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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