Sunday, December 30, 2012

Too Much Gloom and Too Many Opportunities

There are two relatively standard question clich├ęs about travel experience, “Are we there yet?” And, “are we rearranging the deck chairs on the Titanic?” As this post is being composed on Sunday afternoon, the 30th of December, we don’t know whether we are ‘there’ (a solution to the fiscal cliff) yet. We don’t know whether the political leaders in the US Senate can come to an agreement that the President and the majority of the members of both Houses of Congress can agree on prior to Tuesday. There is little reason not to be gloomy as to the result.  The gloom is not on the chances of an agreement, but rather on the probability that whatever agreement is made will not address the problem.

The problem is that the solution did not begin with the originator and popularizer of the term “fiscal cliff.” The Chairman of the Federal Reserve, a professor of economics from Princeton, was warning that monetary policy as controlled by him could not solve the shortage of domestic demand and that fiscal policies had to address the problem. His plea to the politicians was correct according to Stephen Roach’s latest letter, in the sense that experimental monetary policy has not worked in the US, Europe, or Japan. As I discussed in last week’s post, our economic problem is that we are suffering from a cyclical binge of too much debt combined with a multi-generational deficit.

The second question as to the rearrangement of the deck chairs on the Titanic actually may well be focused on a much bigger fundamental question. Often the deck chairs on the open decks of a cruise ship are assigned to various price classes for the voyage; the higher price tickets get the better seats, etc. In earlier days, epitomized by the Titanic, the crew and the management of the cruise line were more concerned about proper deck chair configurations than the absent life boat drills; actually there were too few life boats for the passengers and crew.

The current Presidents of the US and France want to redistribute the wealth among the passengers, akin to moving the chairs on the Titanic rather than paying attention to the life-saving needs for life boats and safety drills. Also like the Captain of the Titanic, the Presidents are not focusing on where they are going and having the best available communication equipment and personnel on board. History will determine whether the parallel is appropriate.

Staying with the ill-fated travel of the Titanic, one should point out that other ships made the crossing that night without running into an iceberg. Cruise ships have provided safe and pleasant travel to many thousands since then. The telling point is that with the correct management one can avoid some major, predictable crises. The key to that belief is the word predictable. One of my favorite Wall Street Journal columnists is Carl Bialik who writes interestingly and perceptively about statistics. In his latest column he writes about some of the pet peeves of professional statisticians. The first of Bialik's two pet peeves is that in too many cases, in the popular press and mindset, a single number is predicted without an accompanying statement as to the margin of error. The principal owner of the Titanic, his navigator, and single radio operator did not recognize a margin for error in their actions. Perhaps even more perceptively, Mr. Bialik mentions his second peeve, that the absence of evidence is not the same as the evidence of absence. (Those of us who live in New Jersey were victims of this misunderstanding when NJ Transit did not move its rolling stock to higher ground when the super-storm Sandy was approaching, for their preferred locations had never flooded. Because something hasn’t happened, doesn’t mean it can’t. The damage to the railcars will take hundreds of millions of dollars to repair and will interfere with commuter travel for many months.)

Many opportunities

I get out of bed in the morning, therefore I am an optimist. I believe that there are many opportunities offered to us every single day. Because of our own preoccupations, particularly about today’s problems, we don’t see the opportunities. In preparing for this blog, I saw information on three such opportunities.

Opportunity #1:  The growing middle class

The President of the US and his political cohorts are focusing on protecting middle class Americans from paying their share of the accumulated deficit. What he should be focused on is that there are already 500 million middle class Asians and it is expected by some to be over one billion middle class Asians in the foreseeable future, as mentioned by Kishore Mahbubani in the Financial Times. This is a  market that is currently crying out for the perceived quality of western brands. The US middle class can earn its way out of its share of the deep fiscal hole it is in by focusing on products/services marketed to this growing segment. Most of our investment portfolios recognize this opportunity by investing in multinationals and indigenous companies through selected mutual fund portfolios.

Opportunity # 2:  Net cash generation

Chip Dickson's daily letter from his firm Discern focused on US (registered) non-financial corporations that are in the longest period of sustained excess cash generation in history. I suspect that companies all over the world are awaiting similar investment opportunities. Most of the US corporate spare cash is being kept where it was earned, overseas. Often commentators blame the uncertainty of tax rates for the unwillingness to spend cash. This is not completely true. In the US, we have had changes in taxes about every two years. The retarding issue is that there is a lack of vibrant demand in the US. In the 19 quarters since the beginning of 2008, again quoting Stephen Roach, consumer spending adjusted for inflation, has been growing 0.7% per year, compared to a more normal 2-3% in the recent past, and over 4% in our halcyon days. Some of this decline is due to deleveraging by consumers, particularly in housing. These people are scared about their future and I suspect they sense the current anti-capital mood emanating from the Beltway. As shown by online buying, they want to spend wisely. The opportunity comes when they feel more confident and start spending. At that point, so will the corporations of the world.

Opportunity #3:  Technology helps

Exxon periodically produces an incisive look at the future for energy many years out. Not surprisingly, it sees growth in the demand for all elements of energy consumption and therefore production. Most of the growth relates back to the first opportunity listed (the growing middle class in Asia), but also in Latin America and Africa. What I found of interest is that this substantial growth will only be partially offset by an increase in energy efficiency. Exxon fully expects that improved technology will help produce, transmit and consume energy. This is another testimonial to the likelihood of growth in demand for technology. My guess is that in an aggregate sense, spending on technology will grow at close to double the rate of growth in the overall global economy. This growth rate is not fully discounted in many technology stock prices.

How are you going to handle the fiscal cliff, or more properly the fiscal slide or slope? Please share your thoughts.  

In last week’s post I compared the ratio of various nations’ debts to GDP.  Further in the paragraph, I referred to “Europe’s deficit as a unit.” I should have written “Europe’s debt as a unit.”

Ruth and I wish a happy, healthy and prosperous New Year to all members of this blog community.
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Copyright © 2008 - 2012   A. Michael Lipper, C.F.A.  All Rights Reserved.


Sunday, December 23, 2012

Four Investment Quandaries for 2013+

·       Debt, a four letter word
·       Killing off the Individual Equities Investor
·       Asset Allocation: Correlations?
·       Learn from today’s investors

Investment analysis is like a narcotic or a very difficulty habit to kick.  At the beginning of the week, I may not have an idea about what I will post the following Sunday night.  Though I am exposed to a myriad of communications, in many ways the most valuable inputs are the conversations I have with investors and investment professionals.  This week I will focus on four suggestive thoughts, or quandaries for 2013.

The worst four letter word

Growing up I was told that it wasn’t nice to use certain four letter words like F*@k or S*#t. What my Mother never told me was the worst four letter word of all; a word that has bedeviled mankind for centuries. That great economist William Shakespeare put the following words into Polonius’s mouth, giving guidance to his son Laertes, “Neither a borrower nor a lender be.” The four letter word is debt.

There are three essential problems with debt. The first is that it must be paid back, often at inconvenient times. The second is the additional payment of interest, which can be either fixed at the time of the loan or flexible, but each is based on the assumption that the rate is high enough to pay the lender to forgo spending and has a sufficient risk premium that is an accurate gauge of the odds on getting repaid in full and on time. The issue here is what appears to be the appropriate lending rate at the beginning of the period may not be the right rate at the end of the period when conditions have changed. The third problem is collateral that in theory guarantees to the lender that he will get his money back in full and on time. Securities can often provide the margin for a loan. Of course, if the securities go down in price the value of the collateral may become less than the size of the loan. Some upstanding people, companies, and nations have been able to borrow based on their good names. J.P. Morgan is reported to have said that he loaned money on the basis of a man’s character. There is a problem with this as fittingly portrayed by Shakespeare again, in “The Merchant of Venice,” in the legally sanctioned, but inhumane attempt to collect on the collateral on a defaulted loan.

The main purpose of debt is time-shifting. The borrowers want an asset that at present they cannot pay for, and the lenders are willing to delay their own spending if they get paid for this indulgence. Unfortunately what has become the custom is that new debt is raised to pay off expiring debt. The question facing both the borrowers and the lenders is what is the optimum level of debt that can be added on top of a given level of assets? This is called debt capacity. It is usually calculated on the basis of assets and/or income that are not encumbered by other debt. What is usually done for nations is to compare their outstanding debt, most often without concern for future debts, to the their Gross Domestic Product or GDP. This number is the estimated annual generation of goods and services within the country. (Two weeks ago, I blogged on the approach of looking to a more complete analysis of both the assets and liabilities for the US.) Nevertheless I will stay with the convention of looking at a nation’s debts as a ratio of its GDP. Europe’s deficit as a unit is now 131% of its GDP. China has a 120% ratio, all of Asia excluding Japan is 104%. (Hong Kong 275%, Singapore 137%, Malaysia 117%, Indonesia 33%) These reported ratios include personal and corporate debt as well as sovereign debt. Thus globally there is too much debt. 
In the US, as is often the case, the private segments of the economy are moving differently than the government sector. The private sector is deleveraging its debt structure whereas the federal government is adding to its debt by issuing bonds that are largely being purchased by the Federal Reserve System to neutralize their impact on the level of interest rates. The combination of the private sector deleveraging and the Fed’s increased borrowings leaves the US debt level, according to one source, at 62% of the GDP which is down slightly from prior readings. 
Translating the economic figures into the bond market, the following three facts are of interest:
1.    Some Investment Grade (corporate) debt is yielding less than some sovereign debt. This would indicate that the market believes that corporates are safer than some nations. One possible reason for this is that Europe, with 7% of the global population,  spends 50% of global social spending.
2.    The yield on the S&P 500 is higher than an index of BAA bonds. Again, the market is suggesting that lower investment grade credits are safer than dividends on the S&P 500 stocks. At the same time this represents an unusual opportunity to view large cap stocks as a more productive source of current income than investment grade bonds.
3.    We may not be out of the sub-prime mortgage mess. The Federal Housing Administration (FHA), is by far the largest guarantor of conventional mortgages. Not only does it already in effect own a number of defaulted mortgages, but there is pressure from Congress and the Administration for the FHA to loosen its underwriting standards. Only a significant recovery in house price and possible individual incomes will bail out the taxpayer liability.

“Who killed Cock Robin”

The somewhat shotgun wedding of the New York Stock Exchange and IntercontinentalExchange (ICE) publicly demonstrates the fact that while derivative trading particularly not based on stocks is very profitable for an exchange (and therefore broker/dealers), trading in individual stocks is not. As an analyst and owner of brokerage firm stocks, for some time I have taken the position that listed equity agency business for brokerage firms is not profitable. Try to get a brokerage account opened to buy 100 shares a quarter of General Motors. What you will quickly find in a broker (if one will talk to you at all), he or she will attempt to sell to you some complex structured product or a high fee fund or possibly introduce you to using a margin account (interest bearing and securities loan revenues). This reaction by the peddlers of our business has been successful in discouraging individual investors from buying and holding individual stocks. Thus, the title to this section, “Who killed Cock Robin” is an English nursery rhyme, but the real killer of interest on the part of individual stocks is the regulatory agencies, particularly the US Securities and Exchange Commission (SEC). In 1968 the Commission forced the beginning of the end of fixed-rate brokerage commissions, which were totally replaced in 1975. Prior to those dates there was a vibrant and useful retail research and individual sales business by brokerage firms. Institutions received tons of reasonably high-quality research and other services from “Wall Street.” Continuing this trend of not understanding the impacts of its actions, the SEC permitted multiple locations where a trade could take place which denuded the central marketplace’s liquidity. Carrying this approach further, the substitutions of penny decimals for fractional prices made professional traders withdraw their capital from the marketplace. The way all markets work is that there has to be a perceived profit potential for the professional participants to play. Without the professionals in the game the market will shrink in size and its use as an important economic indicator will be vastly reduced.

I do not mean to be negative on the announced deal, because the holders of my private financial services fund and I benefited. Our holding in NASDAQ OMX rose 3% on the day of the announcement. My guess, the thinking is that NASDAQ itself may be in a merger situation or that the change in control of the NYSE means that it will be a less fierce competitor for new listings and daily trading. While this may benefit my fellow investors and me, it won’t do anything positive for the individual investor and could hurt.

Is asset allocation really about correlation?

At this time of year, institutional investment committees have meetings to decide on the appropriate mix of assets for their portfolio responsibilities. Historically this was a decision made for them in that the initial funds in both the US and UK were balanced funds with a reasonably fixed percentage in bonds and stocks. Balanced Funds and their modernized versions are still an important part of the mutual fund business. The whole excitement about asset allocation was generated by a flawed study of corporate pension funds that showed that funds with a higher percentage in equities did better. For the most part there were only two asset class accounts, bonds and stocks. Later on other classes were added in terms of venture capital, private equity, international securities, commodities, gold, timber and various forms of real estate. Then 2008 came along, with the exception of US Treasury Bonds all the other asset classes declined and often in roughly the same percentage declines.

My approach to this question is first to have an opinion as to how closely the correlations of the asset classes will be over time. Using US mutual fund investment objective averages over ten or more years, most fall within 100-200 basis points in terms of annual returns which suggests to me that on a long term basis it is difficult to pick winning asset classes.

Jason Zwieg’s latest piece in the Wall Street Journal on a young 107 year-young investor and manager, Irving Kahn, takes a different point of view. At his age he is invested approximately 50% in well-researched global small caps and the rest in cash. I have worked with Irving for many years on analyst society activities. He and his late wife Ruth were on an analyst trip with my wife Ruth and me in Italy more than 25 years ago. They both set a blistering pace which was a challenge for us younger types to keep up. Out of all of these experiences, I have developed a real respect for his acumen; besides he is one of the very few people alive that remembers my grandfather’s Wall Street firm. If the committees have Irving’s research skills, I would approve of their allocation if not some other forward looking approach was warranted. We should be watching and listening.

Learn from today’s investors
Most individuals do not have CFA certificates or have logged more than 50 years as an investor, but we can learn from what they are doing as shown in the following examples:

1.    As already indicated, on a personal level they are paying off their debts. If one disregards student loans, consumer debts are declining. Savings as calculated by the government is rising a bit. Individuals are slowly, but I believe surely are going through their own austerity program particularly in terms of being more astute shoppers.
2.    While retirement flows are continuing to benefit from 401(k) and similar salary savings plans, the purchase of mutual funds for individual retirement accounts through directly marketed mutual funds is well off  peak gross sales. This may be in response to investors' own actual or feared employment picture. Possibly they are using what would have gone into their IRAs to reduce their debts or to improve their homes for a future sale.
3.    The most intriguing demographic trend of all is that there is a substantial increase in the number of singles. In many cases these are, according to Gary D. Halbert, white women who have made the decisions at least temporarily to forgo Children and Marriage.

The young appear to be worried about their future and they should be. Our debt burden and less than wise investing will make their lives more difficult. However, after worrying in American fashion, they will find innovative ways to improve their condition. This is one of the major differences between Americans and Europeans.

You can’t agree with everything I have said.  Please discuss your thoughts with me by reply email.

I hope on Tuesday you can relax with family and friends, not worry about these quandaries and that the rest of the week won’t be too eventful.
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Sunday, December 16, 2012

Three Bullish Presents for Investors

This is the holiday season of giving presents. I have three ideas as presents for long-term, fiduciary oriented investors. These ideas are both presents for those who may need them as well as thoughts that should have presence in an investor’s mind while looking into the future.

1.       Waiting for the big drop

At a recent dinner with a knowledgeable member of a charity’s investment committee, he indicated that he was out of equities for his personal account which is to fund his living expenses for the next twenty years. Yet he was perfectly comfortable with our use of equity funds for the charity. In terms of estimating future returns, I believe my actuarial friends will see little difference in a twenty year and a theoretical perpetual return for the charity. While I recognize and expect the past price patterns to continue, this suggests that in any ten year period, there will be three 25% declines from peak levels. Further, once a generation there is likely to be a drop of 50%. Having experienced these in the over fifty years I have been an investor as well as serving other investors, I know very few market participants that totally side-stepped these declines. I have found it to be more difficult to accurately guess how big a drop will occur once a decline is underway. I have looked over my notes and recollections of my judgments at or near past bottoms. In every case I convinced myself that a deeper bottom was required to bring the market to a bargain basement level. There were always lower estimates of earnings, unfounded rumors of firms, institutions, or well-known individuals that were in dire straits which would become known soon. As difficult as it is timing a bottom price, the decision to buy early on the way up is even more difficult. Because at the time of the sharp decline there was no market-clearing event which would signify the end of the bear market, most lacked sufficient courage to be an early participant on the rise. Often this rise was described contemporarily as a rise in a bear market caused by successful short covering, not the beginning of a new bull market, or at least a sustained stock market rise.

While some may have all the skills of identifying a major decline in advance, recognizing a bottom, and being an early participant in the recovery rally, along with most other professional investors, I do not have these capabilities.  As with many extreme sports, and other dangerous pursuits, I choose not to engage in market timing strategies.

Perhaps more importantly, there are a number of positive features I see on the investment horizon which can be summarized as follows:

A)      The largest gains come from investing into opportunities when others retreat from challenges.

B)      A careful listening to the press conference given by the Federal Reserve Chairman will reveal his view that the monetary policies being followed have not lowered unemployment (and underemployment by those seeking full time work or discouraged workers). I would suggest other countries’ quantitative easing also has not produced significantly positive results. I believe that market and credit rating declines will eventually curtail the need to sell more government bonds to the central and commercial banks. As usual the private sectors, including individuals, are ahead of the government sectors. While governments are issuing more bonds, the private sectors are deleveraging. In the future we may see the private sectors expanding while the government sectors begin to contract. One of the lessons for an equity investor is to look to the bond market for clues to the future.  Each week Barron’s publishes a confidence indicator that measures the ratio between the yields of mid-quality bonds versus high-quality bonds. The index normally moves 1% or less in a week. When the index goes up, which means mid-quality bonds are going up, it is bullish for stocks. In the last week the indicator rose by +1.4%. Bottom line: I would be leaving cash for equity.

2.       Economic bears like stocks

As is often the case, Jason Zweig in his Wall Street Journal columns, reports on thoughtful pieces he has read. This week he reviewed the opinions of two astute thinkers on the economy who see that the US progress will labor to grow at half our historical rate since the Civil War. Nevertheless, both are investing in high quality US stocks. One of them, Jeremy Grantham of GMO believes that such a portfolio will grow for the next seven to ten years at an annual rate of 5% plus inflation. This is a very satisfactory rate as it exceeds many institutional and endowment minimum spending rates. Many conservatively managed pension funds will be able to meet their needs with such returns.

3.       The biggest potential present from Singapore

One of the investment managers that we use for our accounts is Matthews Asia. As one would expect, they are long-term bullish on Asia. In their well-reasoned November Asia Insight letter, entitled “Emerging Asia’s Rising Productivity,” they focus on the smart way to use labor rather than the initial low wages, which are now rising. Part of the reason for the rising labor productivity is the attitudes of the local governments. The Singapore Department of Manpower has a vision statement which states the department “embodies the aspirations of lifelong learning and the need of Singaporeans to adapt, learn and re-learn skills, attitudes and competencies for lifelong competitiveness.”  Now compare this view to that of the US Department of Labor’s mission statement: “To foster, promote and develop the welfare of the wage earners, job seekers, and retirees of the United States; improve working conditions; advance opportunities for profitable employment; and assure work-related benefits and rights. While we can understand the historical political development of each institution, the US Department of Labor raises lots of hurdles to generating high productivity in the US labor force. Indonesia, which has a population that is much larger than Singapore’s, has a similarly charged Department of Manpower. Some of the US Department of Labor activities are good for labor (and in the long-term, capital), but many are anti-competitive. Maybe we will make some future progress by following the emerging market leaders as we recede.

Investment Implications
·        Don’t attempt to time the market.
·        For the long-term, equities are better than cash.
·        Some of the emerging markets understand how to produce long-term value and selectively belong in many portfolios.

Please share your views.   
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