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February 03, 2002

The Struggle For The Legal Tender

If You Run Short Of Money, Honey, I'll Run Short Of Time...
In our modern world of 24/7 streaming information blaring at us from the boob tube, the financial press and the nineteen inch flat panel screen, it's pretty darn easy to get caught up in the short term guessing game. Guessing where financial asset prices will be in the next ten seconds, ten minutes, ten days and ten months. Sentiment indicator after sentiment indicator has been developed in an effort to aid mere mortal humans in guessing what the other guessers will do next with their hard earned investment dollars. The VIX, VXN, put/call, short interest, TRIN, bullish/bearish surveys, over bought and over sold oscillators, you know the rest. We don't mean to make light of shorter term, chart driven sentiment indicators. They can be quite useful in helping to gauge entry and exit points while actively managing assets. But, what may be the ultimate sentiment indicator of the moment is cash flow. Clearly a study of corporate cash flow would have tipped one off to many a corporation stretching the interpretation of GAAP for many moons now. A clue that creative accounting was a deadly serious issue long before it "showed up on TV" or the front page of the Journal. What about cash flow as it pertains to the broader investment community? What may be incredibly important is how this question is currently being answered by Main Street America. Not answered in any type of survey, but rather with the pocketbook.

As you know, the bull market of the 1990's was a bull market characterized by full participation from Main Street America. Mom and pop investors far and wide provided the monetary fuel so necessary for financial asset prices to move ever higher. An era of public participation not witnessed since the period of the late 1960's and early 1970's. As it turns out, the year 2001 was notable not only for the continuation of an equity bear market as severe as anything seen in three decades and a wake up call in terms of global security, but also for the fact that the Main Street American love affair with equities displayed clear signs of coming to an end for now. Like a western gold rush town turned ghost town years after the last nuggets were pulled from nearby mines, Main Street was relatively deserted in 2001 in terms of US equity mutual fund inflows. Only the wind and tumbleweeds dancing along the cobblestone streets. The worst showing in a decade:

The official ICI (Investment Company Institute) number for 2001 revealed that total equity fund net inflows for the year registered a paltry $39 billion. Relative to record year 2000 inflows, the 2001 experience was a hair over 10 cents on the dollar. This $39 billion figure includes inflows to US based equity funds that invest in foreign equities. For US specific funds (which is shown in the chart above), the inflow number was approximately $55 billion, down 80% from year 2000experience. (Clearly there was outflow in foreign oriented funds.) As witnessed by this pocketbook participation, America's love affair with equity mutual funds may have come to a rather silentend last year. At best, maybe this is temporary. At worst, and if history is any guide, it may be over for a good while. So far, unspoken by the streaming media cognoscenti of the CNBC's of the world. Not given too much press in Street strategist missives on the future. Net yet found on the front page of financial media must-reads.

Characterizing what may be additional signs of growing public respect for risk, inflows to bond funds lit up like a skyrocket in 2001. Likewise, moneys that did flow into US specific equity funds found the largest portion being allocated to Growth and Income, an asset class that had gone begging into the height of the bull market. The following chart details the change of heart on the part of American investors during 2001 in terms of where their hard earned dollars were being invested in the greater equity fund complex, or not being invested for that matter:

The Law Of Diminishing Returns?...
Incremental change can often be an incredibly powerful force. Change at the margin is often the first sign of the beginnings of broader shifts that ultimately are fully recognizable only in hindsight. In financial markets. In the real economy. In human perception change. A stock that simply stops reacting positively to continued good news. Or, conversely, a stock that won't sell off any more on a continual stream of disappointment.

Even though absolute dollar levels of public participation in equity mutual funds increased at relatively significant amounts as the 1990's bull market wore on, the law of diminishing returns was already beginning to set in well before the final dollar peak in fund inflows during 2000. To the point where the record year 2000 inflows paled in comparison to the then existing asset base of the equity mutual fund complex in its entirety. Now that absolute dollar flows have diminished substantially from that record peak, current contributions are simply becoming rounding errors relative to existing assets: :

Important from the standpoint of affect on price. If 2001 is the beginning of a trend of lower absolute dollar inflows to equity funds ahead, it can pretty well be surmised that the bulk of public fuel (cash into these funds) has already been spent. Fuel that drove the bull market occurrence in the first place.

First There Is A Mountain, Then There Is No Mountain, Then There Is...
In further exploring the meaning of public allocation of cash, another perspective on the potentially ending honeymoon with equities may be seen in the money market fund complex. As you know, we simply cannot count the number of times we have witnessed Street seers refer to the "mountain" of money just waiting to dive into this market. We keep scratching our heads given the fact that there just has not been that much selling to create this mountain of anticipatory cash. Plenty of credit creation to stoke money funds, though. From the folks at ICI, here's a little view of life seldom seen in most explanatory Street presentations regarding the oodles of cash "circling the game". Just waiting to pounce:

If this money is ultimately destined to purchase the mom and pop new era equity vehicle of choice, then there is no mountain (relative to what has already "pounced", so to speak). As you know, this chart is a study in human trust. In belief. Implicitly, also a study in price.

All That I Am Askin' For Is Ten Gold Dollars. And I Could Pay You Back With One Good Hand...
In complete coincidence with the significant decline in equity mutual fund inflows over the last year is the fact that existing cash in domestic equity mutual funds is also quite low. In fact very low from a historical standpoint. During December of 2001, cash in equity mutual funds declined by about $8.5 billion. Meaning that equity fund managers spent all of the inflows for the month and then some. No great mystery as to why. After one hell of a 4Q in terms of index performance, showing significant cash in the old portfolio at year end (implicitly telling the world one did not fully participate in the 4Q rally) would have been a distasteful "career move" for most equity fund managers. Of course this cash, which represented approximately 15% of total year 2001 inflows into US specific equity mutual funds, was put to work after the market had already risen and just prior to a sloppy January.

Year end 2001 cash in equity mutual funds dropped to 4.9% of total equity fund assets. It's the lowest reading seen since August of 2000. You remember, the month just prior to the market really accelerating downward. Who knows where the indices go from here, but is 4.9% cash in equity funds the level from which new bull markets commence? Especially when equity fund inflows are showing significant recent slowing tendencies? You be the judge:

The last time we checked, financial asset prices do not magically levitate on their own (although sometimes it may seem that way). They need a cash buyer to bid up their price. A sarcastic comment, but the fact that equity funds have one of the lowest cash allocations on record, coupled with the recent reality that mom and pop Main Street investors have significantly slowed their purchases of equity mutual funds, just may be the ultimate, and most simplistic, of sentiment indicators. When you are looking at the short term VIX, VXN, put/call, etc, you are looking at the trees in a diminishing forest of cash. In the struggle for the legal tender, equity funds are losing out in a big way relative to at any time during the "new era".

Liquid Dreams...
While Main Street America is cutting way back in terms of parting with its ever more precious cash, the Fed has absolutely no compunction whatsoever about allowing the creation of more and more of the stuff. As we head into 2002, it's our feeling that we are moving into global economic and financial market waters uncharted at any time over post war history. If indeed we are headed into an inventory rebuild cycle near term, as we believe, that will stabilize and at least temporarily uplift macro economic readings, this stands to be one of the most academically mild (by the numbers) recessions in many a decade.

In stark contrast stands the fact that we are in the midst of one of the greatest multi-year downturns in corporate earnings on record. These two seemingly incongruous characterizations of the current environment leave us to believe that the current experience is far from typical or historically "average" in nature. The purging of classic excesses simply has not happened. Housing, auto sales, debt accumulation - none of these has turned down even for a second during this so called recession. What may certainly be different about the current experience is the incredible desire of the Central Bank to placate the moment. To attempt to put off what has been natural economic reconciliatory pressures of recessions past. The action of placating the moment this go around is either a stroke of genius, if we can avoid widespread economic pain, or a misguided plan that allows excesses to continue accumulating in fallacious fashion. Forestalling ultimate and most likely even more painful reversion to some type of normalcy ahead.

The Fed's pass on a rate cut this week may signal the end of the rate cut cycle for this economic interlude. We would not rule out another 25 or so basis points on the downside, but at this point it's largely moot as potentially being a significant catalyst for immediate economic change. The most significant issue ahead in our minds is money growth. Forget interest rates. When will the Fed have the resolve to back off on the money supply accelerator? It's a paramount question for both the economy and the financial markets ahead. At the moment, a bit momentous for financial asset prices as the public investor is fading from the limelight as a sponsor of price acceleration vis-à-vis cash flowing into the conduit of equity funds.

From the early 1960's until the early 1990's, year over year directional change in M3 and in the economy, as measured by nominal GDP, pretty much moved in similar fashion. Until the last decade:

Another way to view the relationship in the chart above is to look at the difference between year over year M3 growth and year over year GDP growth as follows:

Year over year M3 growth relative to year over year nominal GDP growth is currently at a four decade extreme. Historical periods of near similar peak experience have been quick spike-like affairs. Not a decade long process that has built upon itself each step of the way as we know seem to witness. IF the economy recovers significantly, this relationship reconciles itself. If not, reconciliation lies only in the hands of the Central Bank. The Fed may be done cutting rates for now, but will they truly allow system wide liquidity growth to slow to a pace more consistent with nominal GDP growth near term? At best, we would suggest that the current relationship seen above is unsustainable over any longer period of time. How it ultimately reconciles remains to be seen.

Somebody Stop Me...
The mutual fund data presented above is a wake up call in our opinion. An indication that public sentiment regarding equities has shifted from the rabid avocation of even just a few short years ago to something much more subdued in terms of new purchases. Raising serious questions regarding the nature of the financial asset supply and demand equation ahead. Possibly more meaningful on the road right in front of us will be money supply growth allowed by the current Central Banking cast of characters. With the even more ominous question lurking in the background of how long foreign capital parked in US dollar denominated assets will tolerate what seems an unending supply of "new money" in the US financial system. It is certainly our contention that Fed liquidity creation is providing at least some type of downside cushion to the current financial market environment. Certainly enough to cushion and offset the diminishing appetite of the public. Humble question: Who is going to cushion the potential downside in financial asset prices when the Fed either decides or is forced to temper its allowance of money growth? At the moment, that is the tension found within the legal tender. As you would suspect, it is more of a struggle than not in identifying an acceptable answer or eventual outcome.

Market Observations
ContraryInvestor.com

Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

Contrary Investor is our vehicle for providing what we believe is institutional quality financial market research, analysis and commentary that is characterized by honesty, integrity and credibility. We live the business and hope to bring what we learn from our daily experiences to our work at Contrary Investor. Having checked our egos at the door many moons ago, we hope to allow our work to stand on its own and speak for itself, without the personal promotion of any one individual getting in the way. No investment guru's here. Just lifelong students of and participants in an ever-changing financial marketplace.

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