investors shoveled more than half a trillion dollars into bond funds.

And once the stock market started showing signs of weakness in May, the money gushed out. From May through September, investors yanked $90 billion from stock funds, the ICI says. The S&P 500 has fallen 16.1% since its 2011 peak on April 29, but poor performance isn't all that's prompting investors to cut and run:

Investors are starting to feel like the game is rigged and that there's no way for them to tag along, even with mutual funds. "I have a degree in finance, and I always figured that if you can't beat them, join them," Nijjer says. "But now, even if you join them, you're still too late to the party."

Nijjer has about half his taxable holdings in money market securities and cash. He's thinking of investing some of his cash in India, where interest rates are higher and the rupee has been appreciating, which boosts his returns. "You take some currency risk, but I have family over there, and I know the economy," he says.

Frank Lane, 71, retired last year and just can't take it any more. "When you retire, you have time to think about things, and when you do that, every nickel counts," he says.

Lane, a former doctor who lives in Tampa, cut his stock exposure from about 50% of his portfolio to about 25%.

Lane will soon have plenty more fellow retirees: The first wave of the 77 million Baby Boomers, those born from 1946 to 1964, are starting to hit age 65, the traditional retirement age. Typically, older investors gear back on stocks in favor of income-producing investments such as bonds and bank CDs. And they become more risk-adverse, because retirees don't have income to replace stock market losses.

The CBOE Volatility Index, or VIX, has reached levels last seen at the bottom of the bear market in March 2009. So far this year, the S&P 500 has fallen more than 2% on 15 days — 14 of those since July. Worst day: 6.66% plunge on Aug. 8. "It's scary," Lane says.

All that up-and-down movement has shaken his faith in long-term investing. Lane used to think that if you buy stocks of good companies and hold on, you'd be OK. "That doesn't work any more," he says.

Sam Pelton, 38, has notched his stock holdings down to 50% from 100%. "Even that is making me nervous," he says. Watching the market gyrate because of events overseas has given him the jitters. What would it take to get him back? "More stability," says Pelton, who works in supply chain operations in Charlotte. "Not necessarily politically, but globally, especially in Europe." He has decided to use more of his cash to pay down his mortgage: "It feels good to have something a bit more real than stocks."

Timothy McIntosh says the biggest difference he notices today is a lack of confidence in the future. "It's down significantly vs. 10 years ago," he says. Statistics bear him out. The University of Michigan Index of Consumer Expectations, based on a monthly survey, stood at 49.4 in September, up slightly from 47.4 in August — the lowest level since 1980.

That lack of confidence in the economy's future has also translated into a lack of confidence in the stock market's future, McIntosh says. Ten years ago, he had a hard time persuading investors to buy a corporate bond yielding 9%, because they felt the stock market offered better returns. Now investors are clamoring for bonds and money market funds, both of which are near historic low yields.

Will it come back?

Wall Street has long made a practice of using the small investor as a contrary indicator — that is, when investors are most pessimistic, it's time to jump back into the market. Supposedly, Joseph Kennedy dodged the crash of 1929 because he sold his stocks when a shoeshine boy gave him a stock tip. Kennedy figured that if shoeshine boys were buying stocks, there was no one left to put more money into the market and push it higher.

In that light, today's terror of the stock market and pessimism about the economy would be a buy signal. Ned Davis Research, an institutional investment adviser, noted early last month that sentiment was low enough to be encouraging. (They remained neutral on the market because of recession worries.) "They could both be overvalued, but relative to bonds, the pessimism on stocks looks overdone short-term," Davis wrote.

And, in fact, you would have fared reasonably well if you had invested at points of maximum pessimism about the future.

But pessimism about stocks and stock mutual funds can last a long time. The crash of 1929 left lasting scars on investors. "Those who grew up in the Depression were comfortable with low returns that were guaranteed," McIntosh says.

After the bear markets of the 1970s, investors avoided stock funds in droves. Stock-fund assets were $45 billion in 1970; they didn't break that level until 1981. And people entering the workforce now have watched their parents suffer through a decade of stock booms and busts: They're not likely to jump into the market, either, McIntosh says. "When you grow up with that as your framework, why would you ever invest in the stock market?" he says.

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