Sunday, November 24, 2013

A Stock Market Peak Is Coming, What Should an Investor Do?


While a somewhat premature warning of an on-coming market peak may be upon us, we need to think about the implications for our various portfolios.  I believe a sound investment advisor attempts with difficulty to anticipate major problems rather than being forced to react.

Growing evidence

Though no two market peaks are identical, many of them have similar characteristics. Expectations become elevated beyond normal valuations and knowledgeable bright people get sucked in with the belief that they can exit the burning movie theater before the mob behind them. With the benefit of their history (particularly of financial matters) and a cooler disposition, we Americans have a hard time believing our British cousins would get caught up into theses speculative surges. However, Sir Isaac Newton, Sir Winston Churchill and the famed British economist John Maynard Keynes all suffered major financial losses from the collapse of markets. Today the current versions of these “worthies,” many in the investment management business, are imploring us to get fully invested in equities. This is despite the combination of lackluster corporate sales growth and peak profit margins and the increasing prospect of higher taxes on the so-called wealthy.

In this last week both the Dow Jones Industrial Average and the Standard & Poor’s 500 reached new high points. We have come a long way from the bottom reached in March of 2009. Many of the pundits are looking for materially higher prices often with a “2 Handle” or 20,000 or 2,000 points respectively for the popular averages.

What are the signs of a peak?

Margin debt is at an all time high. With trading volume low, there is a presumption that those who are borrowing against their securities are institutions or sophisticated investors who are acting like hedge funds or other aggressive investors. While there is no public disclosure as to which security owned or to be purchased is the beneficiary of the borrowing of margin, I suspect that a good bit of it is to support being long or short Exchange Traded Funds (ETFs) or similar vehicles. In addition there is some borrowing to support “carry trades” where one borrows money cheaply and buys higher yielding securities.

What set my particular concerns off is when a retired CFO and CEO mentioned to me he was arbitraging interest rates by using low cost margin money. He probably does not need to do this, but it appears to be a sophisticated trade for a retiree to do. Some of the carry trade is in buying high yielding stocks and bonds globally. My concern is from a recent headline describing the frenzy as a “dash for trash.” More such evidence is needed before one can definitively call a top or peak.

If there is a peak, what should an investor do?

Before one initially invests in stocks, one should understand that 25% declines from peaks happen regularly, perhaps three times in every ten years. Once a generation, the drop has been 50%. After such a calamity, if companies don’t go bankrupt, their stock prices recover. I will share an extreme example of this. As a junior analyst I was doing work on the Radio Corporation of America (RCA). There was something of a celebration during the 1960s when the stock finally surmounted its 1928-29 high. In the 1920s RCA enjoyed the enthusiasm that the “Dot Coms” had in 1997-2000 era.  While this fact is of interest it should not be a mantra for investing. A better strategy has to do with time horizons.

Time horizon investing

Most institutions and individuals have multiple purposes for the proceeds from their account, but they think in terms of a single portfolio. I have been urging them to break up their investment portfolio into time horizons or Time Frame Portfolios. This principle works for wealthy investors as well as sophisticated institutional investors.

The first slice is the amount of money needed to meet current or near current obligations. Ideally the size of this portfolio will cover up to two years worth of expenses. Highly liquid, high quality, near cash investments should make up this portfolio. When the first slice is exhausted through payouts, it needs to be reconstituted out of the second Time Frame Portfolio which should be made up of intermediate high quality bonds and good stocks.

One way to look at these time horizon slices is the first is for the treasurer or controller.  The second slice should have an expected duration similar to the current CEOs career or the principal wage earner’s life. The third slice should have long-term duration similar to the way Warren Buffett buys operating companies and most of his selected major stock positions which he often says is “forever.”

Application of time horizons to peaks

Fears of peaks should eliminate securities with meaningful downsides from the first portfolio. Some small amount could be tolerated in the second portfolio. Not only could the third portfolio tolerate a declining price investment, it could look for an opportunity to add more.

Harvest time celebrations

This is the time of year in many cultures in the Northern Hemispheres we gather to celebrate the accumulated harvest. In the US we celebrate this coming week as Thanksgiving. My family and I have a lot to be thankful for our blessings. What I am particularly thankful is for an ability to convert some of our problems into opportunities for others as well as ourselves.

Please write and let me know about your:  Peaks/tops, time-horizon investing, and thankful opportunities this year.
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Sunday, November 17, 2013

Active Grandparents Can Be Good Investment Managers


Investing is an abstract art that is non-sensible to many. To the contrary, I believe that investing in general and portfolio management specifically is representative of the real world. In most cultures, most of the time, we celebrate what was done well in the past. Most educational institutions base their pedagogical outlines on learning what were good achievements in the past, and not enough about past mistakes or failures. In many families passing down of this knowledge is done by the grandparents.

Portfolio management should benefit from grandparents

I spend almost all of my waking hours and some of my sleeping hours looking for good investments for my clients, my family and the beneficiaries of the charitable institutions that I serve. While the rewards for finding a single great investment can be huge, in many cases the search is akin to the search for lost gold mines of El Dorado, which thus far has proven to be mythical. For me and those whom I serve, a better use of my time is the search for good portfolio managers during their periods of both leading and lagging performance. I am increasingly drawn to portfolios of managers that combine what is new (if anything), sound past practices, useful thinking, and perhaps even wisdom.

Grandparents come in different sizes, shapes and experiences

One of the better questions to ask a possible investment manager is, “Who was your mentor and where did you learn about life?” If the answer only includes academics or other people in the business, you are getting the rehearsed expected answers. When I press further, I am often told that an older person served as a mentor; either parent, grandparent, uncle, aunt, and in some cases the person responsible for the day-to-day childcare. Few, if any of these people can impart portfolio management skills. They can and do explain the rise and fall of their life’s rewards. If none of these life teachings go into problems encountered, either the prospective manager is na├»ve or is not forthcoming, not a good beginning to a relationship.

What can be learned from grandparents?

In the following discussions about the value of grandparents imputes, I am generalizing well beyond my and my family’s direct experience and including those families that have shared their experiences.

This time is different

One of the impatiences of youth and inexperienced investors is the belief that the old patterns of behavior will not apply to the “new, new” environment. This powerful idea will overcome people’s greed, fear, inefficiency, counter-balancing forces and the application of the unpredictable laws of nature. Those who have been walking around upright for years can inform those who are willing to listen that they have seen and believed similar things in the past.

I can play the Bigger Fool Game better

In past posts, I have mentioned that studies have shown that many of those who have been caught up in these bubbles have recognized the fallaciousness of the “new, new thing,” but they think they are going to be able to jump out of harm’s way. The historical odds are that in a steep decline when the bubble is broken, very few can exit and stay out.

My children and their partners will do exactly what I say

Every generation wants to show to their parents that they are smarter than their parents. Thus, they do not follow the proscribed rules laid out by their parents. One of the ironies is that when the children have children the grandchildren also do not follow their parents’ dictates. In some respects, grandchildren are the retribution delivered to the children. Eventually the children then begin to believe that their parents have gotten much more intelligent than they were when they were growing up.

Translating into portfolio terms

The best defense against the wipeout caused in many bubbles is to be broadly diversified. This is easier to say than to accomplish. The bigger the bubble gets the more it will suck money from other portions of the global economy. In turn this will weaken the credit conditions of the late-comers. Thus, the latest “new, new thing” could affect the credit quality behind pensions, bank, insurance companies, suppliers and other communities. This is precisely where the boring work of a detailed security analyst can be extremely valuable. Most of this kind of diligence is done by buy-side organizations including some credit oriented hedge funds.

The wisdom of families in terms of estates

Any in-depth analysis of families will reveal that any one generation with all of its knowledge of their decedents did not fully anticipate all of the following possible, and some may say impossible actions of the decedents:

  • Premature deaths
  • Change in various tax laws 
  • Lack of legal competence
  • Unexpected medical conditions
  • Divorces
  • Change of domiciles of people and assets
  • The willingness of various family members to take responsibilities for others (some of which they hardly know)

Probably the most difficult decisions have to do with children of unequal needs and abilities. All of these require the very careful work of one or more trust and estate attorneys in conjunction with an extremely knowledgeable tax accountant and an investment advisor who can structure the initial portfolio but also to keep it in appropriate balance as conditions change.

Post-estate governance

While Wills and Trust documents provide a framework for the continued governance of the assets, there is a much larger set of issues. One can not truly predict the changes in personalities after there has been a disposition of the assets, the critical issues remain how well various individuals carry out their deemed responsibilities including the management of their assets and those of others that they may influence.

November gives us a governance clue

In November two individuals who have donned additional political power are President Xi Jinping in China and New Jersey Governor Chris Christie. Each portrayed himself as someone in the middle of his political spectrum. Clearly, I do not know what they will do in the future. The lesson from these two leaders is that while each could have shown more political strength, they opted to take the somewhat safer middle. Translating this into Trust and Estate Management, suggests staying in the middle is the safest and gives the most maneuver room.

What did you learn from your grandparents and what are you teaching?
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Sunday, November 10, 2013

Mostly Positive Adjustments for Investors


In last week’s post I mentioned one of the slogans used in the US Marine Corps, “Adapt, Improvise, and Overcome.” As today, November 10th is the 238th birthday of The Corps, I was thinking of all the adjustments it has had to make to become the nation’s premier fighting force. Though The Corps can handle almost any mission assigned to it, much of the slogan has to do with overcoming the rigidities imposed within itself and the US Defense establishment. I wonder whether Pope Francis is using a similar approach as he tries to adjust the behavior of the Roman Catholic Church, which could have impacts on many other organized religions.

Less cosmically, while painful in some cases, we are seeing a number of current adjustments that are subtly or perhaps not so subtly adjusting investment thinking as outlined below.

Lessons from the Twitter IPO

Twitter with the help of its lead underwriter Goldman Sachs* had a successful launch of its IPO. While they did raise the price of the offering several times similar to Facebook, they did not adjust the number of shares being offered as Facebook did. The NYSE, the venue for the aftermarket, went through exacting trials under stressed conditions that NASDAQ* did not with Facebook. The President could have learned a lot from the Twitter launch and adjusted his attempts to re-launch a somewhat more successful Obamacare.

A possible lesson to be feared

In a syndicated column by George F. Will entitled “The Enigma of Janet Yellen,”  the author  was concerned that by past experience and training, Ms. Yellen has been amenable to penalize savers to benefit equity owners around the world. He fears that in the absence of fiscal policy leadership, monetary policy led by the Fed is going to in effect, become the conscience of the government, and lead to adjusting our social priorities through the use of various monetary devices. If Mr. Will’s concerns are realized, the rate of inflation will rise and the dollar may shrink.

Unwinding of the 4% rule.

For many years’ wealth managers within or outside of trust departments have believed that a 4% withdrawal rate during retirement was possible without destroying the capital base. Today, based on the current low interest rates, some careful advisors are more comfortable with 3%, and T. Rowe Price* believes 2.8% is more prudent. If these lower numbers are to be believed, spending and saving efforts will need to be adjusted. A similar exercise is needed for a number of endowment and foundation boards to contemplate.

Liberal Arts needs to be liberated

Currently a significant number of liberal arts colleges are facing declining enrollments, rising expenses and less than great returns on their too small endowments. Part of their problem is that often these organizations are governed with a high level of rigidity. Even in government, during periods of stress high-priced workers can be laid off. Granting tenure in higher education is often a one-way street, in that after being granted it, the tenured ones can stay employed as long as they want regardless of their productivity. 

One of the fields of study that should be examined by the payers of college tuitions is Macroeconomics. Robert Shiller, a 2013 Nobel laureate wrote a blog published by the Guardian entitled, “Is Economics a Science?”  He properly questions whether it is a science like Physics. He accurately says that the study of Economics has to do with policy. I suspect that is how this course is taught which could have some benefit to Political Science majors whose aim is the Presidency or slightly lower. On the other hand, Microeconomics introduces some techniques which could be useful to both consumers and producers. In my particular case the focus on price-setting with different degrees of inelastic supply and demand was useful in my business and investment career. What I am suggesting is that the rigidities found in much of the non-profit world need to go through serious adjustments and that will happen whether the occupants of the various ivory towers like it or not.

Investment thinking is being adjusted

All investment organizations are being caught in a pincer movement of lower investment returns in equity, debt, commodities, derivatives and cash concurrent with rising expenses for technology, compliance, marketing, and keeping their good people from going entrepreneurial either directly or to smaller shops, such as hedge funds. In this light it is interesting that Goldman Sachs* will no longer produce research that is based on “growth at a reasonable price.” This is a policy that worked well in the mutual fund business for many years. In his leadership days at Fidelity Magellan, Peter Lynch was a major proponent of this strategy. In Peter’s search for good investments he found a large number of companies who were growing, not with a high growth rate but who were selling at prices that did not presume a continuation of their growth rate.

How are we are adjusting?

The first thing I do is look under the hood of various labeled classifications to see the spread of options that have been grouped under a simple label like growth or large cap. While it is useful to know how a manager performs relative to his peers under varying conditions, markets are not two dimensional up vs. down, most of the time they are in some form of equilibrium. The more you study people, the more different they appear to be. This is why an All-Star team picking the best player for each position often does not do well against a team of good players that has played together benefitting from natural leadership within the group.

I am looking to add a new fund to our portfolios. My key concern is whether the fund being examined, which is in a particular market phase, will add or subtract to the results of the existing portfolio.

One of the adjustments that I am making as I move away from labels is to look for good, understandable managers in broad categories. That is why I now group equity managers for my purposes under the banner of “equity exposure.” Because of the dynamic changes in the world’s intellectual leadership, I expect that the rate of adjustments will accelerate. I need to pay attention to these changes as they creep over the various time horizons that we must accommodate.

How do you expect to adjust to the future? 
*Owned personally, by my private financial services fund, or both.
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Contact author for limited redistribution permission.