Dow Nears Record High

May 16, 2006

Part of our job at MAXfunds is to get you excited about investing when everybody else is not, and fearful of investing when everybody else is excited.

To us, “everybody” refers to mutual fund investors. The tens of millions of fund investors have a nasty habit of getting most excited about investing close to the top of market cycles, and getting negative at exactly the worst time – when stocks are close to bottoming out.

As you’ve been reminded every few minutes by the financial news media, or just every few hours by regular news channels, or every day by newspapers, stocks (or rather the Dow Jones Industrial Average) are always within spitting distance of an “all time” high.

While the bear market ended in late 2002, to some the market is not “over” the bubble era until the stock indexes pass their old highs. Today, many stock indexes are way past their old highs – larger-cap and tech indexes are the only ones still below the high water mark. These were the areas fund investors over-loved in the past – the higher they rise, the harder they fall.

Too bad the financial media doesn’t make more of a to-do over record fund investor inflows and outflows. The last time fund investors put over $50 billion of new money into stock funds in one month was February 2000. As it turned out, this was the month right after the Dow peak – at 11,722.98 on January 14th. The Nasdaq peaked on March 10th, and the S&P500 on March 24th.

Over the next couple of years, the Dow fell 38%, the S&P500 almost 50%, and the Nasdaq almost 80%. So much for investing with the herd.

Toward the end of the bear market investors had finally had enough. The largest one-month outflow from stock funds was in July 2002 – when investors pulled just over $50 billion out of stock funds. Though the Dow didn’t bottom until October of 2002 (at 7,286.27) it came pretty close in July of 2002. Today the Dow is up some 60% not including dividends from the 2002 lows.

In fact, the entire period from 2002 to 2004 investors were unenthused about plowing money into stock funds. As recently as last year inflows averaged around $11 billion a month – nothing to sneeze at, but that’s about what Janus alone brought in during the late-nineties’ halcyon days. Considering millions of workers are automatically having their paychecks diverted to mutual funds each week and boomers have yet to retire en masse, $11 billion is almost chump change.

Now that stocks seem to be a good deal to investors again (flirtation will all-time highs will do that) they are getting back in.

In the first three months of 2006 investors have put almost twice as much into stock funds as the first three months of 2005 – $93 billion compared to $47 billion. In March investors placed $34 billion in new money into stock funds – the second biggest buying month in almost six years. When all the numbers are in, April and May should eclipse March – especially with all the Dow-near-a-record hype.

Sadly, fund investors are not plowing into funds that buy large-cap U.S. stocks so much as funds that invest in far hotter areas: natural resources, commodities, newfangled ETFs that focus on ever smaller areas, and anything international. In other words, the opposite of where they sent their money in early 2000.

The current hype of record stock prices and resulting record inflows by fund investors is a nice time to pause and take a look at what you are doing to your portfolio.

Are you more excited about stocks than you were before they ran up 60%? Are you plowing into funds that ran up 100% or more in the last few years? Are you investing with the herd?

If you are not swayed by our warnings, you should read the current missives of a handful of top investors we read regularly. All have track records far longer and better than 98% of the fund managers, experts, reporters, pundits, charlatans, and the like. Certainly better than fund investors who buy after run-ups and sell after wipeouts.

Miller Time

Bill Miller has among the longest S&P500 beating streaks in the fund business, managing a few successful Legg Mason funds. In his latest commentary (read a PDF of it by clicking here) he warns investors against making the exact same mistakes they have made time and time again, buying whatever is hot that the media covers with the most optimism and gusto. While his focus this time is on the overblown commodity bull market, the logic applies to all investments:

“Investing is all about probabilities, and just because there appears to be a strong consensus prices are going to keep going up, doesn’t mean that is wrong, or right. The consensus does tend to be wrong at the turning points, being invariably bullish at the top and bearish at the bottom. Remember all the advice to go to cash AFTER the 1987 Crash, since it was clear a depression would follow. Or how “risky” the high yield bond market was in the summer of 2002 AFTER the Enron and Worldcom collapses led to record spreads? I can’t help but be skeptical of the advice to start or increase a position in commodities AFTER the biggest bull move in 50 years.

The excitement and enthusiasm surrounding commodities, and the belief that they will continue to rise, is not surprising. People want to buy today what they should have bought 5 or 6 years ago; call it the 5-year psychological cycle. Today people want commodities, emerging market, non-US assets, and small and mid-cap stocks. Those were all cheap 5 years ago and had you bought them then you would be sitting on enormous gains. But 5 or 6 years ago, everyone wanted tech and Internet and telecom stocks, and venture capital and US mega-caps. The time to buy them was in 1994 or 1995, when they were cheap. But in 1994 or 1995, people wanted banks and small and mid-caps, which should have been bought in 1990, and well, you get the picture.

In general, you can get a good sense of what to buy now by looking to see what the worst-performing assets or groups were over the past five or six years. That is long term for most people, and long enough to convince them that the malaise is permanent and to have migrated their money elsewhere, such as to whatever has done best in the past 5 or 6 years.”

The WB channel

Warren Buffett is the world’s richest investor. He is often quoted, but rarely followed, as if acknowledging his wisdom is enough for reporters before they go back to writing their 75th article on gold, oil, and commodity prices, just as they did in the late 90s (only then it was multiple articles on Internet and telecom stocks).

At his latest annual meeting of Berkshire Hathaway investors, Buffett was quoted opining on the insanity in housing and commodity markets. Buffett has $37 billion of Berkshire Hathaway’s money in cash – waiting for a little less optimism in the stock market before he dips in and buys (though he picked up a few companies recently).

“…At the beginning, it's driven by fundamentals, then speculation takes over. As the old saying goes, ‘what the wise man does in the beginning, fools do in the end.’ With any asset class that has a big move, first the fundamentals attract speculation, then the speculation becomes dominant.

Once a price history develops, and people hear that their neighbor made a lot of money on something, that impulse takes over, and we're seeing that in commodities and housing...Orgies tend to be wildest toward the end. It's like being Cinderella at the ball. You know that at midnight everything's going to turn back to pumpkins & mice. But you look around and say, 'one more dance,' and so does everyone else. The party does get to be more fun -- and besides, there are no clocks on the wall. And then suddenly the clock strikes 12, and everything turns back to pumpkins and mice."

Mr. Scaredy Cat

Robert Rodriguez has the best 15-year return in actively managed, non-sector mutual funds (albeit with some rough spots along the way, and a recent small-cap tailwind at his back). One way you don’t destroy a 17% plus average annual return over 15 years is by not going all in when valuations are stretched (like they are today in smaller-cap stocks, his area of focus).

FPA Capital (FPPTX), which is closed to new investors, currently has 43% in cash and bonds. In his last shareholder report (a PDF of which is available by clicking here), Rodriguez notes, “We remain convinced that prospective stock market returns are likely to be viewed as substandard by historical standards,” and closes on a dour note about our financially reckless government:

“Between questionable accounting and control over current spending, expansion of new entitlements, i.e., the payment for hurricane disasters and fighting
the war on terror, this entire government is creating liabilities that will one day come home to roost. I do not believe that we, as investors, are being sufficiently compensated for these potential risks as well as for economic and stock market risks. When your investment team uncovers investment opportunities that compensate us for these various risks, we will deploy your capital. Until then, we will wait patiently.”

GMO – OMG! (Oh my god…)

We’ve long recommended funds managed by GMO (Grantham, Mayo, Van Otterloo), though few of them are available to smaller investors (one no-load was Pelican, an old favorite fund pick in large-cap value around here that was merged into a load fund). A nice, low-fee choice today is Vanguard U.S. Value (VUVLX). GMO manages about $100 billion.

Investors can read their Quarterly Letter to the Investment Committee by registering for free on the GMO website. In the latest report, Jeremy Grantham notes the decision to sell after a long run of losses and buy after a hot streak hurts returns for all investors, including supposedly smarter institutional investors:

“Ironically, most of the risk to long-term investors in equities comes from panicking in the short term and closing out positions that then mean revert. (Classic examples of this would be institutions firing value managers and hiring growth managers in 1999 because they couldn’t stand the underperformance, and a whole generation of investors in the 1930s moving permanently out of equities.) Selling in declines throws away the powerful risk reduction effect of mean reversion. Most investors would be better off if they had a hard rule that everything they bought had to be held for 30 years or longer. Even more certainly, they would benefit if the rule only allowed the selling of an asset class at a price well above its long-term trend.”

Grossly Overvalued

Bill Gross at PIMCO has the best track record in bonds. While his opinion that the Dow was worth around 5,000 never played out in the market, his free monthly investment outlook is a must-read. In his latest As GM Goes, So Goes the Nation” + link- ) Gross casts doubt over the future of the U.S economy by likening it to GM – a company that is uncompetitive with lower cost, better, and more efficient global producers, and burdened by massive future underfunded liabilities,

“I think it important to recognize that General Motors is a canary in this country’s economic coal mine – a forerunner for what’s to come for the broader economy. Their mistakes have resembled this nation’s mistakes; their problems will be our future problems.”

While these experts differ on where you should put your money, they are in agreement that whatever the bulk of investors are infatuated in is generally a lousy investment going forward.

Mark Twain, after losses from ill-timed speculations, said it best: “I was seldom able to see an opportunity until it had ceased to be one.”