March 31, 2000
Dear Congressman Pete Stark:
Today on CNBC Franco Modigliani, a Professor of Economics at MIT and a Nobel Prize winner was interviewed. Mr. Modigliani reiterated many of my concerns I addressed to you in numerous, previous letters. Mr. Modigliani stated that certain stocks have extremely high valuations based on fundamental analysis (what won him the Nobel Prize), primarily price to earnings ratios, and that, "Somebody is foolish [whoever is buying these stocks]." He also showed concerns for his own investments in mutual funds, he was concerned that in the mutual funds he owns there were stocks that he considered to be overvalued.
This is the specific reason why I have asked you and my employer to come up with some way I can invest my retirement savings (a 403B) in individual stocks and not be required to buy a mutual fund. There is absolutely not one single stock mutual fund that I can buy through my company's 403B plan that does not have stocks that are fundamentally overvalued based on mine as well as Nobel Prize winner Mr. Franco Modigliani's model. I can't buy a mutual fund that has only solid value as well as growth stocks in it. If I was allowed to setup my own portfolio, I could easliy do it.
Why can I do it and mutual funds can't? The main concern for a mutual fund is first profit (their's) and second liquidity. For example, if a new small cap stock mutual fund has a high return in its first year relative to the market, the fund will draw new investors, if the growth of new investor money is very large, the mutual fund will be forced to buy stocks with higher market caps, not because those are necessarily the best stocks, but because they will need stocks with better liquidity. The mutual fund gladly takes the extra investor money even though they know changing the mutual fund's criteria, that is, buying stocks that have higher market caps, could hurt the mutual fund's performance in the coming year.
Unlike a mutual fund, I do not have to worry about liquidity, nor do I have to find, as in many cases with mutual funds, hundreds of stocks to fit my criteria. I only have to find 10-20 stocks and that's very easy to do (I say 10-20 because that's the number I need to have in my portfolio to be diversified or to eliminate most firm risk.). I can find 20 stocks that have high growth rates and at the same time, they have low valuations based on a value investor's criteria. It's the best of both worlds. Granted, the stocks have lower market caps, but that's not a problem for an individual investor, it's only a problem for mutual funds. (To learn more about liquidity and diversification and the number of stocks required in a portfolio to be diversified go to: Diary of a Small Investor, Chapter, Why Stocks?)
In your letter to me dated March 15, 2000, you stated,
"...mutual funds are set up to provide the same rate of return on investments for all participating individuals and to guard against individual investors, not as experienced as you, from losing everything in the unfortunate investment in a single stock."In my opinion, you are not completely looking at the facts. Do you know that the vast majority of mutual funds have most of their assets in a few companies? Granted, they own hundreds of stocks, but many mutual funds invest most of the funds assets in a small number of companies and many of those companies are severely overvalued. Being invested in a mutual fund does not necessarily mean the investors are truly diversified.
Do you realize MSFT, INTC, CSCO, DELL, ORCL, AND SUNW, together have a market cap of over $2 trillion, that's only 6 stocks, that's almost a third of what the total NASDAQ stock market's market cap is? Do you realize that not one of these stocks has a price to earnings ratio of less than 60 and that half of them have a 3 digit price to earnings ratio? Do you realize who are the biggest buyers of these stocks, institutions? Have you heard of the rule of 17.5 which states,
"As previously indicated, in determining the direction of P/Es, we have found the trend of inflation to be a good indicator. This is vividly illustrated by the 'rule of 17.5.' Simply put, the rule of 17.5 states that over the long run the sum of a given year's inflation rate (as measured by the consumer price index) and the same year's average market P/E multiple (as measured by the S&P Industrials' P/E) tends to eual 17.5." A.G. Edwards & Sons Inc., Securites Research, Special Report, The Growth Stock Approach To Investing, Donald T. Spindel, CFA, 1990.From 1945 to 1990 the calculation for the rule of 17.5 was never over 22, it's currently 40, almost twice as high as it's ever been between the period 1945-1990.
My point is that being in a mutual fund that holds 100 stocks and has an overall P/E ratio of greater than 50, but has an overall growth rate of 10-15% (what first quarter S&P earnings are expected to be) is not as safe or will not be as good as performer for investors as an individual portfolio of stocks that holds 20 stocks and has an overall P/E of less than 50, but has an overall growth rate of greater than 30%. To maintain the latter portfolio is only possible through an individual portfolio, it is not possible through the vast majority of mutual funds, if any. I personally have seen no mutual funds that mirror the latter portfolio's fundamentals.
I believe the mutual fund business as a whole and as it stands now is bad for America's future. As stated above, the mutual fund business has grown so large that they, as a whole, can no longer buy the best stocks, but can only buy the stocks with the best liquidity (larger caps).
I offer a solution to this problem. Don't wait until the tragedy occurs like you (congress) did with the tobacco companies, attack the problem now. Have a committee headed by someone like Franco Modigliani (since everyone seems to like titles) investigate the mutual fund business as a whole. If the investigation proves that mutual fund companies are buying more stock based on liquidity issues than sound, fundamental investment practices, make the mutual fund companies warn investors clearly, not with small type at the end of commercials that consumers can't even read, but with clear warnings stating that due to the large asset bases of mutual funds, a mutual fund's first priority is with liquidity and not necessarily with what's in the individual investor's best interest. Change programs like 401k's and 403b's and ERISA laws to allow individuals the right to setup their own portfolios. Don't allow mutual fund companies to mislead investors about long-term investing, that is, a momentum driven stock market with a PE of 38 has not been proven to produce good returns over the long-term, yes, the stock market has gone up over the long-term, but that upward long-term trend was when the rule of 17.5 never exceeded 22, since the rule of 17.5 is now exceeding 40, no one really knows what the future long-term growth of the stock market is going to be.
There's talk everywhere about the overvaluation of the stock market, but no one wants to really do anything about it. Everybody just wants to wait for the disaster to happen. Why can't congress realize that the mutual fund companies are the biggest buyers of stock in the world (I realize investors are giving the mutual fund companies the money to invest, but I believe it's mostly investors who don't really have all the facts and experience, kind of like with smokers, congress feels that smokers need tons of clear warnings, well, I think investors deserve the same warnings about mutual funds and I don't personally believe they are getting them). If the mutual fund business inherently does not have its investors best interest at heart, it could be disasterous for future generations. Why not do an independent analysis of the mutual fund business before it's too late?
I would like to end with the following quote from from Wall Street Week (PBS) on April 30, 1999:
Rukeyser asks John C. Bogle, Sr. Chairman, The Vanguard Group, "What do you think when you see a TV commercial in which Peter Lynch talks with Don Rickles." Bogle replies, "Well, my first thought is who's paying for this and it's of course the shareholders of those funds which does raise interesting questions about whether this industry is, has moved from a traditional focus on management to a whole new business, a business of marketing and if it's any big concern I have about the mutual fund industry today, it's turned its back on trusteeship, fiduciary duty and management [you notice how he did not use the term investing], and turned its face toward or its emphasis on, marketing, bringing in large assets to earn large fees and I don't think that's the right think to do for the investor."
Sincerely,
Congressman Pete Stark is the only politician who has taking the time (I guess that's better than nothing) to read my letters and reply. Senators Barbara Boxer and Diane Finstein showed no interest in my letters to them regarding the stock market, mutual funds, and the individual investor. I say "showed no interest" because I never received any meaningful remarks about my letters from them.
ADDENDUM (April 1, 2000)
The above letter to Congressman Stark is what Inside the Stock Market is all about. The news media, politicians, corporations including CEOs and financial services companies like mutual funds, do not always care about what's best for you. You're the only one for that job.
With Inside the Stock Market I write about my personal experiences with the news media, politicians, and corporations in an attempt to help you make better decisions regarding financial planning. With The Diary of a Small Investor, a chapter of Inside the Stock Market, I outline my model for investing which basically says, for those of you who have no time and want to invest in the stock market, pick a broad based index stock mutual fund. For those of you who want to manage your own portfolio, if the government and the company you work for will let you, I outline a more specific strategy.
Be advised the stock market is not only at all time highs with tremendous growth in the ninties, but it is also at all time valuation, that is, based on price to earnings ratios, price to book ratios, and dividend yields.
With the biggest investors being institutions, and in my opinion, investing not based on what's best for their customers, but what's best for them, the stock market is indeed a very dangerous place to be. To back up this statement I want to point out to you that it's in the best interest of any mutual fund company to maintain high asset levels because their profits are based on that specific number, however, larger asset bases mean the mutual fund will have to hold more and more stocks with greater and greater liquidity which are larger cap stock which may not be the best investments.
Realize that the Microsofts, Ciscos, and Intels (the stocks institutions are buying by the truck load) are some of the biggest buyers of smaller cap stocks. They're buying them for a reason.
On top of the fact that mutual funds are more concerned with liquidity than the quality of the specific investment, I am concerned about Social Security and the boomers retiring. In 2010, the first of the boomers will start to retire. Medicare alone, not including Social Security, has over $10 trillion in future obligations. And remember, the current administration which includes the hourse and senate has not done one single thing to shore up Medicare or Social Security even though they have had a decade of unpresidented economic growth (Yes, they have talked about it, but that's it.).
This could cause another type of liquidity problem. The boomers who are being forced to invest in stocks, I say forced because the government is making them pay Social Security first which is a big chunk of the boomer's salary, and what's left the boomers can invest in their own retirement accounts, since there is not much left, the boomers must invest somewhere where they can get decent returns, the only place for that is the stock market. If Social Security is not there for the boomers when it's suppose to be, the boomers will be heavy sellers of stocks when they retire.
The boomers selling will create a liquidity problem for sure, liquidity meaning heavy redeptions from stock mutual funds. This could be catastrophic for the stock market.
One other point about the mutual fund companies buying larger cap stocks. I state in my letter to Mr. Stark that I can find companies that are not only growing their earnings at a rate which makes them growth stocks, but can find value in these same stocks (value based on a value investor's criteria). Why is this? Because the large institutions that control the vast majority of investment capital, in many cases, can't buy these smaller cap stocks due to liquidity problems. That's what keeps their stock prices low enough for them (small cap growth stocks) to still be considered value stocks, most of the investment capital isn't going into them.
This simple fact about institutions buying mostly large cap stocks has many implications:
You add this to the fact that the US government still has tons and tons of debt and tons more of future obligations they have done nothing about even during one of the best economic decades in history...spells trouble sometime in the furture. I believe the time will be around 2010. My planned retirement year.
ADDENDUM (April 18, 2000)
After a couple weeks of pounding the market recovered some of its losses today. Where did the large institutions put most of the money? Where else, but in the over-valued large cap tech stocks. The NASDAQ 100 was up 10.1% today, whereas the Russell 2000 was up only 1.2%.
There was a story today in USA Today titled, "Losing investors play market blame game." The article said that Susan, director of the SEC's investor education office, received more than 30 email complaints last week. Susan encourages people to take responsibility for their own investments decisions.
That's what I'm trying to get through to Mr. Stark, investors who are forced to buy stock mutual funds (if they want to own stock) through retirement plans under ERISA, can't make their own investment decisions. They have to buy all the stocks that are in any one particular mutual fund which means they will have to buy the overpriced stocks the fund is holding as well as the reasonably priced stocks. Virtually, ever stock mutual fund owns stocks that have no earnings, stocks that have huge price to earnings and price to books, and price to revenues. I feel investors should be able to make their own decisions when it comes to which individual stocks they want to own and not be forced to buy what some foolish fund manager wants to buy.
I thought it was interesting how Susan only got 30 emails, I feel she should have gotten a whole lot more. From the article,
"Behavioral finance expert Richard Zeckhauser of Harvard suspects most investors are quietly taking their losses as a fact of the market or faulting themselves for not having sold high. 'I don't think the majority blame someone else.'"I don't agree with Mr. Zeckhauser at all. I think the typical investor doesn't even know what's gone on in the market in the last two weeks. They're too busy with work and family to watch their investments on a weekly or even quarterly basis. They're lucky to watch their investments yearly. But just wait until the market goes down and stays there for a longer period of time and see if investors don't start bitching, even though by then, it will be too late.
To back up what I'm saying, I don't see smokers taking responsibility for their own actions and decisions. I remember when I was nine years old, it was 1964, and my elementary school brought a lung in a jar up on a stage to show all the kids. Spokesmen for the school told the children, "If you smoke, your lungs are going to look like this one [the one in the jar that was black and falling apart]."
Now adults are saying it's the fault of the tobacco companies. I'm not debating who's to blame: the tobacco companies or smokers. What I am saying is that just wait until investors find out that long-term investing doesn't necessarly hold water when it comes to their money (like smokers who get a smoking related health problem). When investors find out that mutual fund companies don't guarantee nothing, they will bitch.
Mutual fund companies are misleading investors as much as the tobacco companies misled smokers and it's as obvious to me as that lung in a jar was to me back in 1964 at the ripe old age of nine.
ADDENDUM (May 17, 2000)
Here's an excerp from a CBS.MW article today:
Mutual UnderstandingToday on CNBC a CEO was interviewed and asked what's the problem with your stock, why is the stock price going down when your earnings are going up? The CEO didn't show much emotion probably because he's still making a ton of money off his salary and bonus (the real losers are the shareholders), he simply stated that the sector his stock was in was out of favor with Wall Street at this time.New call for increased disclosure.
By Craig Tolliver, CBS MarketWatch, Last Update: 4:36 PM ET May 17, 2000
Mutual Fund Center
"SAN FRANCISCO (CBS.MW) -- As mutual fund titans prepare for the annual meeting of the Investment Company Institute, MetaMarkets.com called on the industry's trade group Wednesday to revamp disclosure information on holdings and investment strategies.
'The fund industry is entrusted with the care of America's future through its management of over $7 trillion, and yet shareholders and third-party watchdogs are given only a pittance of information about where and how that huge pool of assets is being invested,' Donald L. Luskin, CEO and co-founder of MetaMarkets.com, said in a statement.
'The current policy mandates only that ICI member firms report their full list of holdings a meager twice per year with a lag time of over a month and is of no real practical use in gauging what is really happening with your money.'
MetaMarkets is home to the OpenFund (OPENX), which publishes its daily trading activities on its Web site. The firm sent an open letter to ICI's president Matthew Fink, arguing that outdated holdings information cause shareholders and their advisors to make incorrect assumptions. Morningstar, the IPS Funds, the National Association of Investment Clubs and On24 Inc. have all added their support to the issue, MetaMarkets said."
One thing the CEO could do is get off the golf course and start to lobby Washington in giving individuals the right to make their own investments decisions, not only with Social Security, but with 401k's and 403b's. You see, many 401k type retirement funds still have restrictions put on individuals, that is, you can only buy mutual funds and you can only buy the mutual funds the plan offers. For example, I watched CNBC today, if I wanted to buy the stock of the CEO interviewed with my 403b money, I couldn't. The 403b plan I'm in says I have to buy a mutual fund, I can't buy individuals stocks. I have to buy what some inexperienced fund manager at Fidelity, Vanguard, or CREF says I should.