Beware Mutual Fund Markups at Month's End (this is deadly accurate and representative of GNSS and EMLX...Sun)
By James J. Cramer
02/01/2002 09:13 AM EST
We have so many new people reading us that I thought I ought to do a quick primer on what happens at the end of the month around Wall Street.
A long time ago, when there were only a handful of mutual funds and families, firms used to be concerned about their quarterly performances. They were concerned because if the numbers were bad when clients received their statements, money would flow out of the funds.
But in the late, great '90s, money did nothing but flow in. And the funds that got the most money tended to be the ones that got the most publicity.
The easiest way to garner a lot of publicity was to shoot the lights out. If you had big numbers, then the press would come calling and would praise you. That's how it worked. You would get in the papers, the magazines and ultimately appear on television with breathtaking figures. No one considered that the way to get those numbers was to take maximum risk. You simply bought the hottest stocks and let them ride.
As the markets got hotter, the notion of "buying the usual and letting them ride" became too risky, too much a roll of the dice. A handful of mutual funds developed a novel method of notching the risk up even higher in order to generate ever shorter-term gains: They decided to concentrate their holdings in a few winners, and with every dollar that came in over the transom, keep buying those winners.
In the late '90s, some mutual fund companies turned this into a science. They bought giant truckloads of stocks, particularly Nasdaq tech stocks, day after day after day. Many of these stocks, while looking like they were "liquid," actually were hard-to-find stocks that had very little "float," owing either to their newness or to the lack of insider selling.
As the Nasdaq roared to 5000, we began to see a familiar pattern: Mutual funds identified their favorite stocks. Because these funds had no sell discipline whatsoever and arrogantly believed that stocks were never overvalued if they were growing, they were willing to pay ever-higher prices to earnings, and then, when that got ridiculous, they changed it to price to revenue. Whatever metric that allowed these funds to stay long served its purpose well. And why not? Their charters all said they were high-risk, as if anyone read the darned charters.
At some point, these funds decided it wasn't just good enough to buy as much as you could of a stock you loved. It was important to buy those stocks aggressively at the end of each month because those funds became aware that the better they did each month, the more money they could get to flow in.
So those funds that bought 10,000 shares of say, Ask Jeeves (ASKJ:Nasdaq - news - commentary - research - analysis), every day because Ask Jeeves was the next Microsoft (MSFT:Nasdaq - news - commentary - research - analysis), would come in at the end of a month and begin to buy huge amounts of Ask Jeeves. That way, a $500 million fund with a million-share position of Ask Jeeves was able to influence the price of Ask Jeeves.
The fund was able to do so because there was never that much Ask Jeeves around at a given moment -- insiders don't print stock, you know; they have to file it for sale and there are limits of how much can be sold per month. The fund, let's call it the SecondHand Fund, for clarity, might have forced a market-maker to "go short" Ask Jeeves, or borrow Ask Jeeves to sell to SecondHand, with the idea that the market maker could "recover" the stock from another seller or an insider shortly after the trade.
But with this aggressive, concentrated buying of Ask Jeeves, the market makers all became short, which then forced them to come in and take the stocks ever higher to find supply so that they could stop losing their firms big money by helping these clients.
Near the top of the market, daytraders at sophisticated daytrading houses began to recognize these patterns. When they saw large buyers "lift offerings," they would go in and lift offerings themselves, causing more market makers to be short.
It would all crescendo on the last days of the month, when the SecondHand funds would come in and take offerings from everybody, get everyone short, while the daytraders ran ahead of orders and made things even tighter. Given the blitzkrieg nature of the takings, no market maker could ever recover, and a frenzy broke out at the end of each month that could cause stocks to dance upward.
Why not? Nobody would get hurt, except for the market makers whom everybody despised anyway. The companies weren't hurt; they loved the higher stock prices. It enabled them to do deals and to attract employees with good stock incentive plans. The mutual funds loved it because it helped performance. And the folks who did the manipulating, well, they could boost their performance by 5, 6, 7, maybe even 10 percentage points in the crucial last-day derby of the month.
Of course, because they did so well, these funds got more money in, which then justified such aggressive buying.
Everyone knew this stuff went on. As long as the market was rising, who cared?
But eventually the insiders caught on and they wanted out. Autumn 1999 and spring 2000 led to unprecedented insider selling that relieved the "tightness" the process had developed. Of course, many of these companies were connected either to the dot-com bomb or to the explosion in telecommunication technology. Both of those ran out of gas at about the same time.
Finally, the Federal Reserve decided to make it so that short rates were so high that marginal new dollars didn't flow into the funds. That, plus an increase in margin rates for daytraders, led to the curtailment of those run-aheaders who made things especially tight.
Everything collapsed at once in 2000, and nothing's ever been the same -- except for the desire of these funds to "mark up" at the end of the month. But now they do it to try to get back to even or to gain a few points back from the losses racked up during the month. This marking up is what you saw Wednesday from after the Fed meeting to the closing bell.
It would stand to reason, of course, that we would then drop back after today. But a funny thing happened. The feds got wise to the process. They started looking for stocks that ran up furiously at the end of the month or quarter and then fell back mysteriously at the beginning of a new month or quarter. They even pursued a couple of funds for doing this, under the legitimate guise that anyone lured into one of these funds by these kinds of gains is just going to be a sucker. So the SecondHands of the world decided that they would buy aggressively on the first day or two or even three days of a new month or quarter in order to throw the feds off the scent.
Lordy, how I wish I were kidding, but believe me, I know this world all too well, and it happened constantly, so constantly that at one time I even made up characters called Buzz Gould and Batch Hammer who played these games. I knew it because, well, like many games on Wall Street, if you have been around long enough you know who does what to whom and when. It is called experience, and it is a term that was denigrated severely during the final years of the millennium.
Anyway, suffice it to say that this stuff gets done. It's crummy. It happens. And it is cruelly manipulative. It's one of the reasons I always suggest that you use these month-ends and quarter-ends to bolt from the stocks that these games get played with; that's the best moment.
When I first heard about this stuff, I was completely incredulous; I thought it was too conspiratorial, too dark. I thought it was my own paranoid fantasy. But, sure enough, in the past four years as I wrote about it endlessly, enough buy- and sell-siders have shared horror stories with me about the process that not only do I know that it is done, I know that it is gospel, that it has to be done, especially at a time when performance is so awful that these funds would have massive redemptions without it. Before, they did it for a shot of being on television; now they do it to survive.
Of course, now there are fewer and fewer stocks that can even handle this kind of buying without becoming completely absurd. They tend to be the stocks I identify as being in the "70 times earnings" club. I know if I were in the hedge fund business now, I would, on the fifth-to-last day of every month, begin to buy these stocks, and then on the third-to-last day begin to lay them out, completing the sale on the first day of the month and then going short beginning on the third or fourth. That way I would have plenty of ammo and not be subject to the inevitable short squeeze that happens on the second day when the dumber shorts don't realize that these mutual fund bad guys are still doing their buying to fool the regulators.
What a world. I made great money doing it. I felt badly about it. I was buying stocks I didn't like. But it sure was -- and is -- a great ride! |
