The stock market vaults ever higher, and cash continues to pour into equity mutual funds. It doesn't take a genius to figure out that these trends may be connected. And therein, notes a study in the Federal Reserve Bank of New York's current Economic Policy Review, lies the basis of a recurrent nightmare haunting Wall Street.
For, as authors Eli M. Remolona, Paul Kleiman, and Debbie Gruenstein point out, if surging stock prices are sparking strong mutual-fund inflows that tend to push up prices even more, then it's possible that a sharp drop in prices could reverse the process, setting off a cascade of redemptions by fund investors that could escalate into a market crash. To assess the likelihood of such a scenario, the researchers review the historical record--and particularly the influence of short-term shifts in stock prices on fund flows.
The study comes up with several reassuring omens. One is that directly owned stock funds represent only 5.5% or so of household financial assets (an additional 2.4% is held in pension plans, which tend to take a long view of stock market performance). Moreover, over half of equity-fund assets are held in funds charging an up-front sales fee, and such "loads" inhibit short-run selling. And since mutual funds still account for only 14.9% of equity market capitalization, outflows alone seem unlikely to cause a sharp market decline.
But the key question is whether sudden shifts in market returns significantly affect fund flows. And here the economists' statistical analysis of data from 1986 through early 1996 indicates that the impact is extremely weak. Further, they find that funds investing in growth stocks, which usually lead the pack in market swings, are less sensitive to price shifts than income funds, suggesting that growth fund investors aren't spooked by price volatility.
What of the big market declines in October, 1987, and October, 1989? In the first, as growth stock prices plunged by an average 37.7%, net outflows from growth funds hit 4.6% of assets, compared with average fund liquidity levels of 9.4%. In the second, growth stocks fell by 6.2% and growth funds suffered outflows of just 1.3% of assets.
"At least up to now," says Remolona, "the evidence suggests that the impact of stock-price movements on equity-fund flows is not strong enough to sustain a downward market spiral."