The bull market we have seen since the middle of the fourth quarter has caused bearish analysts, investors and traders to point out many indications that, on the surface, illustrate that the rally is not supported by data and will end abruptly and painfully. One of these indications has been the outflow of funds from equity mutual funds. On the surface it would appear that an outflow in equity mutual funds indicates that investors are more bearish than bullish towards the market. Below are four possible reasons for the outflow of funds from equity mutual funds:
- Investors are placing money into less risky bond funds due to the uncertain macroeconomic environment; which is supported by an inverse relationship between equity and bond mutual funds since the week ending September 30, 2011;
(Table courtesy of StopETFs. Data courtesy of ICI.)
- A second reason is that investors are fearful of missing the top just as in 2007; thus investors are taking profits in equities in anticipation the stock market is near or at a top;
- A third reason equity funds are not improving is because common investors are, per the usual, waiting for the economy's lagging indicators to tell them to invest in risky assets; and
- And a final reason equity funds are flowing in the negative direction may be due to investors reaching retirement. This would explain the increase in bond fund inflows because bond funds are ideal for income oriented investors; which is an important aspect of retirement investing.
The truth is a combination is the likely culprit for equity mutual fund outflows, but the third and fourth reasons will be the main focus of this note. Beginning with the third reason, equity funds are struggling because the majority of investors are simply looking at the current economic data. The current economic data is not bad, but it is not anything worth rejoicing about. Unfortunately economic indicators are useless with regards to predicting the future.
For instance, by the time the employment and GDP data indicate that the economy is strong, it is likely that the economy has stopped or will soon cease to improve. Hence, the stock market will soon decrease in this scenario. Moreover, if investors wait until the economic data tells them to invest, then it will be too late.
The proof for this can be seen by going back to the 2008 equities collapse. While it may take luck to sell at the top, by the time equity mutual funds began to see a mass exodus in June/July 2008, the market had already declined about 20%. Bond funds did not see an exodus for another 3-4 months (See Mutual Fund Inflows and Outflows table from above.)
Unsurprisingly, the economic data also lagged the equities sell-off by several months. The unemployment rate, a key figure concerning income, did not begin to show weakness until late June 2008. While the unemployment percentage was mildly increasing, it was not until June and July that the amount of unemployed began to take a turn for the worst.
(Table courtesy of StopETFs. Data courtesy of BLS.)
Similarly, the GDP growth rate did not give investors a sign to sell until late 2008. Since the GDP growth rate is reported quarterly, it is difficult for investors to make investment decisions based upon a strong or weak GDP growth rate. However, a declining GDP growth rate would be a strong indicator that the economy is in a recession, or headed for a recession.
(Table courtesy of StopETFs. Data courtesy of BEA.)
To review, these two economic indicators are important because they show that if investors are simply watching economic reports, then they will be selling their mutual fund shares after the market has declined a significant amount. More importantly, this indicates that the simple investor is waiting for these two economic indicators to provide conclusive evidence of a strengthening economy before investing in equity mutual funds. Unfortunately, once this happens there will be little left in the rally.
As you can see, the first reason equity mutual fund flows have been negative is because many investors are not convinced the economy is improving; which by simply viewing the economic data is easily understandable because their has not been impressive improvement. Unfortunately for these investors these lagging indicators are simply providing facts about the past; while the stock market moves based upon the future prospects of economic and business cycles.
The second possible explanation for the outflow of equity mutual funds is retirement. This explains the increased inflows of bond funds. As the so called "baby boomers" begin to retire they will begin to switch to bond mutual bonds that provide current income with less risk compared to equities in order to avoid losing a substantial portion of their life savings.
We may in fact be undergoing a combination though. While Americans are retiring, they may be finding the present an optimal opportunity to transfer their equity funds to bonds because the markets have rallied very well. And instead of leaving the risk on the table, investors may be making a switch to bonds to provide income during their retirement years.
There are several other reasons equity mutual funds may be struggling as well. Some of these consist of investors pulling the plug on investment banks, needing money for bills and credit cards, or perhaps just out of neglect towards their retirement years. But even these are not bearish indicators.
There is a high probability that a combination of all these events is the cause for the disconnect between the equity rally and a lack of funds coming from equity mutual funds. But as you can see from above, it appears these reasons are not bearish. It is most likely the case that the common investor is simply waiting for the economic data to give the green light to invest. Unfortunately for these risk averse investors they will miss the rally and invest near the top, while the more risky investors will reap the profits. Keep in mind that there is always a high possibility for losses when there is a high possibility of gains. But this is not a problem because this conundrum has kept investors and traders coming to the stock market for decades.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.