Do Mutual Fund Flows Predict Stock Market Valuations?

As we hear more about investors switching out of bond-oriented mutual funds and into stock-oriented mutual funds, it might be an interesting exercise to see if mutual fund investors have recently been as contrarian a predictor as most stock pundits would have their audience believe. That is: mutual fund investors pour money into the stock market at its peak and withdraw funds at its bottom. Or, is there wisdom in crowds: do changes in mutual fund flows portend changes in valuation?

(Click to enlarge)

Funds Flow Versus the S&P 500: The following chart is a quarterly comparison of “Monthly Net New Cash Flow” for “Domestic Equity” mutual funds provided by the Investment Company Institute versus the month-end S&P 500 index from its most recent stock market peak (10/07) to the end of 2010.

Important Considerations: The first important thing to note in the chart is that monthly net new cash flow into domestic equity funds was mostly negative (left scale)—it was just a matter of degree.

Secondly, excluding the market crash in early 2009, which represented an unusual period in the equity markets, net new monthly inflows appeared to track the S&P 500. The question is one of causation. Was it the rising equity prices that attracted investors, or the incremental funds that created the higher valuations?

Curious: The most curious feature of this chart is the net new funds flow into domestic equity mutual funds in-and-around the trough of the stock market. Theory should have held that mutual fund investors would be panicking at the market bottom and accelerating withdrawals of funds through mass redemptions.

Yet, that didn’t seem the case. In fact, domestic equity mutual fund investors on a net basis added to their holdings both just before and after the stock market trough. This action generated what few monthly net positive cash inflows there were during the period. For those who added to their positions during this time and held those positions, it appears to have been a good investment decision.

Conclusion: Maybe mutual fund investors aren’t “dolts” as they’ve been characterized; or, maybe, a preponderance of them were just too “shell shocked” to sell.

Disclosure: No positions