Surprise! Mutual Funds Aren't Driving The Market
Deutsche Morgan Grenfell Chief Economist Edward E. Yardeni could not be more confident about his prediction for the U.S. stock market: "Dow 10,000 by 2000," he boldly states. To Yardeni and a vast array of other market commentators, the reason for the market's strength can be boiled down to two words: mutual funds. "Mutual-fund investors are doing to stocks in the 1990s what they did to real estate in the 1980s, sharply marking up prices," says Yardeni.
A compelling argument--one that is rapidly becoming part of the market's conventional wisdom. And on the surface, at least, it seems to make perfect sense. For one thing, no one can deny that mutual funds are a significant source of market liquidity, with small investors stepping in to buy stocks, via mutual funds, in virtually every market setback since the crash of 1987. But the fast-spreading view that mutual funds are pushing the market skyward--and might easily trigger a crash if fund customers grow wary--simply is not supported by the hard data. Market fund-flow experts, in fact, take a contrary view. Far more important, they argue, is the confluence of low interest rates, low inflation, and strong corporate profits. "The market is not especially sensitive to changes in fund flows," says Laszlo Birinyi, president of market consultant Birinyi Associates Inc.
HAND OVER FIST. Indeed, one of the few academic studies of the relationship between fund flows and stock prices shows that the correlation is, at best, weak. A soon-to-be-published study by Columbia University finance professor Michael Adler shows that while fund flows influence stock prices, and have since late 1993, they have all the impact of a pebble tossed in the ocean. According to Adler, on a scale of 1 to 10, with 10 being direct cause and effect, funds are only a 3.
Even huge changes in fund flows do not seem to affect stock prices. A Birinyi study shows that after the 10 largest monthly declines in equity-fund cash flows during the six bull markets since 1970, the market actually rose by as much as 6.7% (table). The market has also remained flat for long periods even after money has poured into the fund industry hand over fist. In 1994, when cash flowing into equity funds was at a near-record $119 billion, the Standard & Poor's 500-stock index rose a mere 1.3%. The culprit: rising interest rates.
Even when mutual-fund sales and the stock market appear to be moving in unison, a chicken-and-egg question arises. Do rising stock prices
drive people to invest in mutual funds, or is it the other way around? A strong case can be made for the view that fund investors are following the trend--not causing it. Leah Modigliani, a U.S. equities analyst at Morgan Stanley & Co., thinks fund investors chase performance, as they are now doing with index funds. "People follow performance. It's not an unintelligent thing to do. They're going into index funds just the way they went into Magellan," says Modigliani.
Even big inflows of cash into equity funds can't prevent a market setback. The first five months of 1996 were among the strongest on record for new money going into equity funds. Yet the market was flat in June and dropped 5.9% in early July--due largely to fears the Federal Reserve would raise interest rates. It was only after these fears proved baseless that the market resumed its rise.
Why are funds so lacking in market-moving influence? The reason might well have to do with the source of the funds used to buy mutual funds. While the prevailing view is that fund investors are bashing in piggy banks to buy mutual funds, they are, in fact, often selling stocks--thereby drastically reducing the overall market impact. One clue comes from Fed flow-of-funds data. Through the third quarter of 1996--the latest available Fed data--individuals sold $165 billion in equities while funds bought $184 billion. Thus, much of the cash used to buy equity funds may well have come from selling stocks.
CASSANDRA WATCH. So the doomsday scenario raised by some market watchers--that a falloff in fund purchases will cause a crash--has little validity. If the past is any guide, a sudden change in fund flows won't be the trigger to a market calamity. A more likely cause would be a significant jolt to the economy, such as the sudden surge in interest rates that induced the 1987 crash. Morgan Stanley market strategist Byron R. Wien thinks that if anything stops the bull market this year, it will be rising rates, not a drop in fund flows.
To be sure, tracking mutual-fund cash flows has its place. Such data have become a valuable tool to analyze short-term movements in market sectors. Investment bankers use it to gauge interest in initial public offerings or municipal bonds, for example. Wien compares fund flows to underwriting volume to assess the supply of new cash available for equities. "It's just one of many variables for looking at supply-and-demand conditions for stocks," says Wien.
The enormous growth of mutual funds has certainly turned the industry into a critical component of the stock market. But are mutual funds really the driving force behind the market? Don't bet on it.