Trader’s Narrative

The trend in the fund flows data continues. Investors are shunning the US stock market and embracing the international equity markets.

According to AMG Data: for the month of May 2007, domestic funds reported an outflow of $5.2 billion while non-domestic funds report net inflows of $11.6 billion.

For the month of June 2007, domestic funds report net outflows of $4.2 billion while non-domestic funds report net inflows of $9.3 billion.

The only other market which is even close to as unloved as the US is the Japanese market. Every other market, emerging and developed gets some love (aka capital).

While this dovetails nicely with the other data suggesting the retail investor’s apathy towards the US stock market, in the long run it can’t be good. Typically, a bull market starts out with everyone being skeptical and ends when no one is.

But the market needs the participation of the regular guy. Right now we are seeing the “smart money”, commercials falling over themselves to get long. This is a fantastic vote of confidence in the intermediate to long term. But they can’t sustain the market forever.

While sentiment data and my proprietary sheeple index are interesting, they are both circumstantial evidence.

To see what people are actually doing, we have to look at funds flow or liquidity data. The last time I brought this up was last summer when a skittish public started pulling out significant funds as a result of a small correction in the markets. That had panic written all over it and as a contrarian, one would interpret it as bullish since it took very little to scare people enough to have them pull money out.

Right now we aren’t seeing that sort of fear in the market. However, as we have come to suspect from the other evidence (sentiment and traffic data of online brokers), the retail investors are not believers in the US markets. In fact, they are putting money to work everywhere and anywhere except the US markets.

According to AMG Data: Last week, for data including ETFs, investors pulled $1.6 billion out of the US markets and in contrast, sent around $700 million to work in non-domestic destinations. In April domestic funds saw net outflows of -$4.9 billion while non-domestic funds reported net inflows of $20.2 billion.

So while the average investor is shunning the US markets, they are hitting within spitting distance of all time highs. Interesting. Where are they putting their money? In the emerging markets: Asia (except Japan), Latin America (especially Brazil and Mexico), Russia and Western Europe.

In the face of such evidence, I wonder how people can continue to call this market “frothy”? or the price action, “a melt up”?

But although funds flow data is an accurate and meaningful gauge, it must be approached wtih the right time frame. As the example from last summer, it works great when you have a medium to long term point of view. Anything shorter and it isn’t really helpful.

While a bull market requires active participation by the retail investor, today it is the private-equity sector who is the primary force behind the demand for equities. Every day we read about one large deal either rumoured, announced or concluded. My take is that as the market moves higher, the retail investors will ultimately succumb and start to buy stocks again. And finally, as in all cycles, in the later stages we’ll have a real “melt up” and “froth” as the masses rush to invest in a hot market.

But until then, we’ve got a long ways to go.

With the historic and surprising bearish AAII sentiment, I wondered about the “sheeple” index that I mentioned about a year ago.

This proprietary index of mine looks at the retail brokers web traffic and uses it as a measure of retail investor participation in the market. I look at the three most popular online brokers: ScotTrade, E-Trade (ETFC) and TD Ameritrade (AMTD). I ignore the more trader oriented brokers like Interactive Brokers (IBKR) and CyberTrader (SCHW) because I’m trying to only measure the activity of Mom’n'Pop investors who are casual in their market participation. I want to track only those who are less knowledgeable about the market and more apt to get swept up in the vicissitudes of the market, swinging from euphoria to despair and back again.

The graph shows the merger of TD Waterhouse (red line) with Ameritrade (yellow line) so the spike up you see is the new website coming online, replacing the old one. Anyway, in the graph you can see that the traffic for the different online brokers not only ebbs and flows as a group, it does an impressive job of reflecting the moods of the average retail investor out there. For example, notice how in the summer of 2004 the traffic hits a low just as the market was forming an intermediate bottom.

Click for Larger Graph

Alexa has several ways of measuring web-traffic. Here is another way (daily reach) that shows very similar patterns:

Click for Larger Graph

The retail investor has definitely been sitting this one out. Since early 2006, even as the market has powered ahead, less and less people have logged on to their online accounts to participate.

Interestingly, the most recent results for May are showing a dramatic uptick - but is it short-term noise or are the retail investors and traders beginning to enter the market?

The Alexa numbers are very erratic and this could very well be just a blip. Only time will tell. All we can say now is that it confirms the lack of love towards the market by the casual investor and trader. Which means that the market participants are for the most part commercials, institutions and professional traders battling it out.

Even more surprising, analyst buy recommendations are at a 10 year low for US stocks. This, eventhough we are seeing a powerful showing of earnings on Wall Street. Which is, in turn, helping to give this market a reasonable price/earnings ratio.

And finally, according to Commitment of Traders the small speculators are positioned short right now.