SERIOUS MONEY:The lesson is clear: poor stock market performance has a lasting and meaningful negative impact on new equity fund sales, writes CHARLIE FELL
THE SEEMINGLY irrepressible upward march in the major stock market averages came to a halt during the last week of October, with prices falling below their 50-day moving average for the first time since mid-July and registering the first negative monthly return since February.
The modest sell-off has been characterised by a notable increase in trading volume, as compared with the pronounced inactivity that accompanied the unprecedented surge in stock prices off the March low.
Judged against the trading volume data apparent following previous bear market lows, the current record-breaking advance stands as an extreme outlier. Perennial bulls all but dismiss the price/volume divergence and point to record levels of “cash on the sidelines” as sufficient reason to remain positive. Careful analysis suggests that this optimism may be misplaced.
The idea that cash reserves are close to record levels is beyond dispute. The total net assets of money market mutual funds surged more than 70 per cent in less than two years to a peak of almost $4 trillion (€2.7 trillion) during the spring as investors displayed increasing risk aversion and a preference for capital preservation in the face of the most savage decline in stock values in decades.
Falling stock prices, combined with record money market mutual fund inflows, saw the total net assets of money market funds soar to an amount equivalent to roughly 47 per cent of total stock market capitalisation, more than 20 percentage points higher than the comparable figures at the market low in both 1982 and 2002.
The stock market recovery in recent months, combined with a reduction in cash reserves, has seen total net assets of money market mutual funds drop somewhat relative to total stock market capitalisation but, at roughly 30 per cent, the figure is still unusually high by historical standards. Thus, there is sufficient potential ammunition to drive stock prices higher should investors’ risk appetite return.
Historical evidence, however, suggests that this may not happen as soon as the perennial bulls seem to think.
The historical data shows that there is a strong correlation between stock market returns and new sales of equity mutual funds. Poor stock market performance from the late 1960s through the 1970s saw individual investors shun equity mutual funds. Total net assets dropped from a peak of $56 billion in 1972 to less than $33 billion in 1978. Money market funds gained in popularity as investors’ appetite for risk disappeared, and these funds’ total net assets surpassed those of equity funds in 1979 and remained dominant until 1994.
Simply put, it took more than a decade of stellar returns for the individual investor to embrace the stock market once again.
The crash of 1987 was large in magnitude but brief in duration as stock prices hit bottom relatively quickly and climbed to a new all-time high within two years. Nevertheless, individual investors were deeply scarred by the event; new equity fund sales collapsed in 1988 and did not exceed their pre-crash level until the early 1990s. Investors were equally traumatised by the prolonged deflation of the equity market bubble from 2000 through 2002 and, once again, new sales registered a substantial decline and have yet to surpass their peak level.
The lesson from history is clear – poor stock market performance has a lasting and meaningful negative impact on new equity fund sales.
Mutual funds’ net cash flows are determined not only by the level of new sales, but also by the redemption rate and, once again, the historical evidence is not on the side of perennial bulls.
Redemption rates are influenced by stock market direction though typically with a lag, as individual investors are generally unwilling to realise losses and, if possible, postpone sales until prices stage a recovery.
This behaviour is consistent with prospect theory, a leading model of decision-making under uncertainty, which predicts that investors are “loss averse” and prefer a gamble to a certain loss. In other words, investors typically hold on to their losing positions and hope or perhaps even pray that they will be able to sell at higher prices.
Consequently, mutual fund redemption rates can be expected to remain high long after the stock market bottoms.
Recent trends in mutual fund flows are consistent with historical experience. New equity fund sales are down sharply on 2008, and redemption rates remain elevated despite the more than 50 per cent jump in stock prices.
Indeed, net cash flows in the year to date are negative for only the fourth time in the past 25 years.
This is hardly surprising given that investors have suffered two savage bear markets and negative 10-year real returns for the first time in decades.
Money market mutual funds have also suffered net cash outflows in recent months, just as the perennial bulls expected. But the firepower has not gravitated towards equity funds. Investors have instead sought out the relatively higher but low-risk returns available from bond funds, as compared with the near-zero interest rates available on cash instruments.
Mutual fund investors have not demonstrated a notable increase in their appetite for risk and the history books suggest they are unlikely to do so for some time. The perennial bulls need to find more credible arguments than record “cash on the sidelines” to justify an optimistic stance.
