Sunday, December 27, 2009

Boxing Day and Bond Funds

As members of this blog community know, my wife Ruth and I do our investment research by visiting the local high-end shopping mall near our home. We have commented on the density of the crowd of shoppers on “Black Friday,” (the day after Thanksgiving or the following day) in my blog this year and in 2008. This year, the mood at the mall on “Black Friday” was subdued, as evidenced by our ability to find a parking space close to our favorite second floor entrance. What a difference it was a month later!

“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

More Positives than Negatives Ahead

Using an often-repeated term of Donald Rumsfeld, the job of investors looking to their future returns could be characterized as a search for the “unknown unknowns,” (as opposed to the “known unknowns”). This is the exact task before me today. Based upon past experience, I do not believe that the future will suddenly reveal itself to me with such sufficient clarity that I can immediately place orders for individual securities or funds. Since the unknowns are truly unknown to me, I start collecting what is apparently known to me. I cast my net wide to gather bits and pieces of the current scene with the hope that, in sum, I will get useful insights into the future. The members of this blog’s audience will have to determine whether what follows is useful or insightful for them.

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


By a slim majority, the US House of Representatives believes it can make all forms of securities investment safe. As perhaps Henry Higgins of “My Fair Lady” might declare, “How delightfully, naïve.” Staying with this musical theme to describe all of the losses sustained by investors, I say “It takes two to tango.” The buyer seeks the advantage of ownership and/or use of some asset and the seller sees some disadvantage in maintaining the position. In the language of the law, they are consenting adults. Not for one moment am I saying that there was sufficient disclosure of facts and motivations on both sides. What I do believe is that the buyers did not look carefully at the disclosures and historic backgrounds provided. In my mind it is questionable whether additional disclosure within the legalese framework would have prevented a willing and anxious buyer from completing the transaction. The seller also could have sought better disclosure on the ability of the buyer to pay for the asset, particularly if it was going to be paid for over time. The motivation and sophistication of the buyer might well have helped the seller avoid some of the after-sale problems. In truth, there was insufficient prudence around many of the transactions of the last several years. Disclosure documents, like prospectuses and instructions for most electronic gifts received at this time of year, remain in their envelopes or in their shrink-wrapped places. Think of the uplifting language that confronts voters when they are asked to vote on various bond issues. I doubt that the Congress or the Government in general will be able to produce reader-friendly documents. Further, there is a belief on the part of the drafters that they have addressed all of the issues that have caused people to lose money or to put the economy at risk. There is an old expression among the religious which states, “We plan, and God laughs, recognizing our human frailties.”

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


Symbols or letters carry a lot of assumptions and emotions. The most feared letter right now is “W,” referring to a chart pattern not to a former President. Depending on who is asking the question, it either refers to the economy or the market, and for some both. Those that fear the “W” pattern in terms of the economy, acknowledge that we have already hit bottom in terms of GDP or similar measures, not unemployment. They fear another decline, or perhaps a series of saw tooth moves that introduce the “Japanese Disease” into the US economy. According to John Mauldin, Japan has not added any jobs since 1989, and what is worse is the fact that Japan’s nominal GDP today equals its 1982 total. Mauldin contrasts that statistic with the US, where our jobs are approximately at the 2000 level, with our nominal GDP at the 2004-5 level. He and others are fearful that tax increases will kill job creation and will lock us into very slow growth and perhaps stagflation. But on the other hand, securities analysts and most portfolio managers are not professional economists, but are often forced to have their own thoughts on the economy.

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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hand portion of this screen. If you are not sure, use the box above to review past blogs that may interest you.

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