Usually, when people think about money flowing into the stock market, they associate it with positive returns. However, as this week’s featured indicator shows, that isn’t always the case for exchange-traded products (ETFs). Specifically, asset flows into inverse ETFs can serve as a contrary indicator for the market.
But what is an inverse ETF, you might ask? Well, let’s say you think a stock market index like the S&P 500 is going to go down in value. You could use something called an inverse ETF to try to make money off that. An inverse ETF is a special kind of investment that lets you bet against the S&P 500. It uses financial derivatives and other complex strategies to “short” the market so that if the market goes down, the value of the ETF goes up.
But here’s the thing: when large amounts of money are flowing into these funds, it tends to be a sign that market participants are becoming bearish all at the same time. Typically, these are less sophisticated individual investors using these products, not larger institutional investors. And historically, we’ve found that the “crowd” tends to be wrong at the extremes. In other words, large asset flows into inverse ETFs are a positive signal for market returns, whereas large outflows are a negative signal.
The chart above shows a measure of the 5-day cumulative dollar flows into domestic inverse equity ETFs as the orange bars on the bottom half of the chart. When this measure is below zero, it has led to an average S&P 500 return of less than 2% per year. But, when this flow measure exceeds zero, the S&P 500 returns a much stronger 10.4% per year, on average.
Just glancing at the chart, you can visually see that the S&P 500 (green line, top clip) tends to rally when there are large spikes in the 5-day cumulative flows into inverse ETFs measure. But when the measure dips well below zero, the S&P 500 has typically fallen.
So, here’s the bottom line: when a lot of people are buying into inverse domestic ETFs, it might be a sign that they think the S&P 500 is going to go down. And when a lot of people are selling their inverse domestic ETFs, it might be a sign that they think the S&P 500 is going to go up. But the historical record of the market shows that the opposite tends to happen, making this indicator a particularly handy tool to have in your back pocket if you’re looking to manage your stock market exposure in a smart, objective way.
This is intended for informational purposes only and should not be used as the primary basis for an investment decision. Consult an advisor for your personal situation.
Indices mentioned are unmanaged, do not incur fees, and cannot be invested into directly.
Past performance does not guarantee future results.