It is true that "disbelief" is an important factor in driving equity prices higher. That is a large reason why powerful Year 3 Presidential rallies have followed recessions, bear markets and/or corrections larger than 20%; these events have had the effect of moving investors out of equities and into the relative safety of fixed income and cash (post).
The question now is whether the recent 10% correction in equities created enough disbelief among investors that they moved out of equities. If they did, a strong and sustainable rally lies ahead.
Lipper tracks fund flows into and out of both mutual funds and ETFs. The last 10% correction in SPX in mid-2012 caused a $20.6b equity outflow from the April top to the June low (left side of the chart below). Fund flows were negative for 8 of those 9 weeks. No doubt, this was significant in setting up the long rally that followed (chart from SentimenTrader).
In comparison, the recent 10% correction caused just a $1.4b outflow (far right side of the chart above). This correction was so swift, and the bounce back equally so, that investors did not have a chance to react. From the September top to the October low, fund flows were negative for just 2 weeks. Remarkably, inflows in the past week were $8.8b, the largest since August 20.
Fund outflows during the recent correction were also less than during either of the smaller drawdowns in SPX in January and April this year (middle highlights in the chart above). This is intuitively unsurprising: when investors see that drops in equity prices are brief, their rational decision is to remain invested.
Last week's strong inflows suggest that investors embraced the recent correction as a buying opportunity. That is quite different from mid-2012. Looking at the chart above (left side), outflows continued to skew negative even after the low in price. That is the very definition of equities climbing a wall of worry.
Fund flows, of course, are hard money measurements of investor sentiment. You can get a similar view by looking at surveys. This week, the Investors Intelligence survey shows that there are already 3.6 times more bulls than bears. That is a bullish extreme. A month after the mid-2012 low, that ratio was less than 1.5 times, a veritable wall of worry.
Rydex fund flows tell a similar tale. Assets in Rydex bullish equity funds reached a new 7 year high this week (circles in chart below). That is a quite different set up than during the last mid-term election in 2010, when bullish assets were roughly half as large (rectangle). Investors were demonstrably underweight equities. That's not the case today.
It takes bulls to make a bull market. It's always possible that the inflow of money into equities will cause even more investors to flock to stocks. In the past, however, SPX has struggled under similar circumstances.
The bottomline, based on the hard data, is that investor "disbelief" in equities is close to nonexistent.
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