WED COMSTOCK PARTNERS "PUBLIC PARTICIPATION"

We have discussed many times in past comments what we considered to be imperative in order to complete a typical bear market. Bear markets are usually comprised of three stages—Denial, Fear and Capitulation. The first two stages of the latest bear market were evident during the period of February 2000 to October 2002. However, to complete the bear market that followed the greatest financial mania in history, we are still missing one major ingredient—Fear and Capitulation. One of the hallmarks of a secular market bottom is widespread public fear, disillusion and disgust with the market followed by a long period of outright apathy. This certainly did not happen in October 2002 as strong public participation in the market has come back rapidly.

One of the best ways to measure the third stage of the bear market is to monitor the public’s participation in the equity market through the net purchases and sales of equity mutual funds. Thanks to the Investment Company Institute, such figures are readily available. For example, net inflows into equity mutual funds during the first quarter of 2000 were far greater than in any other quarter in history. As you know, this coincided with the peak of the financial mania. Net inflows in the quarter amounted to $101 billion ($141 with foreign equities included), largely concentrated in the Nasdaq high tech and growth stocks that were the main targets of the blood bath that followed. These purchases along with some additional buying in mid-2000 brought total equity mutual fund assets up to a record $4 trillion ($4.6 trillion with foreign equities) in August 2000.

History is replete with examples of massive herd-like public purchases at the peak of financial asset prices and emotional liquidations at the troughs. A number of financial and economic studies have covered this topic from the tulip bulb craze in the 1600s to the crash of 1929. Although culture, technology and financial instruments undergo great change over time, human nature remains the same and emotional highs and lows in financial markets are a fact of life that never changes. A modern example is the early 1980s financing and marketing of oil and gas shelters from the drilling areas of Texas and the Gulf of Mexico to Wall Street where there seemed to be unlimited demand for anything to do with oil and gas. This demand coincided with the peak in oil and gas prices in the early 1980s leading to heavy losses, bankruptcies, a crash in Texas home prices, and the necessity to bail out every sizeable independent bank in the state. Another quick example of public “irrational exuberance” was the lines of people around the blocks of downtown Manhattan seeking to buy gold and gold coins just as the price of gold was peaking in 1980 at over $850 an ounce. Time after time, it's apparent that the public always buys heavily what it most recently missed, and subsequently liquidates with major losses.

Some may believe that the net liquidation of about $91 billion ($98 billion with foreign equities) of equity mutual funds from June to October 2002 represented enough fear and capitulation to qualify as the third stage of the bear market. This liquidation, however, pales by comparison to the prior bear market. Total equity mutual fund (EMF) liquidation for the entire year of 2002 was only $25 billion ($26 billion with foreign), representing only a little more than 0.5% of the $4 trillion of total EMF assets. To put this in perspective, there were 12 other years since 1970 where total outflows were much higher. In fact, after the bear market of 1973-1974, every year between 1976 and 1979 recorded outflows between 10 and 12% of total EMF assets. Furthermore, eight other years recorded net outflows ranging from 1.2% to 8% of assets. This means that the net outflows in 2002 were only the 13th largest on an annual basis since 1970—and this followed the greatest financial bubble ever.

The fact that the public has come back into equity mutual funds with a vengeance over the past couple of years is of even more concern to us since it is likely to make the final stage of eventual capitulation that much worse. After net inflows of $239 billion over the last two years ($330 billion including foreign equities), total assets of EMFs are just shy of the peak reached in mid-2000. Until the third stage of the bear market is complete, and the fear and capitulation become much more obvious, the market remains extremely vulnerable.