On May 16th 2006 we posted an article on MAXfunds.com website entitled, “Dow Nears Record High - Dumb Money Excited, Smart Money… Not So Much”. 

The crux of this article was our observation that smarter investors did not seem very enthused about investing in stocks as the Dow neared an all-time record. Meanwhile, investors who have a history of bad timing – namely mutual fund investors – were quite excited about adding new money to stock funds. We use fund investor enthusiasm for the broad market and specific fund categories as a contrarian indicator of what to do in our own Powerfund Portfolios.

The Dow hit 11,709 on May 10th, and has been sliding ever since. While the roughly 7% decline in the Dow is modest, hotter stock indexes are down as much as 30% – notably emerging markets. The broad emerging markets index is down about 20% from the early May highs.

As we noted in the article, “...fund investors are not plowing into funds that buy large-cap U.S. stocks so much as funds that invest in far hotter areas: natural resources, commodities, newfangled ETFs that focus on ever smaller areas, and anything international. In other words, the opposite of where they sent their money in early 2000.” By and large such funds have been hit the hardest in the recent market pullback.

So is now a good time to jump in? Valuations on the U.S. stock market are not too bad. Unless a recession kicks off in the next year and interest rates don’t rocket upward (which could tank an overheated real estate market and the resulting wealth effect we’ve enjoyed in recent years), stocks should work out over the next few years from these levels. But that doesn’t make it a particularly great buying opportunity either.

Let’s check in with what fund investors are doing – and as usual, consider doing something else.

Fund investors put about $11 billion into stock funds in May. Most of this inflow happened in early May before the market started to fall. In the first three weeks of June there was no buying into U.S. stock funds. Funds that invest in foreign stocks actually saw an outflow. What little inflows did occur went mostly into exchange-traded funds (ETFs) – the hottest of the hot money and the kind of cash that spills back out on a dime (or rather on a drop). With the recent weakness in stocks it’s likely there will be a small outflow of cash from stock funds in June.

In general, it’s a good time to invest when there is an outflow of money from stock funds. During most months there are inflows into stock funds, if for no other reason than the automatic investing plans of millions of workers’ 401(k)s. In fact, in a month of no new money to stock funds, there was probably $10 billion or more of investors actually selling from their fund portfolio, neutralized by billions of automatic investors on 401(k) cruise control. Someday when baby boomers retire this natural inflow may slow, or even reverse.

As our article noted, this year has seen a big move by fund investors into stock funds. By the end of May, fund investors had put roughly $120 billion into stock funds – again, most of it into foreign funds. Investors only put in $150 billion in 2005 so this year was running at a much faster clip. 

The biggest place for new money in recent weeks has been money market funds, which could see $50 billion in new cash in June before all is said and done. Generally, when investors favor cash, you want to favor stocks, and when they favor stocks, you want to favor cash.

Cash (money market funds) offers an additional draw these days. In addition to the safety factor (which becomes appealing when your fund is down 20% in a few weeks), a good money market fund now yields just under 5%. 

Valuations across the board are certainly lower than they were a few weeks ago. We’ll likely make some minor changes to our allocations in the coming months. Notably, as interest rates go up we’re likely going to shift to longer maturity bond funds (we’ve largely dodged the downdraft in longer-term bond prices by staying in shorter-term bonds in our model portfolios). We may consider increasing our recently reduced international and emerging market stakes in our higher-risk portfolios, but not without another 10% - 20% hit – the sort of move that will get fund investors to flee at a faster clip. 

Bottom line: Fund investors need to start bailing out of funds in a bigger way before we make any major shifts in stock exposure. This is not a bad time to have some U.S. stock exposure (as we do in all of our portfolios), but we’re still wary of all things international, which means small allocations – as you can tell by our downgrades over the last year in many fund category ratings.