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Economic Insights

Mutual-fund data show that retail investors remain reluctant to commit money to equities. That actually could help extend the rally in the months ahead. 

To judge from money flows into and out of mutual funds, the scars of 2008–09 run deep. Perhaps that could be better described as the scars of the first decade of this century. Investors, particularly retail investors, suffered such shocking setbacks in stocks during those years that even now, after a tremendous equity rally, they remain reluctant to commit to the asset class. No doubt this reticence has kept the stock rally less extensive than it otherwise would have been. It also suggests that there is support for an extension of the rally—ammunition, so to speak, for further buying—especially if investors turn to the more aggressive investment approaches of the past.

Professional investors have talked of what they call “the great rotation” for some time now. They have anticipated that past gains in stocks would encourage retail investors to buy equities and prompt them to trade out of their fixed-income holdings or, at the very least, redirect their investment cash flows toward equities instead of bonds. According to mutual fund data collected by the Investment Company Institute (ICI), that rotation has yet to begin.

A year ago, it looked, for a while at least, as though retail investors were beginning the rotation. During the first nine months of 2013, funds flows, which had favored bonds for years and had come out of equities, began to turn. Overall bond mutual funds saw net outflows of $27.3 billion during that time, about $3.0 billion a month on average, mostly from municipals, while money market funds suffered outflows of $21.7 billion, $2.4 billion a month. Equities and hybrid funds received all those monies plus net new flows as well. Hybrids during this time enjoyed $64.3 billion in new flows, an average of $7.1 billion a month, while equities saw net inflows of $116.8 billion, about $13 billion a month.1

But even as the stock market rally continued this year, the rotation hinted at in 2013 lost momentum. During the first nine months of this year, new fund flows into hybrids slowed by more than half to $31.9 billion, $3.5 billion a month. Net new flows into equities slowed by almost two-thirds, to $46.5 billion, which is only $5.2 billion a month. What is more, this gain was all in foreign equity investments, which enjoyed inflows of $80.3 billion, or $8.9 billion a month. Domestic equity funds actually saw a net outflow during this time of $33.8 billion, or $3.8 billion a month. Meanwhile, retail investors returned to bonds, which saw inflows of $45.4 billion during this nine-month stretch, or about $5.0 billion a month. The only trend of 2013 that saw an extension was the outflows from money market funds, which came in at $114.7 billion, almost $13.0 billion a month.

From early October and early November (the most recent time for which data are available), these anti-equity trends persisted. Domestic equity funds saw outflows of $1.5 billion during that one-month span. Hybrid funds saw net outflows of about $1.6 billion. Bond funds also lost, however. More than $7.1 billion flowed out of them during this one-month span. Presumably, some of these monies found their way back to money market funds, but the ICI does not provide such data on a frequent enough basis to state for sure.

The only way to explain such durable anti-equity biases is by reflecting back on the recent past. Bond investors since the turn of the century may not have done as well as in the prior 20 years, but have suffered less trauma than equity investors. They have seen the value of their assets cut by half or more for a time in two great market crashes. Over a 10-year period, for example, stocks, as measured by the S&P 500® Index,2 may have averaged annual returns well in excess of 8% a year and far better than bonds. But it is not the averages that stick in investors’ minds. It clearly is the shocks suffered between 2000 and 2002 and then again between 2007 and 2009. 

The cautions, engendered by this history and evident in those fund flows, have, however, created an opportunity. By holding back the pace of the equity advance, they have kept stocks from fully realizing their value as quickly as they might have. That likely effect helps explain why equity yields still, even after all the gains of the past five years, look attractive, historically, next to bond yields. This fact and the clear indication that investors remain less than fully exposed to equities argue for a continuation of this equity rally. Only after the much-looked-for rotation occurs and investors have accumulated stocks as fully as in the past will they reach full valuations. In the meantime, further gains look likely. 

 

All data herein from the Investment Company Institute (ICI).
The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries. An index is unmanaged, does not reflect the deduction of fees or expenses, and is not available for direct investment.

 

 

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