Sunday, December 27, 2009
“Boxing Day” is a term that comes from the time of Henry VIII, when presents were re-gifted, wrapped in boxes and given to the poor. In secular modern America, the day is one to return gifts of wrong size or wrong taste. On a rainy, cold 26th day of December this year, the car line to get into the mall spilled over to the adjacent highway, and could have been a mile long at one point. Both local police and mall security people were out in force to keep traffic crawling along in the anxious search for parking spaces. Walking in the mall, we encountered many more people than we encountered on any day during the shopping season. (Many of the habitués of this mall have at least a black belt in competitive shopping.) Clearly many people were returning gifts, but judging by the new shopping bags with the word ‘sale’ imprinted on them, they were also buying. Some may have been using their new gift cards with the perception that the cards contain a "decay mechanism," motivating people to use them quickly on what they might have believed to be favorable prices and available merchandise. In actuality, many bargains were scooped up already by Christmas/Chanukah gift buyers. The intensity of buying was high, with lengthy lines at cash registers to ring up new purchases. The well-dressed crowd was not only buying merchandise, they were also showing off their new forms, and were wearing full daytime makeup and assorted items of “bling.”
The analyst in me could not help seeing what I felt was unusual volume and participant vigor. My training suggests that when one sees these conditions, something of importance is happening. Here are my guesses. First, store visitors make a reconnaissance visit early in the season to determine price and availability, and think they can do better at the post-Christmas sales. Second, some shop the Internet and receive goods from the very same stores that pay the high rent for location in the mall. Their gifts are more easily exchanged in-person at the mall than by mail or express delivery. Third, there was significant growth in the purchase of gift cards this year. All three of these motivations drove people to the mall on Boxing Day 2009.
In last week’s blog I said I would discuss lessons from mutual funds this week. Throughout 2009, the volume of both gross and net sales of bond mutual funds has been higher than those for equity funds. In many historic ways, this is remarkable. Bear in mind that one of the steadiest inputs to fund assets are the monies from 401(k) salary savings plans for retirement. My experience as an adviser to a number of such plans at different income levels is that on average, about two thirds or more of 401(k) money goes into equity funds. Further, once most people set their initial asset allocation, they do not change it. Some may have shifted into bonds in 2009 as a reaction, perhaps an over-reaction, to the stock market performance in 2008. My guess is that the over-reaction is enough of an explanation for the high sales of taxable bond funds. In addition, retail taxable brokerage accounts do not appear to be increasing their trading of stocks at the firms that I monitor, and/or in which I invest. Fixed-income underwritings are strong, with both the public and institutions buying.
What is happening to cause this wide-scale interest in bonds and bond funds? As with most trends, there is both a long-term shift and a more current accelerator. For many years, the buyers of bonds looked to interest payments to fulfill specific spending needs, often retirement spending. (Remember the phrase that someone was “living on fixed-income?” For some, this included interest payments and slow moving pension plans.) The eventual repayment of principal was a significant event, either to cause a reinvestment or to make a significant purchase of an asset. (This could be to pay off a mortgage or to send a child to college or similar such expenditures.) Historically, once a high quality bond was issued at a currently acceptable interest rate, the vast majority of the issue would be held to maturity. Over time, some bonds would come back out on the market to meet estate needs or to meet the needs of a change of circumstances. With the recent rise of professional fixed-income managers, trading profits in addition to interest income were promised, and some delivered. Today fewer bond issues are locked up, and it is not unusual for bonds to have transaction turnover rates similar to stocks. They have become trading vehicles. Becoming trading vehicles changes some of the participants in the market place. In today’s low interest rate environment, trading can add or subtract much more than the coupon rate on the security.
What do bonds have to do with Boxing Day? To add to potential trading profits, traders look to find what they believe to be mis-priced issues, similar to the differences in pre- and post-holiday sale merchandise. Often the mis-priced securities are scarce. One of the reasons they are mis-priced is that the bonds may have been difficult to sell, which created a liquidity discount in terms of price, or a premium in terms of rate. Not dissimilar to post-holiday shoppers fighting over the one remaining great sweater in the right size. Inventory and liquidity are interrelated.
In taxable bond land, 2009 was in some respects three years in one. In the one year ending December 24th, the average non-money market fund had a total reinvested return of 19.53%, according to my old firm. The average income yield on high quality bond funds was in the range of 5%. In the long term funds, the average rates of return in 2009 rose from the Corporate “A” Rated Bond fund return of 15.95%, to Loan Participation funds returning 42.01%, and High Yield funds 50.82%. In my judgment, these are dangerous returns. To show the excess returns compared with the long-term trend for the five years ending on Christmas Eve, 2009, there were six different types of bond funds which had average annual reinvested compound returns between 4% and 5%, and two above 5%, (GNMA funds at 5.1% and Emerging Market Debt funds at 7.25%).
Next week we will look at the equity sides of the investment house, which did better in 2009 after such severe contraction in 2008 that the five year returns are below the fixed-income levels.
Nevertheless, just as the intensity of manic shoppers in the mall on Boxing Day is exhilarating, it sends a warning sign of an unbalanced activity. Translating that into bond land, I would prefer to be a supplier rather than a buyer of bonds. The summer sales are likely to have fewer buyers and more bargains.
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Sunday, December 20, 2009
In terms of the real economy, the most bullish press account that I have seen is about FedEx, which has been a long term holding of the PRIMECAP fund that we own for clients. FedEx stated on the busiest shipment day of the year that its shipments were up 17% over the busiest day in the prior year. Citing this improvement, the company announced that it would resume salary increases and make contributions to its retirement plan. This comes from a company that recently reported a 30% decline in earnings. While a possible reason for the surge of shipments is a shift in the behavior of clients’ inventory management, I find the company’s wage and benefit decision to be encouraging.
I find it somewhat ironic that the Russian finance minister announced last week that the Russian recession was over. Note that the US recession has not been declared ended, though many believe it to be over. Considering mineral production and mining are much more important than financial and other service sectors in Russia, the minister’s declaration is a good sign for the global recovery. (One wonders whether Russia is becoming more of a capitalist state as the US is becoming more socialist.) A possible sour note to the global recovery is the announcement that Tokyo Steel has reduced its prices for the second time in three months. This decrease is in the face of rising Chinese spot iron ore prices. Clearly there are leads and lags to the global recovery story.
Gold is always a barometer of people’s fears and the willingness of those who will take advantage of these feelings. There are six Indian gold ETFs which had a 57% increase in the number of shareholder accounts in the six months ending September 30th, 2009. In the same period, these six ETFs saw assets rise 72%, showing some fear for the value of the Indian Rupee. Taking advantage of this increase in demand for gold at the retail level, the United Nations has recently licensed its own gold bullion coins to be minted and sold in Europe. The so-called World Government appears to be taking advantage of the inflation that is being seen in practically all of its members. Judging by how well the UN manages its own fiscal affairs, my guess is that we may well be seeing a top in the price of gold. That does not mean a near-term peak in inflation fears.
In the heart of almost every stock market bull is a Chinese noodle. Not only is China becoming the paramount buyer of many commodities (it has been reported that Chinese-built Cadillacs are outpacing those sold in the US), Chinese interests are becoming increasingly active in a number of stock and bond markets around the world. The National Social Security Fund of China intends to raise its maximum overseas investment from 7% to 20%. Within two years the fund will be at $ 146 billion. The fund’s goal is to beat inflation by producing an average annual rate of return no smaller than 3.5% in the 2008-2012 period. In the “out years,” the gain must be higher, as it lost $5.77 billion in Fiscal 2008. There are similar demands on other sovereign wealth funds who have suffered losses in 2008, and in some cases 2009. This suggests to me that in so-called high quality paper, we will see more speculation. Too early to call it the next bubble, but one we need to watch.
As the Chinese become wealthier, one should watch their consumer behavior. One interesting trend is that expectant mothers in China are traveling to Hong Kong to give birth. There are three possible reasons for this trend. Healthcare is better in Hong Kong, the purported advantage of the child having a Hong Kong passport, and/or a decision on the part of the parents to have more than one child. (Interesting how individuals react to the plans for them dictated by their government. I believe expectant mothers are part of a global medical tourism trend.) As the Chinese become more concerned about inflation there will be a sharp increase in the proportion of car purchases that will be financed, expected to rise from 8% currently to perhaps the 70% found in India, but not as high as the 85% found in the US. This is important as it will drive greater use of financial services, which eventually will be a plus to the global financial services industry.
One of the safest bets about the future is that the US financial service industries will undergo material structural changes. In a well-reasoned opinion piece in The Wall Street Journal by Robert Wilmers, the CEO of M&T Bank, the financial results of the five largest bank holding companies are contrasted with the rest of the bank holding companies. The five are Bank of America, Citigroup, JP Morgan Chase, Goldman Sachs, and Morgan Stanley.
Through the first nine months 2009, these five banks earned $30.1 billion compared to combined losses at the remaining bank holding companies. The “big five” lost $14 billion last year. The turn-around in their fortunes did not come from increasing lending, but from their trading activities. The first three banks alone had trading revenues of $26.8 billion in the nine months, having lost $41.3 billion in the year before. The two new to the bank holding status probably did even better. The rest of the bank holding companies aren’t in that league in a meaningful way.
Prior to the 1920s there was a separation of commercial and investment banking which was stipulated under the National Banking Act. In the heyday of speculation of that era, it was repealed. Due to the collapses set off by the use of leverage and banks bailing out their lending customers by securities underwriting sold to their depositors, the Glass-Steagall Act was passed. Ten years ago the Graham-Leach-Bliley Act repealed two of the four sections of the separation of commercial and investment banking law. This week, Senators John McCain and Maria Cantwell introduced a bill to return to the separation. Something is going to happen. I will be watching it closely not only as a concerned citizen, but also as a portfolio manager and investor in a financial services hedge fund. Currently we have no positions in banks that are primarily commercial banks. We expect both long and short opportunities will present themselves in 2010 and beyond.
Bottom line: I see a market for opportunists in 2010 on the one hand and not a bad market for long-term investors on the other hand.
Ruth and I wish our readers and their families a very Merry Christmas.
Next week I would like to focus on what I see in terms of mutual fund trends that will be of use to our members.
Please let me know your own thoughts on these topics.
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Sunday, December 13, 2009
The biggest drawback to this less-than-complete legislation is that it is meant to generate the feeling that both individual transactions and the economy will now be safer. From my standpoint, this is unlikely to be true. Just think of all the scandals that occur after each of the so called “reform” laws or movements. I believe the Romans got it right when they enunciated “Caveat Emptor,” which translates to “buyer beware.” We will be at great difficulty to prevent greed-driven buyers from over extending themselves. Many of the factors that drive buyers are discussed in my book MONEY WISE, now available in paper-back edition, and in e-Book versions on Kindle and Nook. Knowledge however, is rarely a driver for investors.
There is something novel in the legislation as currently presented, which is to attack the compensation of employees of large investment banks and other enterprises, supposedly to prevent them from putting the economy at risk. There are a couple things wrong with this approach. First and foremost, most of the large losses were not contemplated as possible before the series of transactions began. If you will, this is the “Black Swan” risk of an unanticipated event. Normally we count on greed and fear to keep prices in some appropriate plane of equilibrium. In the heat of the cheap money- driven frantic dance, there was little fear expressed by either the buyers or sellers. Clearly at the end of the musical chairs, one did not want to wind up with cash and its depreciating value. Second, the cap on compensation and bonuses are focused on employee agents. These are often highly paid people representing very large financial and industrial organizations that are successfully playing with the house’s money. A good bit of the so-called “shadow banking” participants are organized in some form of partnerships, where the partners are participating in the trading gains of the partnerships. A number of these partnerships have capital bases larger than many of the banks that received “TARP” money. Most of these groups are hedge funds, and they remained solvent without any taxpayer assistance. (Caveat Emptor: I manage a small financial services hedge fund.) As someone who owns shares in many publicly traded brokerage firms, I see a significant risk that talent is moving from these large, visible firms to smaller and often private groups, thus escaping the salary and bonus limits.
As unfortunate as it may be, a prudent investor should assume the passage of both of the so-called reform bills on Healthcare and Financial Regulation. There are two safe bets one could make on the outcomes. First, expenses for the buyers will rise, and second there will be large scandals in time, as some will learn how to play the new game ahead of the regulators. Changing conditions always create opportunities for wise and legal investments. Some of these opportunities are likely to be overseas where money is regulated differently, and there is a rise in the need for financial services, particularly in Asia. Domestically, a sure bet is that in the aftermath of Healthcare and Financial changes, there will be legitimate confusion, which will put a premium on groups that can guide affluent users. Intermediaries that possess bureaucratic and communication skills and are trusted, are likely to increase their share of revenue and profits. The sales forces of some brokerage firms and a few insurance companies come to mind.
What are the opportunities that you see?
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Sunday, December 6, 2009
All of those who got out of bed this morning, including me, are optimists. My view is that those who are fearful of the “Japanese Disease” are somewhat like those who believed in the flat earth centuries ago. All of their learned thinking was based on what was known at the time. They were dealing with a closed system that was not open to new inputs. The new inputs that I am counting on are technology, rising consumer demand from emerging economies, and the output of our educational institutions (students who want and will change the world). Unlike Japan, I foresee a growing population in the United States, not an unmixed blessing, which will increase the demand for goods and services sold here. One hopeful example is that a German auto producer is switching jobs from Germany to Alabama. Bottom line: I believe we will see some forward progress for the US in the years and decades ahead.
The “popular press” and many others want to believe that there is a tight correlation between the movements of the economy and the stock market. For many years, there is little in the way of correlation and there are periods of inverse reactions. The followers of known data on the general economy are somewhat like the “flat earthers.” The stock market is an auction of expectations. When the market has steep declines it is usually after a period of excesses. I do not see much excess currently, except in some commodities and in some fixed income securities. Credit has not expanded, with the exception of margin debt, however still below the 2007 peak. Thus, I believe the inevitable stock market correction will be limited to a 10-20% decline, not a 25% fall opening a new bear market.
In viewing these comments, please remember my only promise to the institutions and people that I manage money for is that I will be wrong some of the time, and it is our collective challenge to know when mistakes happen and to make appropriate changes.
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Sunday, November 29, 2009
The first intervention began late Wednesday, when I was happily notified that there was going to be an earlier-than-anticipated, sizeable contribution to the money we manage for a long-term client. One’s initial reaction to cash flow into an account, after expressing gratitude, is to apply the new money in the exact proportion in the existing allocations. However, my rule is that any addition or subtraction to an account is an opportunity to reexamine the entire structure of the account to optimize the potential net reward. (The term net reward includes risk reduction as well as looking to the upside.) In this particular case, a number of the mutual funds which this account holds are “hard closed” to new money. A few other funds are in limbo or have portfolio managers whose actions are a bit disturbing, thus I am not comfortable adding new money. In one case the inflow was large enough that it could fund a number of new positions without causing too great diversification. Much time was devoted on Friday to examine whether the new fund candidates had sufficiently different portfolios from one another that we weren’t double counting our exposure. Further, we reviewed all the funds’ total expense ratios to watch that we were not inadvertently raising the costs to the client’s beneficiaries. (This work will continue next week.)
The second intervention, which may be much more important to investors around the globe, was the announcement on Thanksgiving Day that Dubai World was asking the holders of its $ 60 billion debt to extend maturities by six months. In view of the near-term memory of the credit crisis that became a liquidity crisis coming out of sub prime mortgage defaults, the markets reacted violently. Dubai World’s real estate subsidiary, Nakheel, has a bond issue that is due for repayment on December 14th. Prior to the announcement, I am told that the bond was trading at 109 and on Friday was quoted in the 40's. In response, European and Asian banks led their markets down. In the US, significant, initial lenders to Dubai were weak. (The reason I stress initial lenders is that we have learned from the residential mortgage decline, that often the initial lenders sell out all or almost all of their positions.) Both Goldman Sachs and NASDAQ OMX fell in sympathy with their Dubai customers’ problems. As with the residential mortgage problems around the world, there were signs of trouble prior to the headlines. I know one respected investment manager, who upon returning from Dubai, stated that Dubai was out of cash to complete its various projects or to start new ones. As this brewing crisis had too great a potential to be really disruptive to our existing investments (let alone any new investments), I was glued to my computer and television screens on Friday. Thus, I did not go out except briefly for a late lunch after the NYSE early close for the day. (I expect some calming news will come out before the Tokyo market opens Sunday evening.)
Having delivered my excuses for working on Black Friday, I will now briefly describe my positive and negative reflections to my abbreviated visits to both the mall and our suburban downtown, along with a number of insightful conversations. Perhaps, the single biggest clue to how the shopping season was going is that both the mall and downtown had ample parking spaces available. In fact, I found better parking than on a normal Saturday. Walking around, we did not encounter crowds. In a number of stores the slimmed down sales staff outnumbered the purported customers. Some stores did have customers, but were not overflowing. My wife Ruth, who had a Black Belt in shopping when we married 23 years ago, noted that there were no customers at numerous cash register positions and one store had only four shoppers waiting to pay for their selected merchandise. Casual conversations with various sales clerks revealed no interest in contacting supervisors to get a more favorable price on a high-priced item. A major department store was advertising a short fur jacket rather than their normal full length fur, in their way lowering price points.
Focusing on prices was revealing. Several stores had significantly lower-than-normal priced merchandise in their display windows. Not lower prices on their normal products, but lower value, lower priced goods. Perhaps, the most revealing input we got was how the mall’s management reacted. Prior to the season there were a number of empty store-fronts. Most of these are now filled with “pop-up” stores that can quickly open with easily moveable fixtures, signage, and support equipment. These “pop-ups” are usually for seasonal items or marketing tests. Often these stores do not occupy the full store bay of the prior tenant, adding short space stores to the category of short-sale real estate transactions. The mall management is vigorously protecting its base. According to local real estate gossip, the mall gave significant rent concessions to a brand name merchant to prevent them from moving out of the mall and into the town, (reversing the normal pattern). I suspect there must have been a major concession, as the downtown now has 19 vacant stores. (We saw a similar pattern when we visited Birmingham, Michigan recently; another wealthy suburban community that has had a vigorous downtown retail district.)
An additional cause of concern to me is that it now appears appropriate to call this the “Shopping Season.” In our politically correct world there is little mention of Christmas or Chanukah. Religion and religious events seem not to be discussed in polite society. This approach has supposedly been taken so as not to offend anyone. As a Marine, I find this a defensive, or worse, a passive stance. We should stand for care and concern for others, which can even include our families and friends, but most importantly to those who are less fortunate. The muzzling of religious and spiritual thoughts is an attack on another pillar of our society. Institutions are important to our way of life, and incidentally important to how and in what we invest. Without strong, viable institutions in which we believe, we will be lost in a morass of meaningless politeness.
The job of a good analyst is to see things that others don’t. In the aforementioned “glitzy” mall, there are a number of higher-end jewelry stores. In these times one would expect to find at least one of these stores to be in the bankruptcy process. I found it encouraging that, in an auction of one store’s assets, the winning bid was by a respected professional liquidator. To my mind, the existing competitors were more logical buyers, as they already have sales outlets to sell the acquired merchandise, and wouldn’t have to employ the failed store’s people. That a professional would put up cash to buy merchandise from a failed firm in order to sell it out of existing locations, is a very positive sign. I hope they make a lot of money on this bet. Their past history would indicate that the odds are good.
One of the reasons that the US has been traditionally successful is that we adapt to calamities well. We rise to the occasion. Taking a leaf out of the liquidator’s book, adding the “pop-up’ stores, lowering price points but maintaining price discipline, are all signs of adapting to the current economic problems. Unlike a number of other recessions which impacted lower wage people primarily, the current one is a trickle-down recession with the problems hitting the wealthy either before, or at the same time, as the general population. Thus the adaptability at the high end is a good sign that unless materially higher taxes don’t prevent it, the high end will lead us out of the recession.
Therefore I expect we are coming out of our recession if we haven’t already done so. While we may take a little bit of time in making new equity fund commitments with new money, we think we will look back from the future and see that today’s prices will look as opportunities.
Please share your thoughts and reactions.
Sunday, November 22, 2009
We are not blameless for the mistakes that caused us, our clients and our society to pay the risk penalty. We are guilty of not looking for the unexpected, or if you will the “Black Swan.” Under the pressure to meet human needs for housing on the one side and income generation on the other side, we failed. I am not suggesting that there weren’t liars and others driven by greed, but for the most part the mistakes that were made were made by relatively honest, upstanding people who had no knowledge or experience to guide them through their next set of troubles. Even many of the traders, with their own and their firms’ capital, were unaware of the risks about to fall on them. At the end of the day, the fault was poor, one-sided research, not the compensation arrangement.
In our natural desire to avoid future penalties, we look at what went wrong in a mechanical sense and wish to institute changes to prevent what happened from happening again. I guess this comes under the headline of avoiding a second lightening strike. The theory holds that if one attacks the motivation of the guilty, (compensation), they will become reformed and won’t stray again. I believe that this type of change is unlikely.
To avoid future problems there is a tendency of the great and the good, (to use a British expression), to codify a new and more stringent Code of Conduct. Some of the popular headlines would require more transparency, more capital, and less leverage. These lists of “Best Practices” attempt to correct the past in a systemic approach. Perhaps, they should look at the lack of complete success at past lists of Best Practices. I believe they will find two obstacles in designing effective risk penalties. First, we live in a dynamic world that is always re-inventing or perhaps more accurately, re-packaging financial instruments. In this most creative community, good and bad people will find ways around the current rules. The second drawback to believing that Best Practices or regulations will prevent future problems, is that problems are caused by people, not procedures.
People are human, so they can and will make some mistakes. People have friends and family that they will treat differently than total strangers at times (and in some cases, very subtly different ways). People also have unfulfilled desires which can override their natural caution. I suggest that most problems will be avoided by those groups or families where the supervision knows their fellow workers/members, and can anticipate many of the human problems that drive people to take risks.
Changing financial compensation procedures without changing the psychic benefits gained from various forms of risk taking is like closing the barn door after the animals have fled. Better results will be had by leading people to the benefits of avoiding unwarranted risks rather than by promulgating Best Practices or by additional regulation.
We look for fund managers who lead their organizations effectively, they manage risk well.
Sunday, November 15, 2009
The history of the rise and fall of markets and related economies goes back to the beginnings of recorded time. This history can be described graphically as undulating waves following a cyclical pattern. As these waves began long before the creation of hedge funds and credit default swaps, there must be something more basic in human nature. I believe the drive that causes these cycles is the four letter word that a well known labor union leader enunciated more than a century ago when asked what his laborers wanted; the reply was “More.” It is each person’s desire for more of what is in short supply that drives the demand side of the economic equation. The supply side is provided by those who produce or possess “more” than what they can consume. In periods of population growth and net immigration, there is normally more demand being generated than supply coming onto the market. Spurred on by the dynamite of rising expectations driven by all forms of media, the demands for higher priced goods and services drove demand. There is hardly a human alive today who does not want more of something, including ‘peace of mind,” which itself can be costly. (Think of various forms of physical, medical and financial protection.) In this sense, we are all the sinners of driving for “More.”
There is a two letter word that we do not want to hear from our government or employer. That word is “No.” Thus, governments rarely say no to a demand for more services. The normal solution is reliance on inflation, as governments can repay their enlarged debts with currency that is worth less due to inflation. Employers also want to avoid saying no to increased wage demands if they can avoid it. Employers count on both increased productivity and higher selling prices to meet wage demands.
The growing demands for more goods and services could not be satisfied in their entirety through growth of the market. Most developed economies, including the US, have been growing more slowly than the escalation in demands. The solution to this problem was to borrow money in ever- increasing amounts. In effect, borrowing new money to repay old debts. In the corporate world, debt grew faster than equity, so any shortfall in the ability to issue new debt for old debt would have a dramatic impact on a proportionately smaller equity base. (Leverage has this annoying characteristic of working both ways to magnify gains and shortfalls.)
As an equity analyst and portfolio manager I did not pay much attention to fixed income securities. Neither did most individual investors. I should have been more conscious that segments of the fixed income markets were showing signs of distress by requiring higher yields to clear transactions. These particular securities were housing-related, and mostly the hot new Wall Street product called structured finance securities (which were large packaged and sliced residential mortgages). Their rising prices at the same time that more of the financial community’s capital base was being devoted to this trade, should have been the proverbial chirping of the “canary in the mine.” Like most others, I missed these early warning signs. Along with the regulators, I further failed to understand the implications of counterparty risks on a global basis. I missed the fact that overseas participants had taken on much more leverage. One could borrow more money, at better terms, in London than in New York. The poorly identified mortgage products were sold around the world to satisfy local needs for income to meet “more” demands.
Space and time do not permit for a more inclusive analysis of what went wrong and how we missed spotting the problems. What I want to focus on now is the possible “Pre-Mortem” for a future decline, which history tells us will surely come at some point. (Let us hope years in the future!)
Many people fear two possible causes for the next major decline that I do not. The first is a dramatically worse real estate market. Could residential market prices drop further, causing more defaults? Yes, but in terms of magnitude unlikely to be major. (Remember, I missed spotting the first decline when I knew local prices were unsustainable.) Many have identified commercial real estate as the next big problem. I think these problems have been largely identified. Vacant properties are a problem but I believe the order of magnitude is much smaller than the residential real estate hit we sustained, and the market is prepared for defaults.
The second popular worry at the moment is the relative decline of the US dollar. In the last couple of weeks, I have commented on the decline compared to other currencies, not commodities.
My true concerns however, are for two other problems that I perceive on the horizon. Either one could cause major instability in our markets.
The first concern is the increasing level of speculative foreign exchange trading. Corporations, financial institutions (including hedge funds), and increasingly individuals, have discovered these markets whose daily volume is larger than the traded securities markets on many days and nights. (Currencies are traded around the clock, around the world.) The advertised leverage potential for the retail participant is 500 to 1. (Many of the frauds in the financial markets have been caused by attempting to regain undisclosed losses by the rapid trading of highly leveraged products.) Foreign exchange that goes through banks has some regulatory oversight, but not heavy. Those trades executed outside the bank channel have little or no oversight. Either a suspected (or actual) fraud, or a surprise devaluation/revaluation by a government could cause a significant amount of margin calls. Many organizations and individuals could not immediately meet the repayment obligations on their loans from such margin calls, possibly leading to some bankruptcies. Nevertheless, a foreign exchange collapse is analogous to other kinds of margin calls, with enough case law in place that we should quickly seal off the problem.
My second concern is pure conjecture. Assume, whether, we like it or not, some healthcare legislation is passed. Initially the first victims of this price- control legislation will be the profit margins of doctors, hospitals, pharmaceutical companies, medical equipment providers, as well service companies. Most important of all, individuals will find their costs will rise; particularly the elderly and the formerly wealthy. Many different approaches will be attempted to restore their past financial relationships. Almost guaranteed, more debt will be found on hospital balance sheets,* doctors’ practices, as well as many other organizations. I suspect some individuals either by happenstance or by conscious decision will find it necessary to borrow money against some future financial stream. As many of these groups are inexperienced in shopping for, and managing external debt, they will fall behind in their repayments. My fear is that we will see medically-induced bankruptcies with enormous emotional pains, and very little easily convertible collateral. As a society, we are not prepared for this contingency. Pity the judges who will have to deal with these issues.
*I sit on the Financial Oversight Committee and chair the Investment Committee for an important not-for-profit hospital group that currently holds a very good credit rating.
Sunday, November 8, 2009
The first correct call was the recognition that the month of October, 2009, had specific characteristics; which this year resulted in a negative bias to equity performance for the month. I also pointed out that mutual funds end their tax reporting year in October. While most funds have accumulated large realized losses created in ’08 and ’09, it would be possible (and perhaps prudent) to recognize some gains. The gains would not trigger a tax payment because the gains would offset the losses. Since there are no “wash sales” rules on gains, the smart thing to do is sell some of this year’s winners and either repurchase the same stocks, or perhaps to use Sir John Templeton’s phrase, search for “better bargains.” As the SEC no longer requires funds to disclose transactions on a quarterly basis, we no longer see a list of transactions made by the funds, thus I do not know what happened.* However, during the last three weeks of October, a significant number of the best performing stocks for the year were met with selling. On an overall basis, the month of October was down. My supposition is, that with the removal of the incremental mutual fund selling, the short term performance (at least in early November) would be up. This actually happened. I call it a win.
The second call was on the relative value of the dollar, which I felt was bottoming. This appears to be happening. Please note that I phrased my comment in relative terms. I agree with many of the views of the dollar’s detractors, that the buck should be worth less due to the present deficit, the almost certainty of a larger deficit, and the strong odds of a pick-up in inflation, probably induced. Why then should the dollar stop falling? World trade currencies are priced relative to other currencies. From a managed trade point of view, the decline in the US dollar is an increase in the value of the counter currencies. In many countries exporters are politically important. They see a rising price of their own money as an inhibitor to their export sales. Thus, I believe that other countries will buy some dollars to prevent their own money from being priced out of the world market. I have great respect for George Soros and his investment accomplishments over the years, even though I rarely am in agreement with his political views and actions. When he was recently asked about the worth of the US dollar, he replied that it was over-valued, except in comparison with other currencies. Today, I do not see a better value in other paper currencies, even though personally I own some other currencies to support my foreign equity investments.
From the standpoint of those who are focused on the absolute value of the dollar, that is to spend rather than trade, the price of gold (and to a lesser extent prices of some other commodities) is instructive. The nominal price of gold is at record levels, about $1100 a troy ounce. However when translated into today’s dollars, the old record price of over $800** an ounce in 1980 would be at least a thousand dollars higher. One reason for the recent strength in the gold price is that several central banks have made it known that they will not be carrying out their previous plans to sell gold. In addition, both India and China are buyers. I will claim this call as a winner in light that the other side is not winning.
On a tactical side, my recent calls for long term investing for growth, and particularly technology-driven innovation, appears to be winning relative to bets on value, and to some degree on industrials. I will claim these as short term winners, even though they were meant for long term investment.
Emotionally, the final two words in last week’s blog, “Go Yankees,” (written by the ‘born in Manhattan boy’ in me) proved to be the week’s biggest win. Please remember that there are legions of New York haters who resent the swagger generated by this culture of winning. Thus while I am very pleased, after eight long years of lack of fulfillment, my guard is up to defend against those who wish to punish New York. New York is a state of mind and not just a place. The biggest threat we face is a repeat event as severe to our economy and the financial markets as we experienced last year. We will retain our “license” to be central to the progress of the world only if we have learned something and we change our thinking.
I believe that we must change our thinking, thus next week’s blog will be devoted to my attempts to become more aware of the shape of future problems before they overwhelm us.
Any contributions from readers will be appreciated.
* Years ago, the SEC required mutual funds to report their transactions quarterly, allowing a deeper dimension to the analysis of funds than is now available. The SEC caved-in to the funds in abolishing this report, reasoning that the SEC and its staff could get the specific information anytime they needed it. Fund owners and their analysts no longer have access to that insight.
** A very valued former associate of mine, the late Alling Woodruff, of Greenwich, CT, did sell his physical gold position above $800. He was an independent director of what was then the largest US gold fund and was going to South Africa to visit some mines, thus out of touch with the market for a couple of weeks.
Sunday, November 1, 2009
- Peggy Noonan writes in The Wall Street Journal that many people either believe our various structural problems will not get better and we have to live with the current imbalances, or that they have a sense of optimism without any focus on innovation. I believe that both views are wrong. Some of the structural imbalances are cyclical, made worse by government intervention which prolongs the period of healing. Other imbalances will get worse, such as structural unemployment; we have produced a labor force that does not know how to labor in today’s world. I am afraid this is a multi- generational problem of education in the home. On the optimistic side, I believe that technology will create new products and services that will make much of our existing ones obsolete to a point that we will replace the old with the new, even before the old wears out. My optimism, particularly in technology, leads me to favor funds that have significant technology holdings, often found under healthcare and energy classifications, as well as those that have a separate technology classification.
- Alan Abelson in Barron’s quoted John Williams of Shadow Government Statistics, stating that 92% of the 3.5% gain announced for the 3rd quarter 2009 GDP was essentially contributed by “one-off” items, i.e. “Cash for Clunkers,” and expiring first-time home owner mortgage credits. Abelson’s comments reinforce my concern on the reliance on government numbers. One might add to the list, the President’s claim of 1 million jobs created or saved by the stimulus. As primarily equity investors, our focus should be on the revenue production of companies and the bottlenecks they are discovering in their sales and delivery processes. Commodity prices and transportation data are much more reliable indicators.
- Little mention is being made in the financial press, and none in the stock market comments of the general press, about the fact that Mutual Funds operate on an October tax year. Most of the equity funds have large realized losses created in 2007 and 2008, as well as earlier this year. I suspect that in October, a number of portfolio managers sold some of their positions that had gains, without incurring any additional tax liability for their shareholders. They may share my point of view that it is unlikely that any significant news will break in the next thirty days, suggesting at best, a flat market for a month. This hiatus in the market recovery will allow them to reallocate their portfolios or return to their prior positions, (we will never know for sure, as the funds that report on a calendar quarterly or semiannually do not have to report on intra-quarter activity). In my mind, I believe this factor is a possible additional explanation why the month of October was flat. If I am correct, the stock price weakness shown in the last week is not a canary in the mine giving us a signal to get out of the stock market.
- Another market phenomenon is that in the last week Berkshire Hathaway disposed of another major portion of their holdings in Moody’s, at current prices. The credit rating company is regularly under attack in the press, the regulators and some well known short sellers. What I find significant is that the stock absorbed this selling without further declines. As the company is not currently buying back its shares, the other side of the trades may represent one or more substantial buyers, as the public does not appear to have any interest in this stock. Often I find when a stock does not decline much in the face of a strong, well-known seller, there is a “story” in the unidentified buyer. Perhaps these thoughts are wishful thinking in that Moody’s is a long-standing position in our Financial Services Hedge Fund.
- Now for a non-market thought: Saturday night’s, or more accurately Sunday morning’s, victory by the New York Yankees in the third game of the 2009 World Series is something of a cultural identity. People have a visceral reaction to the New York Yankees; they either like them or hate them. Friends of mine from all over believe that everyone who currently works or lives in New York, or ever did, is a Yankee fan. Never mind that many of these people are not baseball fans, and like me, have difficulty in naming the starting team, but the Yankees represent something. I would suggest they represent a culture of winning. (The image is greater than the statistical history. Nevertheless they have won more pennants and World Series than any other team, although in any many years they are not the best team). To many others, the Yankees represent a swagger or arrogance. This is one of the deep root causes for the current Administration’s and Congress’ desire to “reform,” or some may say punish, Wall Street. During the rain-delayed game I saw the Vice President of the United States in the front box seats. As a kid growing up in Pennsylvania, and a long-time Senator from the neighboring state of Delaware, one can easily understand his affection for the Philadelphia Phillies. Parenthetically, I find it interesting that his brother and son are involved with a hedge fund.
We should not expect any solace from the vice president, his administration or Congress for New York. One of the critical issues recognized by the current CEO of the New York Stock Exchange is that its future is dependent upon on what Washington pitches at New York. In the long-run, those of us who are spiritual New Yorkers have to find ways to become more loveable to the rest of the country. This tension is not new, as Alexander Hamilton and Thomas Jefferson, as well as Theodore Roosevelt and JP Morgan somewhat successfully worked on creating conditions from which all benefited. That is our job today. Go Yankees. .
Sunday, October 25, 2009
One can often learn more from reading the apology letters from poor performing funds than from winning funds. Brandywine Funds is one of the better communicators of this group. Their basic investment approach is to invest in stocks that they believe are selling at a discount to a future price, based on their estimate of future operating earnings. In bemoaning their under-performance, they focus on the “Quality Ranking System” of Standard & Poor’s, an analytical approach that focuses on relative growth of earnings and dividends over time. Using letter grades to signify the best of these measures, S&P assigns “A” to the best and “C” and “D” to the worst. In the first nine months of 2009, the “C” and “D” companies gained on average 134%, while the high quality “A” stocks were up 21%. To add insult to injury to the earnings modelers, the best performing stock in the Russell 3000, Human Genome Science, was up more than 3,300%. The company has not reported an annual profit since 1994, and is expected to have larger losses in 2010 than in the current year.
Another currently poorly performing manager focuses on the fact that the companies reporting earnings gains often are doing so by significantly reducing expenses. In many cases they are also experiencing reduced sales and/or share of market. Yet in the current market, these stocks are substantially outperforming others that are showing revenues gains and increasing or maintaining market share. Consumer stocks are doing well on Wall Street, but not on Main Street, and they have attracted significant short interest.
Under normal conditions, the focus on accelerating earnings produces performance leaders. The apologists for current relative poor performance have, in some ways, been bitten by one or more Black Swans. In the nineteenth century many Europeans believed that all swans were white, thus there was shock and consternation when they were introduced to Black Swans from Australia. This introduction violated their experience. For hundreds of years before the early twentieth century, the world was an orderly place following the rules of science as pronounced by Isaac Newton. Then Albert Einstein’s thoughts changed the way we looked at the world. In these two instances we are confronted with the choice of the experienced and normal, but recognize that under some conditions exceptions will occur.
Our market and economic experience over the last two years does not follow the normal past experiences. We clearly have been in an exceptional time. History suggests that past exceptional periods eventually coalesce into some form of repetitive patterns that become the new normal. I am not sure what these new relationships will be. PIMCO believes that they have found the new normal, which produces more subdued growth. I am not sure. In view of the fact that, in general, equity returns for the last ten years have been flat, I am of the view that over a longer period we will see growth. My feeling is that at least we will see high single digit growth with some years, like 2009, showing double-digit gains. Further, I believe some form of the old “normal” rules will work for investors, perhaps when we least expect it to work. In other words, this is not like saying to hold on to your Confederate Dollars. But rather, it is a recognition that the South did recover eventually, and is now often a growth leader.
Keep an eye on formerly successful managers, for some of them may be future leaders again, particularly if they do not chase the new normal.
Sunday, October 18, 2009
Almost everyday the global financial headlines discuss the decline in the value of the US dollar relative to other currencies. Many economists and others talk about a slow recovery here, and faster in Asia. Because of the difficulty in obtaining student visas for university students since 9-11-01, there is wide-spread concern that we are no longer attracting the brightest minds to study and work in the United States.
The fear (and perhaps a distaste) of investing in US stocks has been translated to Main Street. As of September 30th of this year, 53% of all money invested in Stock funds are in US Diversified Equity funds, according to my old firm. Another 6% is invested in Sector funds, some of which have a distinctive global tinge to them. Combined, Global and International funds alone account for 22% of American fund owners’ assets. These numbers understate the total exposure we have to non-US influences on our wealth. A number of analysts have estimated that over 40% of the revenues of companies within the S&P 500 come from overseas. Foreign earnings of these companies are not often disclosed, but I would not be at all surprised to learn that they represent over half of the total earnings of American companies (particularly if we include earnings from exports). I am well aware, and have benefitted from the fact, that investing globally for many years have produced better results than investing primarily in the US. This may not continue forever.
One of the first things I did as a Wall Street bank trainee was to physically account for the foreign shares in our bank’s vault (investors were issued American Depository Receipts or ADRs). Many years later my fellow trainee became one of the leading investors in both domestic and foreign bonds for central banks outside of the US. Almost from the beginning of my personal investing at the odd-lot, below the 100 share size, I invested either directly or indirectly in foreign trends. At times over recent years my foreign exposure in equities was over 40% including funds, individual stocks, currencies and some operating investments. I am no neophyte to investing globally.
One of the many lessons that I have learned from a number of older and wiser investors is to tend to invest against the headlines. The current pessimism about the long term future of the US is just such a time. For the accounts that I am responsible for (including my own), I seriously doubt that I will be adding to the international allocation in the near term.
Why do I take this point of view? Is it just to be contrary? No, while I am professionally trained to look at the other side (or sides) to any investment before making purchases, my optimism is based elsewhere.
We are incredibly fortunate to have three of our family beginning studies this year at William and Mary, Georgetown, and Carnegie Mellon. Not only are we listening to them discussing their courses, but also hearing about what their friends are doing at other leading universities here and abroad. They all appear to be working long and hard, and their courses are subjects that their parents and grandparents would like to take now. Our young will be much better prepared for the globally competitive world that they are inheriting. Their youthful enthusiasm, with some idealism thrown in, has a much more practical base to them than when I was in college. We are producing great raw material for the future.
While waiting for our young to earn their commanding positions, the current pace of technological development in many fields appears to be on the verge of major improvements for mankind. The discussions from graduates, professors and current students that I hear from my exposure to Caltech, suggest that we do not live in a static world. There will be breakthroughs in energy, medicine and their underlying physics, chemistry and biology. Big problems will be addressed and solutions identified. In the scientific fields, most of the awards are going to people who teach or were educated in the US. In science we have been punching way over our population weight class for some time and this is likely to continue at least for a few more years.
Focusing briefly on the price of the dollar, I would rather be a buyer than a seller. At some point, perhaps right now, our trading partners will want to prevent a further decline in the dollar. They will become buyers rather than sellers to protect their own export books and internal currencies.
My bottom line is I believe that one should not now be increasingly short of US dollar investments.
Sunday, October 11, 2009
Sunday, October 4, 2009
How we choose to invest is primarily a function of our experience. Our experience is not just what we individually have lived through, but also what we have consciously learned through the experiences of others with whom we choose to identify. Whether we like it or not, one of the inputs to our experience is our own DNA. This DNA is composed of elements of human race characteristics and more directly, family background. This is not to say that since there have been four separate (and not connected) Lipper brokerage firms, that for all time members of my family are condemned to be members of the New York Stock Exchange. What it does suggest is that we have a disposition to be attracted to transactions and services for others who transact. These tendencies can be applied to the various worlds of art and computer services among others. Luckily for the world, people are wired differently so we can find essential diversity in what we do. For the most part, our experience, no matter how formed, does not trap us into certain behavior, despite our propensities. Thus, as we enter each new theater of experience, we either treat what we are about to do as something new, or part of a continuum from the past.
Experienced investors, or if you will, old money, invest differently than those with new money. Each of us is human, and therefore makes mistakes; but often the mistakes of old money are different than the mistakes of new money.
Most of the old money that I know did not materially change the disposition of their financial assets after the experience of the last couple of years, even though their money piles are smaller. Their “normal” asset distribution might have been 5% in cash, 35% in bonds, 20% in domestic growth stocks or funds, 20% value stocks or funds and 20% international stocks. At the end of last year they may have had over 60% in cash and fixed income, 15% in value-oriented stocks or funds, 15% in international and 10% invested with a growth objective. An experienced investor believing that almost all relative performance is cyclical, might not change any commitments. For what the market takes away it will return over time. Further, from their experience, they believe after a major decline they should not change most managers or stocks of currently profitable companies. Old money has an affinity to long term records as they have had their money over the long term. They also generally prefer investing with organizations rather than in the success of any particular CEO or money manager. Thus, they chalk up the declines they have experienced as just a “normal’ cyclical decline which will be corrected by a “normal” recovery followed by some secular growth. In many ways this is almost a Newtonian view of a grand watchmaker overseeing our universe.
Owners of new money are full of themselves. They earnestly believe that their investment results are largely, if not totally, dependent upon themselves. They look at the current market always as an opportunity to show how bright they are relative to the mistakes of others. This personality-driven approach often identifies with specific hero CEOs or hot money managers. A somewhat over-simplification of their choices is that they believe in participating, if not leading momentum. Everyone recognizes that at any given time there are numerous unknowns that are likely to dramatically impact security prices and trends. If momentum won’t supply the answer, the new money is more likely to divine the right answers. They have more tools, or if you prefer gadgets, than the old money players and this give them an almost insurmountable advantage.
In these stylized cases, both the old money and the new money are making fundamental investment mistakes that others have committed in the past. Old money is betting on repetition, as in history repeats itself. If that was entirely true there would be no progress, as everything would circle back to our beginning point. In truth, history does show an uneven upward bias to the human condition and valuations. What many do not realize is that the upward bias is caused at least in part by the abandonment of failed, or too weak to survive, elements; as well as the pull of some new potential riches. Further progress is made by recognizing mistakes/opportunities. In the “old money” asset allocation example shown above, some wise investors might reallocate their money back to their “normal” portfolio. (There may be a seldom-declared advantage to this tactic: By increasing one’s commitment to a currently depressed area, if successful, the quicker one will get to the upper limit of the allocation causing a cut-back. One of the reasons for the dramatic declines in numerous portfolios last year was their over-investment in what was “hot” was not automatically corrected.)
New money often does not recognize that what is working so well now is very similar to similar beneficiaries of momentum in past market cycles. One of the many lessons coming out of the Great Depression of the 1930s was the peril of the extreme use of leverage or margin in the 1920’s by various utility holding companies, the great Goldman Sachs Trading Company and individual investors. Applying those lessons from the ancient past might have reduced the 2008 losses in various leveraged vehicles.
Both the stereotypical old money investor and the new money investor do not take into their considerations that they may be wrong. Their “system” like those of many disappointed race track bettors, does not contemplate that judgment mistakes are as normal as other accidents. Both set of investors can reduce their odds on big individual mistakes of judgments by using professionally sound funds. (Caveat Emptor: I manage portfolios of funds for institutions and a very limited number of individuals.) One might combine both the old money and new money approaches (using the asset allocation example above), by reweighting the equity portion of the account in favor of growth stocks or funds as momentum appears to be picking up in that direction. Another example of combining the lessons from these two habit patterns is taking the view that in terms of high-quality fixed income, it appears unlikely that interest rates will drop materially and therefore the capital appreciation potential from this particular segment is limited, and thus the commitment to high quality fixed income should be below “normal.”
Which kind of an investor are you old or new?