A well-known indicator of small investor stock market sentiment is mutual fund cash flows. If more cash is coming in than is going out, sentiment is bullish and vice-versa.
Mutual fund cash flows are used because institutional investors typically purchase individual securities and hedge funds to get their equity exposure while small retail investors typically favor the diversification of mutual funds.
The theory is that small investors traditionally invest based on emotion (selling low out of fear and buying high out of greed). Therefore one should be cautious when money is flowing into stock mutual funds and aggressively buying when funds are leaving.
Consider the historical evidence. Through the end of 1999 there was NEVER a month in which mutual fund cash flows exceeded $30 billion.
Then in the year 2000 this occurred:
January 2000 $44.5 Billion
February 2000 $55.6 Billion
March 2000 $39.9 Billion
April 2000 $35.3 Billion
The market topped in March of 2000. The S&P 500 index declined roughly 45% over the next three years. How about the crash of 1987? The single worst day in the history of the US stock market on a percentage basis. It took nearly 18 months for the S&P to recover to its pre-crash level.
Mutual funds were in net liquidation for 16 of those 18 months. In 1990 the market topped in mid-July. Stock mutual funds were in massive net liquidations in August and September. The market bottomed on October 11. Then stock mutual funds had 94 consecutive months of net stock fund inflows. The market topped on July 17th. August saw the largest monthly net outflow in history: $11.5 billion. The market bottomed August 31 and made a new high within two months.
It’s been said that patience is a virtue when it comes to investing. I like to say that a strong stomach and a reasonable brain is more important.
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