The S&P 500 recovered nicely last week and has been challenging its prior short-term highs in a range around $2800. Small cap indexes, such as the Russell 2000, have not fared as well, unfortunately. Normally, investors would like to see better performance among small companies because it indicates that traders are willing to take on more risk.

Just looking at price performance between large-cap (safe) and small-cap (risky) indexes does not always reveal the whole picture for traders. A more complete understanding of market sentiment can be found when we compare rising prices with how much money is being invested in those assets.

For example, if large caps are rising in price and investors are putting a lot of money into funds that track large-cap stocks, we can be more confident that the trend in large-cap stocks is strong. Similarly, if small-cap stocks are rising in value but small-cap funds are losing investors, we can assume that investors are concerned about those assets even though the price is rising and the trend is weak. We can do a similar analysis for other asset classes like bonds and commodities to form a complete view of the market’s money flow and investor sentiment.

Unfortunately, money flow into the market’s largest ETFs have recently mirrored the relative price performance between large caps and small caps, which indicates that investors are still cautious. Although the market is certainly not bearish yet, a similar bias in favor of safer investments is apparent in bond and commodity money flows as well.

A Preference for Safety

On the bright side, investors were much more interested in stock funds over the last week than bonds. However, the kinds of stock funds that have been performing the best are a little concerning. For example, the iShares Select Dividend ETF (DVY) was the third most popular ETF for the week ending March 15. Three more dividend-focused ETFs were also in the top 10 funds for the week, and the rest of the spots were taken up by S&P 500 funds or lookalikes.

The focus on safety over the last two weeks is a reversal from January and February when emerging markets ETFs dominated the fund flows. However, even during that period, Emerging Markets (EM) funds shared the spotlight with a variety of mostly investment-grade bond funds like the iShares 7-10 Year Treasury Bond ETF (IEF) and its 20-year counterpart (TLT). Seven of the 10 funds that attracted the most capital flow in January and February were bond funds despite relatively low price-performance.

Adding some insult to injury, while investors were pouring money into bond and EM funds, the SPDR’s S&P 500 ETF (SPY) experienced the biggest outflows. Although SPY is up 12.56% since the beginning of the year, it’s total funds under management is only up 6.9%. You can see this difference in the chart below. While these fund flows may sound contradictory on the surface, they reveal some interesting pressures on the underlying market.

  1. Investments in emerging markets are notoriously dominated by so-called “hot money” which means funds that are invested quickly to take advantage of short-term upside, then withdrawn just as quickly. So, although interest in EM is usually a good sign for bulls, it is inherently a short-term signal.
  2. Bond prices move inversely to interest rates. If rates are expected to fall, bonds and bond funds should appreciate. Therefore, if investors anticipate a decline in interest rates, they will move capital into bond funds and ETFs. Falling interest rates are also very correlated with lower economic growth rates, which means bond fund flows are revealing a bias for estimates of lower growth among investors.
  3. The expected impact of lower interest rates (growth) on bond funds is also true for dividend payers. If rates fall, the value of future dividends paid by income stocks should rise as well. Even though investor sentiment seemed to improve last week, the bias in favor of dividend paying ETFs confirms the same cautious outlook that was already apparent in fixed income ETFs.
Source: YCharts.

Commodities Moving the Wrong Direction

What is happening with stock fund flows is being mirrored in commodity funds. For example, one of the largest commodity-focused funds in the market, iShares GSCI Commodity ETF (GSG), is up 14.5% from its lows on December 24, but its total assets under management are up less than half that at 6.78%.

GSG’s fund flows are representative of what has been occurring across the commodity sector, which is a reversal from 2016-2017 when the ETF’s price rose 14.41% while fund flows increased 108.8%. The shift in 2019 indicates that investors are not as willing to invest behind the recent commodity rally because they aren’t convinced it will last.

This divergence between price performance and fund flows is even more dramatic when we look inside the individual groups of commodities like energy. The popular U.S. Oil Fund (USO) is up 26.29% on a year to date basis while fund flows have added a mere 2.98% over the same period, that makes it one of the worst performers on a fund flow basis in the group. You can see the difference between USO’s price performance and its total assets under management in the following chart.

What does the dried-up flow of funds into commodities tell us about investor sentiment?

  1. Commodities and emerging markets tend to move the same direction. If investors are only interested in short-term momentum in EM and aren’t expecting any positive fundamental shifts, they will avoid exposure to commodities even if the price is rising.
  2. Some developed markets could be at risk because of the weak fund flows into commodities. For example, the U.K.’s economy is overweight to commodity producers like British Petroleum (BP). BP supports directly or indirectly 1 in every 250 jobs in the U.K., which means a disruption in the oil market could be a catalyst for a negative economic surprise in the U.K. that is already being hammered by Brexit. 
Source: YCharts.

The Bottom Line

Fund flows certainly aren’t bearish yet, but the preference for safety and lack of interest in commodities indicates that investors aren’t confident about economic growth in 2019. Keep in mind that the investors behind the flow of funds aren’t perfect at predicting the future so any estimates should be provisional on new data. However, while the future remains cloudy, it makes sense for investors to remain diversified and conservative until fund flows start to move in a more definitively bullish direction. Greater inflows into small-cap, and non-income stock funds would go a long way to convincing me that growth estimates have reached a bottom and are starting to improve.