Mutual Fund Managers Move Into Cash as Prices Swing Wildly

By Eric Martin and Alexis Xydias
Bloomberg News
Sunday, March 30, 2008

Mutual funds are selling stocks and hoarding cash just as trading surges to a record and prices grow more volatile than at any time since the Great Depression.

Forty-three percent of managers surveyed this month by Merrill Lynch moved more money into cash than their funds stipulated, the highest percentage since the New York firm began compiling the data in April 2001. Their cash relative to total assets also rose to a five-year high as managers found fewer stocks to purchase and anticipated redemptions.

Investors who usually "buy and hold" are selling as price fluctuations get larger and less predictable. The swings are confounding valuation measures based on earnings after $200 billion of credit losses caused analysts to overestimate bank profits by more than 50 percentage points last quarter.

"If you've been out there playing in traffic, trying to trade in this, you'll run out of money before the market runs out of time," said James Dunigan, 55, the chief investment officer at PNC Wealth Management, which oversees $78 billion.

Daily changes of 1 percent or more in the Standard & Poor's 500-stock index, the benchmark index for American equities, have occurred on 54 percent of trading days this year, according to S&P. That's the most since 1938, as hedge funds and other speculators use borrowed money to magnify returns from rapid-fire trading.

One consequence is that volume on the New York Stock Exchange has ballooned to an average 1.75 billion shares a day, the highest on record and 11 percent above last year's figure. More than half of the 10 busiest days in U.S. options markets have occurred in 2008, fueled by strategies designed to profit from rising volatility.

The Chicago Board Options Exchange Volatility Index, a benchmark of price swings used to value options, is averaging 26.15 percent this year, its highest since 2002. Price swings in a gauge of bank stocks in the S&P surged to the highest since at least 1989, based on 10-day historical volatility, data compiled by Bloomberg show.

Lehman Brothers Holdings, the world's fourth-largest securities firm, lost almost half its market value during trading on March 17 before surging by a record 46 percent the next day. The market value of Bear Stearns, the second-largest underwriter of mortgage bonds, tumbled 84 percent to $655 million last week when J.P. Morgan Chase agreed to buy it after a Federal Reserve-led bailout. Bear Stearns rose 89 percent after J.P. Morgan quadrupled its offer.

"Trading financial stocks on a daily basis is a very difficult, if not foolhardy thing to do," said Edgar Peters, Boston-based chief investment officer at PanAgora Asset Management, which manages $25 billion. Peters, 55, said the firm's asset-allocation strategies have boosted cash to 10 percent of their holdings from zero at the end of last year. The last time the firm held so much cash was in March 1997, when the S&P 500 tumbled 9.3 percent in about a month.

Citigroup, which has fallen 20 percent since reporting the biggest quarterly loss in its 196-year history, may have write-downs of $15 billion in the first quarter, according to Merrill Lynch. That would add to the $22 billion that Citigroup already lost because of the worst housing slump since the Depression. Citigroup, Bear and Lehman are based in New York.

Last week, Citigroup traded at 0.82 times its stated net assets of $113.6 billion, the cheapest since at least 1998. That suggests the biggest U.S. bank would be worth more if shareholders fired management and liquidated it.

Citigroup's book value exceeds its market price only if the bank's $133.4 billion in so-called Level 3 assets is being accurately priced. That includes loans, asset-backed securities and derivatives for which market prices are so scarce that companies use internal models to gauge their worth.

"Lots of people are arguing that stocks are cheap," said Philippe Gijsels, 37, senior equity strategist at Fortis Global Markets. The problem is that when estimates of earnings and asset values prove unreliable, "those measures break down."

Mutual fund managers who invest for pension accounts, insurance companies and individuals raised the cash they held to 4.9 percent of client assets this month, according to Merrill. The last time the level was higher was in March 2003, after the S&P 500 had lost almost half of its value from its 2000 peak.

In the last U.S. bear market between March 2000 and October 2002, when the S&P fell 49 percent, U.S. mutual funds lost 19 percent, including dividend payments, Bloomberg data show. That compares with a 5.6 percent gain for hedge funds, according to Bloomberg data.

Jeffrey Mortimer, chief investment officer of equities at Charles Schwab Investment Management in San Francisco, which oversees almost $40 billion, said investing in stocks now is worth the risk because prices are historically cheap. Companies in the S&P 500 trade at 14.03 times estimated profit, according to Bloomberg data. Index members last traded at a cheaper valuation based on historic earnings in October 1990.

"The price of admission for playing is that the market sometimes gets quite violent on the downside," said Mortimer, 44. "If you're a long-term investor, you should welcome this stuff."

Stefan Wintner, 25, who helps manage $4.6 billion at Kathrein in Vienna, disagrees.

"We'll wait for volatility to come down, prices to improve across the board," he said. "Prices look cheap, but if earnings fall 20 percent, then they don't look that cheap anymore."

Michael Tsang in New York, Sree Vidya Bhaktavatsalam in Boston and Demetrios Pasigos in Skillman, N.J., contributed to this report.