Institutional Investors Stumped by Market

If you're an individual investor, have you ever been curious about what the biggest institutional investors are thinking? I don't mean the sound bites you hear some of them give you on CNBC. I mean what they really think, when you get them alone in their offices or at a dinner table, and really talk to them.

I can tell you, because those people are my clients: 61 firms that represent the biggest, the best and the brightest, including hedge funds, mutual funds, pension funds, university endowments and investment counselors.

What they think might be interesting on any given day, since when they act on their ideas they do it in market-moving size. But in today's crisis environment, listening to them is really important, because they spend all day, every day in the center of the market maelstrom, and they're in a position to know what's really going on in all this apparent chaos.

It's hard to sum up a consensus view from such a large group. There are, in fact, many views that are quite diverse. But on average, it's fair to say my clients are bearish.

For many, it starts with the belief that markets are efficient. They think that the sharp drop in the stock market must be signaling very tough times ahead. But then I ask them, if that's so, if the future turns out to be just as bad as the stock market is predicting, then why should stocks fall any further than they already have? Why not buy them?

They have a decent answer to that question. They say, OK, maybe if the future doesn't turn out to be so bad, stocks could really rally. But if it is bad, then stocks may not have to fall much further, but they'll still deliver lousy returns for the next year or so. Why take any risk at all, just in case things turn out even worse than expected?

What could be worse? Many clients fear that while stocks have already discounted a deep recession, they may not have adequately figured on an extremely long-lasting one. I hear over and over that this recession will be worse than any in the last several decades, because (my clients argue) America needs to painfully break itself of the over-consumption habit.

The theory is that, over the last decade, consumption has become a greater-than-usual fraction of gross domestic product. When a country consumes a great deal, it has less wealth left over for savings and investment. And when you don't save or invest enough, the economy doesn't have the risk-capital it needs to grow.

I'm not sure I believe that theory. I don't know how much is the "right" amount of consumption and the "right" amount of investment in order to sustain growth. Considering the technological advances of the last decade, for all anyone knows, capital is now so productive that we actually need less of it to produce growth. So why not consume?

There's no determinate answer to that question. The clients that worry about this may be right, or they may not be. Time will tell. But for now, it's a story that many of them are telling themselves that's keeping them from buying stocks and other riskier securities at bargain-basement values.

But that's not true of all my clients. One of them, who thinks more about technical factors than economic factors, thinks that stocks are massively undervalued here, and is buying them super-aggressively. He thinks they're as oversold now as they were at the very depth of the Great Depression in 1932. He calls this "the mother of all bottoms."

It so happens that he failed to predict the current bear market, and lost some serious money in it. So I suppose you could say that he's just getting desperate, and trying to justify his past mistakes by trying to call a bottom that will never come. But I don't think so. I've known him for many years, and he's far too disciplined for that.

Also, that's not the mistake investors usually make. Just the opposite. After taking a big loss, all too many investors reverse their position at exactly the wrong time. They sell right at the bottom. That's human nature. But this client is doing the opposite.

There's another client who's spent a long and very profitable career investing in distressed securities, and he definitely sees today's crisis as an opportunity. And he's not just buying stocks. Believe it or not, he's going into the mortgage business. Yep, the very thing that has blown everybody up this year.

He's a smart man. He sees that homeowners will always need mortgages, and that most homeowners are excellent credit risks. Yet many of them can't get mortgages from conventional sources. Half of them are out of business, and the other half are too scared to write any loans. So my client plans to do what great entrepreneurs always do: find a need and fill it.

There are other clients who are optimistic that, even if the economy is going to continue to be dodgy for a while here, stocks have nevertheless gotten way too cheap. Yet few of them are actually doing anything about it. Their minds are telling them "buy," but their guts are telling them "stay away." In other words, the biggest professional investors can get just as scared as anyone else, and let their fear cause them to turn away from what they really believe is a terrific opportunity.

It's no surprise that they are scared. For most readers of this column, investing is not the way you earn your living. Your retirement probably depends on what you do with your 401(k) and your IRA, so investing is extremely important — but at least your paycheck isn't at stake. For my clients, it's not that way. Their entire economic life, now and in retirement, is tied up with how they invest. If they make a mistake, it's lethal.

That's one big advantage you have as a nonprofessional. You have a lot at stake, but a lot isn't the same as everything. You can be more objective. In my subjective opinion, the objective reality is that stocks have become insanely cheap. Yes, times are tough. But stocks are cheap enough to compensate for that.

That's what I try to tell my clients. I hope they'll listen. And that you will, too.