Investors Moving Back To Funds, Stocks

04/17/09 9:00 AM EST

Good Friday morning...We begin the day with a flat indication in the pre-market futures.  Every day this week, we've seen the S&P 500 futures begin at least a 10-point rally shortly before or after the opening of European markets, and we saw that again today.

The steady rally off the March lows has been quite impressive in almost every respect - magnitude, breadth, persistence, etc.  As is usually the case when we see such a performance, it has gotten the attention of everyone, including mutual fund investors.

The last time we looked at weekly mutual fund inflows and outflows, as calculated by AMG Data, it was on January 23rd when the four-week average had turned positive.  We looked at a chart at the time that showed a big red dot (i.e. caution!) on the current week.

It is updated below:

You'll notice another red dot on the chart, this time on the hard right edge of the chart.  Once again, the four-week average of fund flows has turned positive.

Let's zoom in and concentrate on the current bear market:

This one shows both the raw weekly flows (the blue histogram) along with the four-week average (the red line).  The correlation looks pretty clear - when the market has done poorly, fund investors pull their money; when the market recovers, they move back in.  That can be either prudent or [insert euphemism for "stupid" here] depending on their time frame, but typically it's not to their benefit.

When we saw massive one-week outflows, usually the market was about to turn around, especially when it occurred after several consecutive weeks of outflows.  We haven't really seen any massive inflows - the largest spike up on the chart above was from the last week in December, which could very well just be a seasonal blip due to the end of the year - but we have seen a few instances when the four-week average at least turned positive.  None of them were optimal times to join mutual fund investors by plowing money back into stocks.

As I noted in January, at some point this warning sign is going to fail miserably.  At the start of a new bull market, we'll see money pump into funds and just keep going as the market rises - there is a massive amount sitting in money markets just waiting to return to the market.  So far, though, the market has rolled over when we've seen the current setup and until it behaves differently I'm assuming it's guilty until proven innocent.

As investors have returned to the market, they have apparently become more comfortable trading individual stocks as opposed to the most liquid ETFs.  This dynamic is the basis of the Liquidity Premium, which looks at the volume in the primary S&P 500 ETF (SPY) versus the volume in all of the underlying components.

What we often see is that when investors are uncomfortable holding individual stocks, they flee to the most liquid funds, likely because it spreads out risk and there is exceptional liquidity in them.  When investors become more comfortable, they feel less of that need and move back to stocks as opposed to ETFs.

If you check out the chart on the site, you'll see that all three moving averages of the SPY Liquidity Premium are now above their red trading bands (bearish for the market).  In the chart below, we combine those three averages into one composite.

The green arrows highlight times when the composite reached +50%; the red ones highlight readings of -25%.

Like everything, this is not a perfect indicator, but it did do a good job at pinpointing times of extreme uncertainty and complacency in the market.

The current reading is actually the third-highest we've seen going back to 2000.  The highest was recorded in on February 5th of this year, and the 2nd-highest was from July 10, 2000.

What I also find intriguing about our current level is that it is not rebounding from an extreme in negativity.  When we see a huge surge in pessimism (like from last November), it's then easier to generate an extreme in the other direction due to how the indicators are constructed.  We're not getting that "rebound effect" now, perhaps adding to the validity of the reading.

Bottom line - Intermediate-term

Beginning in early March, we discussed a large number of reasons to expect an imminent rally of one to three months' duration.  Some of those studies were even more positive, and suggested not just a rally, but possibly a new bull market.

After the 20%+ rally, our current juncture is somewhat similar to where we were in January of this year.  On the one hand, we have a number of studies based on past behavior that suggest more upside to come.  On the other hand, we have things like the Indicator Score, Dumb Money Confidence and other potential roadblocks like we discussed recently.

The market has held up exceptionally well in spite of some short-term overbought conditions and other situations when it rolled over immediately before, which is a point in favor of further upside.  But when looking at our current position objectively, it's hard to find a solid edge given the battle between the studies (which point higher) and the current status of many of our indicators (which are becoming considerably negative for the market).

It's entirely possible that we're in an "April 2003" kind of place and we'll just keep steaming higher as we emerge from the bear market, as some of those studies from last month suggested.  I'm not comfortable betting on that possibility just yet, and prefer to back off and look for shorter-term opportunities in what I think will most likely be a multi-week or multi-month trading range between 850-875 on the upside and 730-760 on the downside.

Given what we discussed yesterday in particular, I'm inclined to believe that this push above the recent high at 860 will be a "false" upside breakout and I'm looking for considerable weakness if/when the uptrend is broken.

Bottom line - Short-term

Yesterday afternoon I mentioned the Arms Index on the Nasdaq, which had moved to an extremely low level during the day as volume went overwhelmingly into rising stocks.  That's fine, but the last few times we'd seen it to that degree, the market had great difficulty maintaining that upside momentum over the next few sessions.

Since the March low, there have been five other days when we saw the S&P trade to a new one-month high with breadth as positive as it was on Thursday.  Over the next three days, the maximum gain in the S&P averaged +1.2%, while the maximum loss averaged -3.8%.  That's a pretty notable 3-to-1 risk-to-reward during one of the most powerful rallies in the past 100 years.

We didn't have any extremes among the intraday versions of our shortest-term guides heading into yesterday, but the rally pushed several of them to the kinds of extremes that have signaled short-term exhaustion.

We can see some choppy, unpredictable trading activity on option expiration days and I usually avoid trading them, but I'm looking for this move into 860-875 to fail as we head into next week given everything we've looked at lately, specifically the last two days.

All the best,