The Investment U e-Letter: Issue # 458
Friday, August 5, 2005 Fund Managers: Why do I Listen to Them? Because This Award-winning Study Shows They're an Excellent CONTRARY Indicator…
By Dr. Steve Sjuggerud, Chairman, Investment U
"I was watching CNBC the other day…" Oh no… "And this fund manager came on and said he's bullish on the stock market, and he's fully invested. He said he expects the stock market to finish this year 10% higher…" Stop right there! Whatever else he said, I don't want to hear it! Look, let me give it to you straight… Fund managers don't have a clue where stocks are headed. In fact, I like to use fund managers as a CONTRARY indicator for what to do when it comes to my investments. Why? Because it works! It's amazing how bad fund managers are at timing the market… Literally, a coin flip would have done a much better job of choosing when to be in the market than all of our fund managers. The coin flip would have won by a wide margin. Even worse, in running the numbers lately, I discovered a real danger sign… You see, right now mutual fund managers, based on one measure, are more optimistic on the stock market than they have been at any time in the last 30 years. Actually, I take that back… there was one other month that tied the latest reading… and that was March of 2000. You know this month… it's the exact month that the Nasdaq 100 index started its 80%-plus decline. Could stocks crash again? With the awful track record mutual fund managers have in timing the market, I sure wouldn't bet against it. Let's take a look… Fund Managers Do It All Wrong Fund managers are fully invested at the top of the market, and have tons of cash at market bottoms. It's the brutal truth. And the numbers really make fund managers look bad. Let me show you… When fund managers have a ton of cash on hand - say, more than 9.5% of the fund's assets in cash - then stocks actually do extremely well. Let's look at some historical numbers. Going back to 1970, fund managers were scared of stocks and therefore held more than 9.5% of their funds in cash roughly 20% of the time. Instead of being scared, the fund managers should have been taking that cash and buying up stocks! On average, when fund managers had more than 9.5% of the fund's assets in cash, the stock market was up by an astounding 18% just 12 months later. And the opposite is true, too… When fund managers have very little cash (say, less than 6% of assets in cash, which occurred 27% of the time), then stocks do terribly… On average, stocks were up 1.2% 12 months later. Take a look at the chart below: 
The Conclusion… So stocks did great when mutual fund managers were playing it safe, holding a lot of cash. And when mutual fund managers were rolling the dice, being fully invested to try and bring home big returns, stocks barely made any money. Have you lost respect for fund managers yet? Consider these examples… You'd have made a killing in stocks if you'd bought at the beginning of the 1990s… particularly during the 1990-1991 recession. Instead of buying, fund managers were scared… they had 12.9% of their assets in cash. They should have been buying, not hiding in cash. As the market rose through the 1990s, mutual fund managers got more bold… and complacent. By March of 2000, fund managers held only 4.0% of their assets in cash. That month was the all time low, and it corresponds with the all-time peak in the Nasdaq. I can't believe it… it's only taken about five years, but fund managers are back, and they're as optimistic as ever. The latest reading (for June 2005) shows fund managers have just 4.0% of their assets in cash. Again, this ties March of 2000 for the lowest reading in 30 years. And with stocks hitting new highs these days, when the July reading comes out, we could see a 30-year record for optimism! The Next Level… Award-Winning Analysis My friend Jason Goepfert, proprietor of the excellent website www.sentimentrader.com, took this analysis one step further (and he won an award for his paper on this… the Charles Dow Award from the MTA). Jason basically said, "shouldn't interest rates play a part in this too?" After all, if short-term interest rates are 15%+ (as they were in 1980), shouldn't fund managers have more of an incentive to have some cash than if short-term interest rates are 1% (as they have been recently)? Jason's logic made sense… and it appeared to be true on the charts too. For example, in 1980 fund managers had over 10% of their assets in cash, taking advantage of the double-digit interest rates. In Jason's award-winning paper, he found that there is a relationship here… and that 55% of the cash holdings of mutual fund managers could be explained by the current level of interest rates. So Jason came up with a formula for how much cash a fund "should" have, based on the current level of interest rates. Now this is where it gets scary… With the exception of the stock market peak in 2000, fund managers have less cash right now when adjusted by interest rates than they ever have in the last 20 years. Looking back over history, this is bad news… Here's what Jason said to his subscribers this week: "The Mutual Fund Cash Premium / Deficit that we post to the site has now dropped below -2% for the first time since the year 2000, meaning that we estimate that funds are holding about 2% less cash than they 'should' be." "Historically, a deficit of 2% or more has lead to a six-month return of -1.9% for the S&P 500, with 40% being positive. 12 months later, the average return dropped to -3.6% with 31% being positive (15 out of 48 months)." This terrible performance by fund managers is hardly chance… Jason's study uses data going back to 1956. What This Means for You and Me It should be obvious… Fund managers are holding less cash as a percentage of their assets than they have in the last 30 years. And fund managers have proven to be terrible "market timers," having too much cash in stocks at the top of the market. Even when you adjust the cash level for interest rates (thanks Jason!), the picture right now is downright scary. But the thing about measuring sentiment is, it's more art than science. And it's extremely difficult to use sentiment to time trades. It's better to think of sentiment gauges like this one as one piece of the puzzle when it comes to analyzing stocks. Unfortunately, many of the puzzle pieces all suggest lower stock prices ahead… we've got $60 oil, an overvalued stock market, and now we've got overly-optimistic investors too. Not a good recipe. The only thing going up is, well, the current trend in stock prices. And that's a trend you don't want to fight. Without committing to a prediction or forecast, and without wishing to buck the trend, let me just say that stocks may not do so well in the coming 12 months. And it may be a smart move to lighten your load in stocks, if this move in stocks looks like it's running out of gas. Good investing, Steve Related Articles: Investment U Archives | 
