Sunday, August 28, 2011

Storms on Both Sides of the Atlantic

Normally I think about my blog communications to you throughout the preceding week, then I spend Sunday working on my first draft in order to get a completed version before the end of the evening. As I sit here on Saturday night before the impact of Hurricane Irene is forecast to hit us Sunday, I am concerned that some fallen trees might knock us off the electrical grid. Thus, I am pulling together my scraps of paper and other thoughts about 24 hours earlier than normal. The result is a collection of questions and observations on various bits of news and commentary I have reviewed this week.

Europe: What will it be?

There are two concerns which are keeping investors away from the stock market. The first concern is whether the US will tip into recession (more on this in a minute), and the second is Europe. At its core, the issue in terms of Europe is whether Germany will provide the capital to bail out the Mediterranean and Irish governments, and more specifically, their banks and the banks’ counter-parties in the more solvent countries. The European bureaucrats have maneuvered their creation, the European Central Bank (ECB), into buying sovereign debt issues of some of the peripheral countries in the secondary market. On September 7th, a senior German court will rule as to whether this was in violation of the law (and spirit) of the agreement to create the ECB. Logic from afar suggests that it was in violation, and now questions whether Europe as we know it will continue to exist. Any form of disequilibrium created by these events and discussions will have some unpleasant impacts on US securities, particularly commercial banks.

What does 1% (actually 0.99%) mean to the US?

The latest reading on the growth of the US Gross Domestic Product (GDP) for the second quarter, was a gain of 0.99%, generously translated to be 1%. Subsequent quarters were expected to be higher, with the final quarter generating a 3% growth rate. (Many believe a 3% growth rate or better is required to make a meaningful dent in US unemployment and under-employment statistics.) As disheartening as the 1% figure is to the economy, it suggests other concerns to me. While the financial community will gladly do battle over 1% (or as we most likely will refer to it, as 100 basis points) in this period of declining volume and excess capacity, there is a deeper concern on the part of number crunchers like me. What is rarely discussed (but is included in the full breakdown of the national accounts) is a line item called Errors and Omissions. Considering how often there are significant corrections or adjustments to federal government numbers, I wonder whether there was any growth in the US in the second quarter! My concern was heightened when I read the following excerpt from a fellow member of our blog community who is a corporate environmental counsel and a former FDA counsel. He summarized his interactions with the government:

“The overhead of any program and waste consumes a substantial fraction of the funds allocated. They are spent on feeding the 'perpetual bureaucracy' or temporary managers as administrative costs or the money is simply wasted and does not go to any economically productive use.”

Bear in mind that the government is spending roughly one of every five dollars counted in our economic progress.

Are We Creating a Self-Induced Recession?

Much has been written about the “wealth effect” which states that when people believe that their wealth is growing they will spend more. This was one of the excuses for QE2. It didn’t work in a meaningful way. But are we seeing the reverse, when the uncertainties created by the politicians on both sides of the Atlantic are causing investors to stay away from the market? There are always circumstances when investors desire to sell their securities. In the absence of securities buyers, the forced sales will generate lower prices; that in turn makes bystanders feel poorer, and therefore they reduce their spending for various goods and services.

The “Halo Effect”

Jason Zweig, in his weekend column in the WSJ, places halos on Steve Jobs and Warren Buffett, and then does a good job of reporting on the mistakes each has done without diminishing their overall record. Also, the Financial Times Saturday edition, in reporting on Mr. Buffett’s latest purchase of Bank of America preferred stock with warrants, notes a number of quotes whereby he acknowledges less than perfect foresight into financial services companies. (Disclosure: Berkshire Hathaway is a position in my private financial service fund as well as my personal account.) The halo effect is a constant worry to me in selecting mutual funds to invest for my institutional and high net worth clients. We all find it easier to invest with a successful investor than one who is currently not doing well. We gloss over the past mistakes of our heroes and focus on the mistakes of the current laggard. Mr. Buffet reminds us of his fallibility by maintaining his corporate name on a very bad operating investment he made.

As we are moving into particularly troubled financial, economic and political waters, we should be aware of the risks attached to the halo effect.

Am I Premature?

In a recent investment committee meeting with a number of well-known investment professionals, I was asked whether I was premature when I took contrary positions to the perceived knowledge. My respect for the questioner was such that I had to examine my past thinking on investments in order to answer thoughtfully. As often is the case with this individual, he was right. I tend to look at investments as an entrepreneur rather than as a trader. I look for structural imbalances and opportunities. Most of the time I would prefer to be early than late. Even though it was a favorite song of my late daughter's, when I was expressing frustration about change, I couldn’t relax to go along with her view of “Que Sera, Sera,” but she was a calmer person than me.

Reactions to any of these observations?

Note: We will be in London in late September visiting with investors and managers. Are there additional people we should see if appointments can be arranged?

To read last week’s Blog from Mike Lipper, click here.

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Sunday, August 21, 2011

Managing Against the “R” Word

For most of us who live and think in terms of markets, the “R” word is shorthand for risk, and about what we fear most: a permanent loss of capital. As market addicts, we have long ago cut the lock-step connection between the late developing economy, current market prices, and more to the point, our views as to future prices. As with many of our beliefs, we are challenged by inconvenient facts. Right now the “R” word that is most on our mind is recession (or worse).


Anyone experienced in life or history is very conscious that there are ups and downs in the course of human endeavor, chronicled from as early as the story of Joseph in the Bible. We have come to believe that the cycles are caused by the alternating opposites of excess and scarcity, which drive our behavior beyond reasonable limits. In terms of the stock market, the extremes are characterized by widespread speculation and distaste for accepting any chance of momentary loss.

The Three August Weeks

Only a hermit would not be conscious of the market price turmoil of securities and currencies these past three weeks. Declines of more than 20% are not uncommon. Currency moves of 5% have been experienced. These kinds of sharp declines are more normal after extended and widespread bouts of high speculation and extreme publicized behavior. In my opinion, this is not an appropriate description for 2011. Something else is happening.

What is scaring thoughtful people?

The inability of societies on both sides of the Atlantic to politically come to grips with their now recognized, unsustainable budget deficits is an important concern; for we like many of the “entitlements” we receive and don’t want to pay for them today. The fear of losing some of these in various cutbacks concerns the general population. What is more concerning, is the recognition that we will probably be fighting a two-front war with some to materially cut back government spending (which will not be selective in terms of our own proclivities), and which will thus lower demand. The fear is that less spending, combined with some form of higher tax realizations, will crunch ultimate demand for goods and services in our economies. Many are translating lower demand into a general recession. (At the moment, investors and people in general are not focusing on the money previously released by US government spending into the private and personal economy, which is likely to have a multiplier effect.)

Will we have a recession?

I do not know. If we do have one, as consumers we talked ourselves into it by reducing our normal purchases. People do this. They hoard their cash and capital in expectation that their incomes will be hurt in the future. While I have clearly said that I do not know whether we will have a recession, I am managing our clients’ portfolios against suffering a deep recession. Most recessions and bear markets come as a surprise to most people. Discussions of economic problems have been in the news for more than a year, so the possibility of budget and financial problems is not new. (Even if we were to have a recession, most of the time the US stock market bottoms before the recession is officially announced.) The only sector that I see with rampant speculation or unwarranted thinking is on the part of governments around the world.

What are the problems with the governments?

There are two problems governments on both sides of the Atlantic are suffering. The first is that all too often their estimates of the costs for various programs are too low and their expectations on tax realizations are too high. These breed fears on the part of those who have been asked to loan money to the governments. The second and much more basic problem is answering the question, “What is the proper function of government, as distinct from the political need to stay in power?” What is currently being ruminated is the series of issues involved with the second question.

What are the proper functions of governments?

In terms of the valuation of both debt and currency of various countries, the collective views of the marketplace are in the process of being heard. Historically the first function of a government was to arrange the protection of its people. The second was to create a code of behavior that permitted people to interact within their community with relatively little strife. Out of this second function, governments believed they were empowered “to do something” to “help” their people. Increasingly this “help” took the form of intervention into people’s lives to a ridiculous height. In modern days, the level of intervention has reached what some call the “Nanny State.” An extreme example is California’s proposed law that hotel beds must have fitted sheets. There are many other and better examples of government intervention into our lives. The new difference is that increasingly as a society, we are unwilling to fund these interventions.

How does this impact my portfolio of stocks and funds?

There are many ways to filter through the approximate 100,000 funds being offered around the world. (I am using a global figure, as an increasing number of this Blog community resides beyond the US.) One way that may be useful is to look at how much of the earnings power of the companies in stock portfolios are in a relatively high vs. low interventionist country. That approach was one of the reasons that in last week’s blog I stated that we were adding to our Asian exposure. There are four great examples of the many Asian countries who have relatively low debt and deficits compared with their gross national product. China is moving from a command economy where, on the surface, practically every economic act is governed by the party, to an increasingly consumer driven society. China is producing the highest growth rate of any other large country in most economic and financial aggregates. (This is not a recommendation to buy Chinese stocks wherever they are traded. I leave selection of individual securities up to professional analysts and portfolio managers who spend their lives on these matters.) India is another good example of a country haltingly moving from a command economy to a more private sector-driven one. One hears that India is slowly but finally overcoming corrupt practices. India’s growth rate lags China by a bit, but within a relatively few years India will be more heavily populated than China. Both Hong Kong and Singapore are much freer of intervention in economic activities than their two largest competitors, China and India, and their stocks are valued more highly, due in part, to greater disclosure and somewhat less intervention on the part of their market-oriented governments.

What should we do to our portfolios if a recession does hit us?

I have often said that one can recognize gamblers by whether they get out of bed in the morning. Not only am I a gambler (a balancer of returns and risks), I am an optimist, particularly when others are not. (Perhaps, I am saying the same thing twice.) If the markets continue to decline, I would be selling the fixed income holdings and adding judiciously to our diversified equity holdings.

What are you doing?


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Sunday, August 14, 2011

Lessons from Last Week:
Look to Europe and Go EAST

To lose money realized or unrealized is painful. To lose without learning useful lessons is tragic. Frank Holmes of US Global Investors quotes Baron Rothschild, writing, “The time to buy is when there’s blood in the streets, even if the blood is your own.”

My analysis of what happened last week was not a reaction to the appropriate, if not overdue, Standard & Poor’s downgrading of some US Treasury debt. (The focus of the downgrade was the political unwillingness to stop the growth of the federal government’s deficit, not an inability to pay.) What caused the decline, in my view, was the increasing recognition of the seriousness of the European fiscal, political, and therefore economic problems, and how they may and probably will, impact credit conditions globally.

The fear transmission line

One of the louder voices of concern was Mohamed El-Erian, the co-chief investment officer of PIMCO, probably the largest professional bond manager in the world, who wrote, “Any further mis-steps from American and European policymakers risk converting raging crises within the global economy to a more devastating crisis of the global system. That is how fragile the situation is, and why the world risks not just a recession but -- even more worrisome -- a prolonged one.” His fears are being heard by the American people. In a recent Marist Poll, 68% believe that the worst of the country’s economic conditions are yet to come. What was surprising, 57% of the Democrats agreed. Another poll (Thomson Reuters/University of Michigan) measuring consumer sentiment, reported a sharp drop from the month before to a level that had not been seen since May of 1980 (no misprint). Jeremy Grantham stated in a recent interview that Americans respond to a market signal better than almost anyone.

The historical perspective

Governments of all types have believed that they can only maintain power if their people are well fed. The best example of this management technique was the ancient Romans. Rome's government had to produce “bread and circuses.” To support these basic needs, wars were initiated to bring back marketable tribute, including slaves of both sexes. When the wars became defensive in nature, the costs of these adventures, particularly the military costs of defending borders, grew to a point that the tax burden was crippling the economic growth, which subsequently weakened defense spending and promoted corruption. Substitute the welfare or “nanny state” for “bread and circuses,” with the size of the deficit absorbing all of the gross national product, and you have a good description of Mediterranean Europe, and a fear for the US and the UK.

The role of the banks

In most civilizations, the governments control the banks or the banks control the government. In modern society, banks extend credit often to governments directly or to government favored activities, e.g., mortgages, car loans, commercial loans to faltering employers, etc. In the cases of those countries with well-known problems, the banks are full of domestic loans as well as other allied sovereign debts. The US market reacted to fears that the French banks were following in almost lock-step fashion behind the Irish and Spanish banks, with the Italians not far behind. These concerns on the part of both US investors as well as those beyond, has propped up the prices of US Treasuries regardless of the downgrade, which was not a surprise to anyone who reads financial reports. In just the last week, investors put $50 billion into money market funds, reversing the $49 billion outflow the week before.

What are the lessons for me?

When I look across the Atlantic to Europe, I see an aging population of workers not being replaced by younger people who want to work. In addition, there is an incredibly weak military structure and a population that does not want to declare income to pay taxes. On the other hand, as the surviving economists who have escaped from Lord Keynes’ grip will point out, across the Pacific (with the exception of aging Japan), the populations are younger, eager to work, and possess a healthy combination of savings and higher quality consumption. To me, last week crystallized the need for our clients’ accounts to increase exposure to Asia. We already had significant exposure through exporters in Germany, Chile, Brazil, Mexico, Canada and a number of US companies in our funds’ portfolios. These investments are not riskless due to economic and political cycles, but the secular investment trend is up.

What did you learn last week?


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Sunday, August 7, 2011

Judicial Temperament Required for Credit Ratings and Portfolio Management

In most professional military forces, important punishments are the result of judicial trials. In these cases, relatively senior officers are chosen to be the judges and when a jury is required, those seated need to have a representation of similar rank as the defendant. When I was in the US Marine Corps, one of my collateral duties when aboard ship was to serve as the legal officer. When there were military courts martial of significance, I had to participate in the selection of members of the jury. In selecting marines and sailors, I was required to be guided by choosing people with “judicial temperament.” This term describes an individual, who after reviewing all of the evidence presented, makes decisions based on the facts without any pre-conceived biases. These judgmental approaches to military jury selection are not shared with either the public or the press. If disclosed, these judicial screenings might spur a rush to judgment that could lead to an unpleasant set of reactions. This weekend after the Friday downgrade of the US Intermediate credit rating from AAA to AA+ by Standard & Poor’s, there were harsh and uninformed statements made in the press by various members of the government and their flacks, all lacking judicial temperament in my judgment.

The Recognition of the Downgrade

To put the action of S&P into perspective, I believe one should understand the function of a credit rating agency. (Important disclosure: we have a position in Moody’s in our financial services private fund.) The job of a credit rating agency is to express an opinion as to the odds on the failure of an issuer of timely payment of interest and repayment of principal. Since their establishment, the three main credit raters, S&P, Moody’s, and Fitch have done a remarkably good job adjusting their ratings to expected risks of default, with one glaring exception. The glaring exception was in the securitized packages of residential mortgages. (The mistake made was to treat these packages on the same risk rating scale as corporate and governmental issuers. Further, the short history of payment of interest and principal in a securitized form was not fully appreciated.) The credit rating process is to gather all the known facts about the issue to be evaluated, as well as the issuer itself; then a ratings setting committee of senior researchers evaluates the whole package as to the likelihood of default. The focus is on all of the evidence not just a sub-set. In assessing the risk of default, both the ability to pay and the willingness to pay should be considered.

The published thinking of S&P (which was discussed with the issuer, the Administration, since last April) was to take into consideration the political will to address the growing deficit. The raising of the debt limit was never a real issue, as the government had numerous ways, all painful, to avoid the immediate need to borrow more money. S&P’s view is that fiscal policy is married to political policy. The unwillingness to find a solution to the deficit issues, in the end led to lowering the credit rating. One should note that the AAA rating is like being number one on any ranking list. The history is that over time, most number ones lose their ranking.

As this is being written on Sunday we do not know what Moody’s and Fitch will do immediately, but both have made statements of concern recently. Their methodologies are similar, but not identical to S&P's. At the moment we have a split rating which at least temporarily gives a combination of AAA/AA+. Many in the traditional fixed income world give Moody’s a slight preference, as the older and perhaps sounder agency. Thus, it will be significant when and how it issues a new opinion. At the moment the focus is only on the intermediate debt, as the belief is that both the short term and the long term debt remains with the highest ratings.

While I believe that the AAA credit rating should have been removed years ago because of perennially unbalanced budgets stretching back to the 1930s, there is ample evidence that all of the recognized credit raters are currently exhibiting sound judicial temperaments.

The Fast Reactors

People believe that securities prices move on the latest incremental bit of information. That is why many analysts and the electronic media are very quick to report any and all incremental bits. To emphasize the importance of the increments, often they proclaim that various securities should be immediately bought or sold to move ahead of those investors whose information is not as current, or those who move more slowly. The prize goes to the first movers. Most often there is not a review of all the relevant facts and so there is a lack of judicial temperament being offered.

The Prudent Long Term Portfolio Manager

As fiduciaries entrusted with quasi-permanent funds, we need to balance the current changing environment with the long term needs as to the disposition of the assets that are our responsibility. We need to weigh carefully the likely impact of the news along with the costs of changing positions in terms of meeting our clients' long term goals. I have believed that the US Government and many other governments have been debasing not only their currency, but more importantly their societies, ever since they have undertaken “to do something” about employment. Thus the recognition of the initial downgrade does provide some comfort that the basic laws of economics do work eventually. As most currencies have been debased through years of inflation from unbalanced budgets, and there is only a limited amount of gold available, I would be surprised to see a major shift near term in the disposition of large portfolios. In the longer term I suspect we will put our faith in commercial companies producing reliable earnings to be our principal store of value.

What do you think?


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