Perhaps the most misunderstood phenomenon in the structure of our financial markets is the impact of trading by mutual fund managers. Paradoxically, in my opinion, it is the single most important factor to predict market moves.
As recently as 1980, less than 6% of U.S. households owned mutual funds. That percentage increased steadily to its peak of almost 48% in 2001 and seems to have stabilized in the mid-low 40's (the data is not yet available for 2008). In terms of holdings, this translates to about $10 trillion as of Dec'08 of which about 1/3 are stock mutual funds. There is a wealth of data on this in www.ici.org.
The rationale behind this transformation was that the individual investor did not have the time and/or expertise to manage his or her own money and would be better-off hiring a professional money manager who could do better. Furthermore, asset-pooling would give an investor with an amount as small as $500 access to a portfolio manager with perhaps billions under management and, presumably, better expertise. In the specific case of an equity fund, the manager would presumably chose the best opportunities to "buy low and sell high" which is a sensible way to money.
Unfortunately, the mutual fund industry has metamorphosed into a perverse machine that bears little resemblance with the original design. For starters, most mutual funds are always fully invested (higher than 90%) on the theory that investors who want to hold cash would just sell the fund and, thus, hold cash. Never mind that the average investor is ill-equipped to decide when to hold cash (because most stocks are expensive, for instance) which is why he or she hires a professional in the first place. The industry blissfully ignores this paradox because "stocks always go up in the long run" which means nobody should ever sell them.
In addition, most mutual funds are measured on relative performance against some index. So, according to industry practice, if the S&P goes down 20% and your mutual fund is down 19% you should consider yourself well served. Tracking error, which is the difference between the performance of the fund and its index, is the single most important driver of most managers' decisions (as opposed to cheap vs. expensive). This is why most funds own hundreds of stocks as opposed to a handful (more stocks imply higher market correlation and lower tracking error).
Furthermore, mutual funds charge a fixed percentage of assets under management for their trouble, which means it is NEVER in their best interest to advice the client to redeem the fund and hold cash. Since they never hold much cash themselves either, it is up to the client to decide when the market (or sector) is expensive and get out.
This combination leads to a very different risk reward perspective than one would ordinarily expect. For instance, consider a situation where the portfolio manager, after careful consideration, thinks the economy will be much worse at the end of 2009 than it is today. Furthermore, lets say our manager had decided accordingly to lower the risk of his/her portfolio by raising 10% of cash at the end of February. As the S&P index went from 735 to 666 our manager did not feel too bad as the 10% decline in the index resulted in only a 9% decline in the portfolio. As the index began to recover in March our manager surely dismissed it as a bear-market rally. Unfortunately for our manager, the index decided to keep going piercing the magical round number of 800 which is 9% higher than the close of February. Gone is the outperformance as we are now underperforming.
What would a sensible investor do in this circumstance assuming that he or she thinks the economy will get worse in 2009? I think most people's answer would not be buy more stocks. However, that is exactly what many, if not most, portfolio managers do when faced with this conundrum. Think about it, if the rally continues to 900 and beyond they will be accused of underperforming the market, missing the rally, or worse. On the other hand, if the market goes back down the worst they will have to face is being down with everyone else. Investors are used to bad news when the market goes down. In fact, many don't even open their statements. However, when the market goes up, they expect to make money. The marketing director at the mutual fund company knows this fact and will make sure the portfolio manager is aware of it as well.
Where does this leave the individual investor, who is the actual owner of the stocks managed this way? Thinking that his or her money is managed professionally with incentives aligned to his or her own which is hardly what is happening in reality. As for the market, the behavior I have described is exactly the same one would observe from a short-seller with a stop loss (desperate purchase on the way up, no interest on the way down).
Naturally, while this is happening (recall the period 3/17/08, aka The Bear Stearns Lows, through 5/19/08 before we found out Fannie and Freddie were not really AAA) the pundits think things are getting better because the market goes up while the market is just recovering from and oversold condition driven by performance chasing.
I have no illusions of being able to call the bottom. However, I find hard to believe that the stock market can fully recover while the economy continues to deteriorate which still seems to be the case. While I am fully aware that the market will anticipate the recovery, I think we should be able to see more meaningful signs than "it is getting worse at a slower pace." One thing I am sure of, the current rally has a lot more to do with managers covering shorts (outright or against the index) and chasing performance than with any meaningful improvement in the fundamentals of the economy.