What Can Hurt: Five Warnings/Concerns

As with other investment advisers, I report to our various clients on the progress of their accounts at least quarterly. The first quarter produced reasonable absolute returns, particularly if they were foolishly annualized. I said foolishly annualized, as historically the first quarter is often the best performing quarter of the year until a possible better fourth quarter.

In terms of expected interest rate raises, our conservatism cost us in terms of relative performance compared with other balanced accounts. Unlike other balanced managers who believe that they can trade out of higher rate, fixed-income paper before inflation drives interest rates higher, we have utilized much shorter investments, for example short-term treasuries of various nationalities, short-term bond funds and money market funds.

Any study of large losses should start with the price rise immediately before the major decline. At all times one should be wary of unexpected events, but I believe that this is particularly true now in a period of substantial double-digit recovery gains accompanied by both low volume and a general lack of enthusiasm. In my judgment, there are at least five legitimate concerns which should be viewed as warnings:

1. China is critical to just about every major investment in the world; from dollars, US Treasuries, global merchandise imports, global raw materials, autos, KFC (Kentucky Fried Chicken, the subsidiary of Yum Brands for those who don’t have children or grandchildren), Apple, and General Motors (who sells more cars in China than in the US) among others showing way above-average growth. The potential for the rumor or the reality of social unrest can shake or break most markets around the world. In early May there was a plunge in commodity prices which went well beyond the sharp technical correction in silver. In almost every commodity whose price broke, China was the main swing buyer.
   
   
2. In the first quarter, performance leadership was concentrated in industrials (often exporters to China), commodity producers and their transports sending materials to China and corporations that inhabit the Internet as the main part of their business. Apple was the leader of this pack. Technology is accelerating to the point that rumors of major government and societal issues can have sudden and dramatic impacts. Look how quickly the US Congress introduced legislation to prohibit tracking the location of children without the permission of their parents. Many will congratulate our society for its use of Internet technology for the capture of OBL. Others globally will recognize the intrusive power that has been unleashed by the Internet and will try, so to speak, to put the genie back into the bottle. Whenever a force becomes close to dominating, there are reactions to try curtail its power and growth. Any slowdown in the growth of the various Internet players will lead to sharply lower valuations.
   
   
3. Small capitalization stocks and the funds that own them have been the performance leaders for some time. In the first quarter it was not unusual to see small caps up 10% or more while large caps were gaining at only half that rate. Substantial inflows, as usual followed high relative performance. At some point, history suggests that a reversal will occur, as those late performance followers stream out of small caps. I should have said attempt to leave as easily as they entered. The search for exit liquidity is likely to be painful. With the fragmentation of the market place into many different venues, but none with guaranteed liquidity that floor specialists used to provide, there is likely to be a very painful experience.
   
   
4. Both US corporations and investors are increasingly sending money overseas to escape a perceived slow-growth economy with increasing deficits and a declining value of the dollar. These views are becoming almost universal, as traders crowd the exits. One should be very wary of charging crowds, for at some point there will be a significant event that will cause an abrupt reversal. Notice that in the week of the commodity price slump, the US dollar went up 2.5%, at least temporarily. In the current environment I would be careful to limit my foreign (non-US) exposure to 50% in terms of both foreign and multinational securities.
   
   
5. One of the reasons I devoted twenty-five years of my life in building the data banks of Lipper Analytical Services was the observation that the use of bad data often leads to bad or sub-optimal decisions. Our country is awash with bad data. What is apparent now is that neither the White House nor any members of Congress had any accurate idea of the total long-term costs of what is now called Obamacare. Regularly many of our sharpest minds are substantially wrong as to the number of people employed economically and more importantly, not working. Notice none of the “official” data sources recognize that a significant portion of the cash economy tracks the so-called underground economy that is an essential element to much of our consumer spending. How many times have we heard that housing is turning on the basis of volatile, fragmented data that proves to be wrong the next month? We do not know the eventual size of our deficits. When a company reports results within the window of the analysts’ estimates, we celebrate the brilliance of my fellow analysts. As accounting is much more an art form than a precise science, is it possible that corporate managements, within the scope of the law, manage to their projected result and fail to appropriately recognize other factors that would lead to a surprise? Coming out of this recovery, I believe that more favorable results have been delayed compared with over-reporting the negatives. To an important degree as citizens and investors we are flying blind, as are our politicians.

For long-term investors that have both excess cash reserves and reasonable stock or stock fund positions, I would not rush to add to stocks now. I do not expect that all of my warnings or concerns will become operative soon. After one or more of these reverse expectations occur, I would hope to find some bargains.

Please let me know what you think.

____________________________________________

Add to the Dialogue:

I invite you to be part of this Blog community by commenting on my blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog .

To subscribe to this Blog, or to refer a colleague or family member, use the email box or RSS feed sign-up on the left side of www.MikeLipper.Blogspot.com