What mutual fund flows say about rising stock prices

Given all the negative economic news, many are wondering why stock prices are rising (the S&P 500 has jumped 10% from its August 15th low and has gained 6.3% from its end of July level).

Valuation factors certainly don't seem to justify this rise. After all, many forecasters are slashing U.S. growth forecasts significantly. Goldman Sachs reduced expected 2008 growth from 2.6% to 1.8%. And long term interest rates haven't changed much, although certain credit spreads have eased.

Most likely, stocks are benefiting from asset allocation changes, as noted here. Lower short-term interest rates make money market investments less attractive, while corporate bonds don't look very attractive given the recent turmoil. That leaves stocks as pretty much as the less ugly alternative.

Capital flow data from mutual funds (a less than perfect indicator, but the only current one we've got) backs this up, to a degree. In August, according to AMG Data, equity funds received a net inflow of 5.7 billion, while taxable bond flows saw an outflow of 0.8 billion. However, money market funds saw a staggering inflow of 156 billion.

In the second quarter, taxable bond inflows were twice as big that equity inflows.

More recent weekly data has been seen similar trends, although it seems that taxable funds are attracting some interest again.

Rating agencies: Déjà vu all over again

As was to be expected, the bond rating agencies are catching a lot of (deserved) flack over their (abysmal) performance in the subprime mortgage mess (see here). But then again, what else is new? Ratings have been lagging indicators for as long as I can remember. After every crisis --Mexican, Asian, Russian, Enron, etc.--there's been an outcry over why S&P, Moody's and Fitch where asleep at the wheel.

The answer is obvious: incentives. Issuers pay for ratings. Thus, the agencies have a vested interest in being as nice to them as possible to keep the fees rolling in (this Portafolio piece describes this point well). As Barry Ritholtz notes, it's fundamentally the same problem that brought disrepute to sell-side research after the dot com bubble burst (if you think things have changed, just read this).

What can be done? Politicians may huff and puff, but research can't be regulated, other than by inserting ever longer and totally useless disclaimers after each report.

The only possible solution is for large institutional investors to bankroll serious buy-side ratings research. Of course, putting this into practice wouldn't be easy, as there are obvious collective action/free rider problems, but they're much smaller than those faced by individual investors (hence the private equity racket). If they can't do this, the same old rotten ratings system will continue after the storm passes and politicians get back to the latest Middle East crisis.

So why haven't they stepped up? Fear of changing a century-old system? Fear of retaliation by issuers and the investment banks (both profit from the current arrangement? Your guess is as good as mine.