Ramblings of a Portfolio Manager

When Will The Individual Investor Return To The Stock Market?

Market strategists like to look at dollar flows into and out of mutual funds as a sentiment indicator for the overall health of the Markets. The Investment Company Institute (ICI), a non-profit organization whose members are the majority of investment companies registered with the Securities and Exchange Commission, publishes a monthly report detailing net flows into domestic and international stock funds, bond funds and money markets. ICI is seen as the Industry standard source of mutual fund trends and tends to be the most reliable. In its monthly report new sales, redemptions and exchanges are netted out to show a "net new cash flow" figure, which can be positive or negative for a given period. Average cash levels at stock funds are also shown in the report. The ICI data is often looked at as a guide to retail investor behavior as institutional money and individual shareholders are excluded from the ICI report.

Many strategists believe that strong flows into stock mutual funds indicate that retail investors have become more confident in the Markets signaling further gains ahead. Some economists, however, view fund flows as indeterminate at best with some seeing them as a contrarian indicator or false positive on the future direction of the markets. In their view, individual investors are always “late to the party,” committing more money to the stock market after it has already run up and has received a lot of positive press and mainstream news coverage. In their view the behavior of the so called “dumb money” should be looked at as a negative sign. They often cite as an example the behavior that occurred in the last few months of the stock market peak back in early 2000. At that time, equity fund flows were at record levels those first few months and, of course, the stock market began a steady decline soon after, with the major indexes dropping more than 50% in the next year.

So what is the individual investor doing with his or her money these days? According to ICI equity funds had estimated inflows of $3.23 billion for the week ending March 24th. This is slightly down from the estimated inflows of $3.51 billion in the previous week. Domestic equity funds had estimated inflows of $1.55 billion, while estimated inflows to foreign equity funds were $1.68 billion. Hybrid funds, which can invest in equities and fixed income securities, had estimated inflows of $990 million for the week, compared to estimated inflows of $1.07 billion in the previous week. While inflows into equity funds slowed week over week, bond funds continued their trend of strong investor appetite with estimated inflows of $9.24 billion, up from their estimated inflows of $8.85 billion during the previous week. Taxable bond funds saw estimated inflows of $8.16 billion, while municipal bond funds had estimated inflows of $1.08 billion.

This fund flow data suggest that mutual fund investors remain in defensive mode, preferring bonds over stocks. The trend is similar to what was seen in early 2009, just after the financial crisis began, and suggests that investors who were burned during the Market downturn of 2008 and early 2009 remain wary about joining this bull market. For the contrarian crowd, this is good news for the equity markets going forward.

Last week, however, we posited that a hiccup in the bond markets, resulting from rising interest rates, would drive investors out of bond funds and into equity funds and clearly that has not yet happened. A possible reason is that “retail investors” are not a uniform class of individuals. They are made up of people from multiple age, ethnic and socio-economic groups all with different investment horizons and risk tolerances. One very prominent investor sub-group comprises the “baby boomers.” The oldest baby boomer is just now retiring while the youngest is half way toward saving for that day. The stock market downturn of 2008 hurt many of these boomers very badly, some just at the exact wrong time. While we question why an individual close to retirement would have a significant portion of his or her net worth in volatile stocks, still even those invested in the relative “safety” of corporate bond funds were hurt in 2008. These near-retirees may now be too scared to ever return to equities or corporate bonds under the philosophy that it is better to have half a slice of pie than none. That’s a big group of retail investors to leave permanently out of the market. The $64,000 question, in our view, is will further market gains entice even these gun shy investors back in with hopes of recouping some of their losses? We think so. Dow 11,000 just may be a headline magnet to this last group of hold-outs, driving fund flows into equities and out of fixed income.