Sunday, April 11, 2010

“The People” vs.
the Economies and the Markets

We live in a dynamic world with nothing more dynamic than the markets. At almost all times there are pulls and pushes in many different directions. Each participant hears and sees different aspects as to what is important and how it affects his or her feelings and actions. The various forces keep the markets in some form of equilibrium at any moment in time. Slight changes in supply and demand cause movements up or down whose impact is multiplied by differences in volume of transactions. Sometimes there can be what my friends in the NFL Players Association call a “head feint.” That is a sudden move of the head to get the opposing player to commit to wrong action. We may have had one Friday afternoon, April 9. Very late in the trading day, the Dow Jones Industrial Average (DJIA) peaked its head over the psychologically important 11,000 mark, only to finish at 10,997. Some may take this as an important sign of a positive change in demand. A more careful examination of the trading patterns suggests an example of what we used to call “painting the tape.” In the last half hour, four individual stocks belonging in the DJIA moved serially on relatively little volume. In Chicago there was a surge of volume in the mini S&P contract. Thus, I would disregard the late move in terms of significance. The current picture is sufficiently murky, with numerous negatives and positives present. Nevertheless, there are sufficient concerns in people’s minds to give an appropriate level of friction that would allow a gradual push to higher level to the markets.


When one speaks to people who are not intimately focused on the markets, they distrust the sharpest rises they have experienced in their lives. Whether there will be another major decline allowing distrustful investors to commit their cash at lower levels may be wishful thinking.

In a front page article in the New York Times on April 9 (click here) the renowned columnist Floyd Norris explores this dichotomy between the way Americans feel and the rise in the market. He focuses on the politicians. Neither political party in the US wants to celebrate the turnaround. On the one hand the opposition does not want to credit the current administration for doing anything right and the party in power wants more power through the passage of still another stimulus bill that might create more union jobs. (My concern is that when it becomes politically correct to acknowledge the turnaround, there will be more risks in the marketplace.) As I mentioned in my book, MONEY WISE, it may now be appropriate to invest against the headlines. Further evidence of this distrust comes from a survey by Bloomberg, which found that only 31% of investors were better than they were a year ago, (at the bottom). Perhaps what they heard as the question was whether their investments had regained their peak level, but that was not the question that was asked. Others see vacant stores and factories indicating substantial excess capacity. To these skeptics, not until all of these facilities are filled with workers will we have executed a turnaround. Unfortunately, a number of these facilities are not going to come back. For the better part of twenty years, I made a practice of furnishing my New York office with high priced furniture from various brokerage firms that went out of business. Many of the employees of these failed firms learned new skills and adopted to changes in the economics of Wall Street with some success.

In the early 1970's on the Manhattan block that begins with 48 Wall Street, there were five small office buildings that were vacant. My first employer after the US Marine Corps was Bank of New York, then headquartered at 48 Wall (now housing the Museum of American Finance). In time the five small vacant structures were replaced by the very large and magnificent global headquarters of Morgan Guaranty. The headquarters personnel were later shifted to midtown as JP Morgan Chase was formed. My point in retelling this history is that idled capacity does not have to come back in its original form for there to be a successful turnaround, and then expansion.

Jobs, Jobs, and Jobs

The “popular media” and the politicians are focused on the creation of jobs as the only measure of a turnaround. While on a human scale this is very important for our society, it should not block out the other signs of a limited recovery. I wish the focus was on the numbers in the “U6” category that includes the discouraged workers. Adding the discouraged workers and those who involuntarily are working part time to those registered as unemployed raises the total to 16.7% of the work force. One sixth of those who are not producing or under-producing is a very heavy load for our society to carry. The answer to the problem is what has worked for us in the past. In the twenty-five years from 1980 through 2005, almost all of the new jobs created in the economy came from start-ups under five years old, not from government stimulus. These are the employers and employees that we should be stimulating with less bureaucracy and lower taxes. If we don’t others will. In the month of March, evidently we created some 162,000 jobs of which approximately 40,000 were short term census takers. In the same month, Mexico added 125,000 jobs. There are many messages here for a free enterprise economy if we are going to bring the U6 number down to where it would be healthy for us, in my guess about 5%.

Shop, Shop and more Shopping

Actually the economy is getting better. This week the market pundits and certain economists were surprised by the increase in the dollar level of inventories at the wholesale level. The gain was twice what they expected. Perhaps they shouldn’t have been surprised, as March was the eleventh month in a row that wholesale sales gained. I suggest that this was not all restocking rundown inventories. Look at the retail side: In the month of March, 23 of the 25 leading retailers that the market analysts track had better than expected results.

US Inflation is Not a Worry

The inestimable Byron Wien of Blackstone, while favorably attracted to gold is not worried about inflation for the next two years. Interestingly enough, other observers believe that commodity prices are peaking for this year as they see smaller demands in the near future. The much more sensitive market for US treasury paper agrees with Byron. The spread between the yield on the ten year US Treasury and the ten year TIPS is 2.34% compared with a long-term average of inflation since 1926 of 3.01%. Putting their money where their mouth is, the bids for the latest $21Billion auction for US Treasuries received 3.72 times the amount offered. This cover is the largest at least since 1994.

Lessons from Mutual Fund Performance Analysis

My old firm, now known as Lipper, Inc, groups twenty different types of domestically focused diversified equity funds into a grouping called US Diversified Equity funds. In looking through the first quarter data this weekend I was struck by a number of observations:

1. Ten of the twenty more narrowly defined investment objectives, on average, performed better than the average S&P 500 Index fund, as did the whole twenty as a group (7.57% vs. 6.95%). The better performing groups invested, in general, in mid and smaller capitalization securities.

2. The best performing objective in the US Diversified group was the Leverage Diversified Equity funds +16.37% or just about ten percentage point better than the index funds. These funds are designed to use equity derivatives and the strategy is working for them at the moment. (Caution when the market declines these funds often fall the most.)

3. Small Cap Value funds were the leaders compared to the other diversified stock funds gaining + 12.89%. These managers' selection skills seem to be working as their results are better than the performance of similar indexes of small cap stocks.

4. Micro cap-oriented funds did not do as well as small caps which suggests to me that the wave of Merger& Acquisition activity has not reached into their bin yet.

5. In some respects, at this point in this recovery, leadership is being taken by domestic rather than international stocks. The average financial services fund is up + 15.47%, the average global financial services fund is up 7.27%

What me Worry?

One of the measures that market analysts use to determine whether investors, (read: institutions and sophisticated individual traders) are fearful is the expected volatility in the S&P500 index, or the VIX. The reading on the index is now below 17 compared to 40 at the year end of 2009 and a peak in the range of 80. The followers of this index would say that market participants are not worried. (This complacency needs to be watched as one of the precursors to many tops is a general feeling of complacency.)

Yogi Berra Got it Right!

I believe the great Yankee baseball star said “You can see a lot just by observing.” My training as a security analyst and a business entrepreneur taught me that I could learn a lot by just walking around and observing. Last Tuesday evening I dropped my wife Ruth and a friend at the opening of a photographic exhibit at the Museum of Modern Art. As I walked by several office buildings on my way through Times Square to the subway, I saw something that I had not noticed for sometime. There were fleets of black cars waiting until at least 8 PM for the various people at the M&A investment banks and law firms. Some firms were apparently letting a number of their people leave “early.” Living in a community (or more precisely next to a community) that has many of these Type “A” personalities, I was not used to seeing them return home until after 11 PM. The number of the cars would indicate that many are working on forthcoming M&A activities, which echoes Bryon Wien’s views. I take from this observation that some of the stocks in my financial services hedge fund could benefit from substantial M&A fees. More importantly M&A activities mobilize capital and eventually raise the valuation levels in the market.

Bottom Line

There is enough worry in the general population, that one can take a positive attitude toward investing, but watch out for our own and others’ complacency. There are “Black Swans” out there in the form of unthinkable things.

Please share your thoughts with me.
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