It's the wrong time to flee stocks

The hope has faded. After decades of accepting the stock market as the path to prosperity, people no longer believe capitalism's pledge that by dutifully saving and investing, anyone can participate in the economy's great ability to create wealth.

Trading volumes have collapsed this summer, returning to levels not seen in 13 years, as investors pull money out of stocks and move into cash and bonds. According to Lipper data, nearly $12 billion was pulled out of equity funds last week -- the largest outflow in two years -- despite the market's relatively buoyant performance recently.

Yet, for reasons I'll get to in a moment, it's exactly the wrong time to get out of stocks. So what's the problem?

Disappointment builds

For one, performance hasn't been good enough. The Standard & Poor's 500 Index ($INX) is still trading below its 1999 and 2007 highs as it remains in the midst of an epic, churning trading range. The index has crossed the 1,380 level -- about where it stands today -- on a closing basis no less than 59 times over this period. So while corporate profits have surged to all-time highs, the typical investor hasn't felt that success.

The economy has a lot to do with it; the specter of financial crisis and possibility of another meltdown, along with stagnant wages and weak home prices, have kept investors on the sidelines. We're also in the political season, which means that half the politicians want us to think about how terrible things are now and how we need drastic change, while the other half wants us to remember how much worse things were before.

All the while, everyone wonders what will happen with health care, taxes and spending.

Plus, Wall Street's shenanigans suggest the deck is stacked ever higher against the little guy. There's an us-versus-them mentality -- shown in stories such as the ongoing Libor interest rate scandal -- that has spread like a cancer. You've got predatory computer trading algorithms, an initial public offering process more about letting insiders cash out than raising capital for growth, and a financial system that seems to live off of fraud, criminality and an almost joyous dishonestly.

Still, now's the time to be buying stocks, not stuffing dollars under your mattress or paying the banks or Uncle Sam for the benefit of lending them your money. After all, 10-year Treasury bonds are paying only 1.5% interest, while core consumer inflation -- less food and energy -- is running at 2.2%. The slow knife of negative real interest rates can kill your wealth pretty quickly.

So let's look at a couple of the factors keeping regular investors out of stocks in the hope I can persuade you to get back in the game -- because, even in this environment, you can't afford to stay out.

The fear of recession

The biggest bugaboo for many right now is the specter of another recession, perhaps caused by a eurozone breakup or some other crisis.

I don't believe this is likely right now. Central bankers around the world are unleashing a coordinated dose of monetary stimulus. More simply, while money has been really cheap since the end of 2008, even more cheap dollars, pounds, euros, yen and yuan are about to flow into the financial system.

In fact, never in recorded human history has money been as cheap as it is now. You can see this in the chart below of central bank rates, starting with St. Genoa Bank in 1522 through 1625, the Bank of England through 1913, and the Federal Reserve policy rate now. Here at home, 10-year yields have already dropped below the old low of 1.55% set in November 1945, falling to 1.4% last week. This helps inoculate the system from shocks and should keep recession at bay, because all modern downturns have been associated with tighter money.

Also, while growth of the U.S. gross domestic product slowed to just 1.5% in the second quarter, I don't think we'll succumb to the "stall speed" dynamics you often hear discussed. The thinking is that as growth slows below some minimum threshold, believed to be around 2%, confidence drops and consumers and businesses pull back. This results in a further drop in confidence and a downward spiral leading to recession.

The evidence doesn't support this idea, given all the idled capacity still in our economy -- empty factories and unemployed laborers -- despite the fact that GDP is reaching new highs. Since 1950, economic growth has fallen below stall speed 18 times, but only 10 of those periods have been followed by recession. And in nine of the 10 occasions, the economy was operating above capacity.

Recently, in "A new US Recession? Not yet," (I discussed why I expect the economy to benefit from a few short-term positives in the months to come -- so be sure to check that out if you haven't already.)

So no, things aren't perfect. And there are unresolved structural issues, including the government's long-term problem in funding entitlements such as Social Security and Medicare and the looming fiscal cliff of tax hikes and spending cuts due in early 2013 that are worth some 5% of GDP.

But the situation isn't totally bleak, and recession isn't likely.

Stocks and funds mentioned on the next page: First Majestic Silver (AG), Endeavour Silver (EXK) and iShares MSCI Brazil Index (EWZ).

The fear of fear

A wall of negativity is also scaring a lot of would-be investors out of the market.

Those in the market are afraid, too, and have positioned themselves too defensively. During the recent 9% rally off of the June market lows, people piled into noncyclical stocks that offer a modicum of protection from the economy's vagaries: stocks in areas like consumer staples and health care. Since the S&P 500's April peak, defensives have outperformed economically sensitive areas like materials and energy by 12% as the money has shifted.

In fact, this is the most "defensive" rally in 15 years, according to Sundial Capital Research. People aren't taking chances.

Overall sentiment is also very negative. During the past three months, less than 30% (on average) of respondents to surveys conducted by the American Association of Individual Investors have said they expect stocks to rise. That's big-time apathy, on the same level we saw during 2009 bear market low the early 2008 low, the 2003 bear market low, and the 1998 financial crisis low.

After those four lows, the market did well over the following three months, rising 27%, 4%, 15%, and 27%, respectively.

But what's really strange is that all four examples came during intermediate-term lows when the market was down. At the moment, sentiment is sour even as the market has returned to late-April highs. There's a lot of fear out there, even though the market is swinging up. That's rare.

It could be that retail investors are just listening to what they're being told. Newsletter writers, options traders and futures traders are all very negative, and so are many politicians.

Despite last week's rebound, newsletters reduced their exposure to the Nasdaq Composite Index ($COMPX) by one-half, according to the Hulbert Stock Newsletter Sentiment Index. Since 2000, there have only been four other examples of this sort of selling while stocks were rising 1% or more. Stocks tended to do well in the months that followed.

Call options, which are bets that stock prices will rise and are purchased by speculative traders, have fallen. And speculative futures traders are maintaining extremely defensive positions, piling into Treasury bonds, for instance, while large commercial traders are taking the opposite side of the trade.

Yet the evidence suggests a reversal is in order. For one, as I discussed in my column last week ("It's God vs. the Federal Reserve"), the economic data are slowly becoming less disappointing. Analysts are also becoming less negative toward cyclical stocks after sentiment toward the group dropped to October 2011 lows in April. This helped make energy one of the top-performing sector groups off the June low. And on valuation, cyclicals are cheap versus defensives (on trailing earnings) on a level not seen since the 2009 bear market low.

Being on the wrong side of a reversal is what should really worry the pros.

The least-bad option

Still, the case to get bullish on stocks isn't a slam-dunk. If it were, everyone would be doing it.

Second-quarter earnings season has been a bit of a dud. Profit growth is stalled because companies can no longer compensate for mediocre growth by cutting costs and jobs.

Yet there are many reasons to expect a turn, in addition to those I outlined above:

• Corporate balance sheets are strong (and better than those of many governments).
• Inflation expectations remain high, which would push stocks up.
• The wild up-and-down volatility we saw in stocks in recent months has returned to more normal levels (although it may not seem like it).

All this suggests real gains lie ahead that will beat what you can find in bonds or a bank account.

So where to look? I recommend focusing on the areas poised to benefit the most from more-aggressive central bank action, including precious metals and related mining stocks, as well as emerging-market equities. I've added positions in stocks including First Majestic Silver (AG) and Endeavour Silver (EXK) to my Edge Letter Sample Portfolio. I'm also adding the iShares MSCI Brazil Index (EWZ) exchange-traded fund.

At the time of publication, Anthony Mirhaydari did not own or control shares of any company or fund mentioned in this column.

Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at anthony@edgeletter.com and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.