Sunday, November 16, 2014

Music May Help in Diversifying Your Portfolio

I try to learn from everything that happens to me every day. Most of the time the learning comes from linking one occurrence to some on the surface, unrelated activity. I have been worrying about appropriate levels of diversification of fund portfolios that I manage. Three events that happened to me last Thursday afternoon and evening were:
1.  A non-profit investment committee meeting
2.  A wonderful private violin and piano concert
3.  Picking up the wrong black brief case
A non-profit investment committee meeting
To be asked to join this small group one needs a successful career of investing for others as well as for their own money. This group meets periodically to discuss the individual investments in the portfolio and to consider new investments. Members  are used to commanding their own organization as well as responding to demanding clients.  All including the chair (me), have strong opinions. What has evolved in summing up a point of view by an advocate or a doubter is that the investment future for a particular investment is focused on the answer to a single question. For example the critical question for gold is the current level of inflation. Similar questions and answers were brought out for each investment considered. The other people in the meeting most often did not accept the single question and related answer. Not surprising that no major decisions were made at Thursday’s meeting.

Private concert

Mr. Norton Hall was the host in his lovely home for a wonderful preview of a concert to be presented over the weekend at Bard College featuring the very talented Elizabeth Pitcairn on violin and the equally talented Cynthia Elise Tobey on piano. I expect that the concert will be well reviewed. They played four pieces including one specifically commissioned for the concert. I was seated next to a well-known Professor of Mathematics as well as a refined music lover. I asked him if could he estimate the number of notes that were played. Later after consulting with the violinist who is a music professor, he estimated that perhaps 75,000 notes were played on the violin and since the pianist was actively using both hands she probably played twice that number.

What struck me in comparing the investment committee meeting which lasted for more than an hour was that we intensely focused on under a dozen possible decisions as distinct from the very pleasant concert which was produced by approximately 200,000 notes or specific finger actions of the talented ladies. In the first case we were being directed to make decisions on a single focus whereas in the second we were being asked to enjoy all of the work. My ear is not sufficiently sophisticated to pick up a mistaken note as written or played. 

Getting back to my concern for the proper diversification balance, the thought occurred to me that for the owners of investment accounts the overall result was more important the individual component’s performance. One of the reasons that I enjoy the music of a large symphony orchestra is the blending of many different instruments’ sounds. I find this much more pleasing than listening for the same length of time to a single instrument, for example a tuba. With those thoughts in mind, I believe that many accounts would be better off with a full complement of instruments rather than an equally talented duet. Thus I believe, particularly now that we appear to be entering a period of increased volatility and excessive emotional trading,  many portfolios would be better off with an intelligently wide diversification of instruments. I have thus far been totally unsuccessful in convincing professional committees to begin to add some form of commodity investing, specifically because they have done so badly. As distinct from my learned professional investor friends I resist single question and answer approaches that are so common with sales people. This may be because I lack the willingness to put my faith and clients’ money on a single decision. Hopefully I can find clients who have similar views.

The black briefcase caper

Due to inclement weather, we were among the first to leave the Thursday night concert in Manhattan. By mistake I picked up what I thought was my briefcase and put it quickly in the backseat of our car. As we were in the middle of the Lincoln Tunnel leaving New York I received a call that I had mistakenly picked up the wrong black briefcase. Luckily for the distressed owner, one of my sons was able to return the prominent lawyer’s satchel and pick up mine.

There is an investment lesson from this mishap. To a hurried casual observer, two items or two funds that look to be identical can be quite different when one looks into their interior. This may be a particularly important lesson when comparing ETFs with actively managed funds; while the components might be the same, the result is different. For a musical example, we have experienced two different conductors playing the same piece of music at various times at the New Jersey Performing Arts Center and noticed one considerably more pleasing to hear.

Short bits

1.  Is there a message from the following year-to-date performances?
Apple* +42.5%, 
Microsoft +32.5%,
Berkshire Hathaway* “B” +22.7%,
Exxon -6.0%,
Vanguard S&P500 +16.2%,
 Vanguard Total Stock Market +15.0%.

2.  Moody’s stock* (as mentioned in last week’s post) gets a $100 handle.
* Securities owned personally or in our private financial services fund.

3.  Elliot Management among others, including ourselves, suggesting the inflation data that the central banks are using is “fake.” They and others are referring to high-end real estate prices in places like New York, London, Aspen and East Hampton. My concerns are about the collection procedures and calculations.

4.  In the last 41 years the low on the unemployment rate was 5.25% with the current rate 5.8% which leaves some room to become better, but it is also a possible sign that the cash on the sidelines needs to rush into the market.

5.  Writers and numbers types don’t agree. The Thomas Piketty book earning a best business book prize when at the same time former senator Phil Gramm and Michael Solon in the November 11th Wall Street Journal are the latest to address the author’s faulty analysis as being far too simplistic.

Bottom line

We have entered an important period of cross trends where trading abilities are likely to triumph for awhile over long-term investment skills. A well diversified portfolio can handle both. But the use of the four model Time-Span Portfolios (Operational, Replenishment, Endowment, and Legacy) should make it easier to meet the funding needs for each type of beneficiary.

Question of the Week:

Have you divided your holdings between trading and investment pieces?  
Did you miss my blog last week?  Click here to read.

Comment or email me a question to .

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Sunday, November 9, 2014

Two Worries: “Happy Talk” Stocks + Fixed Income Leverage


Now that the “feel good”  US election is over, investors around the world have only two main worries. The first is the released enthusiasm will be found dissipated by the time a budget is signed at the White House, assuming that Valerie Jarrett approves. However, what could be worse is that the enthusiasm leads to a surge of buying, creating a parabolic price chart. The second worry is one that few are watching: the unidentified growth in leveraged fixed income transactions.

 “Happy Talk” for Stocks

While the Chair of the Federal Reserve is publicly worried about potential volatility when interest rates begin their inevitable rise, I am worried by the volatility on the upside. There is very little in the popular press about upside volatility. When stock prices go up the pundits claim that it is due to some economic statistic, they don’t attribute the gains to market structure imbalance. Because academics want their students to be aware that prices can go down as well as up, they label the gains as rewards and declines as risks; which fundamentally misinterpret the nature of risk. 

For those that have the responsibility of managing other people’s money, risk is the permanent loss of large enough amounts of capital that threaten long-term goals for the use of the money. The academics wanted (and many still do) a mathematical formula for risks and adopted standard deviation of returns which has led to far too many counting risk as volatility of returns, not impacts on outcomes. To solve the need to be able to define the volatility of “the market” our friends in Chicago created the Volatility Index on the S&P500 which then could be traded with the moniker of VIX.

VIX can miss

We have just finished a four month period when the VIX index doubled off a historically low base and then returned to low levels. However, this move to be did not capture the true saw-tooth movement in the market place. My firm has been charged with managing a series of portfolios largely invested in mutual funds for different needs. In this four month period we are tracking 51 separate funds and separately managed accounts for this client. While most of these portfolios invest in stocks, a number invest in fixed income. The movement of the VIX did not really capture the price movements. In July, 39 out of the 51 declined which was echoed in September when 49 were flat or declined. Our client should have been pleased that in October 43 out of the 51 rose. Perhaps, much more significantly over the four month stretch 32 rose. At no point was the ability of these accounts to meet future funding needs ever in question. Thus, there was no real risk to their goals.

Good news, bad news

In a recent investment committee there was a discussion as to moderately changing asset allocation in favor of domestic equities. There was an expressed belief that we are entering a period of increased upside volatility. This view makes sense to me in the short run. In previous posts I referred to the media’s use of “handles” to describe surpassing round number levels. S&P 500 at 2000, Berkshire Hathaway* at $200,000, Apple* at $100 and now we could add Alibaba at $100. It will be interesting to see whether Moody’s* can rise to $100. The stock appears to have stalled out at $99. Also can Goldman Sachs* go over $200?   If investors, both institutions and individuals, translate these handles as rungs in a ladder reaching materially higher levels we could see a wall of money coming out of cash instruments and into the stock market. (One investment banking firm is predicting a 3000 handle for the S&P.)

* Securities owned personally or in our private financial services fund.

If this wall of money enters the global stock markets without discipline, stock prices could gyrate upward in a speculative frenzy. If that would happen, it would fill the main remaining element needed to identify a major top.

Fixed income leverage

Most stock investors don’t realize that the fixed income markets are much larger in size than stock markets.  Historically price movements in these markets are less than those in stock prices. In addition, almost all fixed income investments have a maturity date thus banks, brokerage firms, and governments have felt comfortable allowing borrowers to borrow up to 99% in the case of currencies and somewhat less for other types of issues. In modern times it is not unusual to borrow money in a low interest currency and buy a lot in a higher (more risky) currency. Often the supplier of the leverage is a bank or brokerage firm who will be the recipient of the trading flow of the borrower. That has worked well, in the past. Today each of the banks or brokerage firms for regulatory purposes has had to reduce the amount of capital than can be used by their trading desks to provide liquidity to those fixed income accounts that need rapid liquidity. (In part this was one of the major contributing causes for the Lehman bankruptcy.)

The fundamental fallacy of governments bailing out financial and industrial companies is actually boomeranging and could make future collapses worse.  Collapses occur because a large number of people make rapid, poor judgments. One can not force sound decisions by law. (We probably would not have the political leaders that are present today if we could mandate sound decisions.) Governments don’t want to capitalize bailouts, so through regulation and legislation they are attempting to reduce the size of their exposure by limiting the size of the participants. The Fed has now decreed that no financial company can have capital in excess of 10% of the combined liabilities of all the other banking institutions. 

This has the effect that the US will have ten or more large banks. Other nations have a much more concentrated financial community. With the US institutions being limited in the global markets, their foreign competitors will increase their share of the loans. In time they will have to deal with large global failures which will impact US institutions and put our investors at substantial risk. One of the problems facing all governments is that they can influence, but not rule the global financial community effectively. The attempts to do so is creating a false sense of security which when their balloon is popped could lead to massive movements in the market places.

I would like to learn how big is the potential problem. There is no global tally as to the amount of money that is being provided to fixed income investors and these include important currency players.

When there is a major dislocation in the bond market the institutions involved or fear that they may get involved will reduce their support for all markets as they husband their capital before an eventual redeployment. Thus, one of the major risks to the stock markets is a sudden major contraction in the fixed income markets. This is called contagion and we saw it happen to the Latin American markets when Russia defaulted.

Question of the week:

What are you worried about? Let me know.
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A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Sunday, November 2, 2014

Higher, Lower, and Much Higher Markets Foreseen


The future is obviously uncertain. However, we have learned that having a series of forward views allows investors some freedom of movement compared to a passive role of being carried by secular trends to the extent of participation in various markets. What I hope to bring to this somewhat thankless task are two sets of tools. The first is to provide for the portfolio management task an approach to divide portfolios into sub-portfolios based on the expected time spans to meet funding needs. The second set is a series of analytical tools in looking at the short-term or trading environment, the intermediate cyclical periods, and long-term views as to the future based on selected history and the recognition of basic human motivations.

First higher

The recovery in terms of percentage appreciation has been somewhat greater than expected in that the dollar value of all stocks and high quality bonds was adjusting to a less than normal price correction. (Small market capitalization stocks and funds, the 2013 winners, did decline more than the defining 10% to be in a normal correction evolution.) I frankly don’t know the extent of the recovery but the first area that I am watching is the fixed income arena. I am doing this as I suspect through a combination of derivatives and borrowings as many fixed income securities are highly leveraged. Sudden collapsing of leverage is often the “Archduke’s Murder,” in other words a comparison to the early warning to WWI.  At the moment I am less worried, as I see that this week’s interest rates being charged on mortgages and car loans are inching higher. This indicates to me that there is a slowly increasing demand for loans. In turn this will lead to home and car purchases.

Interest rates and “stores of value”

Most investors do not recognize that the level of interest rates is a factor in setting the price in various “store of value” instruments such as precious metals, prime real estate, farm land, oil in the ground etc. In theory all of these assets have future value. To determine the current worth of these stores of value often one applies a discounting mechanism based on the current level of interest rates. To the extent that rates are low these future stores of value are worth less. If rates were higher they would be worth more, I believe. This could be important as a competitor to most common stocks, but there is little pull in the direction of these stores of value today despite the sad shape of many governments’ balance sheets.


Every now and then changes of daily prices can identify some worrisome instability. Last Thursday the price of Visa added 141 points to the Dow Jones Industrial Average (DJIA) or roughly 2/3rds of the DJIA 1.3% move on the day. Three things concerned me about this move; first the DJIA gain of 1.3% was twice the 0.62% for the S&P 500. Second, the appreciation in the stock added $14 Billion to its market cap and one of the reasons given for the move was a $5 Billion buy back of its stock so the gain in the stock price was disproportionate to the supposed value of the buy back. Third and most substantively I am questioning that the management could not find a sound internal need for the money. I would suggest both some selective foreign acquisitions and increased spending on technology might have been worthwhile longer-term investments. This excessive relative price move of the two major stock indices was back in place on Friday with the DJIA up +1.13% and the S&P 500 +1.17%. I am not arguing with the market level, but aware that internal movements in the market can prove to be early signs of disruption.

My final reason to believe the stock market is for the moment rising is a Saturday comment by my good wife Ruth, a keen observer of crowds. We were spending time finding a parking place on a rainy day at the glitzy Mall at Short Hills, a sign that the delayed Christmas season had just started. She also noted a few signs for sales help wanted in some store windows. A week earlier neither condition was present.

Cyclically lower markets expected

Markets are meant to discount future expansions and contractions before the reported economic figures are published months later. While we have seen some households deleveraging, government and corporate balance sheets are carrying a great amount of debt. Current interest rates are so low that they do not encompass a meaningful credit cushion. Thus a credit collapse could be meaningful. More importantly with the exception of China and to a much lesser extent India and perhaps a few other countries, spending on physical and educational infrastructure is not addressing these deficits. Few, if any governments are incentivizing the private sector to carry out these long term needs efficiently. Raising taxes will burden the economies even more and promote more tax avoidance schemes. Trading oriented accounts can briefly take advantage of the favorable short-term environment, but need to be wary of too much of a good thing which could bring on a major market collapse.

For those investment accounts that have an investment time-span of five years or less they need to be alert to the expected oncoming decline within those five years. Few, if any accounts at any given day will be able to dance out of the way and then at an appropriate time get back into a subsequent rise. The use of averaging out makes sense. As we have seen in the last few weeks, markets can rise quickly after a fall.

Much higher later

Over the long history of humans we have been able to solve many creature comforts needs, but less so successful with basic human fears. This was brought home to me Saturday night when we attended a sponsored New Jersey Symphony Orchestra concert, (my wife Ruth is the Co-Chair of the NJSO), playing two wonderful Russian pieces Petrouchka and Scheherazade. Both pieces musically address Russian concerns about Islamic powers to hurt Russia. All one needs to remember is what the Mongols did to the Russian people.  Today Russians are very much concerned about Islamists uprising in or near them. To some extent almost all conflicts have to do with finding meaningful income for all. While this is an old problem, today there is reason for hope for future solutions to many of these needs. 

In both Friday and the Weekend editions of the Financial Times there is an interview with Larry Page the co-founder and CEO of Google. While we do not directly own the stock, many of the funds that we own for clients own the stock. He wants his company to look forward 100 years and be part of solving lots of the world’s problems. Page feels ambition in general is in short supply. He wishes to convert his $62 Billion in cash reserves into new ventures. Many of the areas that interest him include nuclear fusion, artificial intelligence, self driving cars, diseases of the elderly, etc. He has already set up some quasi-independent groups within Google to work on these challenges. (For those who wish a copy of the interview I would be happy to send to you my marked up version if you contact me or click on the email link provided.)

I do not have any idea what degree of success Larry Page and Google will have in addressing these problems. I do know a small number of other companies in fund portfolios that have similar, but more selective ambitions. Perhaps it is my time served as an electronics securities analyst, or membership on the Caltech Board or the benefit of a very bright nephew at Carnegie Mellon, I do have faith in the future through smart technology and rigorous science.

Thus for endowment and long lasting legacy portfolios, I believe the intelligent providers and skilled users of technology should play a major role.
Question of the week: How do you think about current intermediate and longer term opportunities for your portfolios and those that you influence?
Did you miss my blog last week?  Click here to read.

Comment or email me a question to .

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Copyright © 2008 - 2014
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.