Sunday, April 27, 2014

Are We in a “Flat Earth” Phase?


For most of human history there was the belief that we lived on a single plane of essentially a flat earth. This concept gave order to our belief as to our place in the world, and in our minds reduced the uncertainty gap. Only in the last seven hundred or so years did we appreciate that we live in a somewhat circular earth planet. Soon after Columbus’s voyages we came to recognize how we really live in a context of a spinning globe.

In a much less cosmic sense, stock market chart readers have recognized that there are periods, some of them quite long, when prices appear to be within a range bound with repeated highs at roughly the same level and similarly with recurrent lows around the same price levels. Some of these periods can last for years. It was a period of 16 years from the first time the Dow Jones Industrial Average (DJIA) first reached 1000 and finally decisively breaking out on the upside.  Depending on what measure you want to use, for example the NASDAQ or the Japanese markets, we are still well within these bounded ranges. Normally range bound markets, particularly those with narrow price ranges, last for a number of months not decades. We appear to be in a relatively narrow range bound market with the DJIA laboring between 16700 and 16000. (Some would use a narrower range.) There are two important findings after the market either breaks out or breaks down decisively. The first, the amount of time and the aggregate swings from the high point and the low point is, in theory, added or subtracted to the high point or low point when there is a break-out or breakdown. The second is whether on balance the smart money is accumulating assets from the less intelligent sellers or the smart ones are distributing their assets to the somewhat unsuspecting investing crowd.

A reader asked.....

One of our intense readers who is somewhat short-term focused has asked me if is there a way to successfully predict if we are likely to experience an upside breakout or a downside breakdown. As my crystal bowl is quite cloudy, I am focusing on two aspects that lead to range bound markets. The first, is there a change in the population of buyers and sellers facing each other in changing market structures? The second question is whether those with smarts and capital are changing their investment policies. It is this particular question that the remainder of this post is focused.

Is it smart to be reducing equity exposure?

The answer, or at least a guide, may have been foretold last night. At the New Jersey Performing Arts Center* there was a showing of the movie classic “Wizard of Oz” with its soundtrack music played beautifully by the New Jersey Symphony Orchestra**.  For those who are unfamiliar with the film it turns on the ability of an unseen voice to successfully control a community of happy people. The key to the dreams of the four supplicants seeking special transformative favors was the unplanned revelation that the disemboweled voice was an old man behind a curtain that very well played the role of the announcer that foretold what was going to happen. What occurred to me listening to this magnificent music and watching the film is in today’s financial world the role of the wizard (or in reality, the announcer) is played by the central banks and various media gurus. It is these spokespeople that give investors the courage to invest in an uncertain world.
*I am the chair of the Investment committee for New Jersey Performing Arts Center (NJPAC). 
**My wife, Ruth, is the co-chair of the New Jersey Symphony Orchestra (NJSO).

The question as to whether smart investors are changing their investment policies has a lot to do with the announcers that are speaking, particularly after the curtain has been removed and these experts prove to be humans and not all knowing and powerful wizards. To some degree the power of these announcers is based on the flat earth thesis that provided comfort for centuries. This comfort was based on the belief that the leading religious and technological leaders of the day were all knowing. It wasn’t that the few thinkers that did not buy into the flat earth syndrome were essentially smarter than the established thought leaders, but they started to ask questions that could not be comfortably answered by the established leaders.

Bringing the questions up to date and focusing them on the investment world can be broken down into three sub questions as follows:

1.      Are we so smart or just arrogant as to believe that we can perfectly understand how the economy and financial markets work and can be controlled?

2.      If the supposed leaders are so smart why are their decisions “data dependent?”

3.      Why are the so-called experts' forecasts so wrong, particularly in the long-term?

The constant revisions to the various time-series and the inability to correctly capture relevant information about the “informal” sectors of the economy, suggests that data dependent policies have to be wrong often. (In the computer world there is a germane term: “GIGO” garbage in creates garbage out.)

There are two other somewhat related and troubling concerns about how the governments and their hand-maiden central banks are attempting to manage the round earth’s finances. The first is the use of experimental low interest rates to stimulate the economy. There are at least two long-term problems with this approach. The first is that it makes a mockery of long-term savings, particularly in fixed-income instruments for retirees. Not only are they getting low returns on their hard earned money, but they are planned victims of induced inflation to counteract the experimental low interest rates. (I will leave for others to determine whether their healthcare expenses and quality of the services to be provided will be a sufficient offset to their decline in spending power. As a member of the Atlantic Health System’s financial oversight committee and chair of its investment committee, I have my doubts.)

The second negative to structural low interest rates is that it exacerbates a sound economic recovery. One of the reasons for the various financial and economic crises that have occurred is that for the time and price structure we had excess capacity. The benefit of economic declines is that the excess capacity is withdrawn from the market as supply overwhelms demand. While painful to the workers who have to find new jobs, the removal of these excesses is similar to the way nature handles over-population. The problem with low interest rates is that it removes pricing discipline in making sound investment decisions. Often new capacity is brought on stream by marginal producers whose supply can not be profitably absorbed.

One of the reasons given for the low rates and some of the bailouts is that various markets seized up. While that was true for a moment and perhaps that would have been extended for sometime, but if new markets were not created at reasonable prices, the investments that were shut out of transactions would have proved to be not adequately priced.

The second tool that is being used increasingly by central banks is to spur on their exports to encourage lowering the value of their currency. As most of the central banks are reading from the same outmoded text books, many are in effect entering a global currency war which in the end will worsen their problems and not productively expand their markets.

If you are considering changing investment policies, what to do?

I agree with Liz Ann Sonders and her associates at Charles Schwab that it is folly to try to time the market. This is particularly true if you share their view of a haltingly rising market. However, in my roles with various investment committees I am very conscious as to the time horizons of many members of these committees. This is exactly why I came up with the Time Span Portfolios concept. (We can discuss this approach privately to fit various investment needs.)

The place that may need the most attention is the second or Replenishment Portfolio. The purpose of this portfolio is to replenish the Disbursed Operating Needs Portfolio. The time span for the typical Replenishment Portfolio is probably five years. Over this period two events are likely to happen. The first is that there is likely to be a stock market price decline. The depth of the decline is likely to be driven by the speculative force that creates the price peak. The second event is that one or more members of the investment decision making group will be new to the committee and could be a replacement.

To change even only one member of the committee is often a cause for a change in attitude. Of the groups that I presently know, the Replenishment Portfolio is a type of Balanced fund with at least equity and fixed-income funds in the portfolios. I have been managing most of these portfolios up to the turn of the year with the highest equity commitment that was tolerable. Since the beginning of the year through today we have been redeeming some equity funds to bring the equity commitment to the midpoint in their target range. I suspect that as the market moves higher we will lower the equity proportion to the region of the lowest permitted.

Some changes may be warranted for the third portfolio which I have named the Legacy Portfolio (as distinct to the truly long-term Endowment Portfolio) which can tolerate market volatility but doesn’t like it. I do not want to reduce equities to side step a future decline that will happen. I do want to provide some comfort during a period of turmoil. The way I recommend that one should be in both the stock and bond sides upgrades the portfolio holdings. While some speculative positions will do better on the upside they will fare much worse when the eventual declines occur. Part of the reason for going high quality is that planned long-term expenditures, surprise needs or opportunities occur and the Legacy Portfolio may wish to accommodate these opportunities.

Please share with me your thoughts about changing any of your investment policies.  
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A. Michael Lipper, C.F.A.,
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