What the Rush of Money into Stock Funds Means

Individual investors have finally decided that it's safe to buy stocks again. So far this year through October 31, investors poured $404 billion more into U.S. and foreign stock funds and exchange-traded funds (ETFs) than they took out, research firm Strategic Insight reports. For the full year, the firm projects that net inflows will total more than those for the previous four years combined.

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Here's the bad news. Market strategists, analysts and money managers almost unanimously believe the rediscovery of stocks by individuals is not a good thing for the market. It's as close to Wall Street gospel as you can get: Individual investors almost always buy and sell at the wrong times.

Want samples of that kind of thinking? After a particularly big week of fund buying in late October, David Santschi, chief executive officer of TrimTabs Investment Research, said in a note to clients, "As Silicon Valley bestows multi-billion valuations on technology outfits with neither revenue nor profits, investors are piling into equity funds at the fastest rate since the technology stock bubble popped in 2000."

Two days later, Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch, headlined the firm's weekly report on fund flows "It's Getting Frothy, Man!"

Just one problem with that analysis: The relationship between fund flows and subsequent returns is actually much more complex. At my request, Morningstar crunched the data on flows in and out of domestic stock funds and ETFs since 1993. Morningstar totaled flows over each January–June and July–December six-month period along with stock market returns for the subsequent six and 12 months.

If you average all the periods with positive net inflows into U.S. stock funds, Standard & Poor's 500-stock index returned an average of 4.5% over the next six months and 10.6% over 12 months. That certainly doesn't raise any bear-market warning flags.

By comparison, averaging all the periods with net flows out of stock funds, the S&P 500 returned an average of 5.8% during the subsequent six months and 9.4% over 12 months. In other words, over the short term (six months) the stock market did better on average after periods during which more money came out of stock funds than went into them. But the average 12-month return was slightly higher after a period of net inflows than it was during a period of net outflows.

At first blush then, the relationship between fund flows and subsequent returns seems nonexistent. Indeed, for all 40 six-month periods measured by Morningstar, the S&P went up about two-thirds of the time. And, lo and behold, the S&P went up about two-thirds of the time after investors were net buyers or net sellers of stock funds.

In fact, after the six periods with the largest net outflows from stocks, the S&P rose. Conversely, the market gained after six of the eight periods with the largest net buying of stock funds.

One relationship that's clear from the data is that individuals tend to buy U.S. stock funds after the market has risen and to sell after it has fallen. They're not contrarians. Unfortunately, that information is of no use to investors attempting to forecast the future direction of the stock market. Sometimes the market trend is your friend; sometimes it isn't.

But there is one nugget buried in the data. When net flows out of stock funds are massive, that tends to be a good time to buy stocks. For instance, the biggest net outflows from stock funds since 1993 were recorded for the last six months of 2011. And the S&P rallied 9.5% in the next six months. The second biggest bout of selling was posted in the last six months of 2012. Similarly, the S&P rose 13.8% during the subsequent six months.

Bottom line: A flood of individual investor money into stock funds isn't particularly useful as a contrarian indicator that portends a market decline. But overwhelming investor pessimism, as measured by large outflows from stock funds, has some value in predicting a strong market.

Steven T. Goldberg is an investment adviser in the Washington, D.C., area.