Sunday, December 2, 2012

For Political Types, Traders, and Investors

Recently, the US markets have been headline-driven, focusing only on the so-called fiscal cliff. This fixation is unfortunate, as there are many other (and in the end, more important) issues to focus on than the dances in Washington, D.C. Nevertheless, it is an important subject and I wish to share my ruminations with you.

For political types

The real and present danger is not going over the proverbial cliff.  My fear is “the sausage.” That is how the process of passing pieces of legislation has been described; stuffing together different points of view without any overall or in-depth understanding of what the new law actually dictates. When the current ruling party had control of the White House and effective control of the two houses of Congress, they gave us two classic examples of this phenomenon.  Both the Affordable Care Act (Obamacare) and the Dodd-Frank bill are structurally very important pieces of legislation that are so long, complex, and poorly drafted that to this day the American public does not understand how they work and what implications they have upon the rest of our lives. In the month before we in theory go over the fiscal cliff, and become a victim of the Budget Control Act or “sequester” of mandated overall tax and expenditure dictates, there does not appear to be the will or perhaps the ability to make major progress as to our habitual deficit production. Some believe that there will be a last minute compromise on enough items to get an agreement to “kick the can down the road,” delaying enactment of any meaningful reforms. Based on past legislative history, my deep concern is another omnibus “solution,” written largely by aides and lobbyists that few if any fully understand.  

The fundamental issues facing the dancers in Washington are very deep and are similar to those facing most nations with democratically elected governments. For a number of generations we have been spending too much of our personal money and permitting governments to spend too much of our money. With the example of Greece and possibly France before us, America now needs to begin a very long process of getting out of debt to one another. Without an immediate behavior modification we will bring the sword of Damocles down on our grandchildren. Our personal sufferings should be shared with our children so that their children can better control their lives with the resources required to build a sustainable future. The willingness of politicians to attempt to put their opposition, to use a wrestling term, on their hip in order to bring them down, is very understandable, however lamentable in the face of these multiple generation challenges.

One of the jobs of a good analyst, be it a securities analyst, a political analyst, or a budget analyst, is to think through the so called impossible thoughts. To some extent the fear of going over the fiscal cliff is media made with help from the lead currency manipulator at the Fed. Only very few have examined what would happen if we subject ourselves to “sequester.” Often one can get a different and at times better perspective in listening to those overseas. From its London base, Marathon Asset Management (an institutional manager with large US holdings and a prestigious book of US endowment clients) and Brendon Brown, an economist with Mitsubishi UFG International believe that if we went over the cliff it would lead within a year to an expanding US economy. Nassim Taleb, the author of the famous book “Black Swan,” has similar views. Interestingly enough, even the Congressional Budget Office (CBO) has stated that if we go over the cliff that unemployment would rise from the present 7.9% to an unhappy but not devastating 9.1%. (What the CBO does not say is how many of these newly unemployed would be ex-government workers.) But further along in the CBO’s analysis of the post-cliff period, it claimed “short-term pain would be followed by long-term gain.”  What the people in Washington are neglecting to ponder is the multiplier impact of returning to the private sector the capital that is being absorbed by the deficit-producing government.

Thus, I am more concerned about a poorly crafted set of compromises than a reallocation of the country’s resources. I am looking at this problem not only as an analyst, but also as a human, mindful of the pain any major adjustment will entail for many rather than a few.

For traders

There are many microscopes one can use in examining market actions. Because of my background as a global mutual fund analyst, I pay particular attention to the flows into and out of mutual funds and their kissing cousins, exchange traded funds (ETFs). To my way of thinking the latter are much more important now from a trading perspective and mutual funds remain very important to longer-term investing. Though there is some interest on the part of retail investors in ETFs, there is much more interest on the part of institutional investors. My usage of the term institutional investor includes the traditional definition but also hedge funds, commodity trading accounts and some retail relationships that are part of “wrap accounts” with either an internal manager of the brokerage house or an external one that is making the decisions. Performance measurement is important for all of these investors. I believe this is one of the reasons that we are seeing something of management fee war among the major providers of ETFs. I view ETF flows to be a pulse rate for the short-term focus of the enlarged institutional community. That is why I found the flows in October vs. September of interest. In October, net new issuance of ETFs was $ 1.9 billion compared to the month before when there was issuance of $ 37.7 billion or a drop of 95%. The sharp contraction of sales is understandable as the total net assets of equity related ETFs declined by $17.4 billion on a month-end base of $1.03 trillion. Most of this decline was in the domestic broadly based category ($18.6 billion and $5.4 billion in the sector/industry category). Global/international and fixed income assets rose. Perhaps more significant is the short position in various ETFs of the 13 largest short positions on stocks traded on the New York Stock Exchange (NYSE); 4 were ETFs and 2 were in the largest 7 names. A lot of the ETFs are narrowly focused and 6 of them have more shares sold short than the size of their capitalization. Clearly these are trading vehicles most of the time used as part of a complex strategy.

Harking back to my recent post on our annual walk through a glitzy shopping mall, I commented on the lack of shopping frenzy and lower price points on merchandise at Tiffany. One of the fears in making a specific investment in a stock like Tiffany is that to some degree it is at the mercy of the general economy. One way to protect against the general economy/general market would be to be to short a broadly based ETF index like the Vanguard 500. Unfortunately, Tiffany had other problems with rising silver prices and shrinking gross margins which were revealed this week. I suspect that while the theoretical hedger made some money on the short of the ETF, it was less than the loss for the week in Tiffany shares.  

For the long-term investor

As a member of three investment committees of various sized institutional endowments, I try to avoid following the news accounts of what endowments, particularly large ones, are doing with their investments. First, like the classic picture of a small investor, institutions often follow a herd instinct and could be accused of being wrong at turning points. To be fair, news articles about endowment flows tend to be quite dated and may not represent current prices and conditions. Second, to understand why an endowment makes major decisions it is important not only to know about its spending policies, but also about the overall organization’s financial conditions and future obligations. Third, almost all investment committees are made up of people who are primarily focused on giving the money away and another group who are focused on building the capital base for future and perhaps unspecified needs. Thus the actions of the committee will be a compromise. With these thoughts in mind, I would not be rushing into private equity, unless one thought there would be a sharp increase in smaller merger & acquisition activities and an increased appetite for initial public offerings (IPOs). I would also be careful about quantitatively driven funds primarily investing in the difference between the short-term performance differentials of published indexes.

What would I be looking for as equity investments? In the long run it is believed that there will be 2 billion more people on this earth in 35 years. In order to feed them we will need to produce 70% more food than we are doing now. I believe that this increased production will come from capital and technological resources and probably less from human labor. At some point in the far future more food from the sea and perhaps other planets will play a role.

Back on earth and much more immediate, I would be looking for disruptive companies that are changing the cost, supply and demand curves in our world. These may be tech start-ups or more likely companies that use technology in a different way to create dynamic change. An example of this is the impact of mobile phones in the deeply emerging markets that are radically changing cultures. Most of these investments won’t fit well in many indexes which could be an opportunity for the astute investor. No review of potential investments should exclude the impact of improving economic conditions in China. In my mind the way to participate in this phenomenon is very much open to discussion.  How would you now play the China card?

It is your turn to share your thoughts on the Fiscal Cliff, ETFs and short-term trading signals, Long-term investments and China.
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