"Fully Invested" Bears Start their Selling

By: Ram Seshadri | Fri, Aug 13, 2004
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Below is a commentary posted at http://www.alyxfunds.com/ on 7th August 2004.

Stock markets in the US declined heavily again this week as Oil roared to new records. The tech-heavy Nasdaq composite declined a stunning 6% this week and is down 11% for the year. In the last update, I mentioned that that the decline in the Nasdaq was viewed by market players in the S&P and the Dow "as if it's not their problem", but I predicted "it will soon be everyone's problem". Friday we got confirmation of that problem when the Monthly Non-Farm Payroll Employment Report indicated that the US created 32,000 jobs in July, a fraction of the number expected.

Sneer as much as you want about the lowly Nasdaq, but I think it is a pretty good leading indicator of where the economy is heading time and time again. Looking at the Nasdaq's chart this year, we now know that even as tech earnings were solid in the second quarter, guidance was weak and presaged a likely slowdown in the broader economy in the third quarter. You couldn't have done that by looking at the Dow and the S&P charts. So next time you invest, you may want to think about the market this way: "As goes the Nasdaq, so goes the Dow and the the Economy, three months later!".

Last week, I talked about how "99% of mutual fund managers hide under the thin veneer of the "fully invested" mantra and use it as a way of absolving themselves of any responsibility for managing your money in a "prudent manner"". Well I got some letters to that view split in two camps. One asked me for the names of mutual funds that I was invested in and the other, argued about how being "fully invested" was not a bad thing. Regarding the first question, to those of of you who want a belly laugh, rest easy, no, I am not going to publish a "Ram's Good Housekeeping Seal of Investing in Mutual Funds" anytime soon. For that I will leave our eminent Child-President for the funniest remarks ever made by a President when he was not at a comedy club. Click on this link for the remarks.

Regarding the second question, I will address it briefly here.

I spoke to some mutual fund insiders last week. They were of the unanimous opinion that the markets were going lower. But when I queried what the mutual fund managers were doing to protect their mutual fund holders' assets, they replied (again unanimously), "nothing". One replied as "sitting on his hands and watching the tape". The other was too busy with IPO's but remarked that valuations were cheap but didn't know when the declines would end. One caveat: These guys work for some of the smartest mutual fund managers I know (i.e. managers who have hefty levels of cash and hence are protected from any declines. In fact, these guys would buy in a crash scenario because they actually have that rarest of commodities: plenty of cash). So if these guys are bearish, trust me, there are reasons for you to be careful.

In contrast, think of the 99% of mutual fund managers out there, who are fully invested and bearish! They can't do a thing in the world if the market declines another 10% from here. They have no cash - all the cash they have is for meeting redemptions - that's all. In many cases, if redemptions are fast and furious, these funds will have to sell their holdings in a declining market and make their performance worse (even for the existing share holders who decide not to sell!). In a long market decline, these funds assume they are going to decline with the market (thus vaporizing some of their mutual fund holders' money) and hope and pray that the market rallies by the end of the year to make them look great. One can call this type of investing as a new form of worshipping. My take is that in some cases, you are better off investing in an ETF if all you wanted was to be "fully invested" in the stock portion of your portfolio. At least you will be able to sell at any time during a decline in a heartbeat for about $10 using an online broker.

Also, let's say, there is a big decline one of these days of about 10-20% in one day. Let's also say that you want to sell your holdings at the open. With an ETF, you are sold out in a second at the market price. But in the case of a mutual fund, even if you press the sell button intra-day, your fund will be priced only at the end of the day (down 10-20% as the market may be) and you will be hit with a 4-5% penalty in addition for selling less than 30 or 90 days if you had bought it then. This means you are potentially out of 25% of your money in a day! This is worse than taxes. I think the above discussion gives you some ideas of what goes in 99% of your funds.

Also, I had a chance to talk to many hedge fund managers last week. They were all very busy: forget the fact that they were all busy trying to avoid sinking! Many of them were down for the year and were trying to trade like crazy as if that alone would make their performance go up. But the good news from them is that they have tons of cash (relative to stocks) in their portfolio and many of them are bearish, some outsight bearish, calling for a crash. Since they have tons of cash, they will do quite well in a crash and probably even be doing some heavy buying if that happens.

I am bearish here and expect a 7-10% decline in the indices before this selling squall ends.

With that said, here is how my holdings look this week:


Gold: Gold stocks had a good week but I have mostly silver in my portfolio. I still have only IMXPF (a silver play) in that sector though it's a big position.


Oil and Oil Services: I am short oil plays here because oil has gone parabolic that even the energy stocks may be hurt rather than helped by high oil prices. I am Short VLO and OIH.

Financials: I think the rally in financials was a dead cat bounce that is over. I am long GS Puts.

Autos: I haven't talked much about the Auto bubble but I think that is coming to an end. So I have begun to start shorting some auto names here (HAR is one of them).

Tech: I think tech's days are numbered as macro concerns overwhelm any positive earnings surprises.I think 2005 earnings numbers for tech are too high and as they are brought down, these stocks will be hit. I am long SMH puts and short CSCO calls.

Happy investing and researching! We'll see what next week will bring.


Ram Seshadri

Author: Ram Seshadri

Ramadurai Seshadri
Alyx Funds LLC

Ram Seshadri is investment manager at Alyx Funds LLC

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