Last year, we highlighted a historic surge in municipal bond fund inflows that we speculated would end badly (see: http://www.continentalca.com/home/March-12-2010). The charts below show that the record inflows during 2009 have given way to record outflows in recent months. In fact, outflows in December 2010 and January 2011 rival the largest annual outflows in any of the last 10 years. The recent outflows come at a time when state and local government financial imbalances are widely publicized, yet the record inflows occurred at a time when their financial conditions were just as stressed.

Figure 1. Monthly Municipal Bond Fund Flows

Source: ICI, Continental Capital Advisors

Figure 2. Annual Municipal Bond Fund Flows

Source: ICI, Continental Capital Advisors

Municipal bond fund flows during the past year and a half demonstrate how quickly trends can change and how fast market liquidity can evaporate. Similarly, even though stock investor sentiment is at or near record highs, it too can change at any moment. When prices are rising, investors believe that risk is declining. However, the reality could not be further from the truth. Today, after a 28% rally in the S&P 500 since last September, the downside risk to equity markets is extremely high despite the perception that it is not.

We continue to believe that equities are in an ongoing bear market rally that will eventually end terribly for most investors. Sovereign risks in Europe, deficit reduction measures by US state and local governments, tepid job growth, declining emerging economy stock markets, and civil unrest in the Middle East are problems that stock investors cannot ignore forever.