Introduction
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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