The rally that has taken hold this year has been very strong, but equally perplexing. As discussed in recent articles, it has come amidst falling earnings expectations, warnings from the bond market, and mixed economic data.
In addition, this move higher has come as investors move money out of equities …
The latest fund flow data provided by Lipper shows that while U.S. equity funds saw $4.3 billion in inflows for the week ended April 10th, $19.7 billion flowed out of equities from the beginning of the year through April 3rd. In other words, the market has risen as investors have yanked cash out of the market.
If you’re wondering how that’s possible, you’re not alone. It’s certainly not unprecedented for major averages to move in the opposite direction of aggregate fund flows, but the 1st quarter disparity is quite large. It suggests that equity investors have remained cautious in the wake of last December’s meltdown. It also implies a lack of trust in this quick snapback toward previous highs.
Money that has moved out of U.S. equities has gone toward international stock funds, bond funds and money-market funds, with inflows to the latter of nearly $50 billion. That suggests two possibilities: A melt-up, as some of this money comes off the sidelines to chase performance, or a period of declining prices based on skepticism of the longevity of this bull market.
So which is it?
Some data, particularly from AAII – the American Association of Individual Investors, shows that sentiment is beginning to improve. In the most recent survey reading, a higher than average number of investors predicted that stocks will rise over the next six months, while bearish sentiment fell sharply.
However, as we all know, retail investors are notoriously late to the party. AAII themselves recognizes this, noting that the S&P 500 has historically realized lower than average returns following periods of low bearish sentiment in their surveys (as we have now).
So if we’re to trust movements in sentiment, we could see gains moderate in the coming months. But on the flip side, recent price action has been unrelentingly bullish. In my opinion, all of this speaks to the difficult investment environment we’ve found ourselves in over the past few quarters.
Generally speaking, during long periods of rising prices (a bullish primary trend) or falling prices (bearish primary trend), the vast majority of financial and economic indicators will point in similar directions. It’s as though we’re monitoring many different compasses; when most point north, we can be relatively sure we’re heading north.
But near economic inflection points, and more importantly, potential economic inflection points, those compasses start pointing in all different directions. As travelers, we’d want to slow down our pace during times like this to make sure we don’t advance too far in the wrong direction. As investors, we accomplish the same objective by limiting our exposure to risk assets.
This is partly why I’ve been increasingly conservative in recent months, even as markets have continued to rise. While the market compass is pointing firmly up, other compasses have been wavering.
In all honestly, this transition toward a more conservative stance could turn out to be entirely wrong. Perhaps my judgement is clouded by recency bias, with the sharp selloffs that we saw at the beginning and end of 2018 firmly implanted in my mind.
But even if that’s the case, I think we must be careful not to sacrifice process in the pursuit of an answer. That last sentence probably didn’t make a lot of sense, so let me explain.
Throughout our investing careers, we’re going to have years like 2017, where nearly all indicators are bullish and the major averages march higher. We’re also going to have years like 2008, where warning signs are everywhere and markets plummet. In these types of environments, one can say that “forecast accuracy” is relatively high. In other words, the compasses are all pointing in similar directions.
But there are also periods (arguably, such as we’re in now) when the picture will be much muddier. Rather than devoting excess energy to deciphering which indicators are right and which are wrong (searching for an answer), we need to embrace the process of risk management – which entails reducing exposure when forecast accuracy wanes.
For lack of a better analogy, it’s as simple as driving slower when the fog rolls in. Yes, chances are you wouldn’t have hit anything along the way anyway, and will now arrive at your destination later than expected, but that extra time spent is well worth it. The reason is because one day it’ll turn out that something unexpected is in your way. On that fateful day, the extra caution may save your life.
It’s the same with investing. There are periods when we need to move slowly, and I think this is one of those times. We may miss out on a few percentage points here and there, but by taking a more cautious stance when market volatility rises, when leading indicators falter, when earnings expectations deteriorate, or when global conditions are in flux, we might just make it to the finish line.
So much of our perception of investing is based on being right or wrong at any given moment that I think we often fail to realize that our investing careers are defined by the sum total of all these right and wrongs. To that end, it is the process of risk management – betting in proportion to our confidence in the outcome, that becomes one of the quintessential skills.
Just as a blackjack player who is counting cards will scale up their bets in proportion to the amount of 10s and face cards left in the deck, and place minimum bets when the count is against them (apparently I’m full of analogies today), we must do the same as investors. Right now it seems the count is neither strongly in our favor nor against. But that will change … and as it does, so should our exposure.