Why Budget Woes and Cyprus Didn't Faze the Market

Dumb money or smart, the market is ignoring short-term bad news as fund investors buy into recovery.

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Is it shocking that this stock market has lost its fear of bank runs in Cyprus and budget battles in Washington?

Perhaps not, say some strategists. While "this time is different" may still be a recipe for disaster, the current market is undoubtedly different than the one seen in the years just after the 2008 crash. Unlike the past five years, 2013 started with a powerful flow of mutual-fund money into stocks. That marks a change from the trader-dominated market that tended to react swiftly to such news.

To jaded Wall Street analysts, that means one thing: The dumb money is flowing in and the smart money should be heading for the exits. There are two things wrong with that view.

One, it's a clichéd truth that the average investor always gets it wrong. Sometimes, yes, but a Federal Reserve study showed that the 1980-2000 bull market began with a tenfold expansion of stock-fund inflows that totaled $1 trillion in the first decade alone. It lasted for 20 years and the market rose from 777 to 11,500 for a gain of 1,150 percent. Not wrong at all.

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Second, "dumb money" comes in all forms. Each era is different on Wall Street, and the old saws of the past just don't cut it like they did before. The "smart money" of savvy traders is now tied up in algorithmic speed trading based entirely on price discrepancy, not economics. And a global crisis caused by a Cypriot economy that is 0.2 percent of Europe's economy just does not compute. (Coincidentally, that was exactly how much the FTSE Eurofirst index fell Monday.)

"Headlines are having much less of an impact now," says Hannes Hofmann, head of investment for JPMorgan Private Bank in Miami. "A lot of investors are changing their risk profile. There is concern that bond rates have nowhere to go but up, and that's pushing money into stocks."

Besides, he asks, is it really so stupid to question whether the $10 billion in deposits at risk in Cyprus will bring the $65 trillion global economy to a halt? Or for that matter, should a Congressional dispute over how to apportion the $44 billion in "sequestration" funds make a huge difference in a $6 trillion economy? It will not starve the U.S. economy, he says.

"If you compared it in size to a Big Mac value meal, it's the equivalent to 2.5 french fries," says Hofmann. He sees the market supported by an economy that is fairly positive for the year, though a rise in interest rates may be a concern if the Fed switches its long-term low-rate policy. Still, the economy is recovering, corporate profits are rising and the overall international backdrop is positive, even with Cyprus as a fresh threat to European banking stability.

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Still, the VIX volatility index, the "fear gauge" indicator the pros watch, freaked out over Cyprus. The fear gauge indeed rose 24 percent in the past two days (meaning more fear, not less). It's been increasingly volatile. For those who are lucky enough not to spend their time watching it, the VIX is an index distilled from Standard & Poor's 500 index options, which are basically bets on where the market will be over the next 30 days. Some say it's a measure of where the market is going, and sometimes it does. But like "dumb" money not always being so dumb, the VIX is not always so smart. It failed the supreme test by showing nothing usual in the months before the giant collapse of 2008.

To be sure, fund investors have paid no mind to the VIX this year when it has gyrated (though it has been flat-lining most days) and have been adding to funds with the biggest equity inflows since before the 2008 crash. Morningstar says investors added $51.9 billion to long-term open-end mutual funds in February to build on inflows of $87.2 billion in January. The S&P 500 has risen to near the all-time high of 1,565 with its gain of 7 percent from the start of the year added to 16 percent in 2012. But S&P Capital IQ estimates that with even with another double-digit rise this year, the expected profit increase of the S&P 500 will leave it at just 14 times earnings. That's below the average of 16 times earnings, and well below previous peaks of bull markets. Adding to the value is the fact S&P's dividends of about 2 percent are above the yield of long-term treasuries.