But What about the Fund Consumer?

June 2, 2009

There's been a lot of talk about American consumers and what they'll do with their money once the dust settles. Most market analysts, economists, and prognosticators are quite certain that American consumers have fallen and simply can’t get back up. 

But just a few days ago, the market took off following a five-day slide, inspired by nothing more than news that the "sentiment index," one of the data points published by the Conference Board Consumer Research Center measuring the psyche of the consumer, "surged by the most in six years" in May. 

On the same day, home prices were reported to have fallen nearly 20%, year over year, by March, but investors were apparently more excited that confidence was up, despite the fact that the same confidence index measured far higher back when the market began its epic tumble. Perhaps many need to be reminded that consumer confidence wasn't the problem that drove us into this economic tailspin. Falling home prices were.

However, it's understandable that investors were relieved that increasingly dire consumer forecasts might not in fact be written in stone. After all, the going consensus these days has been that consumers have permanently altered their spending behavior – they’ll be saving more and spending less from here on out, and this collective frugality will keep the economy in the doldrums for many, many years – if not forever.

These dire predictions warned that the consumer balance sheet could no longer run in the red because those providing us capital, including not only the banks, but ultimately China and other nations as well, are now cutting us off like a bartender at closing time. We were also told that the dollar would, of course, collapse, leaving Americans with little ability to buy stuff from abroad. 

Here at Maxfunds, we never believed that consumers would all of a sudden lock their credit cards in a drawer. Our nation was built on consumers using borrowed money. We’re not even sure such borrowing is that bad. After all, some people get lazy when they don’t have car payments to make. 

One of the wonderful things about America is how cheap we've made our core living costs – food, housing, transportation, and clothing. Nowhere else in the world can you earn so much relative to the cost of bare necessities. 

The problem is that debt-fueled bingeing got way out of hand in recent years – and not so much loans to consumers buying TVs and jet skis as loans used to buy homes, which has never been considered reckless spending. Unfortunately, over the last few years, you’d have been much better off going on vacation with $10,000 in borrowed money than "investing" in a property with a $500,000 mortgage, a property that may now be worth only $250,000 in some parts of the country.

So while we’re confident that at some point in the future people will toss their syrupy "McCafe" and "upgrade" back into a Starbucks/Williams-Sonoma lifestyle (because frankly, hanging out in a McDonalds with your laptop just doesn’t feel like an adequate reward for a hard day’s work,) we're growing more concerned about the specific consumer we at Maxfunds spend our time tracking — the fund consumer.

It wasn’t long ago fund investors sought to emulate the lifestyles of rich and famous investors who routinely invest in alternative energy and private equity , the same investors who send their money around the world to exotic hotspots like "BRIC" countries (Brazil, Russia, India, and China) and "frontier" emerging markets in the Middle East, eastern Europe, and Africa. But now mutual fund investors have cut back on exciting mutual funds and downgraded to plain-vanilla bank CDs.

For the majority of the past three decades, mutual fund investors have piled billions of dollars each month into mutual funds, virtually unabated, other than a few brief panics usually coinciding with a sharply down market.

Previously, the worst stretch for fund flows was near the bottom of the 2000-2002 bear market. Over nine months during that period, fund investors yanked about $100 billion out of stock funds – half of it in July 2002 alone. As we want our Powerfund Portfolios to do the opposite of what most fund investors do, we added to our stock positions during this recent panic just as we did back then .

After the 2000-2002 bear market, investors quickly returned to mutual funds, adding about $250 billion over the next year. As the subsequent bull market ran on, investors became particularly fascinated with foreign stocks and commodities.

By 2007, fund investors had more or less given up on domestic stocks. They then began shoveling money into foreign markets since they were performing the best.

By the summer of 2008 – well into the crash in real estate and the drop in stocks – the money started to pour out of mutual funds. We’ve seen about $250 billion sold in both US and foreign stock funds – a record – since the withdrawals began.

We did witness a few brief moments of optimism, like when investors added a few billion in January, unfortunately just in time for the next plunge down. More recently, we’ve seen a few billion – perhaps $25 billion total - come back into stock funds now that the market is hot again.

There was a ton of money put into ETFs in 2008, but a good chunk of it was spent by institutional investors using ETFs in place of stocks or traders – and that group doesn't represent actual longer-term individual fund investors. 

Fund investors may continue to wade back in. They tend to run out fast but slowly return as the waters look safe. But they may also throw in the towel and give up on an investing lifestyle of adding more and more money to stock funds. 

The stock market has been punishing individual investors for well over a decade, especially those that invest like many fund buyers – piling in at the top, selling near the bottom. Fund investors have sunk nearly a trillion dollars into stock funds this decade, and have seen a good chunk of that wealth disappear. If such an environment keeps up, we could see a return to the sentiment shared during the fifty years beginning in the early 1930s and lasting until the 1980s, in which individual investors just didn’t want much to do with stocks. 

On the one hand, we like to see investors bail out of the market, since that means higher long-term returns for those who stick around. An overinvested market is a low-returning one. On the other hand, if investors really depart funds for good, we’re going to have to get used to the other feature that goes along with 50-year periods of under-enthusiasm by investors: low valuations. 

To put it another way, if fund investors check out and don’t check back in, the market isn’t going to move past its old highs any time soon, even if consumers return to Starbucks and other S&P 500 companies that are currently suffering reduced earnings.

At least a Grande Choc-o-holic Frappuccino tastes good. Most mutual fund investors still have a bad taste in their mouth.