Sunday, July 3, 2011

Independence Day:
A Chance to Re-think Our Portfolio Structure

  • Independence
  • Interdependence and Insights
  • Items of Interest

In the United States we celebrate July 4th as Independence Day. Many countries celebrate a Nation Day, observing the date when they became independent from an occupying power. The US appears to be an exception. We celebrate the date we published our Declaration of Independence (actually agreed to on July the 2nd). Thus, we are celebrating a document of principles that we hoped would separate us from what was our Mother country. At the time in 1776, the wish would not have been considered a good bet. The British had the best army and navy in the world, and we had thirteen colonies of very different backgrounds and policies. In at least three states the delegations to the Continental Congress were split and many of our people remained loyal to the Crown, fearing the disruption that would be caused by this new form of government. They were right to be afraid. A number of those successful men who signed the Declaration, who survived capture, torture and death in battle, died bankrupt because of their loss of property during the war. They could not agree among themselves how to govern, even if their independence was won. After twelve long years of debate, a compromised Constitution was passed. Viewing this arduous procedure from today’s vantage point, one of the key political decisions was to create a currency union by assuming all of the outstanding debts of the individual states, and agreeing to make payments in the discredited national currency of the US dollar. I am particularly proud that the driving force behind this and the other financial matters of the new government went to the same college as I did. Alexander Hamilton attended what is today Columbia University. (I need to assure the young in my family that we were not classmates.)

The currency union rested on the ability of the federal government both to raise taxes (largely through tariffs), and to muster a standing army that was under the President’s command. The current problem with the fiscal conditions in Greece, Portugal, Spain, Ireland and Italy are subject to the weak currency union of the Euro. One of the lessons from the American Revolution is that while ideals can flow across borders well, commands do not. I am not suggesting that our various mother countries follow the American experience, but they should use it as a base for their thinking as moderated by local conditions. We also need to apply some introspection to our own activities and thinking, including our investment portfolios, which is the focus of this blog.

Interdependence and Insights

While some early Americans may have thought that they could be independent of the “Old World,” we now know that our very existence and markets are dependent on what is happening both in the Old World of Europe, but even more importantly, China and other countries that we label, somewhat incorrectly, as “emerging.” Perhaps it is my intellectual inheritance from Alexander Hamilton, but I view the world through the prisms of financial lenses. Hamilton, first as the Secretary of Treasury, was very concerned in paying off the war debt of both the country and the assumed debt of the states. He was aided by the development of an active bond market. Only after he left the government did he become involved with the stock market, in part by founding the Bank of New York. (BONY was my first employer after leaving active duty with the US Marine Corps.) Even today investors should first be conscious as to what is happening with the various fixed income (debt) markets. These markets are much more sensitive to changes within the economy than the longer-term focused stock market. Too many stock investors today are not paying attention to the signals from the bond market which can be highlighted as follows:

  1. The interest rate spread between US Treasury securities and Treasury Inflation Protected Securities (TIPS) is widening to 2.7%, indicating that market participants over the next ten years expect inflation to be 2.7% or possibly higher.

  2. A number of the bond dealing desks of banks are shedding both people and capital invested in making markets. This is causing some lack of liquidity with prices becoming more volatile with reduced volume. A similar pattern is expected on the stock side of these dealers. To some degree the use of Exchange Traded Funds (ETFs) is providing additional liquidity for the stock market, on both the long and short sides of trades. Lack of liquidity, at times can lead to sudden, large price movements.

  3. High Current Yield bonds and their bond funds are marching to a different drummer/different direction. While we do not just yet have the final numbers for the second quarter fixed income performance, my friends at Lipper, Inc., to which I am no longer connected, estimate that High Current Yield funds will show the only declines in the fixed income averages. These small declines should have been expected. Again, as estimated, these funds had net redemptions of $1.3 billion for the second quarter. The enthusiasm for these “junk bonds” reached a peak in March, when close to $16 billion was purchased at the time of significant issuance by corporations taking advantage of low interest rates. By May the gross flows into this category of funds had dropped to $6.4 billion, which was lower than 14 out of the last 16 months. One of the reasons for the enthusiasm for these bond funds is that in May, Moody’s* estimated that no more than 2.7% of rated bonds defaulted, and they expect by year end this number could be lower than 2%. I have two reactions to the above elements. First, I view high current yield paper as essentially equity with interest payments due and are really a form of stock investing. When these become less popular, I am concerned that stock investing in time will become less popular (which we may be seeing now). Stock markets have difficulty sustaining a big rise without increased volume. My second reaction is that I believe most things follow a cycle pattern. While Moody’s may be correct that we will be in an era of low bond defaults, I have my long-term doubts and would expect as interest rates rise and there are more high-priced deal financings, that the level of defaults, will unfortunately also rise.

*Moody’s is a position in our private financial services fund.

Items of Interest

One of the benefits of serving on important tax exempt institutions’ boards of directors/trustees is sharing different points of view. Recently, one particular board was asked about the outlook of the various organizations represented. The concerns of the management were first, that during poor times the needs for its services will rise. Second, fund raising is more difficult when the economy, particularly the local economy, is not expanding. Third, could the endowment be expected to raise its contribution to the operating funds? Much of the answers could be expected if one read the local newspaper. However, there were two expressed views that were interesting. The first was from an accounting firm that was increasing its hiring at the entry level. (Considering the training cycle for the firm, this was a bet that business was expected to be expanding in 2012 and beyond.) The other view held by a number of financial types, excluding me, was a bit dour focusing on this country’s debt problems. One could say that the view from these elements of the financial community was already expressed above, in the drying up of liquidity and smaller staffs on trading desks.

Those who know me would not be at all surprised that I had a different point of view. I expected that the near-term would be a period of increased volatility filled with opportunities. Some companies will do unexpected things that they never considered doing in the past. I believe that there is more proven executive talent available now than at any other time. I saw sufficient long-term growth ahead to warrant investment of reserves above the level of contingencies. A few days after the above-mentioned board meeting, I read a survey conducted for Chase Bank (JP Morgan Chase) indicating that 72% of the companies polled expected higher revenues, 62% expected higher earnings, and 50% said they would be hiring. The difference between the Chase survey and my board’s comments was that Chase’s was a national survey and the board was New York centric. The Chase survey did show some elements of concern. First, with revenues expected to grow but less than earnings, raises questions as to a margin squeeze. Second, with revenues expanding, the expansion of employment is less robust.

Two inside baseball statistics hit me as perhaps significant regarding the changing structure of the fund marketplace. First the net sales, (sales vs. redemptions) in the institutional channel was, in aggregate, greater than the combined net sales in the first five months of the direct marketing, sales force, and variable annuity channels. Most of the money recorded in the institutional channel comes from the institutional shares used by salary savings plans, e.g., 401k, 457, 403b, etc. The second and somewhat related statistic was that US Diversified Equity mutual funds had net redemptions of an estimated $4.9 billion in the first half vs. net sales by similar ETFs of $7.8 billion. The impression I draw from these factors, mirrored by slow volume at retail brokerage firms, is that the investing public is disengaged from the stock market, and is only investing involuntarily through employers’ savings plans. While this is very understandable in view of investors’ experiences over the last ten years and what they read/hear from the media, in ten or more years from now they will look back regretfully at what they could have bought.

With the second half beginning Tuesday what are your views?

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