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Dumb Money and Bubbles

|Includes: IEF, IEF, SPDR S&P 500 Trust ETF (SPY), TLT
Retail investor fund flows are a contra-indicator.  Historically money flowing in, raises price and leads to an eventual market decline, while money flowing out tends to presage a rally.

We keep reading about how funds are flowing out of mutual funds and into bonds. 
 
      “In Striking Shift, Small Investors Flee Stock Market” – New York Times, August 21, 2010
 
Much of the commentary suggests that this lack of confidence is a sign of further trouble ahead for equities. In fact, the research indicates the opposite. “Dumb money: Mutual fund flows and the cross-section of stock returns”  a 2006 paper by Adrea Frazzini (University of Chicago) and Owen A. Lamont (Yale), if not obvious from the title, concludes that money flow is a contra-indicator.  Excess money flowing in, raises price and leads to an eventual market decline, while money flowing out tends to presage a rally. They put it simply:
“Our main result is that on average, retail investors direct their money to funds which invest in stocks that have low future returns. To achieve high returns, it is best to do the opposite of these investors... We call this predictability the “dumb money” effect.”
A similar sentiment was expressed by Joan Lemming of Gramercy Capital in Forbes, “Bond Lemmings Headed for the Cliff”. She compares the 2000 tech bubble to today’s bond market and points out that the flows into bond funds “dwarf whatever led to the bubble in 2000 by a long shot.”    
So today we have the “dumb money” flowing out of equity funds and into bond funds. All this supports that the predicted values from my RPF Valuation Model and the thesis of my last post, “Bond Bubble or Inverse Bubble” that equities are undervalued and bonds overvalued.

The
RPF Valuation Model uses current long-term bond yields and current operating earnings to estimate fair value fo the S&P 500.  Lower interest rates and higher earnings both drive up the value of the S&P. It has an R Squared of about 90% since 1960.  Using an adjusted bond yield of 4.0% and Estimate S&P Operating Earnings for Q3 2010 of $78 per share results in a predicted value of 1,466 for the S&P 500 (SPX, SPY), 30% above its current level.


Disclosure: Long SPX, Short 10 and 30 Year Treasuries