As the old saying goes on Wall Street, equity markets tend to top out when the so-called “dumb money” (smug Wall Street jargon for the individual investor) finally realizes that stock prices are rising and dives in. The theory goes that individuals are the last to be informed that the economy and earnings are improving, thereby making the investment decision after all the good news has already been discounted by the markets—coming very late to the party, so to speak. Typically this adage is paired with something about the level of the Dow being published on the cover of Time Magazine or another similar pop-culture publication.
The theory, as we said, is a smug, insiders’ view of the markets and one that is most likely based on ancient foundations, given that the world is now “wired” with the average investor having as much access to financial and economic data as the pros on Wall Street. That’s not to say that the theory doesn’t still hold—only that its underpinnings may have changed. The last three years in the equity markets have probably done quite a bit to reinforce the foundations of this maxim with the financial crisis, huge market volatility, flash crashes and hedge fund fraud all making headlines impactful enough to scare even the professional investor into the mattress as a safe haven. So for the individual investor to begin to put his or her toe back into the equity market waters, there is a huge psychological ocean ahead to cross. And, like anyone facing a long, arduous swim, there has to be preparation—both psychological and structural—and that takes time. Thus, indeed, the individual investor may still be the last large pool of investment funds to commit money to these markets this time around.
With earnings coming in better than expected for the 10th quarter in a row and US equity markets seemingly shrugging off bad news from abroad (i.e. the good news is discounted yet the bad is being ignored) our investing sixth sense tells us that there are cash flows supporting stock prices that either need to or are desperate to be invested. That in mind, we thought we would revisit the ICI Weekly Money Flow tables to see if we can find anything unusual going on.
Estimated Flows to Long-Term Mutual Funds Millions of dollars (courtesy of ICI)
As one can easily see, funds’ flows into the US equity markets (a proxy for the individual investor) turned solidly positive in mid-January. This, while cash flows into foreign equity funds appear to have topped out and begun a decline. Where is the money coming from? At first glance, it is obvious that the outflow from municipal bonds appears to continue, with investors fearing defaults by state and local issuers thanks to dire warnings from the likes of Meredith Whitney. But that doesn’t explain everything. Have a look at the chart below, also courtesy of ICI.
Assets of Money Market Mutual Funds Billions of dollars (courtesy of ICI)
This chart describes what is going on in the money market and Treasury markets over the last few weeks. There is a slow, but noticeable, outflow from the so-called “safety” of short-term and government-backed fixed income securities that, combined with the outflow from munis, can explain whence comes the funds to invest in US equities.
Now, all this data can be very volatile and subject to the psychology of the markets of the moment but it does show a definite trend out of fixed income and into US equities. As talk of inflation in this country ramps up with every strong economic report, we would expect bond prices to make further declines, accelerating this trend. And while the funds flow into foreign equities continues to be positive, that is also in decline and with continued rate hikes in China and now India and perhaps Australia, along with more turmoil in the middle east splashing across the TV screen, we can expect this trend to hasten as well. Combining foreign equities and foreign bonds with US fixed income investments makes for a heckuva lot of money that can be freed up to flow into US equity markets, the one remaining perceived safe haven.
What does this all mean? Well, we hate to agree with the economists but many did say at the end of last year that 2011 may be the year for US equity markets. From our work, with very few other places to earn a “safe” return around the globe, the economists may have gotten it right this time.
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