A Shift in Risk Appetite?

I believe in Marshallian K – so excess money creation goes into financial assets if the real economy doesn't need it. This is what is going on now in American financial markets. We are seeing narrow money creation but not broad money growth. The St. Louis Federal Reserve is showing that the current money multiplier is less than 0.9, that is, printed money is not being multiplied by the banks to the typical extent (2.0-3.0).

What is interesting so far in 2011 is the change in where that money is going. In my last article I made a logical case for flows into stocks rather than bonds based on valuation. I doubted that the flows of mutual funds would reflect that logic, but I have been proved wrong by the data releases* of the Investment Company Institute since. Here is a table showing mutual fund flows on two time frames – the top part of the table is monthly data and the bottom part is weekly data for mutual fund flows this year.

U.S. Mutual Fund Flows

Source: Investment Company Institute

The Table shows some interesting shifts. The pattern last year was for positive bond flows and negative equity flows. Whenever equity flows went net positive last year it tended to be because positive flows to emerging market mutual funds outweighed outflows from domestic equity mutual funds. So for three quarters of the year in 2010 there was a large negative bias towards mutual funds investing in American stocks.

Towards the end of the year holders of mutual funds caught on to the increasing fragility of the finances of municipalities in the States and there were net redemptions from muni bond funds. The outflows from muni bond funds have continued this year. There has been a minor pick up in flows into taxable bond funds this year, and it looks like straight switching within bond mutual funds to safer havens. Net flows across total bond funds are a small positive – and really quite small compared to last year's positive net flows. So the key word in the bond mutual fund story in 2011 is small.

The key words in equity mutual funds investing in 2011 to date are growing and domestic. After some minor end year tidying up, the U.S. mutual fund investor has continued to buy overseas equity focused equity mutual funds as before, but the new new thing is the emergence of significant buying of domestic equity mutual funds. The market for mutual funds in the United States is not like in some European territories where the largest investor in a UCITS funds can be the sponsoring insurer or bank. In the United States, apart from money market funds where institutions own around a third of the assets, mutual funds are held by individual investors. Individuals own 89% of bond funds and 91% of equity funds. And the man in the street in the US has been buying domestic equity mutual funds to an extent not seen in at least four years.

Whilst individual investors are recent converts to the attractiveness of equities, institutional investors crossed that line some time ago and at this point are expressing fervour for the concept.  The Merrill Lynch Fund Manager Survey for February (survey period 4th-10th February) contains extreme conviction on the part of institutions. The Survey overview states "The February FMS is one of the most bullish in years. Institutions have record equity and commodity overweights, very low cash levels and the strongest risk appetite since Jan‘06." It also says that "Hedge fund net exposure rose to 39%, highest since July’07. Cash balances fell from 3.7% to 3.5%, triggering our FMS cash trading rule equity sell signal." 

A mirror of the rated attractiveness of equities is an aversion to bonds in the Survey - nominal bond allocations were very low; the lowest since April of 2006 and near record lows. This is the corollary of the view on inflation (and implicitly commodities) that expectations for global inflation were the highest since June of 2004.  There is a consistency of world view too in the consensus for economic growth. Just 13% of respondents expect the global economy to weaken in the next 12 months. 


Parenthetically it is interesting that professional money managers express the same sentiment now that mutual fund flows have expressed this year  - a strong bias towards the equity markets of the developed world rather than emerging market equities. The expressed appetite for U.S. equities is the second highest ever in the Fund Manager Survey. 

The mental positioning, and Dollar positioning, of investors in equity markets combined with expressed survey views on growth and inflation give a clear road map for contrarian investors. For example I would suggest that the views of Hugh Hendry put across here (Hugh Hendry's views) were for something other than where the consensus has got to. Equity markets are overbought, and extended to the upside. However, overbought conditions can persist and there is little internal inconsistency in the market action for a tape reader to find. One of the market observers I respect puts it that the broad market "continues to demonstrate bullish resiliency".

*Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals in the weekly data. Data for previous weeks reflect revisions due to data adjustments, reclassifications, and changes in the number of funds reporting.

Stocks over Bonds for 2011

Just over a year ago I featured as my Chart of the Day the mutual fund flows for U.S. bond funds and equity funds. At that point I summarised the attitudes of retail investors as "keep me out of Wall Street, I want the return of my cash, and I can only trust Uncle Sam with my money at the moment, thank you." The updated chart (Fig 1 below) shows that 2010 had more of the same, that is, huge inflows to bond funds and net outflows from equity mutual funds.

                                  Fig 1. Monthly Net New Cash Flows to U.S. Mutual Funds by Asset Class

As at the previous point of review (December 2009) the logical case now is very strong for a preference for equities over bonds based on valuation. Looking at the P/E ratio of American shares in isolation the case is not particularly convincing as Figure 2 shows. The S&P 500 trades at 13.6x forward four quarter earnings – this level is neither cheap nor dear in an absolute sense. But the context is very constructive: inflation is low at the consumer level; interest rates, whether real or absolute, are low and will remain so for some time; and earnings growth may be a positive surprise in 2011 as expectations are low.

                                    Fig 2. P/E Ratio of U.S. Stocks based on 12m Forward Estimates

The earnings surprise at the market level could come because expectations are low and the American corporate sector is well set in several regards. First the operating leverage is good after staying lean and mean, and hiring has only recently begun. Secondly the level of the Dollar makes the U.S. internationally competitive (and exports accounted for 1.1 percentage points of the 3.2% increase in real GDP in 2010). Thirdly, and this will be very important this year, unlike the consumer and the government, the corporate sector has a good balance sheet in aggregate. I place an emphasis on the balance sheet because there is good scope for capital spending as well as hiring, and, most importantly for investor psychology, conditions are good for a lot more mergers and acquisition activity this year.

However, even if the earnings growth for 2011 only turns out to be in line with the current consensus, a strong case can be made for a preference for stocks over bonds on the basis of relative valuation. This is illustrated in Figure 3.

                                                      Fig 3. Yield Comparison for Stocks v Bonds 
                                               (Earnings Yield on S&P500 v Real Yield on 10 Year Treasuries)

The widening gap between the real yield on the highest quality bonds and the earnings yield on American blue-chip stocks (the inversion of the P/E ratio) reflects the neglect by investors of stocks relative to bonds. The risk premium for stocks now is higher than it has been for more than 80% of the last decade, and at nearly 3.9% is 1.6% higher than the average over the last 10 years. The logical case is very strong - on the basis of valuation investors should switch out of bonds and into stocks.

On the basis of investor psychology investors won't switch. The aversion of the man in the street to anything to do with Wall Street will continue. ETFs have continued to grow whilst equity mutual funds remain out of favour suggesting that Americans don't want to give money to stock-selecting money managers. Individual investors are dis-engaged with markets to an extent rarely seen before. In short, America has fallen out of love with stocks.