An Asset Allocation Strategy for the Intelligence Investors

[HenryTo]

Latest John Mauldin's "Outside the Box" article originally published by Evergreen Capital. Original link: http://www.investorsinsight.com/print_preview.asp?id=jmotb040405

Part of it is reproduced below. FYI, I was at a Houston CFA dinner last week and three of the four panelists (these three were all equity guys with the other being a fixed income guy) all recommended large caps as the next asset class to buy. One of them (the CEO of AIM Funds) mentioned that this "consensus" among them was pretty scary - however, he said the huge outflows coming out of his large cap mutual funds are somewhat analgous to the large amount of inflows they were experiencing during the early parts of 2000 - suggesting that retail investors are being irrational once again. Only this time they are selling instead of buying. As for myself, I think large caps will start to outperform small caps going forward on a relative basis but the performance of large caps may not necessarily be positive. Still looking for a more oversold situation here, as I have stated before!


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Other studies have looked at equity funds in general and have found little linkage between fund flows and subsequent returns. Yet our analysis, targeting actual mutual fund styles, such as Large Cap Growth, shows a very clear inverse relationship between extreme inflows, or outflows, and subsequent returns. The critical element is to consider only extreme flows rather than attempting to analyze all flows. We believe this is logical since it is only when overly active mutual fund investors en masse reach the tipping point of overt bullishness or bearishness that meaningful contrarian signals are generated. Therefore, it is critical to ascertain what truly represents an extreme flow. This is admittedly easier done for outflows than for inflows.

Our studies show that outflows are quite rare and are clearly indicative of extreme investor pessimism. This is because there is such a powerful and persistent current of money flowing into the mutual fund complex from 401(k) and IRA contributions as well as normal savings that find their way into various fund vehicles. In fact, mutual funds take in between $10 and $12 billion from 401(k) and similar plans in an average month according to Lipper's Fund Flows Insight Report published in June 2004. To actually force a mutual fund style into a redemption mode over an extended time frame requires an intense level of negativity by a large segment of the mutual fund population which, based on our counter-trend methodology, is a highly positive development.

While flows on their own are useful predictors of future performance for major styles such as Large Cap Growth, we have found that their leading-indicator capability is further enhanced by using a second, fundamentally-based factor. Without divulging too much of our proprietary research, it is very clear that when there is an alignment of extremely positive or negative fund flows with correspondingly attractive fundamental readings, a predictive signal is generated. For example, when Large Cap Growth inflows are extreme based on our statistical measures and fundamentals are also exceedingly stretched, the odds are very good that this style will under-perform the broad market over the subsequent two years.

A key element in our analysis is to consider a future time period of at least two years in order to measure outcomes. In the increasingly myopic milieu of Wall Street, a two year time-horizon nearly represents eternity. The herd is often right on a very short-term basis but almost always wrong longer term especially when the second derivative of fundamental analysis is incorporated.

A specific example of where the herd acted correctly was the performance of Small Cap Value funds over the last few years. Due to the massive bull market in the 1990s in Large Cap stocks, particularly of the growth variety, Small Cap valuations were gradually ground down to very depressed levels. Once the high tech bubble burst in the spring of 2000, Small Cap, particularly Value, began to dramatically outperform the Large Cap style. As the excellent relative results gathered momentum, money came gushing in as usual. But in this case, because Small Cap had started at such a subterranean point, the herd was moving the right way and Small Cap continued to eclipse the performance of the Large Cap, especially Growth, style.

However, by using the second factor of valuation analysis this "aberration" was easily avoided. It is interesting that, after five years of Small Cap far out-racing Large Cap, we are now looking at nearly a mirror-image of the beginning of this decade: strong inflows into Small Cap Value funds and very stretched relative valuations and persistent out-flows from Large Cap Growth funds with reasonably attractive, though not rock-bottom, valuations. Accordingly, we believe this is clearly a time to be emphasizing Large Cap over Small Cap and Growth over Value.

As we expect to be the case with Small Cap Value in the relatively near future, even when the performance-chasing mutual fund investors get it right in the initial stage of a trend they still get it wrong when that trend inevitably reverses. For example, in the late 1990s, this cohort began to funnel unprecedented amounts of money into tech funds and, for awhile, they were absolutely right. Enormous gains were produced by this sector, and these intoxicating profits became like a gigantic vortex that sucked in even more billions, the most graphic episode ever witnessed of money chasing performance.

By late 1999, both the inflows into growth funds and their fundamental underpinnings were in the ionosphere. It was clearly not sustainable and, following Stein's law, sustained it wasn't. Those unsophisticated investors who originally caught the updraft of the phenomenal tech bubble, and who initially found investment Nirvana, were soon its hapless victims. Rather than rationally reducing their exposure to this mania, as Efficient Market adherents would expect, they threw caution - and their collective net worth - to the wind. What was initially one of the "little guy's" greatest success stories became, very tragically, his darkest hour.

It is this recurring ignorance of the inevitability of reversion to the mean that allows one to benefit from investors' high optimism in any given sector of the market or their strong conviction to be out of a particular segment. This is despite all the cold logic of Modern Portfolio Theory which tells us so confidently that such anomalies shouldn't happen. Yet the reality is human behavior isn't all that rational at times, and the financial markets are very much a by-product of the emotions of the underlying participants.