Perspective on Mutual Funds and Capitulation
Joseph M. Miller
The modern mutual fund industry had its beginning in 1924 and the idea flourished during the Roaring 20's. The industry atrophied during the 1930's, 40's, and 50's. Mutual funds blossomed again in the 1970s along with IRAs and 401k's. The first "open-end" mutual fund - the Massachusetts Investors Trust - was created in 1924. Since then, the number of funds and firms that manage them has grown tremendously. One of the attached charts shows that in 1960 there was a total of 161 funds; by 1998 the total had ballooned to over 6,000 funds for stocks, hybrid holdings, or bonds. Another attached chart shows the increase in dollar assets held by the funds. At the address below is a rather good article on the origin and the growth of this industry should you wish to learn more.
The data shown ends in 1998. I believe it is reasonable to believe that by 2000 or 2001 those numbers increased a great deal. The point I wish to make is that the number of funds and the dollar amount of their holdings had risen to Bubble Market proportions by the time most stock indexes made their highs over the last two years.
Many of these stock funds have a mandate to stay invested in stocks with a provision to maintain a limited amount in cash for redemptions and emergencies. This is a very important point that I want to emphasize. In many funds the managers cannot place large amounts of funds committed to their management in cash, money markets or bonds. They must stay invested in stocks.
Why is this important? First because it means that until investors in these funds remove their money from the funds, there will be no overall liquidation of stocks from the funds. Secondly, it explains why there is so much sector rotation within these funds. Each fund manager (over 6,000) is competing with all of the other managers to place their assets into the best sectors (lately there is evidence managers are rotating into tech assets and out of other categories - the reason is probably because the tech sector has fallen the most and some of the other sectors have just started to fall.) This does not necessarily mean that the tech sector is a good buy for someone out of the market. It probably only means it is the best buy for a fund manager who has to buy something right now. The foregoing also helps explain the high volatility we have seen recently.
Anecdotal evidence reaching me plus some written sources suggest that the rank and file of mutual fund holders have not as yet become convinced they should remove their funds from stock mutual fund holdings. They have been told to "Buy and Hold" and that seems to be their current mantra. Part of the problem is that Wall Street and Washington have not been honest with the American investor so the truth of how bad things are, and can become, has been hidden from them.
My question is simply this - How can we have capitulation until much of these mutual fund holdings are liquidated as investors call their funds and say "GET ME OUT". I believe capitulation will not happen until this occurs.
What is an alternative scenario if these mutual fund investors do not call and liquidate their holdings? I believe we will then have an eroding market as stock values decline and NAV of the funds decline in unison. If this scenario takes place, there will be much pain and suffering on "Main Street USA".
Are stock prices going to decline? The technical aspects of the market are saying so. See the John Murphy comments at: www.gold-eagle.com/editorials_02/jmurphy072202.html
A good case for the bearish fundamentals is made at this address: www.financialsense.com/stormwatch/oldupdates/2002/0719.htm
How will the bear market unfold? It is almost impossible to know the exact path this bear market will take. What we do know is that the evidence appears to overwhelmingly say that we have ended the first of three phases of a SECULAR bear market (the topping phase), and that in the last week we have entered the middle phase of the bear market. The evidence suggests this middle phase of the bear market will be the worst and that it will last a long time (years). Investors expecting and hoping for a "V" type bear market bottom as in 1987 are hoping in vain. A secular bear market of the type we now are experiencing does not end in a "V" bottom.
John Mauldin has this to say in his weekly letter dated July 20, 2002 on this topic. I will end this discussion with his words because he says it better than I can.
"And that brings us to the topic de jour: capitulation.
The pundits on TV and the press tell us the bear market can't end
until we get to some magical condition called capitulation. This is
that wonderful state of affairs when all the wimps and fearful sell
everything including the kitchen sink and there is no one but
optimists and strong investors left. That is when we see the bottom
and the next phase of the bull market will start.
Massive sell-offs are the sign of this state of capitulation, and
this weekend we will see many pundits tell us that the 700 point
drop in three days certainly looks like capitulation. Now we can get
ready to enjoy the summer rally.
The problem is that there isn't much historical precedent for
capitulation. Bear markets don't end in explosive sell-offs. They
end with massive indifference on low volume days when no one cares
anymore.
Weeks like this last one are typical of the middle of bear markets,
not the end. I was discussing this with Dennis Gartman this morning,
and he reminded me of the vicious drops and rallies in 1974. The
bear continued for quite a bit longer.
We will soon have a bear market rally (I hope), and I think it could
be something to behold. I note in passing that short selling
interest is up, especially among smaller investors. Just like day-
traders piled in bidding everything up in 1999, now we have a new
breed of short-seller ready to make money on the way down.
And after the rally, the market will sell off again. This cycle
will keep repeating itself for quite some time. It will be like
watching a couple doing the tango, back and forth, across the room,
sometimes flowing effortlessly, and sometimes with hard stops and
violent movement." End quote.
One parting thought I leave with you. One way we can tell when we have reached a point near the end of this secular bear market is to keep track of the number of operating mutual funds. When the bottom is reached we will probably have an operating population of stock mutual funds around 10% of the peak total, which means when we see a number below 1,000 we can start looking for good stock investment opportunities again. That day will be a long time in coming in my opinion and will be measured in years and perhaps decades.
I will end this discussion as I always do. Please do your own due diligence prior to making investment decisions.
July 23, 2002
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