The stock market has seen its share of ups and downs lately. Unfortunately, we seem to have seen a lot more down than up — at least it feels that way with all this market volatility. The question is… what does it mean when stock value declines accelerate, and how can you determine a market bottom?

[VIDEO] Understanding Mutual Fund Redemptions

There are a lot of factors that contribute to market dips—credit markets freezing, foreclosures rising, global recessions or slowdowns—but none of those factors can actually make stock prices fall. The only thing that can make stock prices fall is when more and more investors want to sell their stocks and there are not enough buyers at the current market price to absorb the increased supply. So to find more buyers, sellers have to lower their prices, and down and down we go.

When retail investors throw in the towel on the stock market by redeeming their mutual funds, they turn their fund managers into sellers.

Redeeming a Mutual Fund

When you buy a mutual fund, you are giving the mutual-fund manager money to invest on your behalf in exchange for ownership shares in the mutual fund. When you redeem a mutual fund, you are returning your ownership shares in the mutual fund in exchange for an amount of money equal to the value of your shares.

Now, the important thing to remember is that once you give your money to the mutual-fund manager, he puts it to work in the market. Mutual funds do not sit on mountains of cash, they invest it. Why is this important to remember, you ask? It is important because when you ultimately decide to redeem your ownership shares in the mutual fund for cash, the mutual-fund manager has to come up with the cash somewhere, and the only way he can do that is by selling the assets of the mutual fund—like the stocks it is invested in.

When your mutual-fund manager sells stocks, it increases the supply of those stocks on the market. And as we all remember from our Econ 101 class, an increase in supply equals a decrease in price.

When Equity Mutual Fund Redemptions Increase

During a three-month stretch in 2008 redemptions increased at faster and faster rates. According to TrimTabs Investment Research, equity mutual funds saw the following outflows of capital:

• During the week ending August 6 $2,987 million
• During the week ending August 13 $3,932 million
• During the week ending August 20 $5,135 million
• During the week ending August 27 $511 million
• During the week ending September 3 $4,790 million
• During the week ending September 10 $11,926 million
• During the week ending September 17 $17,852 million
• During the week ending September 24 $6,327 million
• During the week ending October 1 $7,159 million
• During the week ending October 8 $43,301 million
• During the week ending October 15 $13,937 million
• During the week ending October 22 $6,470 million

To see the impact the increase in redemptions had on stock prices—especially the week ending October 8—take a look at the daily chart of the Dow Jones Industrial Average below.

Did the Market Find a Bottom?

You will notice above that since the week ending October 8, the rate of equity mutual fund redemptions fell off. At the same time the Dow Jones found support at 8,000. Is it a coincidence that the support level at 8,000 showed up at the same time retail investors stopped stampeding to get money out of their equity mutual funds? I don’t think so.

It appears that all, or most of, the investors who were going to panic and redeem their equity mutual funds had already capitualted and sold. Typically, according to most investment psychology books and books on major market crashes, this happens just before the market finds a bottom. Yes, it’s true. During times of heightened market volatility and fear, all of the sheep eventually jump on the bandwagon of selling at just the wrong time.

I see a reduction of redemptions as a signal we are at, or near, a market bottom. Of course, being at the bottom does not mean the market is going to instantly turn around and move higher. It does, however, mean it shouldn’t continue going lower.

Image courtesy permanently scatterbrained.