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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