The secular bear market in stocks that began during the autumn of 2000 is at an end; at least, that’s the verdict of the uber-bulls, who argue that a sustained multi-year upswing in equity prices is now underway. Unfortunately, the bullish thesis is predicated on suspect assumptions; perhaps none more so than the argument that the individual investor – following four consecutive years of net outflows – is set to embrace the stock market once again. This view is not supported by the historical evidence however, and displays an almost complete ignorance of individual investor behaviour amid a protracted period of sub-par returns.
It is important to appreciate that mutual funds’ net cash flows are determined not only by the level of new sales, but also by redemption activity. Both variables are positively correlated with stock market returns, whereby higher equity values precipitate an increase in new sales AND redemptions. Further, new sales typically exceed redemptions during secular bull markets, while the converse is generally true through a prolonged period characterised by declining stock market valuations.
The pattern-seeking nature of humans means that individual investors react slowly to a pronounced change in the climate for equity investing, such that the level of new sales weathers the first marked decline in stock prices – during a secular bear market – relatively well.
However, a second strike has a lasting impression and leaves deep scars, such that the level of new business falls well short of that recorded at the height of the previous secular bull. Further, it takes several years of strong returns to entice the individual investor back into the stock market.
While increased risk aversion depresses the level of new sales as a secular bear market progresses, loss aversion means that individual investors are typically unwilling to liquidate their positions during a period of stock market weakness, and postpone redemptions until equity prices stage a cyclical recovery. The bottom line is that the combination of weak sales and elevated redemptions means that equity mutual funds can expect to endure net cash outflows for an extended period.
It has been argued that the net cash outflows suffered by equity mutual funds from 2007 to 2011 is an unprecedented development, but this observation simply confirms the dangers of utilising data that extends back no further than the mid-1980s. The Investment Company Institute, the national association of U.S. investment companies, maintains a far more instructive data set that documents mutual fund activity since 1945.
A multi-year advance in stock prices began during the summer of 1949, and although net cash flows were positive throughout the 1950s, the deep scars left by the collapse in equity values during the ‘Great Depression,’ meant that it took more than a decade of robust returns for a new generation of investors to embrace stock market risk. Net cash inflows gathered momentum as the 1960s progressed, and the net assets of equity mutual funds surged from $17 billion at the start of 1961 to $48 billion by the decade’s end.
The secular bull market struck a speed-bump in 1966, but individual investors remained unfazed in the face of falling equity values, and net cash inflows continued uninterrupted. However, the near-thirty per cent decline in stock prices from the winter of 1968 to the summer of 1970 tempered investor enthusiasm, and the surge in redemptions as the equity market recovered – combined with lacklustre new sales – saw equity mutual funds suffer their first net cash outflow in post-war history.
The net cash outflow recorded by equity mutual funds in 1971 marked the beginning of a sustained period of negative flows, which persisted until 1982 or almost twelve years – far longer than the current four-year period. Importantly, cyclical rallies in stock prices, which ranged from the 28 per cent advance between late-1971 and early-1973 to the 57 per cent gain from late-1974 to the autumn of 1976, did not ease the industry’s woes, as the surge in redemption activity on each occasion overwhelmed the increase in new sales.
Data for the period show that net cash outflows from equity mutual funds were consistently greater during cyclical recoveries in stock prices than they were during cyclical declines. For example, the cumulative outflow during the upturn in the stock market’s fortunes from the spring of 1978 to the winter of 1980 was 27 per cent of assets, or more than double the level recorded during the previous downturn.
Recent trends in equity mutual fund flows are consistent with historical experience. The annualised rate of new sales versus net assets is running at little more than half the level recorded during the latter half of the 1990s, and is well below the rate observed during the five-year cyclical advance in stock prices beginning in the autumn of 2002. Meanwhile, redemption activity is responding to the surge in stock prices since the autumn of last year, such that net cash flows remain decidedly negative.
Increased enthusiasm for equity investment by individual investors is been used as one of the reasons to support the thesis that a multi-year upswing in stock prices has just begun. A review of the historical evidence however, suggests that this particular hypothesis is bunkum.
Previously posted on www.charliefell.com
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