Mutual Fund Flows Signal Support And Upside For The Stock Market

Mutual fund and money market fund flows can provide insight on market moves. It makes sense for fundamental investors to keep an eye on these types of metrics.

With everyone focused on the modern-day Greek tragedy and how it might affect the U.S., I decided to go over an important tool that I pay attention to when trying to make heads or tails of these cloudy investing times.

Fund flows, which track money in and out of mutual funds, are pretty illustrative and valuable. They are a good proxy for how the U.S. retail investor is behaving and where they’re putting their hard-earned dollars.

In general, this data doesn’t usually get a lot of attention in the financial press. I haven’t heard much chatter on the subject over the past few months.

What prompted my interest was the data from a chart I came across by Morningstar that tracks these money flows into and out of mutual funds by U.S. investors:

Estimated Net Flows Into Mutual Funds by U.S. Investors

Below are a few of my conclusions.

Preference for bonds over stocks should slow. As illustrated by the 2008 column, we know what a bleak year that was, with $153 billion of net mutual fund outflows. We also are quite aware of how much the market ran up in 2009.

The 2008 data shows the shift to bonds - in other words, the risk aversion that flooded investor minds.

Surprisingly, the dominant desire for bonds is at a time when yields are low and there is a good chance of rising rates in the future. I expect this preference for bonds over stocks to dwindle as retail investors get more comfortable with an economic recovery and seek higher returns on their investments. Earning next to nothing while trying to save for retirement doesn’t work well for most of us.
Note in 2009, the low fund flows into U.S. stocks doesn’t make much sense given that the market was up 25%. Why?

Non-retail money matters. Well, institutional investors (beyond the mutual fund managers) play a much bigger role in the stock market than the retail investors represented by individual trading and through the mutual funds they own. So money from institutional, corporate and foreign investors was the major input into the 2009 U.S. equity markets.

As the market came off its lows in March, these big investors were pressed into keeping up with the competition. No way could any of these money managers fall short in performance compared to their peers. They had to get in (and thus help pump up the market) as momentum and the market rose to the end of the year.

Thin volumes indicate more upside. Also supporting the run-up was the fact that there was lower or thin relative trading volumes. Thin volumes create stronger price moves (e.g. volatility) and partially explain the strong price movements. And the thin volume in 2009 could be an important affirmation of a pending upside move in 2010. The theory is that, as the picture starts to look better, even more powerful (e.g. good volume) could propel the market.

James Paulsen, chief investment strategist at Wells Capital Management, for one, is bullish (more so than I am) on equities in 2010 because of this potential:

“Volumes have never really gotten that high, yet stocks have moved up 60-65 percent from the lows. This rally is more about people finally quitting selling than people buying.”

Paulsen expects that when there finally is job creation in the U.S., much stronger volumes would act as a catalyst for further switching out of cash and into stocks next year.

Going abroad. Make sure you note the positive flows into international funds. A significant proportion of net inflows into funds are going to international funds compared to U.S. funds. As I mentioned to my Safe Haven Investor readers at the beginning of the year, being diversified internationally beyond U.S. stocks is essential. Especially regarding developing markets like China, India and Brazil, which are getting the bulk of the money going abroad.

I expect this trend of a preference for non-U.S. stocks, which includes bonds and foreign stocks, to continue for the foreseeable future given the better growth prospects abroad.

Money Market Data Perhaps More Telling

Perhaps the most valuable piece of information is how much money is sitting in money market funds, a good proxy for cash. Actually, view it as cash sitting on the sidelines by the general U.S. investor, waiting to be deployed.

Now, since many of you probably have some savings in some sort of money market funds or bank savings, or CD accounts for that matter, you’re well aware that your money is earning literally close to zero. That shows how risk-averse investors (still) are.

Money market balances peaked in March 2009 right before the major 65% run-up in stock markets that began at that time. The market run-up was fueled by the cash that came out of the zero yielding money market funds, which held $3.76 trillion at that time, according to the Financial Times.

Since March, over $600 billion has flowed out of money market funds, with most of that going into the other funds listed above.

But there is still $3 trillion sitting there and that is still approximately $1 trillion more than the amount at the peak in 2007 when everyone was already heavily invested in the market. As perspective, the investable float of the S&P 500 companies is around $10 trillion to $12 trillion - enough for that sideline money to continue to affect the market.

At some point, this money will move out of cash and into stocks; into U.S. and non-U.S. markets.

Yes, there are so many other factors generally affecting the market and our investing decisions - especially today. But it is good to know that if we can continue or can substantiate a economic recovery, then retail investors have plenty of powder dry and ready to help move markets ups.

Mailbag: PIIGS or PIIIGS?

Last week, I listed one of the PIIGS countries as Iceland when it should have been Italy, but reader Michael from London pointed out the error.

I had in mind Iceland’s woes that seem so long ago, but it was only 2008. Iceland was one of the early “pioneers” in the global crisis and was effectively bankrupt as its three largest banks defaulted. Actually it’s still in the middle of a horrendous recession with serious social and economic fallout. All while it tries to repay its debt. It is also worth noting that Iceland is not a member of the EU yet (the country is up for 2012 admittance).

While the domino effect from Iceland has arguably been contained thus far (Michael, beware of your own British banks), I think the appropriate spelling of this potentially contagious European swine could easily be PIIIGS, which includes Iceland. Thanks, Michael.