Sunday, September 26, 2010

Emerging Market Warnings,
Crowds Ahead, Smaller Exit Portals

Ever since the dawn of attention to investment performance, the smart guys figured the way to outperform was to invest outside the general experience of others. Often this technique worked initially until too many others copied the strategy. As with life in general, the unexpected happened and the exits became crowded and were blocked for the late movers. This is a repeat performance of a movie I have seen before.

I am a Believer

I am a believer in investing internationally. As a trainee in my first job after my education in the US Marine Corps, I had a tour of duty within a bank’s vault to count the actual foreign stock certificates that backed up the bank’s issuance of American Depositary Receipts (ADRs). More than 15 years later, when I could start to invest for my own account, I began investing outside of the US. Over the years I have invested in Latin American and Asian closed-end funds, individual equities in Canada, Australia, the United Kingdom, Netherlands, Finland and Japan as well as private equities in the UK and France. In addition, at the time of my sale of the operating assets of Lipper Analytical to Reuters PLC, we had foreign clients buying non US-data from our offices in London and Hong Kong. Thus, I believe I have won my stars as an international investor. So why am I raising the yellow flag of caution now? Simply because it is getting crowded out there.


On Thursday of this last week PetrĂ³leo Brasileiro S.A. or Petrobras, sold over $70 billion worth of common stock. This was the world’s largest initial public offering (IPO). According to the Wall Street Journal, options will be available which will expand the common stock offering by 25%, including an undisclosed amount of preferred stock. (It is true that some $43 billion was an exchange with the Brazilian government for the drilling privileges to a potentially huge offshore series of sites. Nevertheless, an enormous amount of cash was invested into Petrobras.)

First Warning Flag

The sheer size of the enthusiasm for this transaction should be enough of a warning to a practiced investor, but there are other danger signs. Petrobras has been a favorite of many well-known global investors. A number of them felt that the terms of this offering were not in favor of the existing outside shareholders but were to the benefit of the government. Among those who are rumored to have sold out are George Soros and the good people at Templeton. One of the risks in any investment is that the government may turn less friendly. (This risk is valid in the US as well.) Based on my experience, foreign investors typically don’t really own foreign securities permanently. They rent them.

The Second Warning Flag

One of the better international money managers that I had the pleasure of knowing taught me the importance of the flows of money into a security. In the 1970’s, he focused on foreign money coming into the Japanese markets. He believed that the “weight of money” would lift Japanese stock prices that were clearly not bargains. He focused a good bit of his attention on mutual fund data and that was why he contacted me. His clue to exit an overpriced market was when there was a slow down in the gusher of money coming into the market.

As is commonly acknowledged, mutual fund redemptions have been larger than the rather lackluster sales of US Equity mutual funds. As of the end of August, according to my old firm now called Lipper, total net assets are approximately $4.7 trillion dollars, with only $3 trillion devoted to US diversified investing. The fifth largest collection of assets is in Emerging Market Equity funds ($253 billion). This excludes $112 billion of the more narrowly focused funds that invest outside of the US and Europe. The two collections together have total net assets of $365 billion as of the end of August, which is somewhat larger than the money invested in S&P 500 Index funds. Clearly, emerging markets are not undiscovered territory. The cautionary flags go up with US Diversified Equity funds shedding $ 10 billion in August, with $2.3 billion going in one month to Emerging Market funds. This shows a significant shift in investors’ opinion. A more dramatic indication is that in the same month $3.8 billion went into Emerging Market exchange traded funds (ETFs). I believe this latter inflow is much more speculative in nature. If you will, they are more like daily renters than annual leasers.

The growth in demand of ETFs is particularly ominous. Money can flow in and out of these funds on a daily basis. When the money moves, the managers must transact as nearly as possible to mirror an individual stock’s proportional ownership in the index. If some negative news event causes a redemption run on an ETF, they will have to sell some of each position. The history of international investing, particularly in small markets, is that when we come in we buy from the locals who feel that our valuations are wrong. When we sell under duress they understand that any price is a good price from the pressured seller’s point of view. The losses can be dramatic under those circumstances.

To put the ETF risk in perspective, each week I look at the twenty-five largest SEC registered open-end funds. On that list are five ETFs, two of which invest in emerging markets. On a combined basis these two funds have $70 billion in assets. They promise their large shareholders instant liquidity during US trading hours.

The Third Warning Flag

The next set of concerns is one of personal exposure. Over the last two weeks I have had three discussions about emerging markets. The first was with a marketing executive of a major broad line fund group who was commenting that its International/Emerging Market funds were selling very well. The second conversation was with a retired international investor who was being pitched to go back in business, focusing on the frontier markets which are exciting many people. I am hearing a great deal about investing in Nigeria and Ghana. (Memories of the “South Sea Bubble” of the 18th Century come to mind.) The final conversation was with a fund president who has been away from the market for some time and is being asked to develop a country-specific infrastructure fund as well as other frontier investments. (The Nineteenth and early Twentieth century investments by the Scottish trusts and Barings also come to mind.)


Despite HSBC’s ten point pitch to invest in the emerging markets and Western Asset’s belief in the attractiveness of the debt side of the emerging markets, I would be particularly careful now. If you are lucky enough to have been there already, cap your exposure at sometime. If you are not invested in emerging markets directly, you can gain some exposure through US companies that export or have operations in the area. As a contrarian bet I would look to large US Growth funds, they have lots of attractive companies in their portfolios at reasonable prices. They should do well enough on a relative basis over the next four years.

What do you think?
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Sunday, September 19, 2010

How to Recognize Risks Before They Bite

While no one rings the attention-getting bell at the peak or bottom of a market, there are often plenty of warning signs. The biggest sign is growing enthusiasm for whatever is the current trend. I perceive that there are some flashing yellow signs suggesting that there may be problems ahead, both for me personally and for some portfolios that are my responsibility.

Previous “Rules” Based on a Different Economy

Last week in the second of a two part blog post, I gave the impression that the next major move is up. Like most people that choose to get out of bed in the morning, I am gambling that things will be good for me that day, if not beyond. To balance this bullish point of view I should recognize that there are a number of structural problems which may put the timing of the expansion in question. The first is the liquidity risk which brought down Bear Stearns and Lehman Brothers, as well as most people facing foreclosure. At the end of their day they did not have the cash to meet the immediate call on their assets. Most personal financial consultants initially urge individuals to have at least one month’s expenses in the bank. By early middle age the pot should be three months, and later one year. All of those ratios were essentially based on the historic experience that a young person could find a job in a month. By age thirty it might take three months and by fifty a year. In a corporate context, for many years the IRS threatened various companies which amassed a lot of cash with a possible surcharge if they did not pay out dividends or use their cash. All of these “school solutions” were based on a different economy than what we have been in for sometime. With at least one quarter of the unemployed and underemployed without a full time paycheck for at least two years, a reasonable contingency fund probably should be built up to a two year level of reduced expenses. In addition, companies have to determine how long they can keep their doors open and maintain critical employee skills in an extended period of an economic slump.

Voluntary and Involuntary Savings Rates

In reaction to these present realities, private sector savings rates have moved up. This is not as positive a sign as we would like to believe. The growth in savings has largely been a function of paying down debt. Actually in most cases the pay downs were involuntary and accomplished through foreclosures or bankruptcies. One should watch bank deposits as well as mutual fund gross sales to spot voluntary saving. What makes the situation worse is that a decline in private sector borrowing is totally offset by expanded government borrowing for low return investments.

A Bull Market, When?

The reason to watch bank deposits and mutual fund gross sales is to begin to gauge the liquidity preference of the population. I suspect that as a reaction to the aforementioned rules of thumb proving to be inadequate, that consumer reserve levels will rise above historic levels. As long as the money isn’t put under the mattress it will be in the hands of various financial services intermediaries who hopefully will make high quality loans to any who wish to accept their own liquidity risk. Only when the public either directly or through 401(k) and similar vehicles invests in equities, will we seeing a rip-roaring bull market. (Note I said when, not if.)

Replacing Structural Underemployment

Another burden that our society has to carry is the weight of the structurally unemployed or underemployed. Many of the jobs of old have been permanently replaced by automated technology. My faith is that technology will enable new products that will provide employment. An example may help. In a bout of the new form of conspicuous consumption, I recently bought Ruth an iPad to match mine. The wonderfully helpful sales person at the Apple store was a former mid to high level executive from a tech company. In her sales pitch (which we had to wait for), she said that Ruth now had the “single most sought-after item in the world today.” While this is a bit of hyperbole, the hyped demand did fill one of the bigger stores in the Mall. We learned that if we wanted help from Apple’s “Genius Bar,” in other words their help desk, we needed to make an appointment by phone or email. Hundreds of thousands of new applications for this and other consumer gadgets are now available to support these items. I am sure that we will see consultants and teachers putting out their shingles to be of help.

Another example is the advent of hybrid cars and particularly trucks, creating needs for different kinds of mechanics and service stations. Gradually I hope we will whittle away the structurally unemployed, but as a society we need to come up with a productive and humane answer for the structural underemployment. Without an effective solution, there will be much more risk.

Until these economic problems are successfully addressed we will be operating significantly under capacity utilization. While these challenges may retard a demand driven inflation, it suggests that we won’t see historically high market valuations soon.

What all of the above is suggesting is that my bullishness could be premature. What do you think?

Next week I intend to write on the risks to fixed income investors and the possible misplaced enthusiasm for emerging and frontier investing.

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Sunday, September 12, 2010

A Contrarian’s Long-Term Outlook

In last week’s blog I described the market measures and representative sectors that comprise the foundation for my long-term outlook. My contrarianism is in contrast to many analysts and pundits, though I am sobered by the fact that of the 90 stocks I track every day, only 7 were up for the five-year period.

Recovery, or More of the Same? Why?

A knowledgeable reader emailed me to ask why I believe a recovery may be in the making. Because there has always been a recovery is not a sufficient foundation for me. In part because of my exposure to Caltech and a background of examining various funds seeking good investments, I am optimistic. Similar to the New York Yankees solving their business problems (as I mentioned last week), the American society comes up with solutions to many of its problems. Some of the products and services that we produce will not only address our problems but will also be in demand beyond our borders. The iPad, Boeing Aircraft (to economically replace aging plane fleets), Deal Making (we lead the world in those skills), wheat( in a period of growing excess demand), social media (Facebook, etc), US movies and televisions shows (with greater international revenues than domestic) and new drugs and other life-altering medical devices. I will be the first to admit that these products and services, with rare exception, are not massively labor intensive. But they are factors that may help us. For example, the vast majority of immigrants (legal or otherwise) come here to make money. They are strivers and in the long term may be more productive than many of our other residents.

In the future some of our military dollars may be shifted to much needed infrastructure expenditure. In the long run I am confident that we will continue to be a nation of problem solvers.

Four Low Hurdles Before the Outlook

There are four brief periods that we will pass through before most investors will be comfortable enough to look at the long term future. Each of these periods is likely to produce higher than normal volatility as the headlines will scare us one way or another depending on our own biases. The first is the period between now and the general election when the control of Congress, particularly the House of Representatives, will be determined. The next and to me the most worrisome, is the post-election session. A significant number of the members in both Houses will be incumbents who will not likely face voters again. These people are prime candidates for government appointments or key lobbying positions. Watching this sausage machine won’t be pretty. The third period will begin with the new Congress, when there will be jockeying for various committee assignments and chairmanships. Not all of these will be in favor of pro-investment legislation. The final period will be after the President’s budget message. That message will give the Congress the choice of bargaining with the White House or just ignoring the Administration’s wishes. There is likely to be some progress, but the execution of the legislation will still leave a lot to be desired in terms of logical clarity.

Contrarian Outlooks for the Long Term

  1. The S&P 500 will likely gain at least 200% (JP Morgan points out that historically when a market recovery takes place, gains of 250% can be expected.

  2. The S&P 500 is likely to somewhat outperform most managers, unlike what it has done over the last ten years.

  3. One would be better off betting on the lagging groups, particularly the Science & Technology funds than the Emerging Markets and Resource focused funds. The real winners are likely to be the companies that use technology to disrupt the ways others do business.

  4. For some time bond yields will rise with the stock market

  5. The US will not default on our debts, our assets are too valuable.

  6. The lost generation of investors will return to the marketplace.

  7. At a low enough price level, the housing market will recover. Often prices will reflect intelligent replacement costs.

Bottom Line

Our stock market has not been capital productive for ten years. Is this a long enough period of base building to support a market expansion? That depends on whether one sees the ten years as a correction and correction for what. If we are correcting primarily for too high equity valuation, we probably have already done that. Well covered yields on many stocks are now higher than Treasury bonds. If we are correcting from an overvalued currency, that has been happening in fits and starts at least for 20 years. What we have not corrected for is lending practices at the consumer, business and governmental levels. The current approach of just requiring more capital to cushion the bad loans does not irradiate the bad loans, as a matter of fact it probably causes more risky loans, as they produce more profits than safer loans, (the potential profits are greater than the additional capital requirements). We still have the need to correct for the bad loan policies and this could delay our recovery. Another correction we may have to make is that of our use of inflation. Governments have been users of inflation to reduce the purchasing power of their debt repayments. Businesses, when faced with assured but flat demand have often elected to raise prices to increase revenues rather lower prices to increase demand. If we need to correct for our inflation biases, it may take along time. For most of our lives we have lived in an inflating society. Any correction may have to represent something on the order of 1/3rd to 1/2 a normal lifetime. I do not know which correction phase we are in. My guess: for a significant portion of your money, you should invest in the future; it will be better than not over the next ten years.

One clue as to whether the correction phase is ending and the next expansion is beginning, is to look to the mutual funds that are characterized as large cap growth funds. With rare exception it has been very difficult for large capitalization growth companies to make significant progress. While there have been some exceptions (for example Apple and Google), to date there have not been a minimum of twenty of these to drive a reasonably sized growth fund portfolio forward. As a contrarian I would suggest a minor investment in this category might alert you when such a move may begin.

The turn could be sooner than we think. On a rainy Sunday with the New York Giants playing locally, the Short Hills Mall was full of people with shopping bags. These were adults not participating in back to school shopping.

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Monday, September 6, 2010

Reluctantly Preparing a Ten Year Market Outlook

The Yankees Win !!!!

Last week I broke one of the practical rules of blogging and will again this week. I promised last week I would discuss my market outlook in this post. One should never promise anything that you don’t believe you can easily deliver. While I had some preliminary thoughts, I certainly did not have a well thought out view. As often happens in life, I got bailed out by unexpected events. Tuesday morning Ruth and I were offered the use of two corporate seats for that afternoon at the new Yankee Stadium. Though it was approximately twenty years since the last time we went to a baseball game in the Bronx, we leapt at the chance to see the new stadium for ourselves after hearing so many favorable comments. Many years ago I discreetly became a Yankee fan after the Giants deserted New York. I should have been a Yankee fan, as professionally I believe the weight (power) of money more often than not wins. We had a good time and the Yankees won with their “patented” home run attack in a shut out.

The Problem Solvers

The Yankee organization, the City of New York, and the stadium’s bond holders had to solve a number of problems to make our visit a success. In the recent past for many of us occasional arm chair types, watching on television seemed better than fighting a large unruly crowd. Frankly, in many respects, it was a boring event to watch compared with our client, the National Football League/Players Association games. For many years in the 1980’s and early 1990’s the Yankees did not seem to be able to win when it counted, at least the American League championship if not the World Series. After all, this is New York.

The new stadium did not have any pillars blocking a clear view of the entire field. There were very large and smaller television screens spread throughout the stadium. These screens, aided by the public address announcer and various musical calls, led the crowd in cheers. NYPD’s finest, plus private security people were evident in the stadium as well as the parking areas and exit roads. Bottom line: the management of the Yankees solved many of the old problems that reduced the size of their gate. They were creative investors solving their problems. At this point, the bond holders do not have much to fear relative to their other holdings.

The significance of the Yankees solving their gate issues shows a typical American approach: we do solve problems, and therefore I believe we will solve the current problem of stock prices.

The Inputs to a 10 Year View:

The Market Measures

As many of our blog community members know, if you cut into an analyst a historian will bleed. So as they say on television, “Let’s go to the replay.” From 1839 through 2009 there were only four out of seventeen rolling ten year calendar periods when the stock market averages produced a zero or worse return. In terms of individual years, the count is nine out of seventy years. For the ten years ending this August, the S&P500 was down -1.81% on a compound basis. (The average S&P500 fund was off -2.30% and the average of the thirty largest of these funds showed a loss of -2.05%, exemplifying the additional costs of indexing.)

The Sectors

Over the same 10 year period, eleven out of the twenty US Diversified Equity fund averages were positive and two others declined less than the S&P 500. One of the better ways to characterize a period is to look at the leading and lagging sector funds. The double digit leaders on a compound growth rate basis were the Gold funds +22.24%, Latin American funds +15.12%, Global Natural Resource funds +10.91% and the Emerging Market (equity) funds +10.66%. There were only two double digit losing group averages over the ten year period, the Telecomm funds -10.41% and the Science & Technology funds -10.17%.

The Five Year Picture

I track the prices of ninety common stocks every day the US stock market is open. Most of these are financials and many are in a private hedge fund that I manage. Only seven of these stocks are up over the last five years.

How Bad is the Economic Picture?

Often one can get a better view of us through the eyes of others. The International Monetary Fund (IMF) has completed a formal study as to the odds that the US will default on its foreign debt sometime in the future. That they would even consider such an occurrence should shake some people up. What is perhaps worse is they put the odds at 50% of a default.

A Lost Generation of Investors

One of the great advantages that my generation had when we entered Wall Street was that there were very few people who were senior to us in age. Those that were older were within five years of retirement. Many of them were unequipped to handle the robust markets of the late fifties and early sixties. Under normal circumstances, the missing middle management would have come from the lost generation of investors who either lived through or were frightened by the Great Depression. Their fears would not allow them to look at the great values that we found. The values we found were augmented by unique career opportunities to advance within the investment structures.

Today many individuals can not completely withdraw from the ravages of fluctuating prices, as the bulk of their retirement money are tied up in 401(k) or similar plans. Further, the current level of interest rates does not provide an adequate return for building their retirement nest egg.

These are my inputs to a long term outlook. Due to the length of these thoughts, I will continue with the specifics of my ten year outlook next week.

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