Sunday, October 2, 2011

London Calling, with Concerns

As regular readers of this blog may know, my wife Ruth and I spent last week in London; several days with temperatures in the 80’s (F). In my many previous visits to London, I have found some of the most sophisticated investors in the world. Topic one for them last week concerned the problems with the Euro and how that would affect other markets. In addition to those concerns, now that I have a Facebook group, I am getting regular inputs from old and new friends who have strong views as to what should be done by various politicians. All of these concerns expressed by many people far beyond the small world of the financial community has led me to think through the large and growing deficits being experienced in Europe, the UK, Japan, and the USA.

There are two causes for this crisis in my opinion. The first is that at least since the great depression of the 1930s, people have believed that they needed help beyond their means and wanted the various governments “to do something.” The second cause is that in our elected societies we are governed by politicians, not statesmen. A statesman has a long term view as to the correct path, often unpopular, and tries to convince people as to the correctness of his/her view. Politicians, always looking toward the next election, try to find an already exiting parade of supporters for a particular policy and place themselves as the leader of the parade. In each of the countries and regions mentioned above, both the governments and their principal oppositions are headed by politicians, as distinct from statesmen. To my analysis, the structural problems facing most of the democratic world is that for about 80 years (or three-plus generations), we have been directly and indirectly spending increasingly more than we have been willing to pay for in taxes as well as fees.

I do not want to appear as an apologist for the current US President, but we need to find a parade of strong volunteers to both cut our spending and to advocate for paying a larger portion for what we receive. As we dug this hole in our national balance sheets over three-plus generations, we should expect the change in our life patterns to take one or more generations. While there are likely to be some “band aid” attempts, progress will be slow until there is general acceptance of shared pain for all. This pain will come in lots of different ways. The deficit problem cannot be solved by simple eliminations, but only by a thorough review of every entitlement and subsidy each of us individually receives; for example, tax deductible mortgage interest and gifts to charity, (which would hurt me). The overall solution will be granular and thus will take lots of time. What I have outlined is not pleasing to anyone, perhaps particularly not to investment market participants.

Portfolio Reactions

The more people contemplate the deficit issues, the more bearish some react. As we know, the third calendar quarter was ugly in terms of performance; and as time passed, market participants became increasingly bearish. One example of these bearish actions is that the short interest ratio rose almost 44%, from 2.92 days to 4.2 days for NASDAQ stocks in just 15 days to September 15th. Over the same period, the short interest ratio of the supposedly higher quality stocks on the NYSE rose to 3.7 days from 3.2 days, a gain of 16%. (This measure is of the number of days volume of transactions that would be needed to cover all of the existing short positions. While the increase in shares sold short is an immediate bearish sign, keep in mind that when the market starts to move up many of these positions have to cover to avoid losses.) One of my personal concerns about the growth in the use of Exchange Traded Funds (ETFs) is their growing short positions. The two largest short positions on the NYSE are two ETFs, as a matter of fact, of the 40 largest short positions, ten are ETFs.

Many of the investment managers that I saw in London use European based ETFs. (Not of minor importance is that apparently the UBS trading fraud was conducted in ETFs, which were meant to be hedged.) I do not believe that there is equivalent public data on European ETFs short positions, but considering there is a smaller retail market in Europe, my guess is some of the short positions could be larger than their equivalent US ETFs.

Is there any good news?

Yes, there are three positive elements that could be of some help. First, the chart pattern on the Dow Jones Industrial Average is displaying something of a bottoming since the August decline. (However, there is not as helpful a sign in the transportation average; this could have some bearing on the Warren Buffett discussion below.) The second positive note is that the Barron’s Confidence Index, comparing high grade bonds with intermediate grade bonds, rose 2.4 points last week to a 70.3 level; most of the time this index moves less than 1.0 point per week. Often when the index moves up it is good for stocks, for it shows that investors are willing to take on more risk (intermediate quality bonds). The third somewhat misplaced positive, in my opinion, is the bullish reaction to Warren Buffett’s decision to buy back Berkshire Hathaway stock. I believe one of the best things about Mr. Buffett is that he corrects some of his mistakes. For many years, he has only bought companies for cash and has not used stock for acquisitions. Because of the large size of the acquisition of Burlington Northern, he had to use stock to supplement his cash to buy the railroad. (I believe despite the uncertain price pattern for the transportation average, over time this will prove to be a very successful investment.) What he is really doing now is buying back at a lower price than what was used for the acquisition, and in effect turning the purchase into close to an all-cash deal after the fact. With the buyback, I believe, he is not making a market call. Buffett and/or his new investment manager is probably buying some “cheap” stock also.

Investment Posture

As indicated, deficit solutions will be a long time coming and there is increasing speculation on the downside; nevertheless I believe that one should view the current market and periodic dips as opportunities to add to sound investments. The next 100% move will be on the upside, even if it takes a long time.

Did you miss Mike Lipper’s blog last week? Click here to read.

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