The Contrarian Signal: Money Flows Favor Stocks Over Bonds

April 13th, 2012 by

Black Rock CEO Larry Fink likes the outlook for stock prices, as does the equity research team at Goldman Sachs, according to calls both have made recently. (Goldman Sachs took an upbeat view of equities in late March of this year; Larry Fink has been bullish since late June, 2011.) But what is the basis for all this enthusiasm for stocks? True, bond yields are low and therefore, unless stocks are overvalued relative to bonds, it would be natural for investors to favor stocks given that they offer greater growth potential. Also, depending on what P/E ratio investors believe reflects a “normal” level, the S&P 500 today is either cheap or hovering around the fair value mark. But in spite of the bullish arguments made for stocks by Goldman Sachs and Larry Fink, Thomson Reuters Lipper Money Flow data indicates that bond mutual fund inflows remain strong, while the stock funds seem unloved and neglected by comparison.

US TAXABLE BOND MONEY FLOWS: “YOU MUST BE KIDDING ME”
Lipper’s Taxable Bond money flows, net of balanced funds, (divided between equities and fixed income) and international funds remain strong, as seen in Chart 1. The steady inflow seems to defy the fact that rates have been inching higher from the September low (end of day) yield of the 10-year Treasury bond at 1.72% to the recent high of 2.28%.

Chart 1. LIPPER TAXABLE US BOND MONEY FLOWS
(EXCLUDING BALANCED AND INTERNATIONAL)

Chart 1. Investors fled US Taxable bonds as interest rates dropped in late 2008, but returned in droves as rates bottomed late that year. Except for seasonally slow periods (year-end and August of 2011), flows have remained strong in spite of historically low yields.

A closer look at the latest year’s worth of fund flow data shows that, except for seasonally-slow vacation periods in August and December, the appetite for US taxable bonds has remained strong. In spite of the fact that interest rates and bond yield have lingered at the lowest levels seen since the Great Depression, the odds of even more gains from still further rate cuts are very low, investors have picked up the pace at which they allocate funds to this asset class. While the trend doesn’t seem to possess the characteristics of a bubble, it’s logical to wonder what on earth these investors are thinking about when they make this allocation decision.

DUMB MONEY: “DUMB MONEY REDUX”
In fact, it’s reasonable to speculate whether this is a classic case of “dumb money” headed into the wrong place at exactly the wrong time. It has happened before: retail investors behaved irrationally during the technology stock, or “dot.com”, bubble, which burst in March of 2000. (See Chart 2, below.) So perhaps it’s worth using this data as a cautionary indicator.

Chart 2.

GOVIE MONEY FLOWS: “REMAIN CALM, CARRY ON”
One potential indicator that real financial trouble lies ahead occurs when inflows into US government securities are rising, as reported by the US Government money market fund flows report. (See Chart 3, below.) As Treasury securities are considered to be the safest place to park money, we use this flows data as a type of “fear” gauge warning us of turmoil ahead for risky assets. These flows spiked up ahead of both the financial turmoil that began in June 2007 and the market meltdown the following year, as investors sought safe havens in what seems to be a favored parking spot for assets during times of crisis. Despite a few hiccups in the second half of 2011, however, net flows into government money funds are negative, and thus not trumpeting any warnings that equity investors may want to heed.

Chart 3. US Government Money Market Money Flows Spiking When Investors Get Nervous

Chart 3. US Government money market funds have been the proverbial canary in the coal mine in 2007 and 2008. The vertical bars highlight equity market sell-offs along with net inflows into government money funds. Although they started tweeting again in mid-2011, the magnitude and duration did not match earlier activity. Recenty things are quiet, which should bode well for equities.

EQUITY MONEY FLOWS: “WE CAN’T GET NO RESPECT”
You would be forgiven for imagining that investors are allergic to owning stocks, given the data surrounding equity fund flows. For the last 12 months, as shown in Chart 4, below, investors have demonstrated at best a grudging affection for stocks. The data includes US mutual funds that report their money flows weekly and monthly, as well as ETFs and global macro funds that have some allocation to US equities. Since last August, the data shows us that far from heeding Larry Fink, investors have been lightening up their holdings of stocks and sitting on a pile of cash, thus missing out on much of the rally that has taken the S&P500 up 32% from its low point last October. Fink might have shown that his ability to time the market wasn’t so great on a short-term basis, given that the market continued to fall after he made his June 29, 2011 call, but since then the stock market has lavishly rewarded investors willing to follow his advice.

Chart 4.LIPPER US EQUITY MONEY FLOWS
(EXCLUDING INTERNATIONAL FLOWS)

Chart 4. Net money flows include all Lipper Equity money flows minus international flows. Note the lack of interest in buying equity mutual funds and ETF’s.

EQUITY VALUATION: “HISTORY REPEATS ITSELF… SOMETIMES IN THE OTHER DIRECTION”
Given that the Lipper fund flows seem to be telling us that equities have become a relatively neglected asset class, the next logical question becomes whether that wariness on the part of investors is justified. Are they still attractive from a valuation standpoint? To determine that, we used DataStream charting and Thomson Reuters I/B/E/S forward 12 month (F12M) earnings estimates for companies in the S&P 500 to look at what’s happened since 2007. You can see the results in Chart 5. Historically, it is assumed that a P/E ratio of 15 is considered to signal that the market is “fairly valued”. Note that the median F12M value since 2007 lies at around 13x, at almost exactly the same point as the current forward estimate value. It’s important to note that investors historically have viewed that 15x as the level that signals the market is “fairly valued”. The F12M P/E remained above that norm from 1997 through 2005; perhaps, then it wouldn’t be so unusual for us to experience a protracted period (to borrow the Fed’s language) during which the F12M P/E remains below 15x, perhaps in the very range of 12x to 13x that we have witnessed over much of the last two years. If so, than it’s also possible that the S&P’s current level, of around 1400, represents “fair value”. But if an investor prefers to view 15x as the norm, the fair value mark for the index lies closer to 1600.

Chart 5. FORWARD 12-MONTH S&P 500 P/E AND MEDIAN P/E LINE

Chart 5. The S&P 500 forward P/E is around its median value of around 13x since the peak in the S&P 500 in October 2007, but below what is typically considered as “fairly valued” at 15x over the longer run.

TAKEAWAYS: “WAITING FOR GODOT IN EQUITIES”

  • While the high inflows into taxable bond funds may be reminiscent of the way investors pursued dot.com stocks right up to the very minute before that bubble popped, they may tell us less about investors’ love for bonds than their wariness of the alternatives, including stocks.
  • Professional investors aren’t sending a warning signal by directing assets into low-risk government money market funds. Sudden inflows into these funds would provide an early warning signal of a change in conviction or sentiment on the part of these large investors.
  • Compared to bond fund inflows, those into US equity funds are skimpy, appearing to confirm the bull-market case pundits are making for stocks.
  • For those who believe that we’re in a protracted period of slow growth, the S&P is probably at around fair value when it’s trading at 13 times the forward 12-month P/E ratio. To anyone who believes that 15x remains a viable valuation, stocks remain undervalued.
    • Dave

      Interesting read.  And I agree with the sentiments.  That said, what boggles my mind is this:  Since Q4 of last year, the 10 year has crossed above 2% yield 15 times (by my count).  And each time, it’s crossed back below that level. (1.92/93 right now  It’s so stubborn it’s confounding.  You can almost double that yield with JNJ for heaven’s sake.  With better tax treatment even.