Passive investment funds popular with bear run expected to continue

Friday 20th July 2001

Hope springs eternal in the investment world. Rallies in sharemarkets are currently greeted rapturously as a return to glory days. Companies that manage to improve on earnings forecasts, such as Microsoft recently, are rewarded with jumps in share price.

A widespread view is that sharemarkets are about to turn the corner, even though the corner itself is still obscured somewhere ahead in the lurking mists of economic downturn.

A bearish view on share investment that advanced the opposite opinion on timing for widespread rebound was argued by David Simons last week in Forbes.com. Entitled "Bear Ware," his article asserted that the present slump in US stocks is far from over.

The parallel he used was the great bear market of 1973-74. That decline wiped 60% off the Nasdaq and lasted 21 months.

The present throes of the US sharemarket have so far dragged on for over 15 months and the Nasdaq has shed 60% in the process. Mr Simons claims there is more to come.

Using the 1973-74 paradigm, he picks that there are another six months or so to go of sagging stock prices, that the Nasdaq may fall to around 1200 in the worst case, and probably revisit 1600 on a more optimistic scenario.

If so, there is yet be considerable blood spilled on the floor. Mr Simons refers to the US media being full of stories about people abandoning hopes of early retirement or even sacrificing their lifestyles altogether.

He analyses the outlook for the sharemarket as reflecting investor mood. He divides the mass psychology of investors into a series of emotional states. In the six months following the March 2000 collapse investors were in a state of denial, expecting things to turn around again quickly.

When this did not happen, the mood soured to disillusionment and then flared into anger directed at stock analysts and corporate accountants.

The prevailing mood diagnosed by Mr Simons is one of apathy. Investors are now too shell-shocked to care much any more.

Loss of interest in the sharemarket is typical of a final bear- market phase but how long such a state of affairs will prevail is unpredictable.

Mr Simons does not recommend giving up all hope however. At some stage a bull market will resume.

The question is what strategies will best suit investor needs in the meantime. He notes that Merrill Lynch, presently a leading bear, has spent $US25 million on an advertising campaign for bonds as a defensive investment.

However, he argues there is still some mileage to be had in shares. Cash returns in the US are a miserly 4%, so it hardly seems worth cashing up when there is the risk that eventual sharemarket upturn will be missed from the sidelines.

Instead Mr Simons favours broad-based index funds, which have been out of favour due to the view that stock-picking is the best strategy in a bear market.

Index funds do not attempt to guess ahead as to which companies will fare best. They simply buy those companies big enough to make it into sharemarket indices and let time do its work.

There is logic to this approach, as companies that achieve index inclusion are likely to be some of the best, or at least the biggest, on offer in their industrial sectors. When the economy picks up again, most of these companies should feel the benefit.

In recommending broad-based index funds, Mr Simons says, "Enduring recovery of major bear markets involves broad participation, and it's too soon to bet on early leaders."

So it looks as though index-based passive funds are back in the limelight again.

Just as well Inland Revenue has issued new rulings allowing New Zealand's various capital-gains advantaged passive funds to continue on until 2004, which should be ample time for the much-heralded bull market to get some legs.

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