Exuberant speculators tend to ignore some sobering math at market extremes. Almost no one who is in a position to sell near the top actually wants to sell. And, hardly anybody wants to own whatever is closest to a multi-year bottom.
Last week, there was a huge inflow into general equity funds, approaching all-time record levels. If this appetite continues it would be a bad omen for general equity indices. It would be even more negative if inflows continued at an intense pace while prices barely moved higher or even begin to decline. The following article, recently appearing on MarketWatch, confirms this current trend: $277 billion into stock funds so far this year; highest since 2000.
Strong fund inflows, positive sentiments and, persistently positive media coverage are good if prices are surging higher, which would indicate more people are coming to the party. However, when average investors are becoming increasingly optimistic while prices are moving lower, then it highlights the unjustified nature of a feeding frenzy.
An historical example of this inflow trend can be found during the 1999-2000 internet bubble. By February 2000 the rush into technology equities was so dramatic that many funds had greater inflows in that single month than they did during the entire fourteen-year period from 1981 through 1994. The writing was on the wall. Investors had become way too excited about internet shares and nobody wanted to miss the party of the technology boom. The NASDAQ reached 5,132, during March 2000. We never reached that level again in inflation-adjusted terms.
This principle works equally well in the opposite direction. When there are major fund outflows, deteriorating sentiment, and continued gloomy media coverage as all the while prices are actually rising, then it shows that average investors are being pessimistic when they should be buying.
To illustrate, in February 2009 we had all-time record outflows from many U.S. and international equity funds. March 2009 marked a 12 year bottom for the S&P 500. In April 2009, a subsequent bull market ensued which has gone on for 4 ½ years, and now we are into the irrational exuberance level again.
In 2013, investors continued selling out of their emerging-market funds (EEM & EWZ) at the end of August and September, even though a rebound had already started for the BRIC. These days, average investors are still making withdrawals from most funds relating to metals and mining. This recent panic selling has created compelling valuations for these sectors, particularly in gold and silver funds (GDX, GDXJ, GLD, SLV and XME).
Now let’s look specifically at where the heaviest ETF and Mutual fund outflows are. That would be precious metals (GLD, GDX, GDXJ and SLV), raw materials (XME) and emerging markets (EEM & EWZ). Therefore there is a very high probability that these sectors will eventually be followed by strong inflows. As a rule in the stock market, whatever people are most reluctant to do is almost always going to be the most profitable path to follow.
In addition to watching the volumes of investor inflows and outflows, it is important to watch what the buying and selling patterns of public company executives. Insiders already sold, back in spring 2013, which is a crucial leading indicator as to what we can expect to come in the market. We at ETF Trade Advisor take the timing of heavy buying and selling by company insiders as a compelling signal. These folks always buy early and sell early much like our strategy for trading for the past three years. For example, if you look at company insider activity records for the fall of 2008, they kept buying during the market panics. They literally ran out of money to do any more buying at lower prices during the first quarter of 2009, just when the average investor threw in the towel and we experienced one of the biggest outflows from U.S equities in decades. That time marked the beginning bull market in April 2009.
As hard as it is to go against the crowd, remember that during the excitement stage of any multi-year bull market, in any sector, doing nothing becomes the most important action.