Sunday, July 20, 2014

I Suspect and I Accuse


Today’s post is a double header with the first part focusing on thoughts as to the current markets and the second on longer-term issues that should be considered for investment policy considerations.

I suspect a “Melt-Up”

In last week’s post I discussed three possible directions for the current market, “melt-up, muddle along, and decline.” At this juncture, for at least awhile, the apparent path of least resistance is to go up in price.


There is a belief that surviving a problem that doesn’t kill you makes you stronger.  Most global stock markets did not fall on the two threats to geo-political peace last week; the downing of the Malaysian airliner over Eastern Ukraine and the beginnings of the Gaza strip ground attack. If the markets did not fall, then some believe the path of least resistance is for stock prices to rise. (Remember it took one month from the assassination of the Austrian Archduke and when World War I was declared on the European continent.)

Often when low to intermediate credits rise in price (decline in yields) relative to high quality paper, it is favorable to stock prices. Each week Barron’s publishes a confidence index based on this relationship. Normally it is quite stable. For the week that just ended the current reading was 69.9% vs. over 74% one year earlier. English translation is “risk-on.”

Because so many analysts and portfolio managers are relatively new to the business they tend to look at past history in terms of calendar movement of the Standard & Poor’s 500 index. They do not recognize that in an average year since 1980, according to JP Morgan Chase there is a 14.4% decline from peak to bottom. I am particularly sensitive to 1987 when for the year the S&P 500 index was up slightly but there was a  -34% peak to trough decline thru the year, and much worse in the average stock. In our analysis of mutual funds for our clients we pay particular attention to the declines of- 49% and -19% in 2008 and 2011 respectively. But who cares, the market always come back.

The consulting community and institutional “gate keepers” pay attention to ranked performance particularly of short periods. We have maintained for some time there is little in the way of persistency of good performance from quarter to quarter and even for one year and particularly for three years. S&P recently did a study of top first quarter performers for the first quarter of 2012. They compared these winners to the top 25% winners for the similar quarter two years later. They found that only 3.78% of the funds repeated in the top quartile. What were even worse were the large capitalization funds where only 1.9% repeated. Remember large cap stocks have more analysts following them than smaller companies. What this suggests is that the market may well be shifting to favor short-term momentum winners which would be leaders in a sharply rising market.

Ignoring what you don’t like

If you can ignore facts and views that are cautious, one can become more bullish quite quickly. Some of the subjects that investors seem to be ignoring are: 

1.      Private Equity Funds are selling their holdings at high valuations.

2.      Lust for yield is forcing investors into less conventional-higher risk paper.

3.      People seem to forget that most Merger & Acquisition deals work out poorly for continuing investors. That it took so long for Steve Forbes to find an acquirer for the majority of his company shows that the private equity buyers are more cautious now than the public investors.

4.      Interest rates are rising each week, for example: 15 and 30 year mortgage rates, new car loan rates and the banks’ cost of deposits (MMDA). At the same time numerous banks are reporting, as forecast, lower quarterly earnings and are looking to new markets to replace their crunched earnings power, e.g. PNC. This is occurring in a period when people are saving less and the spreads between high and low credit quality is narrowing.

5.      Many US investors are turning to Europe to find good investments. This surge in demand has led to a 102% increase in Western Europe High Yield issuance in the first half of the year. (Anytime there is an increase in low credit quality issuance I wonder when we will see a meaningful uptick in defaults.)

I Accuse

This is the famous title of an open letter to the President of France by Emile Zola about the “Dreyfus Affair” which eventually led to Captain Dreyfus being exonerated and a public recognition of societal biases in France. In a far less dramatic context I accuse my fellow members of the global financial community of complacency. While we all see any number of troubling events, most do not change or plan to change our investment positions. In effect many have elected to play “the greater fool theory” card in an undisciplined way.  A few of the things that should cause at least some of us to begin to shift away from risk of loss of capital are as follows in no particular order:

The sale of the Russell indexes to the London Stock Exchange opens more questions as to the future value of index production.

Internally both the US and Canadian central banks are looking for methods of improving their research in private recognition that they have not been very good.

We are seeing considerable “flight capital” movements. In the US the net sales of international funds is increasing as domestic oriented funds are in slow growth or net redemptions. In Europe we are seeing that the bulk of the long-term fund sales are not in funds from cross-border managers and are often going into investments outside of their domestic market.

Some very visible investors have made the following statements:

Carl Icahn:“This is the time to be cautious.”  

David Kotok: of the esteemed Cumberland Advisors indicates that tapering is now going to be tightening.

Kathleen Gaffney: Well-known bond fund manager now of Eaton Vance* noted that traditional bonds have interest rate, credit and liquidity risks which is shoving us into unconventional paper.
*Stock owned by me personally and/or the private financial services fund I manage

An example of a real concern of mine is the discussions of an informal group of retirees, semi-retired and active portfolio managers, analysts both fundamental and technical, and an experienced institutional salesman. In periodic meetings, from my viewpoint, too much of this group’s discussion is on the issues of the day (often political) and not enough about individual securities and portfolios.

This group may well be a microcosm of the investment community trying to get the last high price for what they own while wringing their hands as to problems facing the investment world.  Within my own responsibilities I have only recently started to sell long held positions, but still are very much an investor in equity funds and some individual stocks, mostly in the global financial services arena.

What we should be doing if the melt up gathers momentum is to place sell orders at various different levels so that we maintain our survival capital for the next major bull market, which I expect beyond the next five years.

To my readers at Citywire Global

Thanks to my City, UK and European readers for once again making my blog one of your top choices.  Last week’s post was listed as Number One of the five most read stories on Citywire Global. I appreciate your readership.

Question of the Week: Do you have any specific plans to liquidate some of your “at risk” assets? 

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Sunday, July 13, 2014

Long-Term Investing is at a Crossroads


There are three problems about thinking about the future. The first is not to believe the future as starting with what we see today. The second is “when does the future end?” Finally, “what unpredicted events will occur?”  Far too many investors ignore these questions. However, the best guess answers to these questions are the essence of long-term investing. We currently have the responsibility for investing for the indefinite future for institutional and family accounts and so must deal with these questions. Like all investment advisors, we need to do this well for us to be able to add new accounts.

As our present responsibilities to clients and beneficiaries require certain levels of current income, we managed balanced accounts on their behalf. Thus we need to pay some attention as to what is happening in the fixed- income markets, which leads to the first fork in the road. 

Fixed-income disruption

Usually the exploding bubble that brings down markets is caused by an imbalance of demand over supply. If the market can not supply sufficient merchandise the demanders will increase the prices that they are willing to pay. During the ramp up the owners of supply will become hoarders in the belief that prices will continue to rise; and so it will as sellers become scarce. The bubble pops when the hoarders become insistent sellers and the buyers retreat as their only interest was higher prices. 

In some respects the way fixed-income investors think about securities is the exact reverse as stock buyers. They translate their need for income into a yield calculation. Their literature is full of commentary about rising yields not falling prices which is the direct result of the fixed nature of fixed-income.

Any long-term history of bubbles will reveal that bubbles never really totally disappeared; the surviving “animal instincts” just shift their focus often with the help of governments. The speculative excesses from the “dot-com” arena morphed into the prime mortgage bubble. The way one can spot the next bubble is to look for large instances where there is excess demand over supply. In the fixed-income world that translates into higher prices for bonds and lower yields. We are currently within a huge increase in the demand for income to meet institutional and individual needs.

I have written in the past about the studies done at Caltech and other places as to how the mind accepts risk of sharp declines based on the belief that the mind will be able to execute a rapid withdrawal safely. Growing up in the investment business we used to call this “the greater fool theory” meaning one recognized that they were foolish buyers and owners of securities, but there would be always be a bigger fool who would buy the tarnished merchandise at a still higher price. Today, the nerves of the fool are quieted most of the time in the belief that the major central banks will continue to manipulate interest rates lower and in effect put a floor under these foolish bets.

The fears are not totally put to sleep as we saw this week when a single missed payment by a partially owned upstream affiliate of the largest Portuguese Bank (Banco Espirito Santo) triggered a broadly-based European stock market sell-off. This kind of market action reminds people of the unpredictability of events.

In the past, prior to government/central bank intervention, interest rates covered both the cost of money and a cushion for the cost of credit to make the loan eventually good.  The sharp drop has people concerned that what they thought was the proper attention had been paid to the question of credit repayment. Now they are wondering. This may well be the reason that in a US stock market which is hesitantly but gently rising, the stock price of its most powerful bank JP Morgan Chase* is slightly down -4.6%.

One of the lessons that stock players over the years should have learned is that the fixed-income market is much more sensitive to short-term changes in the chances of getting repaid than the stock market. Thus for stock investors, the bond market plays the role of the warning canary in a deep mine. (This is not a totally new concern. In 2013, the Investment Company Institute reported that both Citi and State Street temporarily suspended redemptions of some of their Exchange Traded Funds.)

As all analysts are essentially historians, I am concerned about the excess of fixed-income demand over high quality supply. In addition, there are two newer concerns. The Federal Reserve has announced that after October they will no longer be regular buyers of US Treasuries and Mortgages, which may reduce the supporting buyers.

My second concern is that because of more restrictive regulations most major banks around the world are finding that they must reduce their expenses in order to get a reasonable return on their equity. This translates into laying people off. Some of these people are in supervisory and/or credit reviewing positions this could hurt all of the services that the banks provide to both institutions and individuals,
Melt up before melt down

As said by Monty Python's Flying Circus “Now for something completely different;” a quantity of  US stock investors is actually enjoying good returns.  I tend to look at stock returns in terms of multiples of pension fund and non profit institutions’ funding needs. If one assumes a 7% required rate of return (which is too high), then on a year-to-date basis the owners of Apple shares* have earned more than double that rate, with an 18.8% gain. The same could be said for Merck with an increase of 16.8%. Even the bond substitute of Utilities is up 14%. (This relates to our fixed-income concerns.)

The truth about the stocks going up in price is that current prices are not drawing in sellers. As many have commented on the current bull market, it is the most unloved bull market in history. While the near-term outlook for revenue growth for most companies is modest and they already have record profit margins and are shrinking their capital base, one wonders what is driving some of these stocks higher.

I have a partial answer from my experience as a leader of a global analyst trip many years ago. I got a call late one night when we were in Australia from a brilliant international portfolio manager. He was asking how the trip was going. I started by reviewing for him our various visits. In his demanding way, he cut me off and asked whether my fellow analysts were believing or not. I asked him what his concern as to what we thought was. His reply was stocks went up on the basis of the weight of money behind each stock.

In a similar fashion I believe that the stocks that are going up are due to the weight of money. Some institutions and many individual investors are not fully committed to this stock market. (Fund net flows are larger for international funds than domestic oriented funds.) I suspect that if the S&P 500 on a price basis goes much higher than the current year-to-date gain of 6.4% (Vanguard’s 500 Index fund on a total return basis is up 7.6%), there will be a competitive rush to get fully invested. 
*Owned be me privately and/or by the private financial services fund I manage

As readers know, I have been concerned about a major top in the stock market caused by stock price acceleration. Typically for a market to get into a bubble condition, the last phase is a parabolic rise where people start talking in terms of short-term doubles and more. It was just such a phenomenon that suckered in Sir Isaac Newton, who knew better, and much later, John Maynard Keynes into participating in the collapse of their bull markets.

I hope this doesn’t happen. But both from my study of history and my research lab at the New York race tracks I can not rule it out. I will be intently watching the action of the crowds, to see whether successful business people are giving up their well paid jobs to day trade from their home computers.

Muddle through

There is nothing axiomatic to the two extreme cases discussed above. The Wall Street Journal which started publishing on July 8th, 125 years ago created what is known today as the Dow Jones Industrial Average. Over this period it has compounded at a little more than 7%. For those who want to catch the extremes, on the same day in the heart of the depression the index bottomed at 41, compared to today’s level of about 17,000. I must deny I had anything to do with the occurrences on July 8th,  even though I was born years later on that date.

What to Do?

I don’t have the luxury of avoiding decisions to wait on clearing developments. I can neither wait until another major bottom appears nor can I be a seller at the top in a meaningful way. Thus, while I can adjust portfolios when warranted I must have a starting position everyday.

For long-term accounts that are looking well beyond ten years I express my faith in the power of well selected equities in well managed funds and would be committed to these holdings as long as I could meet funding needs through income supplemented by total return.

For accounts that for internal political requirements that can not see beyond five years I would reduce risk assets to no more than 66% and no less than 50%. For those unfortunate accounts that will be judged on the basis of annual returns, I would own no fixed-income with maturities beyond one year. I would accept that I might underperform a recovery in small cap and technology, including health care, by focusing on large caps, with adequate balance sheets that had a reasonable amount of secular growth in revenues and mutual funds that owned these kinds of securities.

My question of the Week
As these views are somewhat extreme what are your views? 

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All Rights Reserved.
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Sunday, July 6, 2014

Top Down is Popular, Easy and Wrong


We are all victims of time management. In school, our classes are usually under an hour; we select articles to read based on headlines; our media diet is largely based on twenty second sound bites; our instructions to and from co-workers are brief. In almost all cases these inputs start with an overarching declarative statement followed by the identification that there are supporting details, but these are rarely discussed. The initial overall statement is designed to be accepted without any serious debate. Whatever details that are mentioned are all expected to be in support of the grand top down statement. Over a lifetime of inquiry in just about every activity, I have learned the best defense against the power of the grand statement is the phrase “God is in the details.”

The “Franklin Close”

The American Revolution, unlike most revolutions, was not about the transfer of property to aggrieved masses, but about tax and trade regulations. (The Boston Tea Party was a symptom of a detailed complaint.) One of the wisest, politically most successful, and a good investor/merchant was Benjamin Franklin. Dr. Franklin’s technique in bringing together the strong personalities of fellow members of the Continental Congress was to arrange a list of the positive arguments on one side of the page and the negatives on the other side. His skill was shown in that the number of supporting details was often uneven. Thus the side with the most arguments usually won. For years this technique was called the “Franklin Close.”  In his presentation he appeared to have martialed all the important details and thus his preferred solution had the benefit of seeming to be a well balanced point of view. In the give and take of the debate, the wording of the overall proposition was modified and the final version received general support.

In today’s world the top down statement is expressed as an immutable law for which there can be only full acceptance. Further, because of time constraints and general impatience there is no room for a thorough discussion of details. Typical of these top down pronouncements which lead inexhaustibly to a specific investment conclusion are:  “If interest rates go up, the mid-term election will dictate the next US president.” “A rise in the price of oil is bad,” etc.

Why I am wary about Top Down analysis

As a professional analyst I am trained to take either side of these top down pronouncements. Often, I find that the proponents do not have the command of all the relevant facts and certainly do not understand the other side. For example, I could proclaim that the US economy is getting better for our local town because  I saw a placard in front of a bank reading “We are making loans.” While the overall view may be correct, extrapolating from a single or a small number of signs does not constitute proof positive. Occasionally there are technical factors which drive a particular input that can be misleading. For example, in last week’s post I noted with surprise the sharp rise in the average interest rates paid by banks from 0.37% to 0.43%, a significant change from one week to the next. I mentioned that it could be caused by some technical factor. This week the rate dropped back to 0.40%. I was hoping that the sharp increase in the week before was a sign that banks needed deposits because of a surge in loans. While this may be true, I suspect that at least half of the sharp run up in rates may have been caused by some banks who for regulatory purposes wanted to show more deposits that would reduce their ratio of loans to deposits.

Successful investors are concerned about specifics

When I spend time with successful investors, particularly with competitive portfolio managers, they quickly dispose of geopolitical, economic, and interest rate discussions. What they want to talk about are individual investments and the details behind them in a balanced discussion. Often they use a modified “Franklin Close” to cap their views. The other evening we were having dinner with a well-known manager. He was concerned about a particular trade in Japan. I found it interesting that there was no chatter about the general economic outlook for Japan. When I really go into detail with a manager I discuss the significant losses that he or she had. It is almost like the proverbial fishermen when they chat about  “the one that got away.” These are not top down exchanges.

The biggest problem with those pundits and others with their top down pronouncements is no one has a particularly good record of being right on the specific view or its impact on the price of specific securities. Perhaps we can secure better results if we require history teachers to stay with facts and most importantly figures and avoid thematic lessons. Maybe economists should only teach microeconomics, not macroeconomics; and there should be no financial/investment briefs in the media without someone representing the other side of the page. These modest proposals will not happen, thus my advice is to save your attention capital for detail discussions that are balanced.

Facts that could cause future trends

The following comments could foreshadow important future trends:

1.  Company-sponsored sports events such as softball with other firms are declining. Though in the past this activity has led to inappropriate hiring practices, such events were considered team-building for employees.  This decline symbolizes a significant change in business philosophy, and this is having impact on overall employment totals, length of employment, and long-term valuation.

Lifetime employment is being curtailed as being too expensive in its current and retirement phases. Some may question the productivity advantages of more senior employees, I don't in intellectually   challenging occupations such as the investment advisory segment for intelligent clients. There was a time when to be considered well-managed an organization had to have a deep bench and one or more good replacements for each critical role. This is not the case today in many instances. As I have been involved both as a buyer and seller, I know that part of total acquisition cost is often restarting the firm, thus impacting the value of the deal. A lower terminal valuation should lead to a lower current price earnings ratio. Therefore one could say that striking out in industrial softball is a bad play for both the economy and the markets.

2.  US World Cup Team member Omar Gonzalez‘s comment: “We will never give up, it is ingrained in US spirit.” (A possible return to a wider belief in US exceptionally?)

3.  Martin Wolff in the Financial Times noting that the US recognizes the correctness of the BIS cautionary statements, (mentioned in my last week’s post) but does not accept its austerity solution.  In the US we continue to want to “have our eat cake and eat it too,” even if it makes us eventually sick.

4.  PIMCO Total Return Fund is having net redemptions, but its ETF version has net sales. This shows that investors, perhaps guided by advisors or gatekeepers are reacting to the poor performance of the last couple of years, whereas hedge funds and other more speculative investors are looking forward to markets where this portfolio will do absolutely and relatively better. This dichotomy shows the very real difference between mutual fund and ETF investors inhabiting the same portfolio.

What are you seeing that might influence your investments, particularly anything that will cause you to transact?
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A. Michael Lipper, C.F.A.,
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Contact author for limited redistribution permission.