Stocks: A Wary Good Sign for Bulls

At base, it is a good sign for the equity rally: retail investors continue to sell stocks on balance. In the past, a stock rally of the huge proportions exhibited during the past few years would have induced a flood of retail investment dollars into equity mutual funds. That has not even begun to happen, at least according to the Investment Company Institute (ICI). No doubt this reluctance to buy stocks reflects the newfound caution households have shown in every aspect of spending and saving—a matter discussed from different perspectives in this space at various times. Whatever the cause, however, it bodes well for the durability of the equity rally, suggesting that any push from the retail investor has yet to emerge and that the market is a long way from the overpricing that such a push causes in its later stages.

To be sure, the ICI does report that amounts in equity mutual funds have increased. Assets in domestic U.S. equity funds have increased 9.8% during the past 12 months through April 2015 (the most recent period for which data are available).¹ Assets in world equity funds have increased 8.6% during this time. But especially in the case of domestic equities, the growth in assets was more than accounted for by rising stock prices. On balance, investors have withdrawn monies—and that pattern has persisted. In the four-week period from late April to late May (the most recent period for which data are available), mutual fund investors withdrew $19.4 billion from domestic U.S. equity mutual funds on a base of about $6.5 trillion. In contrast, retail investors have sustained their enormous $2.6 trillion in money market holdings, despite the minuscule rates paid in such investments, and increased their bond holdings, especially in the municipal area, where assets have increased 10.2% during the 12 months to last April. And those patterns, too, show no sign of shifting. Taxable and municipal bond mutual funds during the four weeks to late May saw $8.6 billion in net inflows on a base of $3.6 trillion.

The caution about equities is understandable. Investors have suffered two terrible bear markets during the past 15 years. In each, investors saw losses of 50% or more in equity asset values. The reticence about equities also fits a larger pattern. Households since the Great Recession of 2008–09 have shown an atypical caution in all aspects of budgeting and finance. They have avoided debt, keeping its growth slower than the pace at which their incomes have expanded. They have kept their spending growth in tandem with income growth. Such behavior stands in stark contrast to the way households conducted themselves during the 40-plus years prior to the Great Recession, when they spent aggressively, increased their debt faster than their incomes grew, and favored high-return/high-risk investments. Their wariness of equities now, and eagerness to accept low yields in seemingly safer fixed-income investments, would seem to dovetail with the rest of their new prudence and caution.

The question for the future is whether American households have really changed their spots. If they have not changed fundamentally and do revert back to older, more aggressive patterns, then they should at some future date chase the equity rally. The flow of funds into stocks will, as in the past, extend the rally, though in time it will create the overpricing that would lead to the next bear market. If they have indeed changed, then future money flows should remain subdued and the rally likely would unfold in a more muted way than in the more distant past, delaying that time when overpricing becomes worrisome. Either way, the present circumstance suggests that today’s equity investor has time before he or she needs to worry about excessive pricing and could rather look forward to an extension of the rally in one form or another.

¹ All data herein from Investment Company Institute.