Investors Turning Positive On Funds, Getting Burned Again

01/23/09 8:45 AM EST

Good Friday morning...we begin the day with heavy selling pressure in the pre-market futures.  We were already weak to begin with, then GE's questionable earnings report helped nudge the futures to a new pre-market low as I type.  The major index futures are all sitting at or very near critical support levels from the past week.

One of the market truisms that has stood the test of time is that the main stream financial media is behind the trend on most major issues.  They are bandwagon-jumpers, looking to capitalize on the next hot trend.  You can't blame them for that, as they are simply making the prudent business decision of trying to sell their product to the largest audience.

The problem is that by the time those trends reach the critical mass necessary for the publications to focus their energy, often the trend is about to turn, or at least pause.  Nowhere is this more evident than their celebration of star fund managers, or funds themselves.  Just look at the covers over the past year and check the performance of the "best" managers afterward.  To everything there is a season.

Academic studies have shown that partially due to this phenomenon, individual investors chase the best-performing funds - no surprise there.  And in general, when funds do well, they gather more assets; when they suck, they lose them.

There are a few services out there that track such fund flows, one of them being AMG Data^TM.  What I think is notable is that as of the latest release, the four-week average of equity mutual fund flows has turned positive.

That could be a good sign that the excessive pessimism and tremendous outflows from October and November are finally turning, and the record amounts stashed in ultra-safe money market funds are finding their way back to equities.

At some point, that has to happen, and it will almost certainly coincide with the next bull market.  There is enough money in those money markets to gobble up more than 40% of the entire S&P 500 index.

But here's the catch...if we're *not* about to enter that next bull phase, then what we're seeing now is a decent contrary indicator that suggests investors have gotten ahead of themselves.  During the last bull market, anytime the fund flows turned negative, it was a good sign to go long.  Since then, when fund flows turn positive it has been a good sign to do the precise opposite.

Bottom line - Intermediate-term

Given what we discussed in December (here and here and here), there seems to be a decent chance that the November low marked some kind of major bottom, and the fact that we're flipping to positive fund flows could be taken as a positive sign.

Early last week, I would have given it about a 60% chance of being so, but after what we've seen since then (the spike in Dumb Money Confidence and Intermediate-term Indicator Score, then the failed breakout at 920 on the S&P, the subsequent losses of support at 880 and 850, and the failure to bounce off short-term oversold conditions), I would say it's closer to 30%.  That means I've been a lot more leery of trying to buy into declines than I would have been earlier

For a re-entry point, I've been looking for either a big reduction in Dumb Money Confidence (it's down to 42% but still not "extreme") or a much improved technical picture.

We've seen the first signs of the latter, but it looks like today could be a critical point.  If we can't hold 800 on the S&P 500 index, then the November lows are the next logical target.  If we happen to turn around today and regain the resistance we've discussed (roughly 850), then the picture will brighten substantially.

For a short position, I'd be looking for a choppy move back towards 920 that again generated an extreme level of Dumb Money Confidence.

Bottom line - Short-term

Yesterday I was looking for a pullback of a day or two given what we discussed in the comment, before a thrust back above 850.  The idea of that thrust was more gut feel than anything, though there was some support for that based on the action of the prior couple of days.

The extreme chop of the past couple of sessions has left our short-term indicators all twisted up, and as a result the Short-term Indicator Score has been exactly neutral at 50% for the past two days.

I can find only one other instance of the S&P 500 cash index dropping at least 3% to a one-month low (like it did on Tuesday), then putting in two consecutive "inside days" with a lower high and higher low than the previous day.  That was October 1st of last year, which coincidentally enough also led to a big gap down the following morning like we're seeing today.  It went downhill from there.

There were 7 times that the S&P 500 futures rose 3% like it did on Wednesday, then gapped open -1% the next two mornings.  Buying that second gap down and holding until the next day's close resulted in only 1 winning trade out of the 7, with an average return of -2.0%.  That's pretty much the opposite of what I thought the results would be - that's why we test instead of assume.

A move under the lows of the past few days (800 - 810) will be an obvious negative and bring the November lows into sharp focus.  Given the large gap down this morning, if we set a lower intraday low after the first hour of trading, particularly if it's under 800ish, then I suspect we'll be visiting those lows by early next week.

That 800 area has been strong support lately, though, so if we can buck some of these negatives and put in an upside reversal, then we still have a chance of salvaging a positive intermediate-term outlook.  Given what we went over above, I need some confirmation before being willing to go long, and will probably not be looking to the long side unless we can overtake and hold above 840-860 on the S&P.

All the best,