Sunday, April 10, 2011

“The Archduke Lives For Awhile,” As Speculative Excesses Build Up

  • Speculative excesses
  • The gathering evidence
  • More evidence from theWall Street Journal
  • The Enthusiasm is Growing
  • Trying to focus on the longer-term
  • When will the Archduke be shot?

I suspect that in the colleges and universities as well as our “better” high schools there is little or no attention being paid to why the First World War was inevitable. The process started many years before with the disastrous results from the French side of the Franco-Prussian War, where the French lost 25% of their young men to a newly united Germany, inducing fears on the part of the French of German militarism. Queen Victoria's vast family united the crowns of tsarist Russia, Germany (Prussia) and the British Empire during her reign. Her death weakened those ties. The completion of the first phase of the European carve-up of Africa to secure raw materials, added to the wariness. The intensive study by the German general staff of the US Civil War and the development of the war of maneuver laid the foundations to the way the German Army would fight in the next two wars. Poor economic conditions in Russia, in part due to high taxes and lowered farm yields, pushed the government into many unpopular moves. The Russians were recovering from the expenses of their defeat in the Russo-Japanese war with a smaller, but better equipped and led Japanese. Peace between these two combatants was designed conceptually by the US President, Teddy Roosevelt at his home on Long Island. For his efforts he won a Nobel Prize. (As a trustee of Caltech, the home to so many Nobel laureates, I highly value these awards.)

When the Archduke and his wife were assassinated, the Austrians felt that this was the beginning of an attack on their sovereignty by the local Slavs, egged on by the Russians and/or the French. The Austrians cashed-in their guaranty agreement with the Germans to protect their country. Quickly the French felt that they would be under attack by the superior German forces. The Russians were by treaty required to support the French if they were attacked, and in turn this brought the British into the war. All of these actions were predictable and became inevitable once a spark was fired in the tinderbox of Europe. One could see it coming.

Speculative excesses

In a similar fashion the history of stock market collapses rests on the building of speculative excesses. These excesses suck in many people who should not have put their relatively meager life savings into markets that appear to offer great wealth opportunities, but in reality are based on permanently higher prices. In a recent CFA Digest article, as noted by Frank Holmes of US Global Investors, three ingredients of asset bubbles were identified. Financial innovation, investor exuberance and speculative leverage contributed meaningfully to the bubble. I would suggest that we are in the early stages of again building such a bubble. While it may be the early days of the pieces falling into place, one must be aware of the risk from the unexpected (the assassination of the Archduke.)

The gathering evidence

Some of the elements that are visible to me from the financial press this week cause my long term concerns. Alan Abelson, the heart and soul of Barron’s, in this week’s column bemoans the sharp increase in the level of bullishness being expressed by investment market letter writers. He compares the data from Investment Intelligence, which shows that we have not seen this level of optimism since 2007. Many people treat this as a contrary indicator: the greater the optimism the more wary some get. I think there is more room for higher levels of optimism as we are now stacking the cards in favor of speculators.

The next two items are only linked in my mind through excessive leverage, speculation, and resulting fraud. In this week’s Barron’s, there is an article on one of two publicly traded companies that are serving the retail urge to play in the foreign exchange (FX) game. The article points out that over 70% of the accounts lose money; many of those initiated their accounts with a credit card. Some of the regulators are concerned about the leverage used by these retail accounts and have cut the permissible leverage in half to fifty times (50X) in the US and 25X in Japan. Elsewhere there are no limits and some leverage reaches 200X. (A portion of the record breaking first quarter volume on the CME is also likely to be highly leveraged by so-called professional/institutional traders.) When there is that much leverage being used there will be significant losses, which in some cases will be “temporarily” hidden by “borrowing” from accounts to speculate more successfully. To a degree this is the theme of the extensive interview with Bernie Madoff in the weekend edition of the Financial Times. The promises of riches returned becomes the driver that cannot be denied by some.

More Evidence from the Wall Street Journal

In a recent article the WSJ noted that the SEC is considering relaxing the reporting rules on private companies. Currently only those companies with 500 or more shareholders need report. The current restriction caused an investment bank to withdraw an offer of Facebook shares to its selected private clients. Assuming that this change comes to pass, the firms that we used to call bucket shops here and overseas can claim that their market has expanded (to the detriment of the gullible public). I recognize that many regulators are pretty desperate to shrink their responsibilities in an era of tightening budgets. However, over the next several years the number of inexperienced players that regulators will have to review is going to increase. (As a manager of a private financial services fund and a member of a number investment committees, I am offered the chance to be an early investor in lightly regulated banks, trust companies, and real estate-oriented finance companies run by people who have limited experience in this new world.)

And now the herds are building up. In a March 31st article in the WSJ, it was noted that Merrill Lynch (Bank of America) Wells Fargo (A G Edwards) and Edward Jones were dramatically increasing the size of their broker training classes. Some believe that the cost to train these recruits over a two to three year period is on the order of $300,000 per trainee. Only about 1/3 of these rookies are likely to be employed by the house that brought them into the party. Some will be cut because they don’t make the required production levels and others will voluntarily leave for higher payouts or object to the products being sold. One expert believes that from the houses’ standpoint the firms will only earn a 10% return on the capital spent. My concern is almost the opposite. In order to fulfill the capital generation requirements, these relatively inexperienced brokers will sell complex products that have high profits for the firm and/or encourage margin purchases. They are not going to be happy with agency-only trades, e.g. buy 100 shares of Ford every month for three years.

The enthusiasm is growing

My old firm, Lipper Inc., noted in its first quarter report: “Breaking a two-year trend, equity mutual fund investors injected more net new money into equity funds for the quarter than into fixed income funds.” Interestingly the reported volume on the stock exchanges, unlike the commodity exchanges, is not perking up. (With a portfolio heavily weighted toward mutual fund management companies and brokerage firms, these are trends that I follow closely.) However, I am concerned that few of these investors paid attention to another article in the WSJ. This article focused on measurements that mislead. Included is the point of view that the statistics from the recently completed NFL(*) Scouting Combine are not great predictors of the future playing records of the player. However, the stats probably do track the sizes of the initial signing bonuses. This is similar to SAT scores which do not predict college graduation rates, 4 year grades or success after college. They are somewhat useful in guessing freshman year results. In effect, these statistics which drive lots of actions, are not particularly useful in making long term judgments. I feel the same about the use of mutual fund performance numbers. My guess is that the majority of the flows are going into funds that have shown the best near term results which may mean that they have an oversized position in Apple (*).

Trying to focus on the longer-term

At this particular moment one of the keys to the future is guessing as to future inflation expectations. The Federal Reserve, by its actions, is inducing inflation into the global economy and lowering the value of the dollar at a time when many others do see the threat of inflation. John Mauldin and others see capacity utilization rising, which can only lead to higher prices until new fields, mines, and plants come into production. Many other central banks are attuned to this risk, and those in both Europe and Asia are raising interest rates that will slow their economies a bit. Our own bond market senses inflation is real and growing. One measure I use is to compare the ten year yields of US Treasury Bonds with the Treasury Inflation Protected Securities (TIPS) of approximately the same maturity date. Currently the spread is 289 basis points or 2.89%. Thus the market is predicting inflation at the high end of its “normal” range of 2-3%. My fear is that it may go into the 4%+ range if we do not get better control of our deficits.

When will the Archduke be shot?

Not only do I hope it doesn’t happen and if it does that it is long in the future. Nevertheless, I feel we must be prepared for a sharp market break. I do not yet see enough speculative excess to make a premature move to raise cash, but I am watching for it. One of my three sons is an investment professional with a CFA. This weekend he expressed the hope that we have ten years of good markets ahead of us. I hope he is correct, but history suggests to me that the next five years could be difficult for some.

What do you think? Please let me know.

(*) Disclosures:
1. We are lucky enough to manage a number of defined contribution plans for the NFL and the NFL Players Association.

2. For many years I have personally owned shares in Apple that was a spinoff of a closed end fund that I owned many years ago. Foolishly, I sold some years ago in a tax balancing move. One should never make an investment decision based on tax impacts alone.


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