Sunday, August 19, 2012

When the Stock Market Sleeps - I Get Nervous

Not only have the popular US stock market averages been flat for a period of twelve years, the recorded volume this summer has been scant. The so-called fear index, the VIX measure, is producing returns significantly below averages. 

In another sign of lack of concern, the decision was made at a recent investment committee I attended that a specific inflation defensive fund was not needed. (If you believe the US government’s statistics, the latest available all items count would be a minus -0.16% for the month of May and a core rate of 0.01%).

Somewhat more ominously there was praise for our committee’s market index fund selection, with the question as to why we should pay the high fees for hedge funds that are not producing better-than-market results. In another investment committee meeting it was suggested that many institutions are buying hedge funds directly and redeeming funds of hedge funds. (If the latter approach gains momentum it can hurt the expansion plans for the number two profit contributor to Legg Mason, a holding in our private financial services fund.)

What makes me nervous is that there are lots of facts and opinions that are crying out for significant changes in portfolios.

Start with the negatives

A recent piece by Moody’s* chief economist, John Lonski entitled “Global Slowdown Menaces Ratings,” focused on the recent plurality of downgrades as opposed to upgrades both for High Yield and Investment Grade bonds. As reported in my previous blogs, the appetite for yield at the moment appears to be insatiable. In the current quarter there have been 43 downgrades and 20 upgrades of high yields, and a 13 to 3 ratio for investment grade paper. Remember that one of the criticisms of the credit rating agencies (for understandable reasons) is that their findings are late relative to the market. The sellers and buyers of bond funds, particularly of high yields, do not appear to be following the changes in ratings. As an equity analyst I have been trained to think that the bond market senses trends before the stock market. The ultimate payoff with bonds is the return of principal with interest, as distinct from the equity market’s hope of future capital appreciation.
*Moody’s is another holding in my private financial services fund.

In one of John Mauldin’s well-written weekly letters he suggests that we may be approaching a Minsky moment. Hyman Minsky, a well-known European economist stated that stability leads to instability. After a period where the normal is flat, there will be a violent change. The key to this thinking is that something will dramatically change people’s views as to when the current supply and demand mix will abruptly change, which is easy to believe in our 24 hour news cycle world.   

In another letter John Mauldin mentions that the real problem for the euro long-term is France, which I have felt to be the case even before the last unfortunate election

One of the advantages to investors of the flat performance of the VIX futures, particularly if we do experience a Minsky moment, is that hopefully both the academics and the marketers will stop using volatility as a measure of risk. To me, risk is the inability to meet future payment goals for an investment or portfolio, not whether the return is calm or fluctuates. This belief can be a problem for the sleep patterns of trustees.

The positives that no one believes

If you ask most people about the progress of the market in 2012, they will say they don’t believe that we are up low double digit returns by mid-August. These returns would more than fulfill the annual requirements of most institutional funds; as a matter of fact the returns are close to double the needed returns for the more sensible institutions.

Richard Bernstein, now independent from a career at Merrill Lynch suggests that Bull Markets begin out of a malaise of fear. Investors are fearful of facing an unpopular election in the US as well other unpopular and unknown changes in governments for over half of the world’s GDP. In addition, the so-called “fiscal cliff” comes due to challenge the US at the end of 2012.

There are no apparent signs of valuations which are historically too high. (I would suggest that the excesses are in the bond market where the manipulating central banks are depressing interest rates. As we know, eventually even the manipulators run out of money.)

One of the more bullish pieces that I have read is by Seth Masters of Alliance Bernstein. In his view of a normal market expansion he sees a Dow Jones Industrial Average of 20,000 in five years. Even on a lower multiple basis, Masters predicts the market will reach this level in ten years. What is significant about this piece is first that it is coming out now in a period of malaise, second it is not from a promoter, or a Dow at 38,000 proponent,  etc., and third, if true a move from here to a 20,000 DJIA would fulfill lots of investment requirements. (As long as inflation remains tame.)

Perhaps the single most bullish piece that came out this weekend was the disclosure of the portfolios of Paul Ryan and his wife Janna. I do not know who selected the list of well-known and generally sound mutual funds. What is significant to me is that the potential “second family” of the US has been well advised and has a spread of funds that are appropriate for the current world. If Mr. Ryan becomes the Vice President or stays as chair of the House Budget Committee, we will have someone in a high place that has a sound outlook for his and hopefully the country’s investments.

Sleep well, but not too well.

 In last week’s blog I mentioned a recent study of one account that we manage and said that there was not a single decline in 2012 through July, in the list of 47 funds. The actual number was 37. My apologies for the error. 

Second, for an unexplained reason some of our email readers received a version with the initial letters of some words doubled. If that happens again please let me know and we will send out a corrected copy. 

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