Is it time to get back into equities?

Fear has kept investors out of the stock market, but it might be time for a second look.

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The Canadian and U.S. economies have been in recovery mode for a while now, but try telling that to investors. Even though fixed income investments pay next to nothing these days, investors continue to shun equities in favour of the relative safety of bonds, just as they did during the recession.

While the 10-year Government of Canada bond yields 1.8%, equity markets have made significant gains since the recession. Still, that hasn’t enticed investors back into equities—far from it. According to EPFR Global, a company that tracks worldwide fund flows, between October 17 and October 24, investors sucked $4.2 billion out of equity funds and pushed $9.4 billion into bond funds.

Why are investors still so reluctant to get back into the stock market? Sam Stovall, chief investment strategist for S&P Capital IQ, thinks investors are petrified of what could go wrong. “They’re worried about jobs, about the Federal Reserve pumping so much liquidity into the markets and about the U.S. fiscal cliff,” he says. “Not to mention the European debt crisis and the Chinese slowdown.”

Memories of the 2010 flash crash—when the Dow Jones Industrial Average fell by about 9% in minutes—and MF Global’s meltdown haven’t exactly helped investor confidence either. “People feel as if Wall Street is becoming less and less inviting, or at least less accommodative to the small investor,” he says.

But that’s not the only reason why investors are weary of this recovery, says Bob Sewell, president and CEO of Bellwether Investment Management. Usually a strong bull market follows a recession, he says, but that hasn’t been the case this time around. It’s making people nervous, he says.

Still, some argue this is the time when investors should get back into equities. By the time the average investor gets comfortable with the economy, the stock market will have already increased and they’ll have missed a lot of good opportunities, says Sewell.

Current market valuations seem to suggest prices are attractive right now. The S&P 500, for instance, is trading at about 14 times earnings, which is slightly below its historical norm of 15. In Canada, where financials make up a sizable portion of the S&P/TSX composite index, banks are trading around 12 times earnings. That’s a steep discount to the 15 times earnings the S&P/TSX is trading at today.

Yet, investors continue piling into bonds. But to all of those investors Sewell issues the following warning: “There is far more risk in bonds than there is in stocks,” he says. Interest rates will rise eventually and when that happens bond prices will fall. Unfortunately, the average retail investor usually figures out that their bonds are a bad investment after the market has already rallied, he says.

Historically, people exit the bond market and jump into equities when interest rates climb by a percentage point. Equities tend to outperform when interest rates are between 3% and 4%. But until rising rates force investors out of fixed-income investments, Stovall expects markets will continue to see inflows into bonds.

This could change if issues like the U.S. fiscal cliff and the European debt crisis get resolved, he says. But it won’t happen all at once. “Markets rise by taking the stairs, but fall by taking the elevator,” says Stovall.

Buying into equities now doesn’t mean you need to take massive risks. While equities are usually riskier than bonds, there are some stocks that offer fixed-income-like safety. Typically, large-cap, dividend-paying companies in defensive sectors are less volatile than small-cap stocks or businesses in cyclical industries.

The best companies, says Stovall, are ones with strong S&P rating (A– or above). A strong S&P rating means the company has an above average track record of growing its earnings and dividends in each of the last 10 years. Look for companies that pay a yield of 3% or more and have a dividend payout ratio of less than 70%, he says. “When there is a slowdown in the economy and earnings fall, you want to be sure the company can cover the dividend.”

Finally, read analyst reports and look for companies that have a buy or strong buy recommendation. “An analyst will not give a favourable recommendation if they believe the yield will be cut,” he adds.

Sewell agrees that dividend-paying stocks are the way to go in this market. While they are generally less volatile, the real benefit is that you can still make money if markets are volatile. “You get paid while you wait and when you go through bumpier times,” he says. With the yield on stocks so much better than bonds, investors can’t go wrong.

Finally, if you want to reduce the wild price swings in your portfolio then look for companies with a low beta—a measure of volatility. A beta below one means the company is less volatile then the markets. If stock picking isn’t for you then consider buying a low volatility ETF, such as the iShares S&P/TSX Dividend Aristocrats Index Fund, which has a beta of about 0.6. If you’re looking at American indexes, Sewell suggests buying an ETF that tracks the Dow since it has a lower beta than the S&P 500.

Get into these “safer” stocks now and you’ll likely see capital gains when the rest of the investing public eventually buys equities again. It could take a while for this to happen, concedes Stovall, but investors will eventually come around.

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