The nearly nine-year old bull market in stocks, which has taken major indexes to dozens of records over the last year alone, is masking an important trend occurring beneath the surface of Wall Street: Investors are cutting their exposure to equities, and they have been for years.
According to data from Morgan Stanley, flows into stock-based funds — including both mutual funds and exchange-traded funds — have been negative since 2007, the year that marked the pre-financial crisis peak on Wall Street. Over that same period, bond funds have seen incredible adoption, a trend that has persisted in recent trading and would seem to fly into the face of both market performance and consensus expectations for where both asset classes are headed.
Since 2007, nearly $300 billion has been pulled from stock funds, according to the investment bank’s data. More than $1.5 trillion has gone into fixed income over the same period.
The chart below shows the flows for both asset classes on a more short-term basis. While equity flows spiked in the immediate aftermath of the 2016 presidential election, they subsequently returned to negative territory.
Even though the aftermath of the financial crisis was one of the lengthiest bull markets in history, the losses accrued during the crisis may have made some investors gun-shy about investing in stocks. According to Legg Mason, young investors have only recently warmed up to the asset class, after having missed out on years of gains.
Flows only indicate net changes being made to portfolios; a buy-and-hold investor will see his or her assets fluctuate along with market movements without having an impact on flows. Nevertheless, this trend is on its surface counterintuitive, as stocks have risen in essentially uninterrupted fashion ever since the financial crisis bottom in 2009, while bonds have been mostly stagnant, suggesting the opposite of performance chasing has been occurring.
Over the past 10 years, the S&P 500 (.SPX) has more than doubled. The iShares Core U.S. Aggregate Bond ETF (AGG) — a widely used proxy for the overall U.S. fixed-income market — is up about 5% over the same period, while the Vanguard FTSE All-World ex-US ETF (VEU) — an ETF that tracks the global stock market but excludes the U.S. — is up less than 10%.
The following chart, based on FactSet data, shows the performance of the S&P 500, in blue, against both the AGG (gray) and the ex-U.S. fund (red) over a 10-year period. While equities saw sharp losses during the financial crisis, they since recovered, and have easily been the best-performing group of the three over the past decade.
“In general there are two big trends: Investors are rebalancing from stocks into bonds, and within stocks, they’re rebalancing from U.S. to international equity. Based on performance, this isn’t normally what you’d see, and you also wouldn’t expect to see a large move into bonds at a time when interest rates are moving up,” said Alina Lamy, a senior analyst of financial markets at Morningstar.
The U.S. Federal Reserve has been slowly lifting its benchmark federal-funds rate, last doing so in December, in what was its fourth increase of 2017.
In July 2016, the U.S. 10 Year Treasury Note yielded 1.36%, which represented an all-time low. Since then, it has moved up to 2.54%, and yields are expected to continue rising alongside interest rates. Goldman Sachs expects the 10-year yield to end 2018 at 2.9%, and for it to continue trending higher for the foreseeable future, hitting 3.3% in 2019 and 3.5% in 2020. This would mean a decline in the price of the 10-year over the next three years, as prices and yields move inversely to each other.
That flows into equities have been slight or negative doesn’t necessarily mean that investors have soured on the asset class. Some equity-based products, notably exchange-traded funds and other passive vehicles, have seen massive growth. ETFs in particular have become investor favorites; the category saw record-breaking growth in 2017, with equity products leading that charge, although international stock funds edged out U.S.-based ones in adoption.
Surviving a stock market bubble
According to data from Morningstar Direct, U.S. equity funds have seen about $25 billion in inflows over the past 12 months. That’s almost entirely due to ETFs, which have seen $143.3 billion in inflows over the past year. Stock-based mutual funds have seen $118.9 billion in outflows, a move that largely reflects the exodus from actively managed products, which hasn’t occurred in as dramatic fashion in the fixed-income world, where active management is seen as adding more value.
TD Ameritrade recently reported that its retail clients ended 2017 with record levels of market exposure. In December, the AAII stock allocation index jumped to 72%, its highest level since 2000, according to Dana Lyons of J. Lyons Fund Management. However, such statistics only apply to a relatively small percentage of the population; the top 10% wealthiest own about 85% of total stocks, per Deutsche Bank Securities.
Other parts of the market are seeing more wholesale adoption. Sector-based equity products (ETFs and mutual funds) have had $26.5 billion in inflows, while $247.6 billion that has flowed into international equity funds. Taxable bond funds, on the other hand, have had $392.1 billion in inflows. Municipal bond funds have had $34.5 billion in inflows.
Morningstar’s Lamy credited the rotation into bonds to the country’s aging demographics.
“Investors are not good at timing the market, but in general, now seems like a good time for older investors to lock in their stock gains and move to bonds, which offer more stability,” she said. “Right now there are more boomers entering retirement, which means they’re looking for a steady stream of income without the volatility that comes with equities. They’ll get that in bonds.”
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