Pivot Point: Investors Lose Faith in Stocks

European nations, flirting with recession, can’t agree on how to climb out from under their pile of debt. The U.S. is careening toward a budget fight that threatens to shut down the government. China’s mammoth economy may be downshifting.

And across the financial markets, a sea change is taking place. Investors are abandoning the time-tested “stocks for the long run” optimism that dominated since the late 1980s. Instead, there is a widening belief that the mess left behind by the housing bubble and financial crisis will be a morass to contend with for years.

In a historic retreat, investors world-wide during the three months through August pulled some $92 billion out of stock funds in the developed markets, according to data provider EPFR Global—an exodus that more than reversed the total amount of money investors had put into those funds since stocks bottomed in 2009. The withdrawals matched the worst three-month period during the depths of the financial crisis.

That reversal showed no sign of abating in September. In the first three weeks another $25 billion was withdrawn from developed-market stock funds. Last week the Dow Jones Industrial Average suffered its worst one-week decline since October 2008. It is down 16% from its late-April peak. Investors are also showing less optimism toward emerging-market countries.

For Jason Trennert, founder of economic-research firm Strategas Research Partners, the moment to throw in the towel came Aug. 2, he says. As the summer-long clash over the U.S. debt ceiling dragged on, Mr. Trennert, 43 years old, became persuaded that the process for setting budget policy in Washington had broken at a crucial moment for the economy.

That afternoon Mr. Trennert, whose firm ranks highly in polls of big investors including mutual funds and hedge funds, told his clients that for the first time in two years he had turned bearish on stocks. Mr. Trennert’s team raised the chance of recession to 60% in 2013, and he suggested that investors should be looking to sell stocks, rather than buy.

“We’ve been consistent in our view that equity investors should be ‘bullish until the bill comes due,'” he wrote. “The bill for our past profligacy has finally come due.”

The new environment is one where stock returns are expected to remain below the long-term averages of 9% or 10%, and prices linger at below-average valuations. Conservative strategies aimed at collecting stock dividends, out of favor for decades, are coming back in vogue.

Interest rates are expected to stay very low for longer than many thought possible just a few months ago. In the bond market, investors are lending to the U.S. for 10 years at less than 2%, the lowest rates since the 1940s. Expectations of weak economic growth are registering in bond prices, which suggest inflation will be well below long-term averages until 2021.

At the same time, financial markets are expected to remain prone to kind of white-knuckle swings seen over the past six weeks or so. The Dow rose or fell more than 1% in 24 out of the past 38 trading days.

“People were holding out hope that we were going back to normal,” says Philip Poole, global head of investment strategy at HSBC Asset Management, which oversees $103 billion. “We’re not going back to normal. The post-crisis world will be different…but that message takes a long time to hammer home.”

The gloomy scenario of anemic growth mirrors one laid out in academic literature in recent years by economists Carmen Reinhart and Kenneth Rogoff. It’s long been held by doom-and-gloom hedge fund managers, but the idea that the crisis will continue to reverberate for years has taken wider hold among investors big and small.

For individuals counting on investments to support them in retirement, this means scaling back their hopes. “I don’t see anything changing in the next two or three years,” said John Deal, a 50-year-old individual investor who works in Walnut Creek, Calif. Working with his financial adviser, Mr. Deal is now looking at stock investments only on a very long time horizon—20 years—and downshifting to expect lower-than-average returns of 8% per year for that period. His financial plan factors in bonds earning just 3%.

Many investors began the year optimistic that recovery was taking hold. On April 29, the Dow hit 12810.53, up 96% from its 12-year low of March 9, 2009. With the Dow at that point up more than 10% for the year despite Japan’s devastating earthquake and lofty oil prices, many investors took it as a sign the economy had entered “escape velocity” from the drag of the financial crisis.

In May the tide began to turn as economic data, especially for manufacturing, softened world-wide. Also on investors’ minds: the end of the Federal Reserve’s second round of “quantitative easing,” its policy of buying Treasury bonds. It had pumped $600 billion into the financial markets, but was due to be wrapped up at the end of June.

Still, expectations remained strong for a rebound in the second half of the year, even without the Fed’s help.

For many investors, the first big signal that things weren’t reverting to normal came from Europe. In early July, Italian and Spanish bond yields surged and fears grew of a contagion that could hurt banks Europe-wide.

In London, James Bristow, a co-manager of the $900 million BlackRock International Fund, saw the rising bond yields as reflecting an inadequate response to the crisis by both the European Central Bank and governments across the continent. In late June and July, his group sold some of their European bank-stock holdings.

But it wasn’t just Europe’s debt crisis that frightened Mr. Bristow. He was startled by the pace at which the global economy seemed to be unraveling. In late August he said he expects a “low-global-growth environment” to last several years, with a “huge amount of uncertainty.”

Early in the summer, Charles Bean, president of financial advisory firm Heritage Financial Services in Norwood, Mass., was also growing nervous about Europe. And closer to home, he worried about the tensions over raising the debt ceiling in Washington.

At the 17-person firm, which oversees $650 million, the concern focused on the potential drag on an already weak economy from reduced government spending. When Mr. Bean and the rest of the firm’s investment committee met in the third week of July, they discussed the prospect that deficit reduction could raise recession risk.

Heritage pared back its expectations for economic growth and corporate profits for the next several years. On July 21, Heritage sent a note to clients that sketched out the firm’s concerns, which included a Internet link to research by Ms. Reinhart and Mr. Rogoff on the possibilities of government defaults in a post-financial-crisis landscape.

For most client portfolios, they reduced stock holdings and added to gold investments.

“Until we have a more long-term resolution to the debt problems,” said Mr. Bean, “we’re going to remain cautious and more defensive.”

On Friday, July 29, things went from bad to worse in the eyes of some investors. That day, the government came out with downward revisions to its prior estimates for economic growth. The upshot: The recession had been deeper, and the recovery weaker.

Even before the summer, the economy was “stall speed,” in economist jargon. In other words, during a time when many thought the economy was growing slowly, it was actually vulnerable to falling back into recession.

Then on Monday, Aug. 1, the Institute for Supply Management reported its index of manufacturing had collapsed to 50.9 in July, suggesting that the industrial economy was barely growing. (A figure below 50 indicates a contraction in manufacturing.) It marked a dramatic fall from as recently as February, when the index hit its post-crisis high of 61.4.

By the next day, the acrimonious political battle over the debt ceiling had been resolved; the U.S. wouldn’t default on its debts. But for James Swanson, chief investment officer at MFS Investments, and manager of the firm’s $569 million Diversified Income Fund, the damage was done.

In late July, he had scaled back on stocks for the first time since 2009. He was shocked by the brinksmanship in Washington, he says, which cemented his lowered expectations for the economy.

For Mr. Swanson, the near-default by the U.S., combined with an economy “already flying close to the trees,” meant increased uncertainty for the foreseeable future. That, in turn, will translate into less willingness to pay higher valuations for stocks, he says.

Historically, a stock trading at a price 14-times earnings was considered attractive. But in today’s uncertain markets, Mr. Swanson says, “If I thought P/E of 12- or 13-times was cheap, I’m not so sure anymore because there are so many unknowns.”

As far back as May, strategists in Goldman Sachs Group Inc.’s global macro and markets research group had been weighing whether the U.S. economy was going to be more fragile for an extended period of time after the financial crisis. That would mean cycles between expansion and recession would be shorter than before the crisis and lead to more volatile markets.

During the spring, the team, including Dominic Wilson and Noah Weisberger, were torn. They leaned toward the notion that the economy would accelerate to a healthy pace in the second half of the year. But as contrary evidence built, they shifted their thinking.

Goldman’s analysts in mid-August downgraded the forecasts for economic growth and stock prices. Interest rates, meanwhile, would stay lower for much longer.

Because the economy is “in such a fragile state, if you get hit with a new problem your resilience to those seems to be lower,” Mr. Wilson said. “That’s very much the world we are living in.”