Investing: Fund flows as stock market indicator
Looking for the market's direction? Don't use fund flows.(Photo: John Foxx, Getty Images)
Have you ever driven the wrong way on a highway because you thought you'd get there faster than everyone else? Do you put your shoes on before your socks? Have you put a $20 bill into a dollar-bill changer just to prove it wrong?
If so, you're not a contrarian — a bold thinker who does things differently to get better results. You're a nimrod. Real contrarians know that you make money only by going against the crowd at key inflection points. They also know that some indicators really aren't very good for measuring key inflection points.
Today's Bad Contrary Indicator: mutual fund flows. In theory, when people are pulling money from stock funds, it's a good idea to buy. After all, mutual funds are for small investors, and small investors usually buy high and sell low.
Aside from the annoying snobbery of this notion — most individuals handle their affairs pretty intelligently — fund flows just aren't a good indication of popular sentiment.
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First, let's look at the indicator. Every week, the Investment Company Institute, the mutual fund trade organization, publishes estimated long-term mutual fund flows. In this particular series, "long-term" means "stock and bond funds, excluding money market funds." The ICI breaks the flows down into several categories. We're concentrating on total stock fund flows.
The ICI's calculation shows how much money has gone in or out of stock funds in a particular week, taking into account moves up or down in the funds' share prices. Since March 2009, when the Standard & Poor's 500-stock index bottomed, investors have yanked $247 billion from stock funds, according to the ICI.
That's a decent chunk of change, even in the world of stock funds, which now have about $5.8 trillion in assets. In fact, stock funds have recorded net redemptions every year from 2008 through 2012, the longest streak since the mid-1970s.
And fund investors look particularly dumb because the S&P has gained 121% since the stock market bottomed on March 9, 2009. The average stock fund has gained 143%, including reinvested dividends.
What alarms contrarians even more is that investors have suddenly started putting money into stock funds. For the two weeks ended Jan. 16, for example, the ICI estimates that investors put $23.6 billion more into stock funds than they withdrew. If investors sell when the market is rising, does this sudden reversal mean that the smart money should be selling?
Well, no. Let's start with the fact that individuals may not be as dumb as a cursory glance might indicate. First, investors were net sellers of stock funds from the top of the market in October 2007 through the bottom in March 2009, to the tune of $280 billion. If you're going to view mutual fund redemptions as a contrary indicator, it has to work in one direction, but not both.
Two other factors warp the data from mutual fund redemptions:
• Exchange traded funds. The ICI's most-watched data are from garden-variety open-end mutual funds, which are what you typically own in 401(k) plans. ETFs have soared in popularity over the past few years. Investors poured about $345 billion into stock ETFs since the S&P 500's 2009 low.
• Hybrid funds. After the bone-crushing bear markets of 2000-2002 and 2007-2009, many investors figured that they would be better off in an asset allocation fund, which mixes stocks, bonds and money markets for you. In some cases, investors weren't as much fleeing the stock market as they were embracing ready-mix funds.
• Seasonality. Investors tend to put more money into stock funds in January, in part because they tend to fund IRAs then.
Finally, the notion that individual investors are dingbats should be put to rest. First of all, the majority of money in the market is controlled by institutional investors. By definition, they are the ones who sell at the bottom and buy at the top. Want to know who did all that buying of Apple in the past six months? By and large, it was institutional money.
And fund investors moved $101 billion into bond funds during the 2007-2009 bear market, which was a smart move. The average U.S. government bond fund gained 9% during that period, while the S&P 500 lost more than 50%.
If one were to look for a contrary indicator, it would be from bond funds. Contrarians don't look for trends — they look for peaks of trends in hopes of a reversal. Investors have moved a staggering $1 trillion into bond funds after the March 2009 stock market bottom. Those kind of big moves should be viewed suspiciously.
It hasn't been a bad bet — yet, anyway. Government bond funds have gained about 21% since the stock market bottom, and high-yield junk bond funds have soared 105%.
Nevertheless, given that bonds have been in a bull market since 1981 and have little room yet to run, investors' small steps back into stocks might be a good move — not a contrary sell indicator. And if you're basing your moves in and out of the market on any one contrary indicator, you might find yourself in the wrong lane in oncoming traffic.