More of the Same

May 15, 2002

More of the same. April was another lousy month on Wall Street. The Dow had its worst April since the 1970's, down 4.31%. The broader S&P500 index fell a sobering 6.06%, and the tech heavy (remember when this used to be a good thing?) NASDAQ dropped 8.51%. Many investors are wondering whatever happened to the good old days when you could just buy index funds and forget about them. I'm not even going to bring up large cap growth and telecom indexes - I don't want to ruin your night's sleep.

It wasn't all bad news. Small cap value indexes rose around 3 - 4%. For those keeping track, these types of stocks are now up well over 50% since the large cap indexes hit the skids. That's a pretty big move... for stocks that aren't really growing earnings, broadly speaking. Most of this movement is from the huge gap in valuations between large cap growth stocks and small cap value stocks shrinking. Old MAXfunds readers know this is one of two main reasons we were negative on tech and large cap growth, and positive on value stocks a few years back.

The other reason, the one that is more useful than some subjective discussion on the markets valuations (which always seem high to me anyway) is that everybody wanted to be in large cap growth and tech funds back in 2000. You couldn't give shares of small cap value funds away. Fund companies were launching tech and internet funds to meet the demand, and CLOSING value funds - believe it or not. Janus funds alone were bringing in $10 billion dollars in new assets EVERY MONTH back in early 2000. 

A little money is a good thing. It gives companies capital to grow, it greases the wheels of capitalism. A lot of money is a bad thing. It gives companies enough money to do stupid things to try to grow, and mostly greases the palms of greedy executives of over financed companies. Enron, Global Crossing, Worldcom, and many, many others come to mind. I don't even have to bring up dot-com stocks. What it boils down to is excess money lowers returns for investors - there are simply too many to share the spoils of investing with. 

Is this happening in small cap value? Certainly. A year or two ago, currently hot small cap families like Wasatch and Royce ran funds with a just few million in them. Now many of those same funds have billions in assets. One Royce fund we follow just hit over $2 billion in assets the other day. This fund had $700 million just a few months before that, a less than $100 million a year before that. 

All this new money poses a problem for Royce. In some ways, its more of a problem than it was for Janus who brought in $10 billion a month - at least they were buying stocks with 100 billion dollar market caps. Royce is supposed to be buying small cap stocks with sub one billion dollar market caps. 

So are we taking our chips off the table yet in small cap value in our model portfolios? Nope. Why not? Two reasons. All this money pushes stock prices up higher as the fund managers keep buying the same stocks, and why not get in on some of this action? It's sort of like mid 1999 - tech stocks were already widely overvalued (just look at the NASDAQ now for proof) but still went up another 30% or so because off all the dough). We just realize that the days of wonderfully low valuations are long gone in small cap, and have been for a few months. The other reason is, unlike 2000, there are no other compelling places to go where valuations are reasonable.

Believe me, we'd rather play the buy cheap assets game then the musical chairs game of momentum and cash flowing into hot sectors. However, even with the erosion in large cap growth and tech, valuations are still historically high across the board. Since we don't like taking large cash positions this means all we can do is diversify into a good mix of lower risk funds in the best areas we can find and sit tight.

So far, so good, not that we get too worked up about short term performance, but none of our model portfolios fell more than 2% last month, and only 2 of 7 were down at all - not bad in a month where all the major indexes were in the red. 

We're watching our portfolios closely, and if we get a few more months of large cap growth, tech, and telecom falling precipitously while value funds rally, we may start shifting allocations around slightly. For more detail on the goings on in our model portfolios, click here.