Monday, September 19, 2011

Large Mutual Fund Redemptions--A Reliable Buy Signal?

The investment decisions by mutual fund investors have been a reliable buy or sell indicator in the past.  Are they still?

The investment results of investors in mutual funds have been dismal.  Human nature has repeatedly caused poor decision making by individual investors.  The herding behavior tends to cause individual investors in mutual funds to react to trends in stock prices after the fact, buying after large gains have already occurred (and news is good) and selling after large declines in stock prices (and news is bad).  As a result of these poor timing decisions, the average returns by investors in mutual funds have substantially trailed the returns of the funds themselves.  And since most fund returns after expenses have trailed those of major stock-market indexes, the results of individuals have been even worse.

What have mutual fund investors done during the past three years, and what might this indicate for prospects for the stock market from today's starting point?

During the financial crisis in the fall of 2008 as stock prices collapsed, mutual fund investors responded by redeeming approximately $75 billion from equity mutual funds in the five months following the collapse of Lehman Brothers.  The stock market bottomed soon after, in March 2009, which was a great buying opportunity before stock prices nearly doubled in the following two years.

More recently, after the S & P 500 stock index fell 16% last spring and early summer, mutual fund investors redeemed more than $40 billion in the four months through August 2010, another bottom in the stock market.  The S & P 500 index then gained 13% in the next three months.

Mutual fund investors again have redeemed $75 billion from equity mutual funds during the last four months.  This news, combined with other measures of depressed investor sentiment and reasonable valuations of stocks, persuade me that it is a good time to buy stocks.  Bad news (now the fears over European solvency in particular) alone doesn't mean that one should buy stocks.

But shares of some of the top companies in the world are selling at relatively low valuations of earnings and cash flow while being in superb financial condition.  Their dividend yields range from 3-6%, with excellent prospects for income growth.  In contrast, interest rates offered by banks and money market funds are near zero, and government debt yields only a few percent.  While I continue to exhort investors to always maintain cash reserves for unanticipated buying opportunities, the risk/return prospects for leading stocks is now quite satisfactory in my opinion.

Steve Lehman

S & P 500:  1196

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