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August 04, 1998

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Subject: fantastic 500
Author: solasis

Judy, I have no idea where we're going from here, (7/31/98) but bear with me a moment.

In the 1971-1973 period we had the "nifty fifty". Now we have the fantastic five hundred. Of course I'm talking about the S&P 500 Index, and the myriad of mutual funds that now invest based solely on this index. Contrary to current conventional thinking, which believes that investing in an S&P index fund is a conservative way to invest in a very large, broad group of america's largest companies (what could be more conservative than that?); in the next bear market, whenever it does occur, I believe that investors in the fantastic five hundred will not be a happy lot.

In my investing experience, which dates back to 1982, the market has changed in many ways, the most important of which i believe is the growth in the mutual fund industry. In 1982 there were less than 600 registered mutual funds and over three thousand common stocks listed on the NYSE, now there are over 5000 mutual funds and more mutual funds than listed NYSE stocks. in 1982 mutual fund assets accounted for less than 10% of the US stock market, now that number is nearly 40%. And GROWING.
"The implications are clear, this is becoming more and more of an institutionally controlled marketplace."  
The implications are clear, this is becoming more and more of an institutionally controlled marketplace. Yes, individuals own those mutual fund shares, but they don't make the decisions about what to buy/sell and how much/when. Money managers do this for them. According to NAIC - "Our research of mutual funds verses investment clubs clearly shows that the big difference between money managers and individuals is that individuals invest for the long term, while mutual fund managers invest for the short term. Holding periods for clubs in our survey averaged 4.4 years, while the average holding period for the nations 10 largest equity mutual funds in the past five years has been 1.2 years." The fact that short term trading is now driving the market can also be seen in the volume turnover ratios on the NYSE, i.e. the total trade volume over a one year period divided by the total volume of all listed stocks. (Hint, the ratio has nearly quadrupled since 1982). So the real volume in this market is driven by short term performance driven money managers.

So what, you say? Well there is another, related problem. Open end mutual funds get paid by assessing their shareholders fees, fees that are percentage based so its in their interest to build their asset base. you take out ads on the back of serial boxes and end up with funds that have gazillions of dollars to invest. Now if you have gazillions to invest, what can you buy and sell? Well only about 10% of the public companies listed on AMEX, NYSE and NASDAQ. Because with your gazillions and your short term fuse, your first and foremost need is not value, relative strength, P/E, P/B, dividend yield, earnings growth, or anything of the sort. What you primarily care about is LIQUIDITY, and only about 10% of the listed stocks are big enough to wear the slipper.

Now here's the interesting part. Because you need to be able to do big block trades without affecting price levels too severely, your universe of stocks that you can invest in is limited. And by the time you factor in fees, and cash reserves, it becomes apparent that it is very difficult for you to beat the other funds with your gazillions. So what do you do? You TRADE more frequently and you reduce your cash levels, or in the extreme case, you throw in the towel and buy/sell the index itself. Its easier that way and you don't underperform your benchmark. Result? Steadily lower and lower cash reserve levels at most mutual funds and higher and higher trading volume.

  "...we have been steadily developing into a two tiered market again, similar to, yet different than the early 1970's. And herein lies the crux of the problem, and in my way of thinking, the opportunity."

So what has been steadily happening, in case anyone hasn't noticed, is that since the mid 80's, we have been steadily developing into a two tiered market again, similar to, yet different than the early 1970's. And herein lies the crux of the problem, and in my way of thinking, the opportunity. Because the vast majority of mutual funds appear to be heavily weighted in the S&P 500, and in effect the "market share" of the funds is steadily growing, and may become a majority of total equity in the next few years, the mutual funds themselves now are essentially driving the large cap market higher in line with their inflows of new funds. Factor in the increasing number of index funds, which by definition, carry low cash reserves, And this is why, when the psychology changes, and if we develop a bearish psychology, the S&P500, like the nifty fifty of old, will lead the market lower and become one of the worst performing sectors of the total market.

You have short term performance goals, a narrow universe to deploy capital, high trading volume, high price valuations relative to historic norms and low cash reserves.

But think about it for a moment. When the goldilocks economy changes, and if they want to sell, or are forced to sell, who will they sell all of those fantastic five hundred shares to? To you? To ATV? The French? To me? Of course not, if they own a majority of the equity, primarily they will be forced to sell to EACH OTHER. Yet with relatively low cash reserves, coupled with a competitive short term performance mentality, the amount of buying support in the short term will be limited. This is why Fidelity and others have recently changed their fund charters to allow them to borrow large sums, and why even Vanguard has secured credit lines by offering their NON STOCK MONEY MARKETS AND BOND FUNDS AS COLLATERAL for those credit lines.

If the psychology turns bearish, prices in institutional favorites, stocks with 70% or more institutional ownership, will crash fast and hard like the asteroids in the movie "Armageddon". This is also why we will not see nice rounded tops and slow, steadily falling bear markets in the future like we experienced in the 1970's and before. We will see fast crashes like 1987 and 1990, because once the sentiment turns there is little or no buying support for these large cap stocks as the funds all begin to try to rapidly dump their shares ahead of the next guy at fidelity or janus or scudder etc. Look at a long term chart of the S&P, and you will see what i mean by the change in the character of corrections and bear markets. Look at how rapid the corrections were in 1987 and 1990 verses the 1970's or 1950's. In the future, corrections will be even more rapid.

When it happens, it is going to happen quickly, especially with the collar now at -10%. The next -30% drop we get in the S&P is going to come quick, probably in less than 1 week.

Another $0.02


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