Too Much Cheering Over Stocks

Head for the hills! Or maybe there's gold in them thar' hills.

Investors looking at the very same news about the behavior of mutual-fund investors have drawn starkly different conclusions about the attractiveness of stocks right now. Both groups are operating under some fishy assumptions.

First, the data: TrimTabs Investment Research estimated that more money was invested in U.S. equity mutual and exchange-traded funds last month than the record set in February 2000. Weekly data due Wednesday from the Investment Company Institute likely will show more of the same after $38 billion went into long-term equity mutual funds in the past four weeks.

The date of the previous TrimTabs record surely struck a chord with investors wary of history repeating itself. It was the final full month of the greatest bull market of all time. Does that suggest disaster is around the corner?

Not necessarily. While retail investors notoriously zig when they should zag, the recent trend comes after they withdrew a monthly average of $12.7 billion from equity mutual funds in 2012 and $10.7 billion in 2011, according to ICI. By contrast, investors poured a monthly average of $15.7 billion into them in 1999. Even though big inflows have signaled irrational exuberance before, the trend can continue for a while.

At the other extreme are those pointing to a "great rotation" as money invested in bonds or simply "sitting on the sidelines" pours into stocks. Their optimism, though, is based on a misunderstanding.

Cash invested in stocks or bonds is merely changing hands as savers tired of low rates on money markets and bonds finally are increasing their exposure to stocks. Even after the Standard & Poor's 500-stock index rallied 127% from its March 2009 low, they suddenly are willing to pay up and possibly accept a lower return.

They should brace themselves. The Shiller P/E�a price-to-earnings ratio based on the average of real or inflation-adjusted earnings over the last 10 years�is above 22. Real annual returns have averaged under 1% in the following decade at similar junctures, says fund manager Clifford Asness. They often were negative.

The stock market's cheerleaders may be running onto the field, but the sidelines are safer and only slightly less attractive these days.