Stock Fund Investors Coming to the Rally -- Late

Montreal, Canada

History shows that we've experienced only three major redemption cycles in U.S. stock mutual funds since 1983. And, if history is an accurate guide, then it seems pretty reasonable to suspect that stocks can rally much higher before hitting a peak in this cycle. That's because mutual fund investors haven't come to the party – at least not yet.

Investors typically harbor the worst market-timing behavior. As U.S. and foreign equities went through the roof (+75%) since hitting lows in March 2009, individual investors were still lunging after bond funds and dumping stock funds.

We've witnessed three mutual fund redemption cycles over the last 27 years or so. The first cycle occurred in 1988 after the infamous October 1987 crash. The next one saw mutual fund investors selling stock funds in 2002 just ahead of the market bottoming in October of that year. It happened again in 2008 as the credit crisis pummeled the majority of assets in one of the most brutal market declines since the 1930s.

In each and every episode marked by heavy stock fund liquidation the market subsequently hit a low and provided huge gains thereafter.

Since 2008, however, the big money continues to pile into bond funds. This behavior cements contemporary thinking among battle-scarred investors over the last ten years, whereby stocks have barely posted a net gain while bonds enjoyed profits. But that's rearview mirror investing and a dangerous strategy most of the time.

According to the Investment Company Institute, an industry trade group, equity fund inflows have surged more than fourfold over the past sixty days from $382 million dollars on March 31 to $1.9 billion dollars on April 30. That trend marks a massive shift compared to 2009 when stock funds barely attracted net inflows. Investors are becoming more bullish about owning stock funds.

Meanwhile, net inflows into bond mutual funds are at an all-time high. Investors continue to pile into fixed income funds at an unprecedented rate over the last 18 months, ahead of higher interest rates later in 2010 or 2011 as the Fed begins tightening, if even gradually. PIMCO, the biggest bond fund manager in the world, now manages over $1 trillion dollars.

Once individual investors really get cozy with investing again, equity fund inflows should overtake bond fund inflows, perhaps marking a top in this historical rally.

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