Sunday, December 29, 2013

Is There Enough Left on the Upside?


One of the many necessary elements for a peak to occur is the belief that the current market rise will continue. This belief is nurtured by cheerleaders and there were two highly respected ones sharing their views with us this week. The first was in Mark Hulbert’s column, where Sam Eisenstadt, the former statistical genius of Value Line stated that he believes in the next six months the stock market will rise 8% as the leadership will shift to higher quality companies rather than the lower ones which have been the leaders. 
The second was an observation from U.S. Global InvestorsInvestor Alert which quoted a study by BCA Research which examined the 30 years since 1870 when the market was up 25% or more. They found that in 23 years following the big gain that the market had an average gain of 12%. A number of Wall Street types are now hoping to split the difference and are looking for a 10% gain.

Is 8, 10, or 12% good enough?

On the one hand (as the economist would say) these gains are 2-4x the recovery high on the US Treasury 10 year note at just over the 3% yield achieved this Friday. On the other hand someone trained on using the odds of meaningful success would start to get cautious. Just five years ago the percentage decline in the market offered a potential recovery to the prior peak of 2-3x what is now being offered. This is not counting on going on to new highs. The question now is, are we about to enter Sir Isaac Newton’s “greater fool theory” trap? Remember he participated early in the run up of the infamous South Sea Bubble. He got out early, but got sucked back in when his friends were making more money faster than he did. When the bubble did break he lost all of his gains and more. What we have learned from the recent studies at Caltech is that some people don’t retreat when they sense danger, but stay involved believing that their sense of timing will take them out of danger. As I mentioned in prior posts, I learned about this as a junior analyst and it was called the greater fool theory. To believe that future big gains are possible after large gains are achieved does not show the level of caution that many successful long-term investors use.

I used to question why we researched bonds when I was studying Security Analysis at Columbia with Professor David Dodd.  The name of the class was the same as the title of the book that he co-wrote with Ben Graham. What became clear to them and reinforced in the recent mortgage market collapse beginning in 2005 and culminating in 2008, that at times the fixed-income markets are much more sensitive to credit conditions and therefore the eventual health of the economy than my fellow stock jockeys.

As mentioned above on Friday the ten year US Treasury bond’s yield rose to a psychologically important 3% from a low of 1.63%. This in turn caused bond prices to decline in absolute terms. I look at historic 10-year yields the following way:

  • I view the normal yield for the ten year to be about 4%. 
  • During abnormal times rates would be in the 6-8% range, which should meet the relatively few defined benefit pension funds' actuarial requirements.
  • Under economically stressed periods one could see yields in the 9-12% range if not higher. 
The higher current yields would occur when there is greater demand for capital than what is immediately available, usually with both the private and public sectors needing money to meet their immediate and longer-term needs. We are currently far from these conditions now, but sound equity investors should be alert to credit conditions as both the private and public sectors are short of capital for long-term productive investments.

Is there too much asset allocation?

For far too long investment pundits and those who direct the construction of long-term portfolios have found comfort in diversification into many different asset classes; e.g., domestic stocks, international stocks, emerging market stocks and bonds and now stocks from frontier countries as well as similar fixed-income asset classes going from the most to the least secure. To these lists add private equity, commodities of different types, real estate, timber, and elements from the art worlds plus intellectual property. While not a separate asset class, hedge funds owning one or multiples of these classes are included in the array for diversified investing. Many of these types of investments have badly trailed the simple stock market and some for 2013 are likely to show negative results, such as commodities and volatility measures. I would suggest there are three lessons one should consider before deploying asset allocation.

The first is that in declining markets and particularly sharply declining markets, correlations will increase. Wherever there are pools of liquidity they will be drawn down. Assets that can be sold quickly will be. Second, when there are choices to be made and particularly in the early phases of a rally, selectivity will be important. Along with the skills of the selector it is important to understand the relative sizes of compensation of the intermediaries. Isn’t it strange the highly compensated products and intermediaries get the first mover advantage? The third clue (the most difficult one for those of us who are trained in complexity) is to keep the strategy simple where most of the time is spent on selectivity.  In his weekend column in The Wall Street Journal, Brent Arends quoted a study by Andrew Smithers, a well-known and highly respected British investment thinker, who in a study for the investment committee of a college at Cambridge University recommended that it should have only two asset classes, stocks and cash. Stocks could range from 60% to 100% based on the level of the market, utilizing some long-term ratios. In today’s world this simple but effective approach is making a lot of sense, at least until reset approaches coming off the next major bottom.

What is increasingly missing from our command structure?

As a US Marine Corps officer, we never really retire, we just change uniforms. Over the weekend I enjoyed an interview with Camille Paglia  where she is quoted as saying. “The entire elite class, now in finance, in politics and so on, none of them have military service, hardly anyone. These people don’t think in military ways. The politicians lack practical skills of analysis and construction.” She finds “no models of manhood except on Sports Radio.” (My friends at the National Football League and the NFL Players’ Association will be glad to hear that they are her models of manhood.) However, they are not alone seeing the benefits of military thinking, conditioning, focus, and street smarts for returning service men and women. Prudential Insurance and JP Morgan Chase are among the leaders in seeking out these returning heroes and heroines with job opportunities. I am guessing some of these people will rise to the top of our leading organizations. On a global basis the benefits of a well-spent military life could, and I believe should, give the US an advantage in our international competition. This alone may be a reason to be long-term bullish on America.

What are your thoughts?

Drop me a line.

I hope all of the members of this community will have a Healthy , Happy, and Prosperous 2014.     
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Sunday, December 22, 2013

Thinking About Selling


For the last several posts I have been dwelling on the coming peak in stock markets. I have not been predicting that the current record levels are the peaks before major declines; however I am suggesting that many of the characteristics of a classic top are showing up.

The difference between smart and loud people

We are experiencing the beginning of an enthusiasm epidemic. The clamor of some media pundits echoing comments by economists and a few real market movers is almost becoming deafening. (I wonder whether there are any quiet bulls!) When I parse what they are actually saying I discover that they are looking for another year of rising stock prices and they are willing to see declining bond prices. This was reinforced to me this morning, when leaving our local gym I ran into the director of research of one of the smart new research firms. He said he felt that there was another good year ahead before the size of the government sector’s debt including the central banks would create instability.  This is the equivalent of believing that he can safely dismount from the tiger of “the greater fool theory” that I have written about previously. I earnestly hope he can.

In our continuing discussions with portfolio managers of successful small market capitalization mutual funds, I find they are not waiting to begin their exiting strategies. Quite a number have taken the steps of restricting the amount of money coming into their portfolios by closing their funds and their separately managed accounts to new money. One fund has already started a program of reducing the size of its commitments to some winning positions. Another technique being followed by some is not to fully invest the latest surge of new money that has entered their shop. Their cash build-up already approximates 60% of their maximum cash positions.

What to Do?

In terms of stock positions, one should start to think about net selling slowly. I stress net selling. At all times I would urge investors to follow my late friend, Sir John Templeton’s advice to always seek out better bargains. While a switch may improve the long-term results of one’s equities, it does not reduce the overall market risk of the stock portfolio. What I am suggesting is to begin to plan to reduce the overall commitment to equities. (For me this is a nerve-racking move as I have been long stocks for the last 40 years.)

The One-year Timeframe Portfolio

As regular readers of my posts, you are aware of my concept of dividing one’s portfolio into separate time horizon-oriented sub portfolios, or “Timeframe Portfolios.” At the minimum one should have at least three sub portfolios with time horizons of one year, five years, and ten or more years. My immediate focus is on the one year which is both for the net cash generation to meet current needs and the result most amateurs focus on in their discussions in mixed investment committee meetings with non-professional investors. For this section of the portfolio a selling program is needed to meet cash and competitive needs. The object of the exercise, while enjoying the probable rising market prices, is to raise sufficient cash to meet funding requirements. My suggestions are first to decide how much cash is required at the end of the year and then plan to sell an amount each month or quarter.

The next approach is to set price levels for each position that is a reasonable one year goal. Whenever the price is reached, sell the position and include the proceeds in the required cash raised for the month or quarter. Finally, there will be events, some positive and some negative that will cause the stock price to gyrate. Either way it would be a good time to exit the one year position.

The Five-year Timeframe Portfolio

The middle sub portfolio or the five year portfolio has a different set of issues and therefore suggestions. What is absolutely clear to me is that sometime over the five years stock prices will take a nasty hit, most likely in the 25% range, but possibly as much as 50% before returning to an upward path. The critical question facing this portfolio is, “Who will see the results?” If the only reviewer of this portfolio is its owner, then a sound growth-oriented portfolio would make the most sense as stock markets tend to rise three out of four years. However, if the portfolio is likely to be reviewed by a critic, a significantly different strategy might be best. To be over-simplistic, owners want upsides, critics want to avoid declines. 

Most of the time the discipline of a value-oriented portfolio has had less chance of declines. The overall characteristic of a value portfolio is that the stocks are selling significantly below their perceived intrinsic value. (Not so far below that only a small minority of investors would perceive the same value. These portfolios are often labeled “deep value” and better left in the hands of keen professionals.) Most often to keep value stocks from declining at the same rate as more aggressive growth-oriented stocks, the value stocks pay a dividend and may have a practice of buying back their shares from their shareholders. The dividend yield on these stocks should attract some additional buyers if the stocks go down in price and their yields rise. Currently the ten worst performing stocks in the Dow Jones Industrial Average (DJIA), often known as the “Dogs of the Dow,” have dividend yields of between 3% and 5%. Many so-called value stocks have similar or somewhat smaller yields. And this is what makes them more vulnerable today. 

For months the general stock market has been discounting the beginning of the Federal Reserve’s tapering and bond yields have been rising.  Over long periods of time when bond yields go up, stock yields go up and stock prices weaken. When this happens the partial safety net from dividends become less strong for value stocks. In addition, many value stocks are from companies that require significant capacity expansions to produce the same or higher dividends in a period of rising costs. I am increasingly concerned about some of these in the energy business. Quite contrary to past beliefs there is a multiple year threat of over production of oil which will lead to lower prices. Nice for us as consumers, but it is not a favorable outlook for maintaining or growing dividends. Thus, my recommendation for value-focused portfolios is to reanalyze the intrinsic value calculations as well as the value of future dividends as a price support for the stock.

Bond prices are declining

Contrary to much of market history, we have until very recently enjoyed having bond and stock prices rising at the same time. In the past their price movements have been inverse to each other.  As mentioned the markets have already sensed the slow pullback of the manipulations by central banks to keep interest rates artificially low. In addition, while it is clear some of the most damaged European economies have stopped shrinking and may be rising a small bit, the rating agencies are slightly lowering a number of the sovereign bond ratings. They are showing appropriate concerns as to the willingness of political leaders to continue the various austerity policies that helped to give confidence to the funders of the turnarounds. Removing this discipline runs the risk of a 1937-38 Roosevelt Recession which may well have been a contributor to setting up WWII. With the high-quality bond markets showing signs of nervousness, the yield spread for high yield, if you will junk bonds, will widen.  If this were to happen it will make the current wall of refinancing more expensive, perhaps prohibitively. Without support from the fixed-income world many of the expected merger and acquisition deals are going to be delayed which could hurt the value stocks.

When one hears of transactions, one should make the judgment whether the buyer or seller is smarter. I am very selectively and for specific purposes slowly beginning to sell a little bit.

Please let me know what you are doing.   
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Sunday, December 15, 2013

Peak Ahead, But Not Just Yet


In a somewhat long, scary piece on the re-hypothecation of gold bars, John Hathaway of Tocqueville Asset Management intones “In the financial markets, a person that is one step ahead of the crowd is considered a genius, but two steps ahead, a crackpot.”

I do not claim to be a genius, I am just an investment manager who attempts to anticipate problems. There is a danger in this; my wife and driving companion urges me to forget my learning to drive in New York City. When the center traffic light on a broad Manhattan avenue is yellow, it is a command to speed-up. Ruth stresses the danger in this approach as other drivers perpendicular to my direction may anticipate the change in their light signal from red to green and jump out as my cautionary light is changing to red. The investment message is that we do not know for sure what will happen and thus we can not anticipate every turn of events. All that I can do is to fall back to my handicapping days at the local racetracks. I can assess the reasonable possibilities and probabilities versus the weight of money calculated odds derived from the parimutuel pools (less track and government takes). With these thoughts in mind I will list some of the positives and negatives looking forward for the next one to three years. (For those investors who properly view their investment horizons beyond five years these discussions are less germane.)

Positive outlooks

Annual Statistics - Jeff Tjornehoj from the Denver office of Lipper, Inc., now an affiliate of Thomson Reuters has studied the history of the Dow Jones Industrial Average (DJIA) since 1896. His analysis shows that the year following a 20% gain produces an average 8% gain. Only two down years after 20% gains happened in 18 years. Steve Leuthold’s group also noted that the DJIA in November reached an inflation-adjusted high which took 13 years and 11 months to accomplish. The S&P500 needs to reach an equivalent inflation-adjusted 2061, which is above the 2014 year-end estimate of ten leading market strategists according to Barron’s.

Valuations - We have been looking to add additional large cap growth funds to client portfolios. In three cases of good performing funds we have noticed that the current valuations based on their current measures have taken a significant gain in terms of price/earnings, price/book value and price/sales ratios. In terms of P/E comparing the three funds’ current vs. 2012 ratios: 35.22x vs. 29.46x, 30.52x vs.24.58x, and 33.52x vs27.36x. There is a logical explanation for this escalation. If we go back to the period of the former DJIA inflation-adjusted high some 14 years ago we had 8,823 individual stocks listed on the principal US stock exchanges. At the end of November 2013 there were 4,916 listed stocks. With interest rates manipulated below their inflation-adjusted credit risks, it is not surprising the money flowed into the equity market creating the TINA impact (There Is No Alternative). Most of the almost four thousand missing companies did not go out of business, they were acquired by larger companies or taken private. (See more about the next logical development of this trend in the lists of negatives.)  

Enthusiastic Managers - Saturday night Ruth and I went to a wonderful Pops Concert at the New Jersey Symphony Orchestra featuring John Pizzarelli as well as the Salvation Army Band. Ruth is the very active co-chair of the NJSO. Our guest for the evening works for one of the most successful hedge funds and he repeated his leader’s published bullishness about the outlook for more than the next year. I have read similar comments from three UK managers who are quoted as the “outlook for equities has never been better.” A US small cap manager has now a greater willingness to embrace risk. Part of this enthusiasm is based on the bear market induced concentration of correlation. They all went down. Statistical correlation is becoming less binding and this is the phase when security selection should pay off. In a recent survey, analysts with CFAs were given the choice of what would produce the biggest performance for their funds; 47% voted for security selection with only 26% for asset allocation and only 12% for macro bets. (This raises lots of questions as to the fad of running money through the use of Exchange Traded Funds (ETFs).

Negative outlooks:
Destruction of capital from too much money

As an electronics, broadcasting and aerospace analyst, and eventually a multi-product conglomerate analyst I was in a small department with an aluminum analyst. He was a profitable contrarian. The market got excited when the companies he followed brought more furnaces and mills on line. He recommended sales of these stocks and only recommended purchases when there was a pretty massive shutdown of facilities. He believed accurately that over time when too much capital was committed to a market it would lead to price wars. Price discipline was eventually restored when companies had to earn at least their cost of capital. A somewhat similar philosophy is espoused by a very successful London-based manager, Marathon Asset Management that applies to numerous sectors globally. In the positive section above I highlighted the substantial drop in the number of securities. As someone who has been both a buyer and a seller of companies as well as benefiting from acquisitions of stocks that clients and I have owned, I suggest that most acquisitions lower the buyers’ long-term margins and return on invested capital. This factor plus the need of various private-equity and venture capital funds to produce cash returns suggest to me that we will see at some point and perhaps soon an increase in the number of new issues. While at the moment many financial institutions and individual investors have excess cash, at some point the cash needed to take up these IPOs will come from sales of existing holdings. (This is a familiar pattern in a number of cash short non-US markets.) While the new shares may rise in price the shares sold will put pressure on the older position. 

Perhaps a clearer example of a market that is absorbing too much capital and with a limited number of experienced players is the hedge fund market. This will be the fifth year that the aggregate number of hedge funds has underperformed the stock market. While there has been a number of very successful hedge funds, many funds particularly some new entrants have not been able to generate sufficient performance to get properly funded so that they can attract necessary talent not only on the investment side, but also administrative, trading, compliance, investor relations and sales people. 

Less enthusiastic managers

According to the British newspaper, the Telegraph, BlackRock, the world’s largest investment manager predicts the US rally is near exhaustion. Further they are warning their clients to pull out of global markets at the first sign of trouble.  However, BlackRock does believe that there is a 25% chance of a “growth breakout.”

Other managers, particularly small cap managers have closed their funds to new money. Some of the more successful hedge funds are sending money back to their holders. (Understand the math, with less money and a proportionately greater percent owned by the managers there is an improved chance of earning various performance fees.) In theory all managers get paid on the total of the assets that they manage, doing anything that results in smaller inflows or a reduction in actual size of their funds is a near-term hit to their bottom line, but they may be preserving their good records.

Bond market worries

The first worry is that eventually we will see interest rates go up which will push already outstanding bond prices down. This could start soon. Lower bond prices will lead to negative returns for Bond funds which will accelerate the outflow from Bond funds. Switching Bond fund investors to Equity investors within the same investment complex may be difficult without figuring a way to compensate the distribution channel for the switch. The redemption proceeds can be new money for a different organization and its distributions channel.

The second worry focuses on the high yield part of the market. The current yield spread between the high yield and the high quality parts of the market is historically quite narrow. There are a couple of concerns going forward. First during the period of low interest rates and substantial flows into the high yield arena some issuers may have loosened their financial disciplines and there may be an increase in defaults. The second concern is that we are entering a period where there will be an increased need to issue new debt as a way to pay off maturing debt.

The importance of these concerns to the equity market is that directly or indirectly any of the Merger & Acquisition activities require the sale of high yield bonds to finance the equity deal.

“Brace for a 20% correction”

This week’s Barron’s has an interview with Ned Davis and two of his leading associates under the headline, “Brace for a 20% Correction.” Ned Davis is a very well known and respected source of technical analysis. At the moment they remain positive but they can foresee a 20% drop in the future.

 My investment take

Unfortunately too many so-called investors have short investment time horizons of a year or less. For these accounts I would begin to raise cash slowly, withdrawing a portion each month so that a 20-25% decline would not interfere with meeting short-tem funding requirements. For the investor that has at least a five year time horizon, moving slowly into high quality stocks, particularly well-priced value and high quality bonds makes sense. For my favorite investors who look to a ten year or longer time horizon, I would be shortening my fixed- income maturity so as to have additional cash to invest for high quality growth with an understandable future.

Please share your thoughts with me, I hope to learn from you.
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