The Good from a Bear Market

By on December 22, 2006

Originally published in January 2002:

INDEXES ON 12/31/01

DJIA 10,021.50

S&P 500 1,148.08

NASDAQ 1,950.40

The Good from a Bear Market

The past 1 ½ years has proved to be a very trying time for investors. This marks the first bear market of an extended length (over 1 year) since 1974. However, a bear market is not necessarily a bad thing. Why? Because it washes away many excesses created in the preceding boom, paving the way for a more sustainable path. What kind of excesses am I talking about? An example of an extreme excess that developed during the 1990’s was an incredible increase in the number of mutual funds doing business.

There are currently more than 10,000 mutual funds in existence! As a matter of comparison, there were 564 mutual funds in 1980 and 3,105 in 1990. There are now more funds than stocks on the New York Stock Exchange, NASDAQ and American Stock Exchanges combined. There is no justifiable reason for this many funds. It’s an unfathomable waste of human capital to engage so much talent managing these unnecessary funds. Also included in this incredible squandering of effort are legions of overpaid analysts, whose stock picking abilities as a whole have proven to be abysmal. Remember poster boy Henry Blodgett, who loved CMGI at $200 a share, but sort of hated it at $5? He received a $2 million severance package from Merrill Lynch after littering the airwaves with his “analysis.”

A bear market tends to impel investors to be more discerning about where they place their money. This leads to a more thoughtful, prudent and productive allocation of capital. Many funds will disappear because they can’t attract sufficient assets to make them viable. It will be no loss. Fund managers will be forced to do something necessary and productive with their lives. I will explain further below why mutual funds are not the panacea for investors many financial pundits and advisors claim them to be.

It’s not just the mutual fund industry that will be made leaner and more productive from a bear market. Many areas of the economy received immense amounts of unjustified capital investment during the recent boom years. It was unjustified because there was little or no market for the services they intended to deliver.

The internet and telecom areas were tied together in the biggest bubble of misallocated investment ever. The bear market, which was inevitable, brought these companies down to their true value which, in many cases, was zero. It wasn’t Greenspan’s interest rate increases that caused the bear market, although they did help it along a bit, but a severe case of poor investment decisions by professionals and amateurs alike.

But I digress (back to the mutual fund industry). Actively managed, open ended mutual funds are, by their nature, a poor alternative for investors. It is the investors in the funds that, by their human nature, ensure that the average fund will lag the market indexes. Shareholders of the funds have a marked tendency to panic when the market sinks and pull their money out of their previously beloved funds. These redemptions make it necessary for the fund manager to sell stocks when they are low to raise cash to provide to nervous fund sellers. Other owners of the fund are, in effect, participating indirectly in this bargain basement selling. Likewise, when the market is booming, fund managers are forced to pay high prices for shares because of the preponderance of money flooding into their funds. Either they invest the money in overpriced stocks, or they can keep it in cash and face the wrath of investors who see them holding a large cash position in a bull market. It is for the above reasons that fund managers face a no win situation. They are forced by the nature of money flows to buy high and sell low. This is a recipe for sub-par returns. Add to this bloated expense ratios to pay for useless analysis, exhorbitant manager salaries, and mindnumbing advertising campaigns and it’s amazing they ever have positive returns at all (a strong bull market can mask a lot of ugliness).

Is it any wonder that the majority of mutual funds underperform the indexes by a wide margin? Studies show only about 30% of funds beat the indexes in any given year and much fewer can boast the same result over extended periods of time. No sane gambler with an appreciation of the odds would take this bet, but millions of investors do because of multi-million dollar ad budgets of the fund companies. The underperformance gap would be even worse if fund companies didn’t close or merge their completely hapless funds. In this underhanded way they can hide bad management and skew horrible records into the merely terrible. You’ll seldom read about mutual fund warts in any mainstream publications because these rags are addicted to the gazillions of ad dollars heaped on them by the gigantic mutual fund complex.

There is a great alternative to actively managed mutual funds for someone who doesn’t want to bother picking their own stocks. Index funds are definitely the way to go for most investors. Vanguard is the leader in this area and is one of the lowest cost operators in the business. There are also quite a few Exchange Traded Funds (ETFs) with low expense ratios. The S&P 500 is represented in the Spiders on the American Stock Exchange (AMEX: symbol SPY). Vanguard’s Total Stock Market index, symbol VTI on the AMEX, based on the Wilshire 5000, provides even better diversification and can be purchased through any broker, including on-line discount brokers.

By investing in index funds you won’t receive large unexpected capital gains distributions and won’t be exposed to money manager risk (the chance that your manager loses his touch or goes off the deep end making risky bets).

Enough of the diatribe against mutual funds of actively managed, open-ended type. Both the aggressive and conservative “Real World” portfolios outperformed the major market indexes (S&P 500, NASDAQ, and Wilshire 5000) this year as can be seen at http://members.aol.com/stocksystm/performance.htm. Both portfolios continue to outperform the averages over the past 5 years. It was an unusually volatile and scary year marked by the heinous atrocities of a weak-minded group of madmen. The aggressive portfolio, on September 21, was down approximately 50% from its peak, but made an incredible comeback of about 66% during the last 3 months of the year. I’m not proud of this volatility and am working diligently to make the Tactical Timing System less prone to such wide swings. In order to claim the system reduces risk it is imperative that the standard deviation of returns remains lower than the market averages.

The effectiveness of a timing system is dependant on its ability to measure the level of investor fear and greed. I’m analyzing various tools to gauge these levels and plan on incorporating them into the system. I feel that great strides have already been made toward this end and I anticipate the system will improve over time.

I have little idea what the future holds at this point. The way interest rates have been cut is unprecedented and raises some frightening possibilities. All kinds of unpredictable ramifications could occur from such a jolting move. The obvious is that the dollar could become very weak and set in motion an inflationary spiral. Another possibility is that the rate cuts won’t work because of the massive debt load in the world economy and we’ll experience a Japanese style malaise and deflationary slowdown. There is also the possibility that we’ll muddle through with neither boom nor bust. However, the market should see a bit of firmness in the next couple of months due to the inflow of IRA contributions. In any case, the Tactical Timing System is guiding my investment decisions and my confidence in it has grown. What started out as an experiment has been quite successful so far.

I’ll leave you with this passage from The Bear Book: Survive and Profit in Ferocious Markets by John Rothchild (I’m not really finished with the mutual fund industry ;)

“What happened to the proud boast that mutual funds would help stem any bear market? That, being levelheaded, long-range investors they would step in and buy when others were selling in a panic? These funds had to sell stock into a declining market to raise cash. They worsened the decline rather than stemming it …Amateur stockpickers with homemade portfolios had more flexibility than professional fund managers. Amateurs weren’t forced to sell at depressed prices to raise cash. Nor were they forced to sit on their cash and miss a buying opportunity. They could participate in the bargain phase of the summer rally that began in 1970. Many funds had to pass up the chance. Funds didn’t buy stocks in earnest until they were convinced the redemptions had ceased, and by then, the rally was half over. They continued to buy, at progressively higher prices, until they ran into a second vicious bear, in 1973-74, that came on the heels of the first. This was a bleak phase for the fund industry. Its clients had lost money and faith, and its funds had lost their credibility, just as investment trusts did in the 1930s.”

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