ContraryInvestor.com (For educational purposes)

ESSAYS AND COMMENTARY

UNREALIZED CAPITAL GAINS: THE DIRTY LITTLE SECRET OF THE MUTUAL FUND INDUSTRY

We continue to be the beneficiaries of the greatest bull market of all time. During this decade alone, the public has written the mutual fund industry a depository check for over $1 trillion dollars. What a great deal as investors have enjoyed increased paper wealth. Most believe this will continue as far as the eye can see. The trust in paper generation of wealth is truly extraordinary. For those still wondering just how this market has risen to such a "thin air" atmosphere, we happen to have a trillion reasons why.

With the torrent of cash flowing into mutual funds, those who have chosen to redeem over the past three to four years have been easily accommodated with immediate payment. No need for funds to do a lot of selling to meet redemption's. Net inflows have swamped the demand from those who have chosen to leave the party early. With the top S&P cowboys whooping it up the loudest over the past three years, there has been absolutely no sense of urgency on the part of fund managers to sell the Microsoft's, the Cisco's, the GE's, etc. In fact, they have eagerly continued to buy as these balloons loft ever skyward.

As you know, mutual funds pass out both dividend and interest income as well as capital gains each year. No need to really worry about the dividends as we are currently clocking in at the lowest yield levels ever recorded in US financial history (and have been for some time). For taxable investors it's a minor inconvenience at the moment. Capital gains realizations, however, can be driven by many variables. (Thank God for the current crop of talented fund managers, as a sense of history and valuation are clearly not among their "variables" for selling.) The spectacular performance of the markets, especially over the last three years, has not been matched by capital gains distributions of the mutual fund industry. Clearly there are unrealized gains embedded in these funds awaiting ultimate distribution. Even beyond the last three years, this has been the greatest long term bull market of all time whose origins date back to the early 1980's. Mutual funds are somewhat sensitive to the realization of annual gains. For taxable investors, it's an immediate rebate to Uncle Sam. What's so bad about unrealized gains? At this point, everybody has some type of unrealized gains in funds or individual securities.

We believe the problem will be felt by new taxable investors currently purchasing stock oriented mutual funds. Imagine a scenario where we go into a protracted (2-3 yr.) bear market and the public decides to sell 20% of their stock fund holdings. Just 20%. (We know this is a stretch for some, but believe us, it is well within the realm of human possibility.) Newcomers to stock funds will not only lose value in a bear market, but will also be distributed capital gains they were never there to enjoy in the first place. Imagine losing money and making a very big tax payment for the privilege. The more the public demands fund redemption's, the greater the tax problem will become. It's axiomatic that former winners are sold to meet redemption's because the former winners are the last to lose liquidity. In today's 800 number mutual fund nirvana, redemption means now (1-800-GETMEOUT). Not when it's convenient. In a bear market, liquidity will be sold (hard). This is clearly not the kind of experience that reinforces the "I'm a long term investor" swagger. This scenario is not so hard to imagine at all.

If you think stock oriented mutual funds are a problem, think about the index funds. Fully invested by nature at all times. No cash. Ever. The recipients of mountains of cash during the 1990's. The embedded gains have to be staggering. Index funds will be a taxable investor's nightmare in a bear market accompanied and abetted by public selling. It's no fun losing money. It's no fun paying taxes. Pour in equal amounts. Shake vigorously, and you have the perfect LTHS cocktail (Long term horizon shortener). Redemption of index funds may become a particular problem. We didn't mean to spoil Happy Hour.

Up until now we have quietly suggested the public would redeem and set off the tax fireworks. The ultimate irony may turn out to be that the mutual fund managers themselves spark the selling by trying to maintain performance in a bear market. (As you know, this is accomplished by losing the least amount of money.) Either way, we believe this unrealized gain/tax problem will be a major concern in the next bear market as a potential driver of fund liquidation's. At least when you own individual securities you do not have to sell and trigger any gains. Huge difference from the mutual fund complex as your neighbor becomes your problem. If your neighbor sells, he/she may generate a tax problem for you.

So you're not a taxable investor. You're safely tucked away in a 401(k) and you are definitely in it for the long term (at least for now). Taxes are not a problem. Could the taxable seller drive the market at the margin? Could be. That's our only concern for effect on the non-taxable investor. This issue is really an anecdotal negative for the "future files". It will not be the cause of a bear market. It won't even be a significant contributor. But, in bear markets, it's often movements at the increment that surprise you. If you own mutual funds, go back and look at investment percentage gains versus percentage capital gains distributions for your funds. Be aware of the potential powderkeg. We posit the humble suggestion that perhaps it would be wiser to sell a fund entirely and pay the capital gains on the entirety rather than being bludgeoned by capital gains distributions during a bear market and losing value at the same time (and still not have paid your personal entire capital gain of market over cost). Is it time to bail out of your favorite taxable stock/index funds? Using Alan Greenspan's words of comfort, relax, "we'll only know it was a bubble if it bursts". Thank God. Now we feel a lot better.

-- Spoonfed (spoonfed@spoonfeddd.xcom), February 14, 2000

Answers

This is an interesting article. Thank you Spoonfed.

-- Dee (T1Colt556@aol.com), February 14, 2000.

It can't possibly burst. And nothing bad is ever gonna happen to us- the Good Ole USA. You want proof of this? Just look at all the smiling happy faces on TV! What other proof is needed?

-- canthappen (n@ysayer.com), February 14, 2000.

As my great-great-great-great uncle Chester used to say...there'll alway be a major market for tulips...

-- Mad Monk (madmonk@hawaiian.net), February 14, 2000.

LOL Mad Monk.

Yes, always a market for twolips...I mean tulips. =)

-- Dee (T1Colt556@aol.com), February 14, 2000.

Nothing may not happen, but there's words of dejavue in the following quotes:

In investing, when everything is going you're way, you better start to worry. All of these quotes were published very shortly before and after the crash of 1929. Not to worry, we promise to find a whole new fresh batch during the next "social event" of this type. Enjoy.

"The market is following natural laws of economics and there is no reason why both prosperity and the market should not continue for years at this high level or even higher."

Thomas Shotwell, "Wall Street Analysis," The World Almanac - 1929

" We seem only to have touched the fringe of our potentialities...As long as the appetite for goods and services is practically insatiable, as it appears to be, and as long as productivity can be consistently increased, it would seem that we can go on with increasing activity. But we can do this only if we develop a technique of balance."

From a report by a Presidential committee, "Recent Economic Changes in the United States," early 1929

"The economic condition of the world seems on the verge of a great forward movement."

Bernard Baruch, financier and Presidential advisor, June 1929

"The outlook for the fall months seems brighter than at any time."

The Wall St. Journal, Aug 23, 1929

"The consensus of judgment of the millions whose valuations function on that admirable market, the Stock Exchange, is that stocks are not at present overvalued."

Joseph Lawrence, professor at Princeton University, 1929

"I see no reason for the end-of-the-year slump which some are predicting."

Charles Mitchell, head of the National City Bank and director of the New York Federal Reserve Bank, Oct. 15, 1929

"The market should go a good deal higher than it is today within a few months."

Irving Fisher, professor of economics at Yale, Oct. 15, 1929

"This crash is not going to have much effect on business."

Arthur Reynolds, chairman of Continental Illinois, Oct. 24, 1929

"The worst has passed."

Joint Statement by representatives of 35 of the largest retail brokerage firms on Wall St., Oct. 24, 1929

"This is the time to buy stocks. This is the time to recall the words of the late J.P Morgan that any man who is bearish on the United States will go broke. Within a few days there is likely to be a bear panic rather than a bull panic. Many of the low prices as a result of this hysterical selling are not likely to be reached again in many years."

R.W. McNeel, director of McNeel Financial Service, quoted in the NY Herald Tribune, Oct. 30, 1929

"A severe depression like that of 1920-21 is outside the range of probability. We are not facing protracted liquidation."

The Harvard Economic Society, Nov. 1929

"The financial storm has definitely passed."

Bernard Baruch, cablegram to Winston Churchill, Nov. 15, 1929

We strongly urge our readers to form their own opinions in the current market environment. No one has the answers. No one can accurately forcast change. The trick is to put the odds inherent in investing squarely in your favor. Minimizing price risk while maximizing potential reward is much easier expressed than accomplished. Investing away from the crowd and contrary to popular perception can be a lonely journey.

ContraryInvestor.com (For educational purposes)

-- Spoonfed (spoonfed@spoonfeddd.xcom), February 15, 2000.

Very good points, spoonfed. Thanks for sharing. I can imagine the bloody screaming as I type this. Ugh!

-- ..- (dit@dot.dash), February 15, 2000.

if you loose value in bear market, wont taxes fall at same rate?

-- jdrock number (zero@eronet.com), March 01, 2000.

The Contrarian (Bill Fleckenstein):

b>In the mania chronicles Here's another story from a reader:

"Last night my neighbor and I were having a conversation about the stock market. Before long about a half a dozen people had joined in, touting their tech stocks they were sure were about to double, and 'don't let them shake you out and sell' was said more than once. Somewhere in all this I said I thought the broad market was sick and I thought it wouldn't be that long before the Nasdaq started acting like the Dow and we end up with a severe market downturn. Then everybody stopped talking and I was surrounded by angry stares, and this woman says, 'If that happened, Greenspan will come in and save the day and stock prices will bounce right back!' I left with everyone in agreement: Greenspan will save the day."

This is why I am constantly harping about the Fed and Greenspan. The Federal Reserve board is the ultimate moral hazard and has created this environment from which so many stand to lose so much.

Also known as "The Greenspan Put". There is a widely-held belief that Mr. Greenspan will not allow stocks to fall significantly, which in turn reduces investors' sense of overall risk and thus encourages behavior which in a different climate would seem unwise. The bubble just keeps getting bigger, because fewer and fewer people believe that it will ever be allowed to burst.

-- DeeEmBee (macbeth1@pacbell.net), March 01, 2000.

Formatting got a little messed up. The sentence which begins "That is why I'm constantly harping..." is Bill Fleckenstein's. My tuppence is the last paragraph only.

-- DeeEmBee (macbeth1@pacbell.net), March 01, 2000.

DeeEmBee,

>The sentence which begins "That is why I'm constantly harping..." is Bill Fleckenstein's. My tuppence is the last paragraph only.<

Your tuppence is worth at least a threp'ny bit if not a full sixpence.

I did the TYMARLAT thingy, (Take Your Money And Run Like A Thief), in November of 1998. Bailed out completely and went to TBills & CDs.

I'm now as nervous as a long tailed cat in a room full of rockng chairs just waiting for that moment when enough people, be they individual investors, mutual fund managers, day traders, whomever, try to unwind their positions.

And, before everyone jumps up screaming "No, they will never sell"- it's onwards and upwards forever", I just wish to say:

BS.

Just as surely as God made little green crab apples, this market, not just the DOW, or the S&P, but the entire equity market will go down. The exact date is, however, still in question as of this date.

The last remaining question is simply " Shall it be a soft landing below, or will it be the most awesome wreck that you have ever seen. Liquidity will rule the day, just as it does in every day life.

I am fairly certain that Mr.Greenspan will step on his crank in trying to "gently and deftly deflate" a greatly over pressurized bubble, as his weapons are now exceedingly limited.

Just how does one do such a thing anyway? Can we really "hot tap" this one Mr. Cook? D'ya think so?

To date he has performed an amazable (Thanks Ms. Diane:)) feat of air walking. I think that his (our) luck has run the course though.

Tapdancing on a highwire comes to mind.

The markets now are so intertwingled that they make the fabled Gordian Knot seem childishly simple to solve and to unravel.

The problem, as I see it at least, is that when the bubble *does* pop it will cause a hurricane around the planet, catching all of us. And, thanks to instantaneous global communications, this time around the crisis will be one of but a few hours in meltdown, a week at best, rather than the weeks/months/years of the last big one.

Yet he must slow down this market somehow. Soon.

If he doesn't have a touch as soft and as sweet as the breath of an angel you will see what will surely be the economic sideshow of this new century, if not of the entire millenium to come.

I believe that any safe harbor is really just a figment of our childlike wishes and fairy tale dreams.

Keep your preparations handy folks. We ain't out of the woods as of yet. We are just barely far enough inside of them to lose sight of the sky. Anybody heard the fat lady yet?

S.O.B.

-- sweetolebob (buffgun@hotmail.com), March 01, 2000.

S.O.B., I think Mr. Cook would agree that what you just gave us is worth sus-pence, at least.

-- Chris (@#$%@pond.com), March 01, 2000.