By Mark Hulbert
Think bond funds are safer than stocks right now? Stocks actually look like the smarter bet.
U.S. bond ETFs have received net inflows for 59 consecutive weeks – a contrarian indicator.
The current market environment points to losses for long-term Treasurys and investment-grade bonds.
So much money has been flowing into bond mutual funds and exchange-traded funds, it’s making these usually safe havens increasingly risky.
U.S. bond ETFs, for example, have received net inflows for 59 consecutive weeks, and in 66 of the past 67 weeks, according to EPFR, a data provider that is part of ISI Markets. Total net inflows to both ETFs and bond mutual funds over the past 12 months equal about 10% of these funds’ assets. To put that in context, the comparable total for U.S. equity funds and ETFs is less than 1% of assets.
The reason this huge influx is worrisome is that money flows are a contrarian indicator. Big inflows represent excessive optimism, just as big outflows represent excessive pessimism – and the market tends to do the opposite of extreme sentiment. And right now we’re a lot closer to the excessive optimism end of the bond-market spectrum.
The only other time in recent years in which inflows to bond funds were any greater than they have been recently, as a percentage of total net assets, was in 2021. Bonds in 2022 suffered their worst bear market since 1793, according to the database maintained by Edward McQuarrie, an emeritus professor at Santa Clara University.
That’s just one data point, but it’s consistent with the historical record. Consider the correlation of monthly values over the past decade of two data series: the subsequent 12 months’ total return of the U.S. investment-grade bond market (as represented by the Bloomberg U.S. Aggregate Bond Index), and net bond-fund inflows over the trailing 12 months (courtesy of data provided by EPFR). This correlation is significantly inverse.
Though this correlation doesn’t amount to a guarantee, you should know that it is stronger statistically than many of the other indicators that get far more attention on Wall Street. Consider a statistic known as the r-squared, which measures the extent to which one data series explains or predicts another.
In the case of trailing bond-fund flows and subsequent bond-fund returns, the r-squared is 14.8%, which is statistically quite significant. The comparable r-squared is just 1.9% for the trailing price-to-earnings ratio’s ability to forecast subsequent stock-market returns.
Given the latest data, the historical correlation of trailing flows and subsequent returns implies that the average investment-grade bond will lose 0.8% over the next 12 months on a total return basis, and that long-term U.S. Treasurys will lose 3.8%.
Stocks projected to outperform bonds
One reason bond funds have received such huge inflows is that investors who are nervous about the stock market’s valuation have invested into bond funds much of what they otherwise would have allocated to equity funds. That has the ironic consequence of increasing the forecasted return of the stock market relative to the bond market.
I reached this same conclusion three months ago, based on the fund flow data at that time. Since then (through July 27), the U.S. stock market has gained 4.0%, versus a 0.9% loss for the investment-grade bond market and a 2.1% loss for long-term Treasurys. The latest data strengthen the case.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.
-Mark Hulbert
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