The Real Reason Why Stocks Continue to Rally in 2019

Stocks Rally

Mutual funds on the whole have been actually pulling out of the stock market, with net outflows totaling almost $40 billion year-to-date. Why are we still going up then?

One of the things that people pay attention to is how much money mutual funds contribute or take out of the stock market on a net basis. Mutual fund stock purchases do drive a lot of the upward pressure on stock prices from the sheer weight of the volume they produce, and also can bring down markets pretty significantly when their clients take money out of the system.

While all stock transactions have both willing buyers and sellers, when mutual funds or other large investors buy stock, this adds to the demand side and causes prices to rise generally. The opposite happens when they look to exit positions, which exerts downward pressure on prices.

Let’s say that that we want to buy a million shares, and we can buy 1000 at a certain price, the ask, which represents how many shares investors wish to part with at this price. We buy those, but we need to buy a lot more, but we’ve exhausted the supply at this price and we have to pay more to buy more. We buy the number of shares at the next level and move up.

People who offer these shares for sale see this buying pressure and if it looks to be sustained, they generally will raise their prices, causing us to pay even more for our order. The net effect is that our trading in itself will put the price up, and the upward momentum that we’ve created with the price will also influence it higher. People see the price go up, and this in itself stimulates more demand.

When mutual funds look to sell their inventory, the exact opposite happens, where stock prices are driven downward. These purchases and sales don’t occur in a vacuum though, and all of this is the case with everything else being equal, but there are other forces in the market that exert price pressure as well.

If we sell into a rally, we may just end up muting the rally rather than driving price down from our buying pressure, or if we buy when the price is falling, we can slow down the decline. In this case, slowing down the decline is a good thing for us, and if enough institutional buying takes place during a pullback, this can indeed have enough power to reverse trends.

Funds do switch stocks a fair bit, but equity funds are committed to equities, so the actions of the funds themselves are limited to being in one basket of stocks or another. Index funds just go with a pre-determined basket, so that is already determined for them, and active funds decide which stocks to have their money in at any given time, but in both cases the directive here is to be in stocks because they are stock funds.

Investors pump their money into the system or take them out and this is where we get the net inflow and outflow numbers from. Net inflows have a bullish effect upon the market, where net outflows have a bearish effect.

This Should Not Be Confusing at All

People look at these inflows and outflows to get a sense of market direction, and this is fairly well correlated with the way that the market moves. We could just look at price movement itself, which always tells us the whole story, but we still might want to know what direction the funds are moving in, to see what might happen if the other forces in the market change.

Right now, a comparatively small amount of money is flowing out of equity funds, but prices are continuing to rise. This has confused some people, and not just ordinary investors, who really don’t look at numbers like this anyway, but also those profession it is to understand such things.

“This has been a huge question for us, how is this possible?” asks Bank of America investment strategist Jared Woodward. The answer should be pretty obvious though, and it is that there are other forces at work here and these other forces are strong enough to push us ahead this much in spite of all the people that are taking money out of the stock market.

While this situation isn’t typical, we do see net inflows and outflows diverge from market results from time to time. Investors will generally go with the trend, putting more money in during bull markets and taking it out during bear markets, but not always. There are times when what we can call the public’s net actions are counter to the market, and while this phenomenon is interesting enough, we do need to realize that net inflow and outflow with equity funds and net inflow and outflow in the market as a whole are different things.

In other words, what we are seeing here is a net outflow with equity funds and a net inflow in the market. It is what is going on with the market as a whole that matters, regardless of whatever is happening with equity funds, which contribute to market inflows and outflows but it is the entirety of the movement of money in and out of the stock market that matters here and drives prices.

Mutual funds comprise a pretty big chunk of market activity, but there are other forces at work here, and we actually don’t need to look very hard to figure out what is really powering this current rally.

Woodward does recognize that corporate share buybacks have climbed to $227 billion in the first quarter of 2019, although he does not seem all that convinced that this is a sufficient explanation for seeing the market go up by almost 20% so far this year and all that money being taken off the table by the funds.

It’s the Overall Inflows and Outflows That Matter

This should be easy to understand once we realize that this $227 billion is an inflow, and even when we subtract the $40 million out, we still end up with a pretty nice net inflow of $187 billion taking these two numbers into consideration.

We also need to understand that, while $40 billion may seem like a lot of money to take out of the stock market, it’s just a drop in the bucket percentage-wise compared to how much stock U.S. mutual funds control, which is close to $20 trillion worth these days. We’re only talking a drawdown of just 0.2% here, which is not even a very meaningful number.

While everything does exert effects, and we could say that this outflow from the market from funds does create a little downward pressure on prices, the effect from this would not be in itself that meaningful even if this were the only factor involved. It clearly isn’t though, and is offset several times over just from the buybacks, which do indeed put share prices up and this is exactly why the companies spend all this money on them.

Many strategists try to make things more complicated than they actually are, especially with saying that this fund outflow should be putting us down, and in particular, that the net inflows from share buybacks wouldn’t be enough to explain things. People are even looking at things like options trading to seek out an explanation they like, and while such things can influence prices as a lot of things can, if we’re wondering about net inflows and outflows, and can just add in the inflows from the buybacks to make the world right again, we need to look no further.

There is one statistic that trumps everything though, and that is the way price is actually moving. We’re up a lot in 2019, and whatever the causes, this is what has happened. Whenever something like this seems to tell us this shouldn’t be happening, the only thing we learn here is that these things may not be as reliable as we thought.

This is not to say that there aren’t any takeaways here, and the biggest one is that individual investors have lost a bit of confidence in the market at present, perhaps by falling for all the bearish prognostications that have been out there lately. We’ll have to see how this all changes, and if we do actually get a net outflow, a real one, investors may be more willing to pile on if their outlook remains net bearish.

The usefulness of this information is therefore not to look to explain price, as price explains price completely, it’s to get an idea of how we may react going forward. We may take the temperature of fund investors this way, and see that they may be running a little fever here, but the market can indeed continue to move up with their temperature being up a little like this.

Should the overall outlook become more negative though, to the point where the outflows from equity funds and other market outflows exceed the inflows from share buybacks and from other sources, then we can expect this to put prices down. Until then, we need to make sure that we are looking at the right things and not focus on a single thing like fund outflows, which will indeed leave us pretty confused.