There have been a number of contradictory theses on the “money on the sidelines”, notably of the funds of retail investors. However, an interesting piece from “Trader’s Narrative” points out that the money is actually flowing to the sidelines instead of flowing from the sidelines into the markets.

This actually enlightens some curious behavior of the markets which could only be understood in an environment where mainly professionals are trading.

In the three first weeks of September 2009,  the outflow of funds from equity mutual funds  left some wondering if it was not a similar phenomenon to December 2008 (hence creating de facto what Chuck has been observing as “distribution”). “Trader’s narrative” does not seem to understand the move, but it could well be explained by the fact that investors having broken even are exiting the market as soon as they can when confronted with the dire economic circumstances and a slow recovery (in their experience, at least). So, if retail investors are leaving the market instead of joining in, this also means that the potential for going higher is weaker. The contrarian analysis being that if “dumb money” is leaving the market, it is the time to get in… If it were not for an insecurity on the strength of the recovery.

However, this points out another news, which is much less encouraging for bears. If retail is out of the market or in the process of exiting it, it means that the actors moving the market are mainly professionals… Hence, mostly a traders’ market, with great intraday moves but with finally, always a progression upwards. And if the majority of the market actors trades on fundamentals (which explains the “inflation play” at work this summer), this  questions somewhat the predictive value of TA. The different structure of the market may also change something to the way technicals work (or don’t work in the present case). The fact is that this market calls for some mental flexibility and the capacity of being able to reverse direction quite rapidly if you’re a trader, or some option-related protection of you’re an investor of some sort.

The other point being that the rise in yields on corporate bonds, might also be explained by an influx of that “cash on the sidelines”; scalded by the experience of 2008, investors might want first to reach into more securitized investments such as bonds (but with a higher return) before returning to equity if the recovery is indeed as powerful as the market predicts it to be.

And for the permabears shorting everything on sight and harping on this reporter because he does not (constantly) predict impending doom, they might be inspired to read Marc Faber’s comments back in July as to the timing of the next crisis: “Asked when this would be, he said he could not forecast a precise timing: “it may be 5 years time, 10 years time, but that’s not the last crisis.” Gives an idea of the time span involved, no? Anyway, here’s to you an extract of the article on the “cash on the sidelines”.

The fabled trillion dollar cash hoard that US mutual fund investors are sitting on is well known by now. But what isn’t equally well known is just what they are doing with all that cash. We do know that after reaching a peak right at the March lows, the shell shocked US retail investor stopped stuffing cash into their accounts.

At its peak the cash hoard was about $4 trillion dollars. By the start of this month, it was down to $3.56 trillion and the most current data shows that retail investors have continued to slowly exit their safe haven, taking the number further down to $3.48 trillion. So where have all those billions of dollars gone?

From the fund flows data it seems that the vast majority of it has been funneled to the fixed income market, and more specifically, taxable bond funds. I showed a pie chart of the fund flows in last week’s sentiment overview to juxtapose the extremely skewed ratio of money flowing into bond funds vs. equity funds.

(…)

The data for the bond funds is for both taxable and municipal bond funds. As well, this month’s data point (shown in a darker shade) is partial because it including only the first 3 weeks. Nevertheless, this chart is a telling a remarkable story.

First, not surprisingly, as the bear market took hold, people started to react by taking their money off the table. The worst month was October 2008 (not March 2009) when $72 billion was withdrawn from equity funds – $47 billion of that from domestic funds. At this point of maximum panic, US investors sold everything, even bond funds. They only trusted one thing: cash.

But by the start of the year, while they still distrusted the stock market, they began to change their mind about bonds. Each month they put more and more money into bonds, even as the stock market launched on an astonishing rally.

Month after month, as the S&P 500 went on to higher highs, US investors continued to ignore equity mutual funds. Then most shockingly, during the first 3 weeks of this month, they actually withdrew funds from this asset class! At this rate, by the end of the month, we’ll see outflows equivalent to December 2008. All the more astonishing as the S&P 500 is hundreds of points higher.

This is simply astonishing. What exactly does a stock market have to do to get some respect around here?

Bullish
There are two ways we could look at this. If you’re bullish, you would say that the fact that the retail investor (or “dumb money”) has not jumped on the bull market bandwagon means that this is the real deal. After all, secular bull markets are known for pulling out of the station and leaving all but the most savvy investors and traders behind. And as contrarians, we want to zig where the crowd is zagging. So let them shiver, coiled in the fetus position, terrified of the last (and past) bear market. This is a new dawn. A new day.

Bearish
On the other hand, if you are bearish, you would point out that retail participation is vital to create momentum in a trend. Unless the US retail mutual fund investors start to believe in a bull market, there won’t be a bull market. After all, if the considerable amount of money sitting in fixed income is not used to bid up equity prices, how will we create the virtuous cycle of higher prices (which pulls in more money and so on)? Every secular bull market feeds on this self-perpetuating mechanism.

Could it be that this bear market left a traumatic mark on the psyche of the average US investor? If so, then this generation of investors will simply not be the same. We know from previous brutal bear markets that while the wounds heal, the scars are not forgotten. The generation that lived through the Great Depression continued to distrust banks, the stock market and all manner of ’speculation’ even after the US economy righted itself and went on to new heights of prosperity.

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