Beginning in late 2012, mutual fund and ETF flows indicate that investors have dramatically increased equity purchases. This signals a reversal of the trend favoring safe bonds over equities that has been firmly in place since the 2009 market crash. Despite the 70% rise in the S&P since the March 2009 low, many investors have remained extremely cautious. Preoccupied with macro risks, investors have generally remained below benchmark equity allocation and have favored defensive sectors. The trio of primary concerns—euro breakup, the U.S. fiscal cliff and a China crash—have all greatly receded, causing a mass re-evaluation of risk in recent months.
As always, when the market rises and investors switch rapidly to optimism, the odds of a correction rise. The risk of a short- term pullback certainly exists and will continue to rise if the current optimism accelerates. However, we see the recovery of animal spirits as a longer term phenomenon and it is important to view the risk of short term corrections as necessary and healthy in the context of a long term bull market which we think is underway .
The bearish sentiment that dominated markets since the 2009 crash will take time to unwind. Pension funds are severely underinvested in equities at the moment, and mutual fund and ETF flows over the past year signal a similar trend in the retail sector (Chart 1). Over $300bn has flowed out of equity mutual funds in the past five quarters, while $1.3tn has flowed into corporate and foreign bond funds. The bottom line is that there is a great deal of cash still on the sidelines, raising the likelihood of an extension of this now four year old bull market. The question is where to invest now that the defensive sentiment is receding and when is a good time to raise allocations.