Sunday, October 28, 2012

Unpopular, Unconventional, Painful and Disruptive

Unpopular, Unconventional, Painful and Disruptive is not the name of the new hot law firm. The title is a summation of some of my "out of the box" thinking flying home from a too-brief visit to an offsite board meeting of the California Institute of Technology and a visit to PIMCO, the world's largest bond manager.

"The New Normal"

One of the reasons bond managers think in terms of secular trends is that at times they invest, rather than trade, bonds with long maturities. While those who buy stocks should be thinking in terms of long to infinite time periods, many of them focus on much shorter periods; e.g., quarters, twelve months, five or ten years - certainly not thirty years. That is why understanding bond managers is important to equity investors.

In meetings held by senior PIMCO investment people with a group of Caltech trustees, PIMCO focused on an expected period of prolonged very low interest rates. They also shared their opinion that the various stimulus moves by leading central banks and governments will not lead to effective de-leveraging. I got the distinct impression that these moves would prolong the valley of low employment and a decline in the developed world's standard of living, while many of the emerging countries enjoy rising standards of living. A further examination for the sluggish response to the various government actions reveals that in the US, 71% of GDP comes from consumer spending with 47% of that total spent on services and only 24% on goods. As services are time perishable, the old pump-priming techniques of the 1930s don't work as well.


If the present generalized approach is only going to prolong the problems, why not stop banging our heads against the stone wall and let the natural correction forces operate? In other words, let rapid de-leveraging happen through a normal bankruptcy cycle. During bankruptcies, various contracts can be abrogated. I would carry the process further by removing various constraints and restrictions in government policies that are no longer valid. What should come out of a bankruptcy is a new beginning with an enthusiastic attitude. Unfortunately, only 42% of the American public believes that hard work leads to success as indicated in a recent Wall Street Journal article. This attitude must change.

The whole idea of re-thinking past dictates of government is accelerating. I recently attended a conference organized by the Museum of American Finance at the New York Stock Exchange. The focus of the conference was how to restore individual investors' confidence in the equity market. For some time I have maintained that the regulatory pressure to lower transaction costs is a significant contributor to the problem. When commissions and spreads were large, retail salespeople sold stocks and provided other investment services to the public. As their remuneration rapidly diminished, salespeople gravitated to higher commission products such as hedge funds and structured securities. The chair of the NYSE recognized that the switch from quoting prices in fractions to decimals, including sub-pennies, has reduced the attractiveness of selling stocks as a business. I find it interesting that there are news accounts that the SEC is considering a test of a return to the use of fractions. If the SEC can see itself reversing some of its past policies, there may be hope that other government bodies can re-examine their past actions to become more pro growth.

One of the most rigid congregations in the world is the scientific community. Scientists regularly make pronouncements of various laws and theories. This weekend my wife Ruth and I listened to leaders that supervised the work at JPL (Jet Propulsion Laboratory, an affiliate of Caltech) of the Mars landing of  "Curiosity." Each manager described some of the various scientific beliefs and budget constraints to carry out the mission. This remarkable success is viewed around the world not just as a success of Caltech/JPL or of the US, but of mankind as part of its conquest of knowledge beyond our earth. I hope this achievement and the continuing reports back from Curiosity will lead to a greater understanding of what we are capable of doing with our collected talents. We can achieve growth by re-thinking our various constraints.

Investment implications

The markets ahead can be painful either on a prolonged basis with current government policies or more painful but of shorter duration if we allow normal "animal instincts" to operate. In terms of investment policies, in most cases I would not want to own government bonds. I believe the risk premium will rise and stocks will do better than bonds in general. In terms of stock selections, I favor disruptive companies that can take advantage of significant structural changes in our various market places.

What disruptive securities do you own?
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