Markets and Fear of Cash Flow’s Role

Now that the stock market has recovered much of the ground it lost during July, many investors are scratching their heads wondering just what happened. Among the unresolved questions is this: Did changing mutual-fund cash flows cause the sell-off?

As mutual funds have mushroomed into a $3.2-trillion industry, triple the level of six years ago, many observers have come to fear their influence. Critics worry that the tons of cash that have flowed into funds in recent years could leave just as quickly during a market rout. And that could force portfolio managers to unload stocks, pushing prices even lower.

Are these fears well-founded?

Kevin Kelleher, research director at Liquidity Trim Tabs, a Santa Rosa, Calif., investment newsletter, thinks so. His newsletter projects stock market performance by estimating weekly mutual-fund cash flow, along with other supply-demand stats.

“Mutual-fund flows are currently the most significant component for the stock market,” he says.

Kelleher doubts that mutual funds will be able to keep up the heady rate asset growth they enjoyed in the first half of 1996. From January to June, Americans pumped $138 billion more into stock funds than they took out, says the Investment Company Institute, a trade group in Washington, D.C.

“That pace cannot be sustained for a full year,” says Kelleher, who estimates that Americans’ total personal savings will amount to just $240 billion for all of 1996. This explains why he’s “cautiously bearish” for the market’s prospects over the remainder of the year.

ICI figures show that the net cash flow going into stock funds hit a record $29 billion in January, were as high as $25 billion in May, then tapered off to a gain of $14 billion in June. Then on Wednesday, the ICI announced that new purchases dived to an estimated $3.5 billion--the lowest amount since November 1994.

But the figures also show that it isn’t so much that people have stopped buying funds as that some current shareholders are redeeming shares. The underlying demand exists, therefore--it has just been diluted by redemptions.

Regardless, other watchers question whether cash flows exert much of an influence on the stock market.

“Fund cash flows could be predicted based on market volatility, but market volatility can’t be predicted based on fund cash flows,” says Gavin Quill, a marketing vice president at Scudder, Stevens & Clark in Boston and a past chairman of an ICI statistics committee.

Quill concedes that inflows such as the $25 billion for May are not sustainable, but he thinks stock funds can continue to attract $8 billion to $11 billion a month for the foreseeable future. Trends that encourage people to invest remain in force.

Another observer who disputes the predictive value of fund cash flow is Dean Eberling, an investment-company analyst for Prudential Securities in New York. Cash-flow figures did not reliably forecast other setbacks.

If anything, cash flows dry up after a market drop, as people put off making new investments until conditions settle down. But such statistics “have very little predictive strength during the periods building to crises,” Eberling observes.

In terms of jumping ship, fund investors may be more patient and disciplined than some analysts give them credit for. If so, that would undercut the argument that fund redemptions will snowball into even larger market sell-offs.

In a March 1996 study of redemptions over the last half century, the ICI found little evidence that fund shareholders sold out en masse during past market breaks. The trade group says this confirms other evidence that suggests investors are becoming more knowledgeable and experienced and are maintaining a long-term perspective.

Some of the anxiety regarding cash flows these days reflects the steady increase in popularity of commission-free portfolios. Rightly or wrongly, no-load investors are perceived to be more prone to bail out than people working with a broker or other professional advisor.

It’s also worth noting that mutual funds are not as dominant a force in the stock market as many people assume. Although the number of all mutual funds exceeds the number of companies listed on the New York and American stock exchanges, fund assets are smaller. A 1995 report from the Federal Reserve Board estimated that stock funds at that time accounted for just 13% of the $7.4 trillion total value of U.S. equities.

Of things for investors to worry about, Quill ranks fund-industry cash flows near the bottom of the list.

“Fund cash flows are not a leading indicator of what the market’s going to do,” he says.