Mutual Fund Investors are Bearish: What You Should Do Now

Mutual fund investors are nervous. Stock funds saw nearly $17 billion in net cash outflow in the second quarter alone, and flows have been negative in every week since then. Since 2008 began, net cash outflow from equity funds has totaled $234 billion. And with more storm clouds on the economic horizon, where should fund investors go from here?

There's no denying that fund investors have good reason to ask just that question. Fresh off of a "lost decade" in which the S&P 500's average annual return was -1 percent, the market is off more than 4 percent year-to-date, including a 13 percent decline from its April peak.

That performance, combined with the choppy economic recovery, has darkened the mood of many investors. Last week the Wall Street Journal profiled the creator of the "Hindenburg Omen," a formula that takes a number of technical indicators into account to predict a stock market crash. Despite its modest 25 percent success rate since 1995 (predicting, in other words, four of the past one market crashes), the indicator -- which has been triggered three times since August 12 -- has, as the Journal reports, "been the buzz of talk shows, blogs, and news articles."

Societe Generale strategist Albert Edwards recently estimated the fair value of the S&P 500 at 450 -- or approximately 60 percent below its current level.

And in this month's Atlantic magazine, Megan McArdle contributed to the bearish gloom with an article entitled "The Great Stock Myth." In it, McArdle speculates that we've entered an era of much lower stock market returns, and considers the impact that will have on all of us.

We seem to be in a competition to see who can be the most bearish. For my money, McArdle wins a tight race. Her article reminded me of BusinessWeek's famous cover story from August 1979 on "The Death of Equities." As she points out, a great deal of damage could be done if the stock market provides a long-term annual return of two or three percent going forward. But try as I might, I couldn't find any logic in her article to support the notion that that is a realistic expectation. The closest I could find was a reference to a projection made by Smithers & Company, who estimate a return on U.S. stocks of 1.8 percent for the coming decade.

But that projection is driven by Smithers & Company's prediction of a decline in the market's price/earnings ratio. But even if that prediction comes to fruition, the only way for the market's returns to remain that low in perpetuity is for valuations to continue to decline towards zero, or for corporate America's dividends to dry up and earnings to undergo an unprecedented multi-generational period of stagnation.

Could that happen? Well, sure, anything can. But I'd want pretty good odds if I was going to make that bet.

It's easy to understand the increased pessimism and the hair-trigger approach to the stock market. But sometimes investors' vision can be too clouded by the recent past, a fact that makes investors as a group horrible market timers.

As my MoneyWatch colleague Allan Roth pointed out last week, mutual fund flows are actually a contrary indicator -- flow into stock funds spikes when the market reaches its peak, and bottoms out when markets are at their lows. Investors, in other words, tend to buy high and sell low.

That's a horrible way to build wealth. In fact, investment research firm TrimTabs recently published a study in which they found that doing precisely the opposite of what exchange-traded fund investors are doing is rewarding.

TrimTabs reported that shorting the S&P 500 when ETF flows are above average and going long the S&P 500 when flows are below average significantly outperformed the S&P 500 over the past decade.

Does this mean that investors should rush out and undertake such a market timing approach? Of course not. Nor does it mean that they should adopt a more aggressive allocation than they would normally hold. But it does reinforce the notion that whatever your neighbor, your brother-in-law, and every fiber of your being is telling you to do with regards to your investments is likely to be wrong.

Of course, history could prove that all of these bears are correct, and we could be in for another 50 percent decline -- or worse -- in the near future. It's impossible to predict what the stock market is going to do over the short-term, even in the most benign economic conditions.

But if the past few years have taught investors nothing else, it should have given them a realistic basis to determine their risk tolerance. And in the wake of the credit crisis, whatever stock allocation they've determined is appropriate to help them reach their long-term goals is one they're likely best-served to hold in the weeks and months ahead, no matter how bearish the next article they read is.

Investors who are able to do so will likely look back on mid-2010 many years from now and be grateful that they didn't succumb to the mood of the day.