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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