One of the traditional signs of market tops is individual investors finally succumbing to the lure of apparently easy money and pouring their savings into the stock market. In the past this dumb money flowed into equity mutual funds in general. But today it’s favoring exchange traded funds (ETFs) that, rather than trying to pick winners, simply offer exposure to sectors or broad market indexes.
U.S. ETFs accounted for $44 billion of that, pushing assets in U.S. funds to almost $2.8 trillion.
Most of the money went to cheap, index-tracking ETFs, a sign that the price war in ETFs isn’t over yet. BlackRock’s iShares ETFs were the biggest winner, and its low-cost Core series garnered the bulk of the $38 billion global haul.
“All of the money is going into the cheapest and most boring ETFs. This is the retail investor getting back into the market with a vengeance,” said Dave Nadig, chief executive of ETF.com, an industry website owned by Bats Global Markets, newly a subsidiary of CBOE Holdings Inc.
The Rise of the ‘Do-Nothing’ Investor
Passive mutual funds are growing rapidly, pushing aside stock pickers and changing the investment world.
The fastest-growing ETF so far this year is the iShares Core Emerging Markets ETF, which took in $4.2 billion in the first two months of the year, 18% of its assets, according to FactSet. Three other Core ETFs that invest in U.S. stocks were also among the top gainers last month.
Why is this a sign of a market top? Because small investors tend to trade on emotion rather than logic or expertise. It takes them a long time to forget the pain of the last bear market, so they avoid the early stages of recoveries. When they finally conclude that there’s money to be made, it’s usually too late.
And why are individual investors only the second dumbest money? Because governments are even less astute and more emotional than individuals, and their plunge into equities is just beginning. Japan’s central bank is now one of its market’s biggest “investors” while the Swiss National Bank is a huge holder of blue chips like Apple and Microsoft. See We’re All Hedge Funds Now, Part 4: Central Banks Become World’s Biggest Stock Speculators.
In the next downturn - which, based on most valuation measures, seems imminent – the US Fed and European Central Bank will find that interest rates are too low for big further cuts while the supply of bonds is insufficient for big new QE programs. So they’ll join Japan and Switzerland in buying stocks. They’ll do so indiscriminately, creating their own index ETFs and throwing money at a broad range of large cap stocks, possibly pushing prices to levels that history would consider insane. In other words they’ll act like retail investors on steroids.
But that’s a story for the next cycle. This time around the fact that individuals pouring in is all we need to know.
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As a reminder, in the recent past, these massive floods of retail panic-buying flows have stalled the rallies (and not ended well).
This massive inflow appears to confirm what JPMorgan has been seeing, that the latest "Great Rotation" is one not from bonds into stocks, but from "smart money" to retail investors who have finally joined in the market euphoria, traditionally seen as a topping sign for rallies.
Confirming what BofA observed last week, JPM writes that in contrast to retail investors, institutional investors appear to have overall reduced rather than increased their equity exposure YTD.
"This apparent unwillingness by institutional investors to raise their equity exposures YTD reinforces the argument that it is retail rather than institutional investors that most likely drove this year’s strong inflows into equity ETFs and as a result this year’s equity rally."
There are several implications from these findings.
The first is that with ETFs the dominant vehicle of expressing market sentiment at this moment - almost excluslively by retail investors - it means that certain distinct market "aberations" have become an odd fixture of the market, such as the now daily market ramp in the last 30 minutes of trading, which was on display most recently on Friday when as we discussed, a last minute burst of buying pushed the S&P not only to the green, but sent the Dow Jones to a new all time high just 7 seconds before the close of trading.
The other obvious finding is that the vast majority of professional, active investors and asset managers are taking advantage of the current market rally to sell risk and offload exposure to retail investors, who remain in the driver seat and provide ever higher prices against which to sell.
How long this unstable equilibrium persists is unclear, and JPM refuses to make any predictions. However, with the fate of the market, now hitting record highs in the longest streak since 1987, it won't take much to spook "mom and pop" daytraders and halt the ETF bid, resulting in the first market selloff under the Trump administration. We wonder what Trump, who has repeatedly pointed to the market's outperformance as an indication of his successful policies, will say once the S&P prints its first correction (or bear market) under his watch.