Summary
Did you know that during the 10 often-troubled years of 1972 through 1981, mutual funds disinvested in stocks during all 10 them? Does this piece of history provide an important warning about the contemporary situation? An examination of this question frames this second installment of the "Did You Know?" series.
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About the "Did You Know?" Series
I am authoring a series of articles under the umbrella of, "Did You Know?" These are freestanding pieces about various financial-market matters I believe readers will find of interest and potential benefit. The installments are clearly referenced as part of the overall series and are posted at the GRA website. -- Doug Gillespie
(NOTE: There is additional information about the first installment at the end of the current one.)
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Introduction
This second installment of "Did You Know?" is out of its originally anticipated sequence. Number two was going to examine the impact rising interest rates might have this year on corporate profits. This is more than a worthy topic in the present environment; I will get to it soon.
However, the first "DYK" installment evoked a response from several people that came in the form of a question. A solid question, too, that has inspired the current missive. The question went something like:
"When it arrives, how will I recognize the public's stock-market capitulation?"
This was in response to my observation that stated:
"I have a few key reasons for maintaining [my secular bear market] view, with the following being one of the less scientific. There simply never has been nearly the degree of capitulation by the so-called 'public' that one would expect during an episode as protracted and periodically painful as the one we have experienced."
As was the case in the first installment, I am again going to call upon the great secular bear market of the 1965-1982 era for guidance regarding the current environment.
Onward
Before getting to the meat of the subject at hand, let's take an inventory of where the current secular bear market stands, using the DJIA, the S&P 500 and the NASDAQ 100 as proxies.
(As an aside, yes, it remains my view that we are still in a secular bear market, one that is drawing ever closer to reasserting itself with what will be unambiguous turbulence.)
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BEAR-MARKET PARAMETERS TO DATE -- DJIA, S&P 500,
NASDAQ 100 (Updated Through the Close on 02/15/05)
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2000 - 2005 Closing Prices
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High/Date Low/Date/Change
----------------- -----------------------
DJIA 11722.98 01/14/00 7286.27 10/09/02 -37.8%
S&P 500 1527.46 03/24/00 776.96 10/09/02 -49.1%
NASDAQ 100 4704.73 03/27/00 804.64 10/07/02 -82.9%
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2000 - 2005 Intraday Prices
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High/Date Low/Date/Change
----------------- -----------------------
DJIA 11750.28 01/14/00 7197.49 10/10/02 -38.7%
S&P 500 1553.11 03/24/00 768.63 10/10/02 -50.5%
NASDAQ 100 4781.19 03/27/00 795.25 10/08/02 -83.4%
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Versus Versus
Closing Intraday
------------- -------------
02/15/05 Close High Low High Low
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DJIA 10837.32 -7.6% 48.7% -7.8% 50.6%
S&P 500 1210.12 -20.8% 55.8% -22.1% 57.4%
NASDAQ 100 1547.30 -67.1% 92.3% -67.6% 94.6%
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A couple items of interest about the above numbers:
(1) As of 12/31/04, versus respective year-2000 closing highs, the DJIA was down 8.0%, the S&P 500 was down 20.7%, and the NASDAQ 100 was down 65.5%. Therefore, on a net basis, not a great deal has changed during 2005's first six weeks.
(2) Also of significance in my view is that in January, the Dow celebrated its fifth anniversary of a value below its 2000 closing high. Next month, the S&P and NDX will celebrate their fifth anniversaries of the same travail -- unless they experience rallies of 26.2% and 204.1%, respectively. (They won't!) Five years without taking out former highs is not a bad indication of the "secular" nature of the current episode.
But How Will We Know?
"When it arrives, how will I recognize the public's stock-market capitulation?"
The above question reminds me a little of a certain US Supreme Court deliberation. The one I'm thinking of was in the 1960s, as I recall, involving pornography. The case evoked from Associate Justice Potter Stewart a comment to the effect, "I cannot explain pornography, but I sure know it when I see it."
There are the traditional manifestations of capitulation, the most common being the old-fashioned "selling climax" -- a given day in what has been a bad market in which there is a very weak open, a reversal, a very strong close, all done on a volume spike. You need only go back less than three years, to 7/24/02, to examine a classic one of these.
High Low Close Points % NYSE Volume
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2002 Dow Jones Industrial Average
---- ----------------------------
07/24 8243 7490 8191 +488.95 +6.3% 2.813 bil.
07/23 8008 7591 7702 -82.24 -1.1% 2.442 bil.
Standard & Poor's 500 Index
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07/24 844 776 843 +45.72 +5.7% 2.813 bil.
07/23 828 796 798 -22.15 -2.7% 2.442 bil.
NASDAQ 100 Index
----------------
07/24 952 869 952 +54.76 +6.1% 2.813 bil.
07/23 954 897 897 -32.01 -3.4% 2.442 bil.
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But there also are other, far more subjective varieties. To wit:
Let's say that in late March of 2000, you meet someone at a cocktail party. Eventually, the discussion comes around to the stock market. (It always does, doesn't it?) Your new acquaintance can't wait to tell you that he has just taken an initial position in Cisco Systems -- at 82! (As of 2/15/05, 82 remains the all-time high trade on CSCO, set on 3/27/00.) When pressed, you convey an impression that this gentleman may have made a timing and valuation mistake.
In return, he assures you, in the most vociferous terms possible, that you simply don't understand the new paradigm, or John Chambers' "vision," or the extraordinary value that the tech sector continues to represent! You shrug, then make a hasty retreat to the bar.
Years later, the two of you meet again. Your conversation eventually comes around to how poorly the stock market has performed, on balance, for so many years now. After several drinks, he sheepishly confides that he simply could not take it anymore. Earlier in the week, he had sold his CSCO -- at five!
The moral of this story or form of capitulation is this. In the really nasty market episodes throughout history, the people who help make the tops are often if not usually the same people who contribute mightily to making the bottoms.
But the kind of public capitulation I have in mind would likely fit a different mold. And taken to an extreme, it would require years to play out.
In this regard, the example I'm thinking about occurred during the 1970s. The public threw in the towel and, for a protracted period, stayed on the beach. The following table illustrates the phenomenon.
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Net Acquisition Net Household Change
of Equities by Sector Acquisition in
Year Mutual Funds of Mutual Funds* DJIA@
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(Amounts in Billions of Dollars)
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1966 1.0 2.2 -18.9%
1967 1.8 0.9 +15.2%
1968 2.5 2.2 + 4.3%
1969 1.8 2.2 -15.2%
1970 1.2 1.0 + 4.8%
===================================================
1971 0.4 -0.0 + 6.1%
1972 -1.8 -1.7 +14.6%
1973 -2.2 -2.6 -16.6%
1974 -0.4 -1.5 -27.6%
1975 -0.9 -0.2 +38.3%
1976 -2.4 -2.9 +17.9%
1977 -3.7 -0.1 -17.3%
1978 -1.6 -0.3 - 3.2%
1979 -2.8 -1.9 + 4.2%
1980 -1.8 -0.2 +14.9%
===================================================
1981 -0.6 4.3 - 9.2%
1982 3.5 2.5 +19.6%
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Source: Federal Reserve "Z.1" release. *In this
compilation from the Fed's Z.1 data, the numbers
for households include data for nonprofit organ-
izations. For the big-picture purpose at hand,
I do not believe this creates any material dis-
tortions. @DJIA returns exclude dividends.
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Standing out prominently in the above table are the 10 consecutive years -- 1971 through 1980, inclusive -- in which the household sector generated net mutual fund redemptions. In nine of those years, mutual funds generated negative stock flows.
(NOTE: For the sake of ease in pulling numbers out of the Federal Reserve's flow-of-funds data, the "household sector" numbers throughout this article include data for nonprofit organizations. In many instances, the two areas exhibit very similar investment behavior, and for the big-picture purpose at hand, I do not believe this creates any material distortions.)
By using mutual funds as the proxy for the public, this table actually portrays a conservative picture of the public's behavior towards the equity market during that period. I say this, because away from its activities in mutual funds, the household sector, based on the Federal Reserve's flow-of-funds data, disinvested in equities in all but two of the 17 years broken out in the above table.
The two years of positive flows were 1975 and 1976. This helped fuel the cyclical bull immediately following the DJIA's horrific 45.1% slide between January 1973 and December 1974, discussed in the first installment of this series "Did You Know? - Part One".
To better appreciate the numbers contained in the above table, it is important to look at some aggregate figures.
As of 12/31/65, total mutual fund assets stood at a mere $35.2 billion, of which $30.9 billion or about 88% was invested in stocks. The total market value of all equities at the end of 1965 was about $735 billion, which included a few billion dollars of foreign issues held by US investors. At the time, money market funds were a thing of the future. In fact, at the end of 1974, only $2.4 billion was invested in these vehicles, with the household sector holding the entire amount.
As of 9/30/04, the latest flow-of-funds data available, mutual fund assets totaled, $4.9 trillion, with an additional $1.9 trillion invested in money market funds. (The household sector held about $868 million or 46% of the money market fund total.) Stock holdings of mutual funds stood at $3.3 trillion or about 67% of total mutual fund assets. The total market value of all equities was $15.6 trillion, which included $2.1 trillion of foreign issues held by US investors.
The "Public's" Importance -- Then
Here something else of interest in the earlier table.
Although the household sector did not support the equity market well at all during most of the period shown, the market itself, using the DJIA as the proxy, was able to muster 10 positive years, running from 12/31/65 through 12/31/82.
Ten up years out of 17 years total isn't bad at all. Remember, though, that from 12/31/65 through 12/31/82, the DJIA's cumulative principal return was just under 8%, which works out to a horrific 0.5% per year, on average.
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THE DJIA'S PERFORMANCE DURING THE SECULAR
BEAR MARKET OF 12/31/65 THROUGH 08/12/82
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---------- Closing ---------- Year
Year High/Date Low/Date Change Index
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1965 969.26 12/31[1] 840.59 06/28 12/31/65=100.00
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1966 995.15 02/09 744.32 10/07 -18.9% 81.06
1967 943.08 09/25 786.41 01/03 +15.2% 93.38
1968 985.21 12/03 825.13 03/21 + 4.3% 97.37
1969 968.85 05/14 769.93 12/17 -15.2% 82.58
1970 842.00 12/29 631.16 05/26 + 4.8% 86.56
1971 950.82 04/28 797.97 11/23 + 6.1% 91.85
1972 1036.27 12/11 889.15 01/26 +14.6% 105.24
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1973 1051.70 01/11[2] 788.31 12/05 -16.6% 87.79
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1974 891.66 03/13 577.60 12/06[3]-27.6% 63.59
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1975 881.81 07/15 632.04 01/02 +38.3% 87.95
1976 1014.79 09/21 858.71 01/02 +17.9% 103.66
1977 999.75 01/03 800.85 11/02 -17.3% 85.76
1978 907.74 09/08 742.12 02/28 - 3.2% 83.06
1979 897.61 10/05 796.67 11/07 + 4.2% 86.54
1980 1000.17 11/20 759.13 04/21 +14.9% 99.46
1981 1024.05 04/27 824.01 09/25 - 9.2% 90.28
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1982 1070.55 12/27 776.92 08/12[4]+19.6% 107.97
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[1]Beginning of 1965-82 bear market. [2]Closing
high during 1965-82 period. [3]Closing low during
1965-82 period. [4]End of 1965-82 bear market --
total 12/65 to 8/82 price-only return = -19.8%.
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One reason, the primary reason, the public's negative market participation during this period didn't lead to an even worse outcome was the public's changing participation in the market at that time.
To be sure, the household sector had a very significant direct (non-mutual fund) ownership of common stocks going into the period as well as coming out of it. At the end of 1965, the household sector had total direct equity holdings of $616.1 billion, equal to 83.8% of total outstanding equity value. By the end of 1982, these figures had become $832.5 billion and 53.3%, respectively.
But during this period, a major shift was in progress.
As of 12/31/65, the equity holdings of private pension funds combined with state and local employee retirement plans totaled a mere $43.3 billion -- 5.9% of total outstanding equity value. At the end of 1982, these figures had grown to $354.6 billion and 22.7%, respectively.
A B C
--- --- ---
Total Held by Held by
Value of Household Pension
Equities Sector B/A Plans* C/A
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(Dollar Amounts in Billions)
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12/31/65 $ 734.9 $616.1 83.8% $ 43.3 5.9%
12/31/82 $1562.5 $832.5 53.3% $354.6 22.7%
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*Combined holdings of private pension funds and
state and local employee retirement plans.
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However, an even more important set of data relating to the 1965-82 period is the one breaking out net flows into stocks.
As discussed earlier, the household sector disinvested in equities in all but two of the 17 years from 1966 through 1982, inclusive. The two years of positive flows were 1975 and 1976. On the other hand, pension plans (combined private and state and local) had positive flows into equities in all of the 17 years. And the overall cumulative results were dramatic, as shown in the following table.
12/31/65 Total Net Net Household Net Pension
Through Equity Sector Flows Flows into
12/31/82 Issuance into Equities Equities*
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(Amounts in Billions)
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$97.1 -$191.3 $206.9
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*Combined flows of private pension funds
and state and local employee retirement
plans. Respective total flows = $153.3
billion and $53.6 billion.
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So the logical conclusion you draw from the above data is pretty straightforward. Pension plans, not the household sector, were a major creator of equity-market flows during the great bear stock market of 1965 through 1982.
Of course, pension liabilities are a household-sector asset, but the story told above is that during the period shown, the public was placing a growing portion of its investment decisions about the stock market into the hands of pension plans. In turn, pension plans were placing these funds in the hands of professional money managers, managers almost entirely void of mutual funds. Thus, the public's generally more emotional attitude towards the market had been largely muted.
The "Public's" Importance -- Today
The proverbial worm has turned. And the mechanism for turning it has been the enormous growth of defined contribution pension plans. This has occurred vis a vis a major diminution in the relative importance of defined benefit plans, the latter vesting investment decisions in the hands of the plan sponsors or in the hands of the managers hired by the plan sponsors. In other words, a large and growing amount of the decision-making process is back in the hands of the public.
Unfortunately, the Fed's flow-of-funds data do not break out the split between defined benefit and defined contribution numbers for the 1965-82 period. Many of the vehicles available today did not even exist during much of that period. For instance, as late as 1982, total IRA assets were a mere $51.7 billion.
However, we do have specific numbers for more recent periods from the most recent Fed report. For the following categories, the numbers are as of 12/31/03.
Defined Benefit Defined Contrib- Individual Re-
Pension Plans* ution Pension Plans tirement Plans
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(Dollar Amounts in Billions)
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Total Value as of 12/31/03
--------------------------
$1680.0 $2345.4 $2979.0
Net Flows During 2003
---------------------
-$ 16.2 $ 22.4 $ 124.7
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*Private-sector plans only.
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As a matter of historical interest, the lines between private defined benefit and defined contribution plans crossed in 1996. As of 12/31/96, total assets of the former equaled $1.579 trillion, while total assets of the latter equaled $1.628 trillion.
[blSome Concluding Comments
Perhaps the transition of the last couple decades has changed the public's historical behavior towards the stock market. Perhaps there will be no ultimate capitulation. If this is the case, "it is different this time."
I've highlighted the "it is different..." for a reason that I'm certain is already obvious to many readers. These are the words that have been used so very many times to try to convince people that what has been virtually inviolable in the past will not repeat again. These are bad things, of course, but things that have had a devilishly consistent way of repeating anyway, despite the admonition. Therefore, "it is different this time" just may be the five most dangerous consecutive words in the investment lexicon!
Arguing in the other direction is that as of 9/30/04, the public continued to have direct equity investments totaling $6.133 trillion. In addition, the public held another $3.243 trillion in mutual funds, most of which was invested in stocks. Therefore, if nothing else, the ingredients for a bear-market capitulation at some point in time are in place. As always, time will tell.
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About Installment One
There are some key ways that the first "Did You Know?" installment intersects with the current one. The first installment of the series was published on January 26. It asked, then addressed, "Did you know that from its 1973 high to its 1974 low, the Dow Jones Industrial Average fell 45%?. It is what came afterwards that could be helpful in assessing the stock market's current prospects."
If you did not read that installment but would like to, you may reach it at "Did You Know? - Part One".
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