One of my favorite parts of the stock market game is the fact that employing a logical approach is oftentimes a complete waste of time. For example, it is a well known fact that the stock market has historically produced its best gains when the S&P’s 12-month trailing earnings are awful – and vice versa.
While at first blush this may be more than a little counterintuitive, this concept at least makes some sense when you dig into the details. The idea here is that by the time 12-month earnings totals have troughed, the worst of a recession and/or bear market has likely already occurred. As such, investors have already discounted the bad news and have likely done all the selling they need to do. Thus, really bad 12-mo earnings tend to lead to stellar returns in the market.
Along the same lines, one of the best long-term buy signals available to investors is when the government announces that the economy has entered a recession. Again, the idea here is that since the official pronouncement tends to incorporate a heavy dose of hindsight, and since recession and bear markets don’t usually last very long, when you hear the official word that a recession has begun, you can buy ‘em with both hands .
But using contrary logic isn’t always a sure thing. One prime example is mutual fund flows. The bottom line here is that money flows in and out of mutual funds – when they are outside the norm – do tend influence the direction of the market. This one is simple and indeed logical. When there are big flows of cash into funds, fund managers must put the money to work (remember, the majority of mutual funds must stay nearly fully invested at all times). And conversely, when there is a higher than normal amount of money flowing out of funds, fund managers need to sell in order to meet redemptions.
However, strange as it may sound, this is not necessarily the case with ETF’s – especially when looking at the flows into and out of inverse ETF’s. Here’s the deal; it would be logical to expect the S&P 500 to fall when money is flowing into the inverse S&P ETF’s. This makes sense because the money going into the fund is betting on a decline in stock prices. Thus, if people are buying ETF’s that effectively short the market, a decline would logically ensue. And it would also be logical to assume that when money is flowing OUT of the inverse ETF’s, the market would rise. Logical, yes – but wrong!
The analysts at Ned Davis Research discovered that if you track that 5-day cumulative flow of funds in and out of inverse ETF’s, the market acts the EXACT OPPOSITE as one might expect. The bottom line here is that when the cumulative 5-day flow of funds to the inverse ETF’s is positive (again, investors are betting on a decline in stock prices by buying the inverse ETF’s), stocks go up and when the 5-day cumulative flow into inverse ETF’s is negative, yep, you guessed it; stocks tend to go down.
While there isn’t that much data to work from, NDR found that since 6/30/2006, the S&P 500 has gone up at a rate of +9.4% per year when people were net buyers of the inverse ETF’s (meaning that the 5-day cumulative dollar flows into inverse ETF’s were positive) and down -13.1% per year when investors were net sellers. Hmmm…
So, what is this completely counterintuitive indicator telling us now? Well after a strong rally over the past couple of weeks, it probably isn’t too surprising to learn that the current 5-day cumulative flow for the inverse ETF’s is negative. And of course, this has lead to losses in the stock market.
To be sure, we are not making a prediction here (our crystal ball is still in the shop!). And while we probably need another couple of years or so of data in order to draw sound conclusions, we do find this indicator intriguing.
S&P 500 - Last 5 Years
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