One of the most perplexing things about the recent stock market rally is that it has occurred against a backdrop of equity fund outflows and bond fund inflows. In fact, according to the Investment Company Institute (ICI), from the end of 3Q18 through the first week of July 2019, U.S. equity mutual funds and ETFs had seen nearly -$105bn in outflows, versus $130bn of inflows for fixed income. So how has the stock market been able to rally 30% since the December 2018 low?

It is important to remember that while individual investors rely on mutual funds and ETFs to allocate capital, there are many other players in the market. First, corporate treasury departments have been actively buying back shares, with $206bn worth of buybacks completed in the first quarter and another $257bn expected to have occurred in 2Q19. Furthermore, hedging activity by banks and other financial institutions is not insignificant, as trading desks that underwrite derivative strategies will often hedge their positions by purchasing the underlying securities. And finally, prime brokerage data suggests that although hedge funds have been buying equities, they are still broadly underweight.

Another key source of equity demand comes from investors that strive to maintain fixed allocations within the context of their portfolios – these can be balanced funds, sovereign wealth funds, pension funds, or other large institutional players. Many of these investors leverage separate accounts, rather than funds, so additions to their equity positions have not had an impact on the fund flow statistics. As equities have sold off and bonds have rallied, this group has been forced to purchase more and more equity in order to keep their portfolios in balance. As shown in the chart below, an investor who had 60% of their portfolio in stocks and 40% of their portfolio in bonds would have seen that equity allocation dip below 55% at the end of last year. Furthermore, despite the subsequent rally in equities, this portfolio would still have a below-target allocation to stocks, assuming no rebalancing.

Although retail investors seem skeptical about stocks at this juncture, there is still demand for equities from a variety of other types of investors. While the pace of equity gains will likely slow going forward, this demand could act as a tailwind for the broader stock market into the end of the year.

Despite the equity rally, some investors still need more stocks

Equity allocation of 60/40 portfolio, S&P 500 index level

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Source: Standard & Poor's, Bloomberg, Barclays, FactSet, J.P. Morgan Asset Management.