Mystery of the Missing Buyers, Part 2

The topic last time around was the apparent lack of participation in the stock market rally by ordinary investors, as indicated by data on mutual fund purchases, among other evidence. That would be a bullish contrarian sign if true, but as far as stocks have risen in the last year, someone had to be buying. So who was it?

Charles Biderman, chief executive of TrimTabs Investment Research, suspects that the Federal Reserve and other government agencies have been spending at least $60 billion a month to buy stock index futures, as discussed here. That would be a bearish development, in his view, because it would leave the market vulnerable should such a massive source of support be discontinued.

I expressed skepticism about his theory, which he accepts is not backed up by hard evidence. Even if he's right, it should provide little comfort to bears because it doesn't contradict the widespread observation that mainstream investors have stayed away from stocks.

But other evidence does. A massive source of net buying that TrimTabs does not seem to account for is the futures market.

At the stock market's lows, open interest in futures on the Standard & Poor's 500-stock index - the number of contracts outstanding - was about 700,000, worth about $120 billion. It has since fallen to fewer than 350,000 contracts.

The shrinking open interest suggests an unwinding of the massive short positions, or bets on a falling market, that were in place - incorrectly, as it turns out - around the lows last spring. This short-covering would amount to a significant increase in exposure to a rising market by significantly reducing exposure to a falling one.

A closer look at fund data also indicates that investors have not been all that reluctant to participate in the rally or take other risks. The research firm Morningstar Associates reported a net $25.7 billion outflow from mutual funds specializing in U.S. stocks last year, but funds concentrating on assets that investors seek out when they are in the mood to take a flier received strong inflows: emerging-market stocks and bonds; Asian and Latin American stocks; high-yield (junk) bonds; shares of foreign smaller companies; commodities.

Exchange-traded funds are more frequently traded than mutual funds, so they are more sensitive to changes in investor sentiment. ETF data from Morningstar hint at a growing affinity for risk-taking.

Investors have stepped up their purchases of ETFs in general in the last few months, with emerging stock markets and high-yield bonds attracting particular interest and bear-market funds finally experiencing outflows. Sonya Morris, a Morningstar analyst, notes that several single-country stock ETFs, including ones for Brazil and Taiwan, each had net inflows of more than $1 billion last year.

When the fund flow figures are dissected, an expanding appetite for risk comes into focus and the supposed lack of investor enthusiasm looks to be greatly exaggerated. At worst for bears, they send a neutral message.

Plenty of other sentiment indicators continue to herald a significant decline, as discussed here and here. If it began last week, fund flows may confirm it. Don't be surprised if investors who missed the nearly yearlong rally start buying now, just in time to catch the next downturn.