Sunday, September 25, 2011

Inducing a Recession, Opportunities?

Reading the general and financial media, be it print or on a screen, most of us see disappointment. In part because of our disappointments with political leaders around the world, we are taking away their firepower by inducing a recession. We are disappointed with the various politicians for their reluctance to solve the growing gulf between what we want to receive as a society, and what we are willing to pay for in the way of taxes and fees. Since political leaders wish to get elected, they are reluctant to force the narrowing of this gap.

As political leaders like spending as much as getting elected, we are pressing them to cut expenses, mostly by cutting the other person’s entitlements or benefits. This less spending without an offsetting increase in the private sector will shrink the size of the global economy. Since the expected general level of demand will be reduced thus creating a recession, many are already cutting back on expenditures and have a pessimistic attitude toward investment obligations to themselves and others.

Two extreme behaviors

The first extreme behavior assumes the worst is compounded into tragic levels. Since politicians won’t lead, in this scenario we will see the equivalent of the “Man on Horseback” taking charge and forcing a solution, usually by attacking one or more groups. The dastardly actions of various dictators of the 1930s who “solved” the crushing debts of their country are the source of some people’s paranoia. Following historical precedents, the group to be attacked are the wealthy people, who fear a pillaging of their assets. This fear is palpable today for some. In an investment group meeting last week, we were informed by a third generation dealer in gold bars and coins that sales of these items for personal delivery are skyrocketing. The announced intended purpose for this portable wealth is to pay bribes to cross a border. For some, this was experienced during their lives or their parents' lives in Europe and Asia. Others feel that their wealth is threatened by various left leaning governments, including the present gang in Washington. Their demand for physicals is such that new vaults specifically designed to hold gold, and to some degree silver, are being sold in London and elsewhere. Perhaps another example of this conversion of fiat currencies is that the highest priced real estate properties are selling very well.

The second extreme behavior is that some are buying in the face of plunging stock prices around the world. The buyers could well be traders who recognize, using the past metrics, that both the S&P 500 and the MSCI EAFE are oversold by a significant amount, at least as of Thursday’s close. The other possibility is that the buyers are really investors who know something. My brother points out that our grandfather, based on decades of Wall Street experience, told us that the person on the other side of a trade may know as much, if not more, than we do.

Asian Lessons

Perhaps the rumored flirtation of the Chinese for Italian debt was aborted by their analysis that the rating agencies would lower the credit rating on both the sovereign debt and two of the largest banks in Italy, which occurred last week. A more difficult factor to consider is the announcement last week that FedEx is significantly lowering its estimate of the growth in revenues of expected parcel traffic from Asia for the rest of the year. What requires more study is whether the projected drop in growth is due to an expected dip in the sales of Christmas items in the US. Historically, we have thought of Asia primarily as exporters to the US and Europe. However, our Asian portfolio managers point out that over half of Asian exports are now done within Asia. If the expected decline in the growth of air freight shipments is due to an expected weakness in the Christmas trade, that fits with the induced recession scenario. If on the other hand, the growth of consumer demand within Asia is softening, this could be much more serious. The continued growth in Asian consumer demand is critical to my long term investment philosophy, and to others as well.

What is happening in the “Real World?”

According to a survey done by JP Morgan Chase, 75% of small company CEOs are planning to add people in the coming six months. They may feel that they have a chance to fill a void left by their larger competitors who are pulling back. What appeals to me is that there is an abundance of high quality talent available, either already separated from their employers, or people who are available for the first time.

What should Investors Do Now?

We are reducing our fixed income exposure for our long term accounts who perceive that they have extended obligations to various beneficiaries. Soon the only high quality fixed income that we intend to own will have short maturities. Periodic, planned increases in equities make sense for many of our institutional and High Net Worth clients.

What are you doing with your portfolios?
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Sunday, September 18, 2011

Investment Implications of Marco Polo’s Return

If you scratch a securities analyst, an historian will bleed, or that is my belief. Analysts and most investors rely on the certainty of the past, even if they are portrayed inaccurately. Histories are written by the victors and read by those who wish for simple narratives and conclusions; in other words, they usually read about the side that had the best public relations.

One of the stated impetuses to the sharp rise in markets around the world early last week was the rumor that the Chinese were going to intervene in the Euro markets, and more specifically, the sovereign debt of Italy. Apparently this was untrue. Nevertheless, rumors have value in that many believe it could have been true. When I was first conscious of the rumor transmitted as fact, I thought it was, in effect, like the return of Marco Polo.

The simplistic version of the Marco Polo legend was that of an Italian returned from many years of traveling within Asia; who brought back remarkable tales of the technologically advanced society of China. He was introduced to among other things, paper money. (There are some who believe that paper money, or in today’s terms, electronic money, is the ultimate weapon in destroying the strength of developed countries. I will let others debate the value of fiat currencies, but it is an important issue for the transfer of wealth to future generations.) Marco Polo is credited by many with bringing to Europe, the wonders that existed in Asia and the intellectual accomplishments of its people. As usual, the real story is a great deal different. There were a number of merchant traders who worked the Silk Road before young Marco joined his father and uncle on their journeys that took them to Kubla Khan’s court in what is today’s Beijing. The reason for the fame of Marco Polo is he had many years to tell his stories to a cellmate in a Genoa jail. Copies of these tales then circulated throughout Europe.

What interested me this week was the irony of Italians once again benefiting from the temporary, and perhaps lasting success of China. According to Harry Mount writing in Friday’s Financial Times, Italians invented deposit accounts, double-entry book keeping (as distinct from two or more sets of books for tax authorities and business partners) and the letter of credit, as was demonstrated in Shakespeare’s “Merchant of Venice.” He further informs us that bank, bankrupt, and risk are words derived from Italian.

Italian implications for investors

Italy is the third largest economy in Euroland. There is a particularly close relationship between Italy and the French banks, and to a somewhat lesser extent, the German banks. European governments use, and in turn are beholden, to their banks. If interest rates on Italian debt reflected the true risks of some type of default, Italian borrowers could not afford to borrow, and perhaps more importantly, banks around the world would have to mark down the carrying value they have put on Italian debt. For some, and perhaps many banks, they would appear to be swimming without appropriate attire when the debt tide runs out. In many cases they would be considered under-capitalized, as warned by the lately courageous head of the IMF. The threat of a global banking crisis of insufficient capital would be destabilizing to say the least.

Later in the week there was the announced three month coordinated dollar loans to the European Central Bank (ECB) from American, British, Swiss and Japanese central banks. These activities initially buoyed the markets, however these loans are only one answer to the immediate liquidity needs for dollars of a number of European banks. While this may give some time to the individual countries to meet their budget crises, the weekend news is not encouraging. Liquidity is the surface level of the crisis, but as we learned from the Lehman Brothers’ debacle, at the end of the day the need for fresh capital is critical.

Conspiracy thinking

In a saga that began with Marco Polo almost 800 years ago, one should look beyond the shadows of what could also be happening now. Did the four central banks move in a coordinated way to rapidly scotch the potential Chinese intervention? Some may feel that at this time a more dominant Chinese player, as the world’s second largest economy, could demand too much ceding of Europe’s economic/financial power. As with good shadow players, all will deny that this was a motivation. Unless the deficit reduction issues start moving to a reasonably fast solution, we might see the long term implications of Marco Polo’s return while the world marches to a Chinese rhythm.

What should you do now with your long-term investment portfolio?

First, enjoy the 4-8% gain in your stock portfolios, depending how much of the portfolio was in technology and financial services. Second, you need to separate possible tactical from strategic moves. Many rises in stock prices are often labeled short-covering rallies, and then the market continues to rise. In this case, I see a lot of evidence of shorts rushing in quickly to cover their bets. On August 31st, the short interest ratio for stocks on the NYSE rose to 3.2 days. This compares with 2.1 days two weeks before. A much smaller rise was seen for NASDAQ listed stocks. The biggest single change was a 70 million share increase in the short position on Bank of America, which was an almost 50% increase in fifteen days, and placed the stock as the third most shorted security behind two general market ETFs. BofA was not the only unloved financial. The Financial Select Sector ETF was the fourth most shorted security on the “Big Board.”

All of this suggests to me that now would be a good time to make switches, particularly out of depressed stocks that have inordinately rallied. The key to this maneuver is that it is a switch, not a reduction to the proportion of your portfolio in equity and equity funds. For a stock investor who sells out of a company with deteriorating fundamentals, a temporary move into either a generally diversified or a more focused mutual fund (not an ETF), would make sense.

On a strategic basis, paying up to get into better companies would be a good thing to do now for the long term. The other matter that all investors should consider is the paragraph above on conspiracy thinking. In the long term, I believe that portfolios need a materially bigger strategic weighting in favor of Asia over Europe. To the extent that Latin America and Canada are exporters, I would include them in my Asian focused investments.

What do you think?

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Sunday, September 11, 2011

September 11th, 2011 -
Can We Overcome Fear?

I was born in New York City and worked in the Wall Street district for about 40 years. Though I now live and work in New Jersey, I still view myself as essentially a New Yorker. Thus the attacks on the World Trade Center (WTC) on September 11, 2001 were a particular affront to my being. Many of these feelings were brought back to me on Saturday, September 10th, when my wife Ruth and I attended the dedication of a remarkable piece of architecture, the two memorial walls dedicated to the 746 New Jersey residents who perished from the attacks ten years ago.

The memorial named “Empty Sky,” points directly to where the WTC towers used to stand. The dedication was led by a very moving speech by Governor Chris Christie, with talented musicians from the New Jersey Symphony Orchestra playing the National Anthem. A number of the special guests were once fellow commuters with me when they worked in “The Street,” before they answered the call to public service. The current chairman of the Port Authority of New York/New Jersey spoke, stating that they are rebuilding and expanding the World Trade Center not only as a monument to the nearly three thousand that died, but also to optimism; that we will be even more successful in the future than we were in the past. Because of my personal history, that optimism struck a note with me.

Very early in my business career I commuted by ferry boat from New York across the Hudson River to a train to take me to my then-home community. As usual, I was using the relatively few minutes on the boat to catch up with my business reading and to be in position to be one of the first to get off and to get a good seat on the waiting train. I did not hear from the stern (rear, for you non-nautical types) some excited chatter. When I got to my commuter station I found out that I was on the last ferry to leave Manhattan. That was the afternoon in 1965 when most of the Northeast US, and some portions of Canada, lost electrical power. Along with others, my immediate reaction was to focus on the expected return to normality, and the opportunities that this disruption to our daily lives brought. Less than a year later the official ground-breaking ceremony for the World Trade Center occurred.

From my office windows I watched the building of the North Tower, which was completed in December 1972. With the South Tower finished in July 1973, the total elapsed time between the ground breaking and the finished construction was approximately seven years. The last building of the new World Trade Center will not be completed until 2014. The actual construction time of the WTC’s rebuilding will probably be only a little longer than the original schedule, but due to recovery efforts, litigation, and bureaucratic red tape, the elapsed time to build is about double the original. (As president of the New York Society of Security Analysts, I moved our headquarters into the North Tower in 1992. Luckily all of our employees and members who were in the office that fateful day in 2001 walked down the 40 floors successfully. Without the quick thinking of our executive director we could have wiped out what was at that time, one of the critical organizations to the financial community.)

The key to this history is that smart people are once again committing their lives, professions and capital to a future for lower Manhattan. They are showing their optimism.

Pessimism is Leading to Fear

The recent declines in many stock markets around the world have gone beyond discounting a normal cyclical recession. One of the many lessons that I learned from John Neff, who was the great portfolio manager of the Windsor Fund, (now known as the Vanguard Windsor Fund), was to focus on the earnings power of a company under normal business conditions and not what was thought about the current level of earnings. Thus for him, it was the comparison of earnings power to current price to determine the attractiveness of a stock. Using this kind of analysis, he was brilliantly correct in his purchase of what is now Citigroup. He made multiples on his original investment. Many sophisticated portfolio managers believe that the current earnings projections represent cyclically peak earnings, as margins are at record levels and sales expansion is slowing down. I would submit that this recognition is already in the prices of the shares that they own. If my assertion is reasonably correct, when reported earnings turn down there is not a good reason to further discount current prices. I believe that the general price levels of many stocks presume a decline on the order of 25%, and thus many stocks are selling at perhaps 15X their earnings power and therefore there is no pressing need to mark stocks down further.

However, that is not what is happening currently. We are talking ourselves into a recession by curtailing our expenses where we can, and not taking advantage of the huge talent bank that is available for us to hire. We are afraid of potentially massive disruptions to our global financial structure. Many are focused on the belief that the German government is getting prepared to bailout its own banks on the presumed default of the Greek government. If the Germans are slow to approve increased purchases of Italian debt by the European Central Bank (ECB), Italian interest rates will rise beyond the ability of the country to just pay interest, let alone service its debt. Spain’s problems have to do with weak internal banking structure and too much available real estate underlying its debt. The change in government in Japan is not generating enthusiasm. Both Australia and Canada are showing some signs of strain, etc., etc. The renowned thinker and investment manager Howard Marks of Oaktree Capital points out that markets can handle a single crisis reasonably well, but when there are concurrent problems, the markets go into a chaotic phase. I am hopeful that since the root cause of the structural imbalances is the same lack of political will that I discussed in my Blog post of August 28, 2011 entitled Storms on Both Sides of the Atlantic; that we are dealing with a single problem that plays on many stages, and thus the period of adjustment will be short.

The Lesson from 9/11/2011

Over the last ten years we were alert for a third attack, (I am including the first assault on the WTC in 1993, which I just missed by 15 minutes). At considerable expense and bother, we foiled known and unknown attempts. Up to this point, we have survived and are rebuilding. Perhaps the ten years of a flat nominal stock market in the US is coming to a close. As of today, we have suffered but survived in lower Manhattan. The substantial structural imbalances caused by people in many countries, demanding from pliant politicians more than we are willing to pay for through fees, prices, and taxes, will be addressed painfully and hopefully soon. Nevertheless, I take my hope from the “Empty Sky” memorial, and believe prudent, long term equity investment will see no fixed limits to our eventual returns. Hopefully the waiting period is getting shorter.

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Sunday, September 4, 2011

Liquidity Lessons Re-Learned

When interviewing various investment managers, one of my favorite approaches is to discuss their mistakes. Managers who do not admit mistakes or provide shallow answers are unlikely to be future managers of my clients’ accounts. A number of the world famous managers who I have known over the years are often very quick to discuss their mistakes and frequently how these errors have changed something about their own approaches to investing. I believe we all should periodically review our own mistakes, with an honest attempt to avoid similar ones in the future. Ideally, we should only make new mistakes in the future.

One of my mistakes was that I owned the stock of Lehman Brothers at the end of its fall. Technically I never bought the stock, but got it when Lehman acquired a money management firm for stock. Toward the end, my mistake was that I did not believe comments from European-based managers that Lehman would fail. I relied on the firm’s published balance sheets, statements from management, and regulatory capital requirements. Even if one was smart enough at the time to write off Lehman’s real estate equity holdings, it still had sufficient capital to continue to stay in business. Like others, I was looking at the wrong thing and did not fully comprehend the structure of the business. The critical issue for Lehman Brothers was liquidity. Its ability to borrow in the overnight market rapidly disappeared at the very same time as its prime brokerage clients were drawing down their balances, which were essential to maintain Lehman’s level of business. What was not clear to me, was that Lehman’s separately incorporated (and guaranteed) subsidiary had much looser credit terms than the New York prime brokerage operation. I will let various investigations and books determine whether the hedge funds that withdrew some or all their money from Lehman’s London accounts were also the sources of the rumors of the firm's decline. I do not know whether Lehman in the end was a victim of a “bear raid” by short sellers or just a firm that lost control of its finances. No matter the cause, the firm is no longer with us, and its demise was a tragedy for many good, honest hard working people within the firm, as well as brokerage clients who sustained major losses.

I should have known better! My Grandfather lectured me, either on walks or sitting in his study, about his experiences as the senior partner of an important brokerage firm. One of the things he said that I did not completely value until now, was the statement, “In periods of duress one can not borrow money, even if one has cash sitting in a safe deposit box.” There were two things I did not fully appreciate. First, the ability to borrow when times are tense is critical to survival. Second, that cash or other hidden assets are not good collateral if the lender can not see them or seize them.

This brings us to Europe this week.

Sovereign Debt and Bank Capital

While most of the attention focused on the Jackson Hole conference was on the minuet of Chairman Ben Bernanke, the most market-moving comments came in the last panel, when Christine Lagarde, the new head of the IMF, called for the recapitalization of major European Banks. The reaction on the Continent was severe shouting, that the former French Finance Minister did not understand the situation. The comments quickly focused on the distinction between liquidity and capital for the banks loaded with sovereign debt, particularly of the Mediterranean and Irish varieties. Similar to my unfortunate experience with Lehman and the warning from my Grandfather many years ago, the ability to borrow was particularly critical when the lenders questioned the value of the capital. New cash capital automatically improves their ability to borrow.

I suspect that the falling value of European bonds is the market’s way of downgrading the bonds before the credit agencies do it. Bond prices reflected in yields, and the prices for Credit Default Swaps (CDS) are more substantive than a bunch of letter grades from the agencies.

The US Impacts

If the credit values of European issuers fall, two things happen on this side of the pond. First, various US financial institutions and some multi-national companies should look at whether they need to repair their own balance sheets. Already we have seen considerable flows out of some US money market funds containing European exposure, with assets shifting to US Treasury-only funds. Second, if the Europeans do go on a wave of capital raising, they will have to offer rates high enough to draw capital from other parts of the world, including the US. Quite possibly we will see signs of this in a Labor Day-shortened week. Regardless of what the President says in his jobs speech, (scheduled just prior to the opening of the National Football League regular season Thursday night), we could be in for high volatility. I for one will be watching the Asian markets tonight (Sunday) and the European ones on Monday.

Crisis Betting

If we get increased turmoil, as investors what should we do? I speak with the bias of an investment manager of portfolios of mutual funds and the portfolio manager of a private financial services fund. I believe it is too late to be doing any meaningful amount of selling. In terms of buying, my bias is combined with a contrarian nature. In this week’s Barron’s there is a series of interviews with 12 established market strategists. They were asked which sectors they favor and which they would avoid. Only one would invest in financials, and three would avoid them. Considering that these stocks have led both on the way up and on the way down, I expect that these stock prices will rise along with any general market rise. However, as I started this blog post with some thoughts on liquidity and capital, adding to the subject, I believe the market is questioning the values resident on a number of balance sheets of leading banks and some insurance companies. Thus, the price-to-book value or the Tangible Common Equity Ratio may, in truth, be higher than what the other bulls are using. Statistical cheapness has never been a convincing argument for me. With a long term view, I feel that some of these stocks are attractively priced because of their sheer brain power. Those brains will be able to figure out new ways to make money coming out of the world’s liquidity and capital needs. I am looking for the rainbow after the storm.

What do you see?

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