Sunday, February 27, 2011

Troubling Near Term Indicators and Longer Term Challenges

  • Emerging Markets in Reverse
  • DJIA Peaking?
  • The Threatening State of "USA, Inc."
  • Buffett Reloaded with Itching Trigger Finger

Emerging Markets in Reverse

In January of 2010, the net inflow into regional equity (emerging market) mutual funds was some $500 million. In December, the monthly inflow was almost identical, $453 million. The next month, (January of 2011) saw a net redemption of close to $1.4 billion. Remember that the troubles in Egypt really started on the 25th of the month which did not leave much time for reactions. The $1.8 billion swing from inflows to outflows on a $73 billion base is truly remarkable and a sign as to the volatility of mutual fund demand. True, that emerging market funds are usually no-load funds and are used by investment advisors and hedge funds to a greater degree than the normal mutual fund demand. In addition, there was growing evidence that the gush of capital created by the “QE2” (the second tranche of the Federal Reserve’s “quantitative easing”) had peaked. This flow into the emerging markets helped to set off inflationary pressures in many emerging market countries. Some of the pull back may have been caused by weather related damage which may get us back to the original meaning of “high water mark.” (Not the highest value a hedge fund reaches for performance fee purposes.) Whatever were the reasons, the rapidity of the change is unnerving to longer term investors who were looking for the inflows to continue to raise the valuations in these markets beyond their historically high levels.

DJIA Peaking?

One of my required jobs each weekend is to pore over Barron’s magazine, which has the most complete set of market statistics generally available. This week on the "Market Laboratory" page there are charts of the daily movement of the three major Dow Jones averages covering the Industrials, Transportation, and Utilities since the last week in August through last Friday. The patterns are revealing.

  • Utilities reached a high in mid October barely surmounted in January only to fall back to their end of November reading earlier this last week. Most often utility stocks move as bond substitutes when interest rate moves, but occasionally they react to perceived changes in the prices of heavy oil. On an overall basis, one has not earned any capital appreciation since mid October.

  • The transportation average over this period has risen from approximately 4000 to a high the week before last of 5298, before plunging to the level of November’s last day of 4855. The average regained this week to a final reading of 5060.

  • The Industrial average has been going straight up, the average low in the last week of August was about 9900, before consolidating in November. Last week the DJIA peaked at 12,389. There are lots of reasons given for this remarkable rise; QE2, better third and fourth quarter earnings, a normal seasonal recovery, and the beginnings of a tepid re-engagement by the retail investor.

To say the least, the lack of forward moves by the Dow Jones Utilities and Transportation averages makes the sprint by the Industrials questionable or at least unconfirmed. Later in this blog I will make a few comments on Warren Buffett’s copyrighted letter, but in this context I should mention that he has substantial investments in transportation and utilities, and is generally bullish. When in the latter part of 2010 I came out with my view that we could challenge the markets’ old highs, I intoned that it would not be a straight line and there might be several attempts needed to reach and surpass the old highs. Since then, several times I have indicated that I was getting nervous about the increasing number of bullish comments by pundits of all types, but particularly from the brokerage fraternity. While I earnestly hope that the turmoil in the Middle East quickly settles down and that we reach working compromises on the 2011 and 2012 budgets, prudence demands that I express considerable doubts. Thus, we could have seen a seasonal high in many stock prices and won’t see much in the way of forward prices until the last four months of the year. Please bear in mind all future projections are dependent upon geopolitical events beyond our knowledge and perhaps understanding. For those with a reasonable commitment to equities, particularly those that are labeled domestic equities, maintain your overall positions. For those underinvested in equities, pick your spots and place orders below market prices and if you get some buys, put more orders in further down.

The Threatening State of "USA Inc."

Many of the members of this blog community will remember the name of Mary Meeker. She was the single most effective analyst/investment banker/marketer of the dot com companies. As in the past, she has just published a thoughtful analysis of the United States government with lots of sad detail and many Power Point charts. She is persuasive and may be correct in her analysis. She is not trumpeting solutions. Her approach is to look at the federal government as a business which has both balance sheet and off-balance sheet debt problems of enormous and threatening proportions. She looks at the data as a professional turn-around analyst would. To oversimplify, her base case entitlement expenses amount to $16,000 per household per year and entitlement spending outstrips funding by more than $9,000 per year. (The unfunded entitlement spending includes, in trillions of dollars, $35.3 for Medicaid, $22.8 for Medicare and $7.9 for Social Security.) She has follow-up arguments illustrating that as these debts grow, our balance sheet will lose all of its equity at some point, considering the low savings rate in this country. I would argue with the last presumption, for the federal government has huge levels of assets that are not priced at market, e.g. gold stored in Fort Knox, unused real estate and the strategic oil reserves, etc. (I personally would love to see the transfer of all non-operating assets to a reconstituted Federal Reserve, as some backing for our fiat currency from the current political control.)

Without getting lost in the details of this analysis, there are some very important analytical inputs to each of our own asset allocations. Due to our political system, the “investor class” will pay for the shortfall either directly through taxes or indirectly through induced inflation beyond what is driven by natural scarcities. I would suggest that we need to add a significant contingent liability to our balance sheets that either we, or our heirs will pay.

As our asset listings should be net of expected taxes, this contingent liability is an after tax amount. As a working number, not a good one, I would multiply the $9,000 shortfall of entitlement spending by one’s expected lifetime or (perhaps if one wanted to be really conservative, the life expectancy of one’s heirs). We also need to recognize that the so-called rich will pay the bulk, if not all, of the shortfall, thus a further multiplier is needed, perhaps 4X as the burden of the shortfall that will be placed most heavily on the top 25% of households. No matter how you do the math, it is a staggering amount that can reduce our real long lasting equity. To me, this suggests that we need to move to an all equity and tactical reserve posture. The equity does not have to be in publicly traded stocks. Often private earning property and/or businesses is a better position.

There is one way to avoid this dire prediction, and that is to generate the political will to tackle the very hard job of getting all of our governments under materially better financial control. This won’t be easy or fun.

Buffett Reloaded with an Itching Trigger Finger

One of the pleasures of the last Saturday in February is to read the Berkshire Hathaway Annual Report and Warren Buffett’s letter to shareholders. Point of disclosure: for many years I have personally been a small shareholder, and in later years my private hedge fund has been an owner of Berkshire Hathaway shares. As mentioned above, Berkshire owns the largest freight railroad in the country and one of the leading utilities groups as well. The announced theme for the annual meeting this year is transportation: Train, Plane, and Automobile. Buffett clearly believes that these are good investments. Due to the prodigious ability of Berkshire Hathaway’s owned insurance companies to generate “float,” plus an expected maturity of several investments made at the depth of the last market collapse, Buffett will have about $60 billion to invest and he is anxious to do so in one or only a few major investments. With that kind of buying power in the hands of a skilled investor, I have to be optimistic. For those who are interested in the complexities of long term equity puts of the European version and other intriguing derivatives, the letter and Annual Report are worth reading. Click on the following titles to read:

Warren Buffett’s 2010 Shareholder letter and Berkshire Hathaway Annual Report

My blog post covering Warren Buffett’s 2009 letter

My blog post covering Warren Buffett's 2008 letter

In Conclusion

Be particularly careful now, but you owe it to yourself and your heirs to be an equity investor either directly or with an advisor.

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Sunday, February 20, 2011

That Was The Week That Was

  • NYSE deal demonstrates derivatives are more important than equities in the business
  • FICC is volume-reliant
  • G-20, markets manipulator
  • Advice for Equity Investors

Many years ago the British, the masters of satire, produced a television program that parodied the weekly news. A similar program developed in the US. The title of both shows was "That Was The Week That Was." I was reminded of that title early in the week when finally the announcement was made of the Deutsche Böerse deal with the New York Stock Exchange. As usual, most of the press coverage was focused on the wrong topics: control of the board, loss of national pride, and even the name of the new multinational collection of exchanges and clearing houses. What was generally missed by the popular press is that the key to the future profits of the new group would come from market making, settlement and clearing of derivatives. Already derivatives contribute more profits to the NYSE/Euronext than trading of listed stocks. In the art of investment analysis, one of the key tenets is to follow the profit trail. With rare exceptions, the perceived future decisions of management will be made to favor where the profits are being derived. With this announcement, whether or not this deal is consummated, a tombstone should be erected to the slowly dying equity business. The political powers within the investment banks and exchanges do not come from a stock culture. This deal is only attractive if one sees their future and profitability will come from derivatives.

If you think that I am being unrealistic, try to enter a brokerage firm and tell them that you would like to invest in 30,000 shares of General Motors or about $1 million dollars, and see how quickly the order-taker will dispatch you to a salesperson who will suggest that one or more packaged products would do you much better than your chosen investment. Perhaps it would, but what is definite is that the brokerage firm would make much more money now (and probably in the future) from the sale and/or management of various products and services than executing an equity order. To further buttress this analysis, ask the best and brightest candidates from our premier universities where on Wall Street they want to work. You will largely find they want to work as investment bankers, traders, or hedge fund managers. Few, if any, have a long term objective of analyzing and selling individual equities. If future brains and talents follow the profit trail, the outlook for equities is severely diminished. As a former president of the growing New York Society of Security Analysts, I can see our membership shifting further and further away from the analysis of individual equities and more into the study of derivatives and packaged products (wealth management and hedge funds).
  • Are the prices of your stocks impacted by derivatives?
  • Has that changed your trading techniques?
Click here to reply .


For those of our blog community members who do not follow the investment banking stocks the way I do for our own hedge fund, FICC stands for Fixed Income Currencies and Commodities, the product areas which have been the largest sources of profits for most major investment banks for a number of years. FICC is the magnet that attracts firms’ capital and talent banks. What are the attractive characteristics of these diverse markets? Disclosure and regulation are less rigorous, the majority of dollars are traded privately in an over-the-counter format, market making allows a proprietary profit opportunity, and clients are likely to use leverage with borrowed money from the house, generating net interest income. Supplemental reading on this topic can be found in my earlier blog entitled: "Too much Reliance on FICC Could be Dangerous."

Almost all activities in the financial community have a certain level of fixed costs and variable compensation. Even with the multiplication power of leverage, there is a need to find new participants to reach the desired level of profitability, or in large organizations the desired share of overall profits. The development of the currency market is a good example. Initially, foreign exchange transactions were needed to support cross border physical trading. As orders were placed for goods in advance of shipment and collection of proceeds, producers needed to protect themselves against unfavorable shifts in the value of the contracted currency. Thus they began to hedge the currency just as farmers did with commodities. The trade in “invisibles” such as intellectual properties and debt service payments only magnified the need for trading and hedging currencies. Remember, most hedging involves borrowing which creates net interest income for the provider. Thus, a robust, in-depth daily market in currencies was created centuries ago. (The Rothschild family was expert in the use of its family network in currencies and the ultimate currency of the time, gold.) Pure financial traders without an interest in shipping goods and services recognized that a wonderful trading market was created that encouraged private trades at undisclosed prices. Over time, the trading of currencies has grown to be much larger than the level of goods shipments. One of the key profit elements for most large commercial and investment banks has become currencies. There are at least two profits, trading profits and net interest earned. Within these banks, the head of currencies is politically important but not disclosed.


As with the currency markets, the commodity markets have been in existence ever since farmers sold off their excess crops. As with currencies, the natural market has been multiplied by financial players. Investment banks and others have long discovered the same twin profit streams of trading profits and net interest income. While commodity revenues can be extremely volatile in some years, they can be an important part of the firms’ overall profits and thus their leaders can be richly rewarded and politically important.

Up to the Minute

This weekend, the G-20 finance ministers and central bankers are meeting in Paris at a time of currency instability and sharply rising food prices. The President of France is the host for the meeting, and as he is in fashion, he is calling for restrictions on commodity “speculators,” just as he unwisely called for controlling hedge funds a year ago. I am not able to solve the problem of an increasing number of people going hungry who can not afford to buy enough food to sustain themselves and their families. (I only wish that I or anyone else could.) Most of the current problem is due to changing weather conditions which has produced both droughts and floods. Whether these are cyclical or secular weather changes, I will let others debate. What I do recognize is that many of the affected countries suffer from inadequate physical and financial infrastructure. Further, in many cases past foreign aid from the developed world was surreptitiously exported to private accounts out of their country.

Who are the culprits?

To some degree, those who are responsible both for currency instability and some of the rising food prices are the people sitting around the Paris table (or their predecessors). These days, almost all governments are attempting to manipulate their currencies up or mostly down through either “dirty floats” or more likely, excessive money supply growth and inducing inflation. The nasty, venal speculators and hedge funds only wish it would be legal or proper to manipulate the markets as those in Paris have done and are likely to attempt to do in the future.

What Should Equity Investors Do?

First, we need to recognize that we will get less support from the “best and brightest” from the sell-side of the investment community. In turn, this can create opportunity for numerous stocks around the world. Even with increased disclosure, we will find neglected prices and opportunities. In the near term this could be enough for us, but the lack of historic selling efforts at our near term peak prices may not be as high as they would have been using the past markets' valuations. So we need to be careful.

On a longer term basis I envision capital returning to equities that has been diverted to currencies and commodities. I suspect at some point in the future we will achieve currency equilibrium, as many market forces will be applied to keep hard currencies hard, and these will, in effect, set the exchange rates for most of the weaker ones. Eventually much of the capital devoted to commodity speculations will return to the equity market. Most commodity prices are priced to recognize the current level of scarcity. In almost all cases there are long term forces at work to reduce these scarcities. South African gold mines will dig deeper to bring to the surface more low grade gold that can be milled and mined at today’s prices, new copper mines will produce more silver as a bi-product, new agricultural machines and crop management will be more productive, etc. All of these trends will be incomplete and take time. However, I believe that eventually investors will realize that well chosen equities and equity managers will produce the highest reasonably sustainable results. Endowments and family fortunes please note.

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Sunday, February 13, 2011

Super Bowl Derivatives Results Can Teach About Second Supply Cycle Impacts

  • Sports betting trends can provide investment insight
  • Derivatives acceptable to US

Betting on The Game

For Americans, the most watched television this year was the Super Bowl, a championship football game between the Green Bay Packers from Green Bay, Wisconsin and the Pittsburgh Steelers from Pennsylvania. The game was watched by an estimated 111 million viewers. This impressive number is about 1/6th of the audience for the World Cup. As much of the interest in the World Cup started in English-speaking countries, where waging and bookmaking are established traditions, betting sizeable amounts of money is normal.

While Americans bet substantial amounts of money informally in various office pools on sports, (including the results of the Super Bowl game), the only state that allows sports betting on team results is Nevada. Many Americans view the use of derivatives for stocks and bonds with disfavor, however derivatives appear to be acceptable in the sports gaming world. My local newspaper informed me that if I chose, I could bet on at least 16 different aspects of the game, including the length of time the singer of the National Anthem held the last note, as well as the time of the first successful pass by each quarterback. I am reasonably sure as a client-focused industry, that almost any sort of bet at given odds would have been accepted. The people who book all of these myriad of bets are well-schooled odds-makers that set the betting spreads narrow enough to entice the betters and wide enough to make money. As with other analysts, the odds-makers analyze all the available past records and current available information and rumors. (One can see why I was intrigued with becoming a bookmaker as a kid growing up in an era when neither individuals nor instruments of the state were allowed to accept bets. Thus, I had to accept second best and join the investment community, where odds-making and spreads were common practices.)

What Happened in 2011?

The same local newspaper informed me that while some $ 90 million was bet with the sports books on the Super Bowl game, it was not a great business success for them. As good analysts and with the results that did not surprise, I suspect that the odds-makers got their spreads right. What may have surprised them was that the volume of betting was not up to the expected levels, thus their calculations of overhead absorption were faulty. The avid fans of the Green Bay Packers were too small in number compared to those of Manchester United in the UK or any of the major eastern National Football League teams in the US. I suspect that the betting spreads will widen for the 2012 game, if there is one.* Whether the larger spreads will detract from the level of the betting is not known, but is probably unlikely. What is likely, based on historical odds, is that the return on the winning bet will not be as good as this year’s. It is this change in payout odds that is a change factor in the second supply level that was the focus in last week’s blog .

* For many years I have had the pleasure and honor to advise the defined contribution plans for the National Football League/ Players Association. As almost every American sports fan knows, the current collective bargaining agreement ends on March 3rd, 2011. If a strike/lock-out occurs, all of the individual player contracts would end. What the teams would then do is not known, but it is possible (but highly unlikely) that no Super Bowl game will be played in 2012. I wonder what odds the Las Vegas Sports books will be on that outcome or whether the UK bookmakers will offer a wagering facility on whether there will be a Super Bowl in 2012.

Derivatives are OK

All of the above suggests that many Americans accept the use of derivatives if they understand the terms of the trade (which may not have been clear to them in the financial community’s instruments).

Applying the Second Supply Cycle Concerns to Gold

In response to last week's blog, one member of our blog community questioned whether I thought the gold market was real and that a collapse is inevitable. The simple answer is no to both questions. However, the wise investor in gold, (and there are many), should understand that there are two levels of supply and demand for gold (and other investments as well). I believe the fundamental value of gold is as a contra asset to the world’s paper currency, but principally to the US dollar. The fundamental long term trend in the price of gold will pivot off the supply of US dollars in global circulation and the purchasing power of those dollars. These considerations will push the first level of demand, where supply will be driven by production which is quite low and the dis-hoarding from central banks and private investors. The second element of supply includes the various ways one can access the gold price-coins, (conversion cost to bullion) options and futures (with counter party risks), exchange traded funds holding gold and/or gold mining stocks with production and political risks among other considerations.

I can perceive an unexpected increase in margin rates, tax changes, and transportation or custodian difficulties exciting current owners to dump their holdings. This would be a situation where, at least on a temporary basis, the second source of supply could overcome the reasonable price level created by the primary demand.

Dear Reader: Nothing in this world is absolutely inevitable, with the exception of death and taxes.

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Sunday, February 6, 2011

Yellow Alert: Second Supply Cycle Growing

As an analyst rather than a statistical extrapolator, my mind searches for what can go wrong thus forcing a meaningful deviation from the current trend. In last week’s blog I headlined the twin concerns of “blood in the streets” and the impact of possible contagion as an aftermath of the civil unrest in Egypt. In terms of the markets in the developed world, the impact of last week has not yet been felt in general. The markets, at least for now, seem to be more insightful than the politicians and the English speaking, liberal-tinged press. What we may be seeing in Tahrir Square in Cairo is no more than 250,000 actors in a manipulated intramural contest between the President and the military establishment to bring about a reasonably orderly succession. Thus far, my initial concerns were at least premature or possibly inaccurate. I recognize that these events can well escalate into more meaningful dangers if new actors are released on to the scene.

As part of my functional worrying about the future, last week’s exercise was useful in highlighting what could go wrong. In the same vein I see significant potential market problems arising beyond the near term investment horizon.

The Two Supply Cycles

Many economists disguised as securities analysts or portfolio managers focus on the national generation of economic data. When the data turns positive they become bullish, even though well functioning markets have discounted these turns and have moved prices from the fundamentally cheap levels into the fairly priced levels that are only attractive relative to past valuations and/or other markets. At this point in time, the number of truly cheap investments has shrunk. Investments are cheap when their entire market capitalization can be acquired at a substantial discount from a readily available price, which includes quickly liquidating the company. The cheapest of the cheap are those that can be liquidated at a profit by just converting their current liquid assets against all of their liabilities. These situations are known as “net-nets.” Net-nets are always difficult to find, but can be discovered in all market environments. There are more of them to be found before the published data on the economies turn positive. As the economic data becomes more robust, confidence returns and people and businesses increase their spending and consumption. This increase in supply of good news meets with the demand driven by investors to make up for lost time in the recession. First, they want to restore their capital base to their former peak loads and second, they recognize the need to grow their insufficient retirement capital funds. The frenzy created by this “ever- growing” supply and demand convinces these economists masquerading as portfolio managers and strategists that they have entered into a long lasting bull market, thus they adjust their policies to take on more risk (which they believe is mispriced in their favor).

There is also a second supply cycle. While dependent upon the first cycle to get started, in modern times this second cycle becomes larger than the first at its peak. When it falls, it produces more financial pain than periodic declines in the first cycle. The second cycle deals with the production of securities, funds of various types, and derivatives to give investors and speculators ways of participating in the primary first cycle. One well known example of this is gold. The size of the “paper gold” market is considerably larger than not only annual gold production and “consumption,” it may well be approaching the amount of gold held by all the central banks. We find paper gold in derivatives like futures, gold backed bonds and now bullion or coin owned by exchange traded funds (ETFs). I am excluding the funds that own shares in gold mining companies which is, in effect, a derivative of the price of gold.

The Current Increase in the Second Supply Cycle

For several months I have been dealing with an accelerating number of private fund offerings in my capacities as a member or chair of institutional investment committees, a professional portfolio manager and private investor. Each of these offerings is focused on emerging or frontier market (a frontier market is less economically developed than an emerging market) opportunities in general or in specific countries. The level of enthusiasm of the promoters and their sales forces is matched with high fees and expenses. These costs are for the privilege of locking our money away for some period of time without addressing a fear of the return of redemption gates beyond the lockup period. We have not yet seen much in leveraged plays being offered through the use of borrowed capital. This would be a possible future sign of a top in the cycle.

At some point, the sheer size of the second form of supply cycle may impact the primary supply cycle. This week we saw larger net dollar redemptions from Emerging Market ETFs than from managed mutual funds of the same sector. The ETF owner is fundamentally a price speculator and/or hedger. Many mutual fund owners expect to invest for the long term, on average beyond three years, to benefit from the perceived longer primary supply cycle. In my book, MONEYWISE, and previous blogs, I have written about the risks created by co-investors. The risk is that they want to get out of an investment at precisely the same time that you do. The rush to the exit (if you can get out at all) will be met with lower prices. The nature of the fund-raising for these new private funds is very performance oriented. Long-term investors like us need to be aware of the co-investor risk from the new players.

What do you Do Now?

  • I suggest that one stay with present sound investments and continue to deploy cash reserves.

  • Despite my relative bullishness, one should expect some “air pockets” with sudden sharp declines followed by a general, but not specific return to the upward pressure to get more heavily invested.

  • We should be alert to signs of peaking. If a peak does not occur before, I would expect one by 2013 which will be a politically difficult year for investors. The appropriate mix of strategies for the next three years should include both strategic as well as tactical considerations which is a difficult prescription for many investors.

What do you think?

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