Don’t Be a Hater

November 17, 2010

Fund investors hate stocks – specifically, U.S. stocks. The great bull stock market may have ended back in 2000, but the fascination with American stock investing finally turned in 2007 – the year flows to domestic stock funds turned negative (and have largely remained negative ever since.) 

The mutual fund flow data we study shows $30 billion potentially exiting U.S. stock funds in 2010 – in addition to outflows in 2007, 2008, and 2009. What makes this 2010 flow information surprising, is that it happened in a year in which stocks have not dropped significantly – unlike previous years. 

Although we experienced a U.S. double-dip recession scare with a Euro-area panic chaser a few months ago, the stock market has risen significantly from its late June 2010 lows – going up approximately 20% before weakening again. For the year to November 15th, the S&P 500 is up around 9%, in contrast to the MSCI EAFE (the most-used foreign stock index,) which is up about 5.5%.

Normally, money comes out of stock funds during, and especially after, big drops. Investors yanked over $150 billion out of U.S. stock funds in 2008, and another $40 billion in 2009 (most of it right before the rebound, of course). But stocks have been good since March 2009. The S&P 500 is up about 75% from its crash lows. 

This year’s exodus from U.S. stocks began in May, with nearly $20 billion coming out of U.S. stock funds. May was also the only month with measurable foreign stock withdrawals. Investors have been pulling money out of U.S. stock funds at a rate of $10 billion per month ever since. Meanwhile, stocks have generally gone up. Flows into foreign stock funds resumed following only one negative month in May. In late October, we saw the withdrawals from U.S. stock funds trickle to just a few hundred million per week, and inflows to foreign stock funds increase to a few billion a week as investors' overall confidence in stocks returned somewhat (a strong rally can do that).

All this money flow data fits nicely into the narrative that America is in decline, and the only safety (besides shiny, magic metals…) is to park your money into stocks and bonds from other countries in order to protect your portfolio from the collapsing dollar and pending inflation. You'd almost think other countries were faring much better than we are, and facing much brighter prospects with solid low inflation growth (they're not). 

This narrative replaces one from a few years ago, when investors flocked to foreign funds not so much because America was Rome 2.0 about to fall, but because foreign stock funds simply beat U.S. stock funds for most of the 2000s, and investors like to chase performance. You can no longer make the "foreign stocks are beating U.S. stocks" argument, at least not with major foreign economies. Emerging markets, which landed much harder than the U.S. in the last crash, are still strong, performance-wise, and gathering much of the new money into foreign stock funds.

Money flows into foreign stock funds began beating funds that invest in U.S. stocks in 2005. The last time foreign stock funds were this popular was in 1990 – the peak of the Japanese stock bubble, right before the multi-decade slide of the Japanese market and economy. 

As is often the case, the inflows boosted performance, and reassured investors they were making the smart move, sort of like buying a tech fund in 1999. 2006 saw about $150 billion go into foreign stock funds – more than 10 times the amount that went into U.S. stock funds that year. In 2007, approximately $140 billion went into foreign stock funds, while almost $50 billion came out of U.S. stock funds.

This was also right about the time foreign stock investing stopped beating domestic stocks. Foreign stocks fell harder than U.S. stocks in the 2008 crash, and have generally underperformed since then. Investors who've moved to foreign stocks since 2006 have underperformed U.S. stocks, by and large.

The great move up in foreign stocks, aided largely by a falling dollar, but also by a valuation gap, began in early 2003, the year investors put 5 times as much money in U.S. stock funds as foreign stock funds, and ended in 2007. Needless to say, fund investors as a group did not make much money in foreign stock funds in the 2000s. Their timing was off. 

As long-term followers of our model portfolios know, we largely got out of foreign funds by mid-2007, a process we began in the mid-decade as investors piled into those same funds. You can follow this era in our thinking through our online commentary history.

This new narrative of American Destitutism (as opposed to Exceptionalism) explains why many fund investors have remained enthusiastic about foreign stock funds, adding about $30 billion in 2009, and $40 billion so far in 2010. While this is peanuts compared to the $180 billion or so going into bond funds this year, when combined with previous years, it's enough to give foreign stock funds a greater share of the retirement savings pie.

The Dodge & Cox International fund (DODIX) passed Dodge & Cox Stock (DODFX) in assets. Both have around $40 billion, but Dodge & Cox Stock was launched in the 1960s, and Dodge & Cox International Stock didn't appear until mid-2001 (we recommended it back then). DODIX also had $66 billion in 2006 when DODFX had around half as much. Both are now down from peak asset levels.

There's only one U.S. stock ETF in the top five ETFs as ranked by assets. Three of the top five ETFs by assets invest abroad, and one invests in gold.

Bottom line – U.S. stocks should continue to beat foreign stocks as long as investors favor foreign stocks. That doesn't mean you can’t lose 25% in a U.S. stock fund, but if you do, someone else will probably lose 35% in a foreign stock fund over the same period.

The primary areas of overinvestment remain emerging markets. Some foreign markets are more out of favor, notably perennial looser Japan and larger cap European stocks. 

We’re going to continue to focus mostly on U.S. stock funds. This much money movement can’t be right. Although we recently made good money in some larger-cap foreign stock funds that briefly lost investors’ confidence (as we did adding to some foreign holdings coming off the 2009 bottom in stocks last year when foreign funds fell harder than U.S. funds), we don’t expect to return to our old higher allocations in foreign stocks – notably in emerging market stocks - until we see fund investors favoring U.S. stocks over foreign stocks again. Don’t hold your breath.