The Mutual Fund Merry-Go-Round
October 15, 2002
1. Investors Are Flocking To Bond Funds.
2. Are Bonds The Next Bubble To Burst?
3. Evaluating Professional Money Managers:
Investors loaded-up on stock mutual funds in the last half of the 1990s when the historic bull market was soaring to meteoric, unprecedented heights. Prominent market analysts told us it was a “New Economy” and a “New Paradigm” for stocks, and that the old rules had changed. Wall Street told us that “tech stocks” and “dot.coms” would be the darlings of the next decade – never mind that many of them never made a profit.
Many investors who had never been in the stock market before felt that they had to get on the equity train, even though it had already soared to new highs. And they did, especially in 1997, 1998 and 1999. Equity mutual fund purchases broke record after record after record. It was an unprecedented mania.
But we all know what happened. The stock bubble burst in March of 2000 at the height of the euphoria. The “darling” tech stocks, as measured by the Nasdaq Index, plunged 70% from the peak. The broad market, as measured by the S&P 500 Index, was down 40% from the peak in 2000 (prior to the latest rally).
Unless they bought stocks or mutual funds prior to 1997, they are at a loss today. If they came late to the party, in 1998-1999, and held on, they have devastating losses today. Some have simply bailed-out altogether in recent months; others have held on hoping for a recovery; and recently, large numbers have switched from stock funds to bond funds.
In this issue of Forecasts & Trends E-Letter, I will examine the latest rush from stock funds to bond funds, and whether this is a good idea or yet another huge “crowd mentality” blunder.
LOOKING IN THE REAR-VIEW MIRROR
Hindsight is 20/20 when we look through the rear-view mirror of history. Today, we know that the stock markets became dangerously overvalued in the late 1990s. While the old rules of corporate profits, P/E ratios and real assets were suspended for a few years during the late 1990s, and the mania pushed stocks to the moon, reality has finally prevailed. The bubble was popped, and here we are. So much for the New Paradigm.
Admittedly, I have always been a “Nervous Nelly” when it comes to analyzing the investment markets. When things are really, really good, I usually expect them to get worse. When things are really, really bad, I usually expect them to get better. It’s just my nature. So, I didn’t buy into the “New Paradigm” theory in the last half of the 1990s, and I don’t buy into the “Gloom-And-Doom” theories today. My contrarian attitude has served me well in the last 25 years.
In 1995, I began to worry that the stock markets were becoming dangerously high. Fortunately, my best sources were forecasting that stock prices could still go a lot higher. Yet because of my concerns, I recommended to all my clients that they shift their equity investments from “buy-and-hold” to “market timing” strategies in 1995. Market-timing strategies are designed to be “in the market” when it’s going up, but to get “out of the market” when it’s going down.
Most investors never considered market-timing strategies in 1997-1999. In fact, market-timing strategies were shunned, even damned, by Wall Street in those years. Buy-and-hold, or more appropriately, “buy the dips-and-hold,” was the Wall Street mantra. Unfortunately, most investors bought into this New Paradigm thinking.
ARE INVESTORS MAKING ANOTHER BIG MISTAKE?
Like the mad rush into stocks and stock funds in the late 1990s, we are today seeing a herd mentality to dump stocks and move into bonds and bond mutual funds. Bonds and bond funds have had impressive returns since the bottom in early 2000. In January 2000, the 30-year T-bond yield was 6.63%. The interest on a 30-year fixed-rate home mortgage was 8.21%. Today, the 30-year T-bond yield is 4.82%, and in late September, the 30-year home mortgage rate fell to under 6.00%. Interest rates are at 40-year lows today.
If you bought bonds or bond mutual funds in January of 2000, you have done extremely well in most cases. The Lehman Brothers Aggregate Bond Index gained a total of 31.39% between January 1, 2000 and September 30, 2002. The American Century 2025 Bond Fund (one of my favorites IF you buy it at the right time) has gained almost 58% over the same time period. This year alone, that fund has gained a whopping 22.33% as of the end of September. It has been a sweet place to be!
But the question is, would I buy American Century 2025 Fund today? NO! While bond yields may still fall a bit lower, depending on the economy, it is too late in the game to be buying bond funds, especially Treasury bond funds, in my opinion.
Yet many investors are dumping stocks and stock funds and moving into bonds and bond funds in huge numbers. Here are the latest numbers from the Investment Company Institute (ICI), which tracks mutual fund inflows and outflows. Stock mutual funds saw record-large redemptions (withdrawals) in July and August, while bond mutual funds saw record-large purchases. Stock funds shrank by a whopping $55.5 billion, while assets in bond funds soared by $45.5 billion in July and August. It is widely expected that September numbers will show that this trend is continuing.
BUYING ANOTHER BUBBLE?
In addition to the investment public, many investment advisors and Wall Street brokers have jumped on the “sell stocks/buy bonds” bandwagon in the last few months. Some have entirely sincere motives, and believe in what they are recommending, but others do not. Many know that if their clients dump their stocks, they will simply close their accounts and go away, likely never to return. Yet if they can get them to switch from stocks to bonds, regardless of the risk, they at least get to hang onto the clients’ money – and fees - for another day.
Yet are investors and their advisors making yet another HUGE MISTAKE? I believe that investors who are finally dumping stocks and switching to bond funds now will find that they are making yet another big mistake. They may have come too late to the party!
Stocks have been hammered, hammered and hammered some more (not that it can’t continue a bit longer) to five-year lows. Bonds have been driven higher and higher to the point that interest rates are at 40-year lows. Bonds, in my opinion, are yet another bubble at today’s levels, especially Treasury bonds. Yet most everyone believes rates will still go lower.
I fear that investors who are herding into the bond funds today will end-up with significant losses in the end. A double-whammy, first stocks, then bonds. Especially for those buying Treasury bonds at these extreme levels. Most manias don’t end pretty.
BUT TREASURY BONDS ARE SAFE, RIGHT?
The standard story is, if you hold T-bonds (or others) to maturity, you will get the return they offer today. This is true. But there are three problems with this reasoning. First, while Treasury bonds (and bills and notes) are indeed backed by the “full faith and credit” of the US government, there is no guarantee that you won’t lose money if you sell them prior to maturity. This is true of corporate and municipal bonds as well. The problem is, what if you have to sell before the bonds reach maturity?
Second, many investors don’t buy actual bonds; they buy bond mutual funds. If you buy a bond fund, you are not buying the actual bonds; you are buying “shares” in the fund, regardless whether it is a T-bond fund or a Ginnie Mae fund or some other kind of bond fund. You are buying shares in the fund. You are not buying an actual bond which, if held to maturity, will give you back all of your principal, plus a return on your investment.
Third, interest rates are inherently volatile. As a result, the investment returns on bonds and bond funds are also very volatile. If you buy at the wrong time, the losses can be severe. For example, if you bought the American Century Target 2025 Fund at its October 1998 peak, it would have lost –29.5% by the time the bond market bottomed out in January 2000.
If you buy that same fund today, and long-term interest rates move up by only 1%, you would lose apprx. 20%. If rates move up 2% from the current 40-year low, you would lose apprx. 36%. As you can see, buying bonds at the wrong time can be very costly!
Obviously, some investors buy bonds and plan to hold them until maturity. Some investors use the “laddering” approach where you buy a portfolio of actual bonds (not funds) in various maturities, so that you have some maturing on a regular basis (usually to provide income). Let me emphasize that there is nothing wrong with this approach, so long as you know you aren’t going to have to sell the bonds prior to maturity.
CGM GOES TO CASH
Over the last couple of months, I have been offering my readers a free Special Report entitled “How To Own Bonds Today.” We prepared this latest report precisely because of my concerns about the ongoing rush into bonds. In the report, I introduce readers to a company called Capital Growth Management (CGM). I’ve mentioned CGM in these E-Letters recently as well.
CGM is a Registered Investment Advisor that uses a proprietary market-timing system in bond funds. They have an outstanding 10-year performance record. There aren’t very many professional money managers that use market-timing systems in bonds.
I mention CGM again this week because recently, CGM moved all of its clients OUT of bond funds and into the safety of money market funds.
CGM’s proprietary market-timing system indicates that the risks of a reversal in bond yields is too high at this point, so they moved all their clients to cash. They will stay there until the system issues another buy signal.
So, while the public is dumping stocks and buying bonds and bond funds with abandon, our recommended bond fund advisor has sold all of their bond fund positions and moved to the safety of money market funds, at least for the time being.
As this is written, the Dow Jones has soared over 800 points from the low on Wednesday of last week. Could it be that stocks have bottomed at last, or is this just another bear market rally? Bonds turned lower at the same time last week. The yield on the 10-year Treasury note has risen from 3.6% to 3.9% in the last four trading days. Could it be that interest rates have turned higher, or is this just a “correction” before rates go even lower? Those buying bonds today hope it’s the latter!
The key is the economy. The economy has slowed down significantly in the last couple of months, but is still in slightly positive territory. If the slowdown continues, this suggests that the slide in stocks is not yet over; it also suggests that interest rates will fall somewhat lower. But I don’t expect rates to fall significantly lower – what bond buyers need – unless we are headed back into recession.
As I have written the last several weeks, the odds of another recession have increased, so recent bond buyers at least have that in their favor for the time being. If we dip into a recession, interest rates may edge a bit lower still.
On the other hand, and as I wrote last week, the economy could rebound next year, especially if we go to war with Iraq. If we spend $100-$200 billion on the war with Iraq, that could be just the spark this economy needs to get turned around. In that case, interest rates will move higher, and recent bond buyers will be hurting.
WHAT INVESTORS SHOULD DO
The only way I would be a bond buyer today is under the direction of a professional money manager with a proven market-timing system that can get out of the market and move to the safety of a money market fund, in case interest rates begin to trend higher. Capital Growth Management is one of very few Investment Advisors that has a long track record of doing so successfully.
In the latest issue of my Professional Investing newsletter, I reveal for the first time some of the proprietary methods and practices that we use when evaluating professional money managers. I tell you how to separate the winners from the losers.
Frustrated investors are now turning more and more to professional money managers, rather than making the tough decisions themselves. Interestingly, I have been recommending this since 1995. I highly recommend that you read my latest newsletter and learn how we evaluate professional managers and how only a select few make it to our recommended list. Click on the link below.
To get more information on Capital Growth Management, visit my website at www.profutures.com or call us toll free at 800-348-3601.
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Fall is finally here. Enjoy!!
Very best regards,
Gary D. Halbert
Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.