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Wall St. Fears Fund Sell-Off Is Brewing

Stocks: Small investors are holding on, but analysts worry that new losses will crack resolve.

By JOSH FRIEDMAN Times Staff Writer

September 4 2001

The stock market's summer swoon has Wall Street fearing many small investors might begin to cash in their mutual funds, eliminating a key source of support for share prices.

Americans who own stock funds have been hanging tough so far in the market's steep slide, even buying more shares for most of this year.

But the latest sell-off, which last week pushed the Dow Jones index below 10,000 again, could change more investors' mood, some experts worry.

Heavy selling of mutual funds, if it materializes, could make matters worse for the stock market, which already has suffered its sharpest loss in at least 13 years, as the economy has weakened and corporate profits have plunged.

In previous deep market declines, such as 1973-74 and 1987, stock fund investors became net sellers of fund shares for extended periods, meaning the dollars withdrawn swamped new money going in.

This year, however, the funds--which hold $3.6 trillion in assets and thus are a key source of demand for shares on Wall Street--took in a net $48 billion in new cash through July, despite the continuing market slide. Much of the new money is coming in via Americans' retirement savings plans.

Yet new cracks are appearing in investors' apparent resolve to hold on to their stock funds amid the brutal downturn: The mutual fund industry's chief trade group said Thursday that the funds had net withdrawals of $1.2 billion in July alone, the first outflow since March.

It was a tiny sum compared with the funds' total assets, but it raised fears that more fund investors are losing patience with stocks as the decline in prices enters its 18th month.

That decline worsened Thursday, as the Dow Jones industrial average slumped 171.32 points to 9,919.58, its first close below 10,000 since April, when the market was hitting two-year lows. On Friday the Dow inched up slightly, to 9,949.75. Markets were closed Monday in observance of Labor Day.

Some analysts say most investors in stock funds, which combined own more than one-fifth of the U.S. stock market, probably will continue to sit tight.

They say the reasons net outflows haven't occurred so far include the growth of 401(k)s and other long-term savings plans that draw steady investments directly from workers' paychecks; a better-educated investing public; and perhaps just plain inertia and confusion among those stunned by the market's tailspin that began in the spring of 2000.

Warning of 'September Storm'

Many small investors insist they are in the market for the long run.

"I got caught in the crash of '87 and got hurt pretty bad by not having the good sense to ride it out. In retrospect, it was a short-lived dip," said George Hutchinson, a 67-year-old retiree in Corpus Christi, Texas, who is among those with no intention of bailing out of stocks this time around.

The next few months could be critical, analysts say: If share prices fail to recover in the fourth quarter, investors will be facing a second straight calendar year of losses in blue-chip stocks--something that hasn't happened since 1973-74.

"Very seldom do you have two down years in a row, so we'd have to see how people react, whether they get freaked out," said Kurt Brouwer, an investment advisor in Tiburon, Calif.

"If there's another leg down, I think there will be a kind of forced selling among people who have held out but finally say, 'I can't take it anymore,' " he said.

In a report Friday, Banc of America Securities market strategist Tom McManus warned of a possible "September storm" of stock fund outflows, noting the rash of fresh corporate profit warnings amid the struggling economy and the dismal market performance that has left the average U.S. stock fund down more than 13% this year, on top of a 2% drop last year.

Some popular funds are down much more than the average. The Janus Fund, for example, has lost 25% year-to-date. The Fidelity Growth Company fund has tumbled 26.5%.

"I think we're going to see a wave of redemptions before year-end," McManus said in an interview. "This selling is likely to crimp any upside potential in the market."

After the 1973-74 market rout that followed the first oil crisis, the Watergate scandal and other bad news, net outflows from stock funds were the norm until 1982. In 1975, for example, a net $1.6 billion was withdrawn from stock funds, or about 5.3% of their assets at the start of the year.

After the market crash of October 1987, stock funds had net outflows in 16 of the following 18 months, totaling $29 billion, or about 12% of their pre-crash assets.

Outflows from stock funds in 1975 and in 1988 did not stop the market from recovering in either year. Indeed, the Dow rebounded 39% in 1975 and 12% in 1988.

Stock Market Sentiment Gauge

But Wall Street watches mutual fund trends today as a gauge of general public sentiment toward the stock market. And because small investors have become a much bigger force in the market over the last 10 years, widespread disillusionment over stocks could raise questions about the market's prospects longer term.

That, in turn, would have implications for U.S. companies' ability to raise capital to expand, and for Americans' wealth in general.

Stock fund net cash inflows totaled more than $180 billion a year in four of five years from 1996 through 2000, helping the Dow to zoom 111% in that period. The technology-dominated Nasdaq composite index soared 135%.

By contrast, in the late 1970s the public's lack of interest in the market contributed to what was a dismal period for stocks from 1977 to late 1982.

Yet some analysts say this bear market is less severe than the mid-1970s one. "In the '70s the sell-off was broader and the cries of pain were louder," said Charles Foster, a financial planner in Del Mar, Calif. "These days it's mostly the people who got sucked into the 'new economy' stocks that are getting slaughtered. The rest of the market is down, but far less."

Indeed, whereas the Nasdaq index has collapsed 64% from its 2000 peak, the Dow has fallen 15% from its peak.

Retirement Savings on 'Auto-Pilot'

Even so, the biggest reason stock mutual funds have continued to see net cash inflows is the effect of retirement savings plans, said Geoff Bobroff, a fund industry consultant in East Greenwich, R.I.

"That cash flow is a huge natural pump," he said--a pump many investors have so far left on auto-pilot.

Nearly half of all stock fund assets are held in employer-sponsored retirement savings plans, such as 401(k)s, or in IRAs. Earnings on those assets are exempt from taxes until withdrawn in retirement. Thus, investors have a strong incentive to retain a long-term focus, which favors stocks because the market has historically provided the best returns of all assets in the long run.

Congress this year boosted the maximum contributions investors can make to retirement accounts, providing even more incentive to save, analysts note.

Whether putting money away for retirement or another goal, small investors have more of a long-term focus than ever, some experts argue.

"The typical retail investor does not run for the hills when stocks fall," said Brian Reid, an economist at the Investment Company Institute, mutual funds' chief trade group. "They know they are supposed to be investing for the long term."

J. Carlos Jiacinto, a graduate student at American University in Washington, D.C., typifies that attitude.

"My Invesco Technology fund is one that has punished me badly, but I'm only 23--it's not like I'm 40 or 50," he said. "I just don't look at it." Jiacinto, who began investing a year and a half ago after receiving an inheritance, holds the fund in an IRA.

Kathie Larsen, a clinical psychologist in Seattle, said her stake in the Janus Global Technology fund has been halved in value since its peak in early 2000.

Still, "I'm hanging tight," she said. "I think tech will eventually come back and when it does this fund will come roaring back."

Analysts say the market's quick snapbacks from sell-offs in 1990, 1994 and 1998 conditioned investors to hold on or buy on dips, as they were consistently rewarded.

"If you ever pull out in a panic, it takes a heroic amount of resolve to get back in at a price higher than what you sold for," investor Hutchinson said. Time is still on his side, he said. "Even at my age, the horizon is pretty far out there." He said he stays fit and plans to live to 100.

Investors' growing use of intermediaries, such as financial planners, may also be a stabilizing force for stock holdings, analysts say.

Direct sales of mutual funds to individual investors, excluding those made through 401(k)-type plans, now account for just 16% of stock and bond fund purchases, according to the ICI, compared with 23% in 1990. The balance of sales are made through financial advisors, including planners and brokers.

The hand holding that intermediaries provide, especially in choppy times, helps investors stay focused on the long term, analysts say.

But another reason mutual funds have continued to take in new money overall might be simple inertia.

"There are two possibilities," said Shlomo Benartzi, a UCLA professor who focuses on investor psychology. "One is that people have been educated about saving for retirement and not worrying about the ups and downs. The other is that they are lazy and don't do anything with their retirement funds--when stocks went up they didn't [sell to take profits], and when stocks go down they don't want to sell because paper losses then become reality.

"I wouldn't be too quick to celebrate the idea that the individual is doing well and sticking to a long-term plan," he said. "Many people don't even check their balances. It's possible they're not aware of what's happening."

Investors who are paying attention, however, may have noticed other investment choices are performing far better than stocks this year.

For example, many bond mutual funds have posted gains of 6% or better year-to-date. Bonds are interest-bearing IOUs from companies or government agencies. As the Federal Reserve has slashed short-term interest rates this year, higher-yielding longer-term bonds have gained in value.

'Rebalancing' Portfolios

More mutual fund investors have begun to shift savings to bonds. Bond funds have taken in $45 billion in net new cash this year, through July. In the same period in 2000 bond funds were seeing cash outflows, according to data from the ICI.

Savings accounts at banks also have surged in popularity this year.

Financial advisors say that despite optimism about stocks for the long term, some people who are heavily invested in the market should be moving some of that money into other assets, for the sake of diversification.

Thus, if stock funds experience cash outflows in the next few months, it may not reflect panic selling by investors so much as an effort to "rebalance" portfolios to improve diversification and lower risk, some analysts say.

Bond mutual funds hold $900 billion in assets in all, but that is equivalent to just one-quarter of the assets Americans have in stock funds. In the late 1980s, by contrast, Americans had more money in bond funds than they had in stock funds.

-- Martin Thompson (mthom1927@aol.com), September 04, 2001