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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