Can Mutual Funds Stave Off a Bear Market? Maybe Not

One of the guiding precepts of the U.S. stock market’s bulls in the 1990s has been that mutual funds are there to save the day.

No matter how bad things get, short-term stock market corrections can’t turn into full-throttle bear markets so long as millions of individual investors keep plowing money into mutual funds, especially through their 401(k) retirement plans.

Funny, but that’s exactly what individual investors did in June and July, funneling a net $40 billion into domestic equity funds, according to Trimtabs.com, a data research service in Santa Rosa.

Yet during that two-month span, the blue-chip Dow Jones industrial average lost ground and the small-stock Russell 2,000 index plunged nearly 7%.

And between July 10 and Aug. 10, as small investors plowed a net estimated $7.7 billion into U.S. stock funds, the Standard & Poor’s 500 index of blue-chip shares lost nearly 7%.

Which raises the question: Just how important is mutual fund investors’ buying to the market’s trend, anyway?

Maybe not as important as we once thought.

“A lot of people have used fund flows to defend high [price-to-earnings] multiples on stocks and to argue that the market won’t correct itself,” said Standard & Poor’s sector strategist Sam Stovall. “Obviously, the market is showing us that this notion could end up being more a fantasy than a fact.”

Jim Stack, editor of the InvesTech Market Analyst newsletter in Whitefish, Mont., and a longtime bear, points out that, historically, mutual fund investors’ buying hasn’t prevented bear markets.

“Something Wall Street hasn’t publicized much is that in the devastating bear market of 1969 to ‘70, stocks fell even as money flowed into mutual funds every month,” Stack said.

Indeed, in 1969, the first year of a two-year bear that saw the S&P; 500 lose as much as 29% of its value, a net $2.1 billion flowed into mutual funds, according to figures provided by the Investment Company Institute, the fund industry’s chief trade group.

That was slightly more than was invested in 1968, when the S&P; gained 11%.

In fact, a 1996 study co-written by ICI chief economist John Rea showed that in eight of the 12 market contractions between 1944 to 1990, more money flowed into mutual funds than was redeemed.

Of course, one could argue that there’s significantly more money flowing into mutual funds today than ever before, and thus that the funds’ potential heft for the market has increased significantly as well.

Stack’s response? “That’s the common argument before every bear market--that individuals are better informed and have more money invested in stocks,” and thus that they’ll save the day.

What’s more, though more than a third of all U.S. households own mutual funds today, the funds overall still hold only 19% of all publicly traded U.S. stocks, according to ICI estimates.

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That means more than 80% of the market’s value is in the hands of other investors--pension funds, private money managers, foreigners, corporate insiders, and individuals owning shares directly.

“Individual investors [through mutual funds] don’t play as big a role as people think in propping up a market,” notes Michael Metz, managing director for equity research at CIBC Oppenheimer known for his long-standing bearish outlook on the markets.

But, Metz argues, “they play a bigger role in derailing markets.”

When the stock market is going up, the funds’ buying of shares, as investors shovel money their way, is incremental demand--important, but incremental. That might help the market rise, but it typically takes a lot of money, from various sources, to push the market substantially higher.

When demand dries up, however, the market can fall like a stone. If mutual funds become sellers, rather than buyers, their incremental selling can be much more damaging for stocks on the downside than their buying was on the upside, Metz and other analysts say.

So far, there’s no sign that mutual funds have been heavy sellers of stocks because individuals haven’t been rushing to sell their fund shares. But with fund cash reserves near 20-year lows, it might not take much in the way of redemptions to force fund managers to begin selling stocks, some experts warn.

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Small Slice

Mutual funds controlled only about 19% of the U.S. stock market’s nearly $10-trillion value at year-end 1997. Who owns U.S. stocks:

The funds: 19%

Other investors (pension funds, individuals, foreigners, etc.): 81%

Source: Investment Co. Institute