Municipal Investing From a Contrarian Perspective

In a recent blog written by Barry Ritholtz, he presents a chart that illustrates the buying and selling behavior of stock buyers in relation to global stock performance.  Illustrating a phenomenon often referred to as ‘dumb money’, the chart shows the tendency of investors to buy when prices are rising and redeem into a market when prices are down.  Essentially, there seems to be a natural allure to ‘up’ markets, enticing buyers to act aggressively and often clouding their better judgment.  At the same time, bear markets can be depressing, convincing investors to avoid bargains or sell investments at a loss.   As you can see from the chart below, net flows into and out of equity funds have a direct correlation to stock prices.  Contrary to simple logic, the inflows into equities are at their greatest when prices are high and outflows are greatest when prices are low.

We decided to take a look at municipal bond outflows versus yield levels to determine whether investor behaviors in the municipal bond space mirrored those of equities.  The chart below demonstrates the correlation between municipal bond flows versus long tax-exempt yields.  Much like the case with their equity counterparts, the ‘dumb money’ phenomenon has been in full effect, with buyers loading up on tax-frees in lower rate environments (prices higher) and selling when yields trend upward (prices lower).

This begs the question: Why do investors buy when prices are high and sell when they are low?  While this may seem counterintuitive, the fact remains that the herd mentality is hard to resist.  Most investors come up with their investing strategies by listening to the consensus opinions of friends, family, colleagues, and talking heads.  Consequently, ‘following in the herd’ can have significant effects on overall market price levels.   American households own $1.1 trillion of municipal debt, or about 37% of the market, and represent the largest holders, according to Federal Reserve data.  When fund managers are faced with mass redemptions from panicked sellers, they are forced to sell existing positions to raise cash – often in the most unfavorable market conditions.

 Conclusion:  The present is an excellent time to put money to work in the municipal bond market.  From the perspective of a municipal bond investor, the time to buy is during those periods when the majority of the market is selling.  As history has demonstrated repeatedly, once market participants overcome irrational concerns brought on by ‘doom and gloom’ propaganda, dumb money will filter back into the municipal marketplace, causing opportunities to be more fleeting, resulting in higher prices and lower yields.

 MainLine West continues to view 2011 as a year of opportunity.  Please refer to the 2011 outlook post (link below), for our perspective on the current state of the market and our commentary on how municipal credit concerns have been overblown.  We will remain active participants in a municipal marketplace that continues to provide numerous opportunities to capture value and can help you devise a strategy to navigate an uncertain marketplace and best position your portfolio in the current environment.

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Posted in Economic theories, General, Munis in the news

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