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As we approach the third anniversary of the stock market bottom in early March 2009, it is reasonable to reflect and ask the following question. Who exactly has been buying the stocks that have been driving the market up over the last three years?

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The answer? It certainly is not the average investor.

The Investment Company Institute (ICI) tracks the monthly net new cash flows for various mutual fund categories. Now during the period from March 2009 through the end of January 2012, the stock market has effectively doubled off of its bottom. So certainly, we must have seen a massive increase in the amount of new monthly cash flows into domestic equity mutual funds over this time period, right? After all, if investors weren't putting money back into the market, what else would be driving it higher? But not only have we not seen a meaningful net increase in monthly net new cash flows into domestic equity mutual funds, we've instead seen a meaningful net DECREASE.

Over this same time period from March 2009 through January 2012, domestic equity mutual funds experienced monthly net cash outflows totaling $259 billion. This is a massive DECREASE in cash flows out of domestic equity funds during a time when the stock market itself DOUBLED in value. Now call me crazy, but a $259 billion decline is not chump change, so it would be reasonable to expect stock prices to actually DECLINE over this time period instead of RISE, and certainty not DOUBLE.

Given this disparity, it's worthwhile to break apart the data. Perhaps domestic equity funds were experiencing inflows during the periods when the market was sharply rising and disproportionate outflows during corrections. But this is also not the case. During the period from March 2009 to April 2010 when the stock market was up well over +70%, domestic equity mutual funds experienced monthly net cash outflows totaling over $21 billion. And over the period from September 2010 to July 2011 when the market was fully engaged in another +30% rally, domestic funds leaked another $85 billion. So what we have here is a phenomenon where stocks are sharply rising while investors are selling out of their positions and exiting the asset class. Go figure.

Of course, a counterargument that could be made is the rapid growth of exchange traded funds. Sure money is flowing out of domestic equity mutual funds, but it's likely to be more than offset by the money flowing into domestic equity exchange traded funds, right? Not necessarily so, according to the ICI. While data is not available for the period from March 2009 to April 2010, the total net assets in domestic equity exchange traded funds, never mind monthly net cash flows, over the period from September 2010 to July 2011 increased by $114 billion. Given the capital appreciation over this time period included in this number, the total monthly net cash flows into exchange traded funds would fall short of the $85 billion deficit from mutual funds cited above.

So what gives? How can the stock market double when at the same time the mutual funds that are investing in stocks are hemorrhaging assets?

The answer of course is the Fed. Over the last several years, the U.S. Federal Reserve along with its global central bank counterparts have injected massive sums of liquidity into capital markets that vastly exceed the $259 cumulative monthly net outflows from domestic equity funds. So as the average investor continues to head to the exit, the Fed is stepping in to fill the void through its ongoing stimulus programs.

This presents an increasing conundrum for the Fed, however. According to the Greater Fool Theory, the monetary stimulus flooding the market is promoting an environment where stocks are being bought by an ever shrinking pool of investors with the idea that as prices continuously melt higher that these same securities can be sold to some other Fed liquidity recipient at an even higher price. Unfortunately, the end game of such a scenario is that the Fed via the liquidity it is injecting will eventually be stuck as the greatest fool once the market peaks, as the already exiting average investor certainly won't be stepping in to buy since their already well out the door at this point.

This helps explain why the stock market collapses so quickly following the end of each Fed stimulus program, as nobody else is truly buying to a measurable degree. And the higher the stock market is induced to float, the more dangerous this game becomes. Stay tuned.

So when investing in such an environment, seek to capitalize, but do so with caution. Defensive names such as Family Dollar (NYSE:FDO), Kellogg (NYSE:K) and Bristol-Myers Squibb (NYSE:BMY) have demonstrated the ability to participate to the upside in these Fed driven markets while holding up relatively better during the subsequent corrections. And negatively correlated categories outside of stocks such as Long-Term U.S. Treasuries (NYSEARCA:TLT) and Long-Term U.S. Treasury STRIPS (NYSEARCA:EDV) have performed exceptionally well during periods when stocks enter into full correction mode. For example, the TLT and EDV were up +1.30% and +1.92% on Friday when the S&P 500 was down -0.69%. Applying strategies such as these can provide stability in an environment that continues to be marked by uncertainty resulting from ongoing policy actions.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Source: Who Is Buying This Market?