Sunday, April 6, 2014

Signals or Static Perspective?


I can’t avoid thinking like a US Marine this Sunday. We just received the notice of the memorial service for General Carl Mundy who was the 30th Commandant of the USMC and my fellow classmate in Basic Officers Class. As Marines we learned to observe every detail about our surroundings and most particularly about our enemies. As in the battle for investment survival, which requires a degree of investment success, we also need to observe all elements that are visible and look for those that are beneath the surface. We know that each day or week could hold the clues to future actions. The difficulty that I face is separating meaningful signals from day-to-day statistical static. Carl did these well both in battles and in his post active duty service and I will try to emulate his skills.

First quarter 2014 mixed messages

Extrapolating the large gains achieved by equity funds, particularly the Small Capitalization funds with significant holdings first in technology and second in financial services, one would have been prepared for a continuation of these trends. On the surface there were very few surprises in the first quarter based on the financial headlines. Yet the natural order of performance was quite different. The leading performing large asset class was commodities, not across the board but a number of industrial and agricultural goods, in addition to gold and energy had positive results. Under normal circumstances this kind of price behavior would indicate inflation and significant shortages of supplies. But this was not the case as the central bankers were complaining about the lack of inflation to provide economic stimulus that the fiscal authorities were not.

Focusing on the next best asset class for some, which was taxable bonds, the best performing fund group was those funds that had mostly “A” rated corporate bonds in their portfolios with an average gain of +3.94%. They were followed by funds with somewhat lower credit rated bonds (BBB) which gained +3.32%. Somewhat surprising in a period of expansion, the third best bond category was the High Yield or junk bond funds up +2.75%. They normally lead in bullish times as in the last twelve months with gains of + 7.32%. What may be happening is that the wave of acquisitions that were being financed through high yield paper may have created supply bigger than demand. Further, those with a historical perspective may have felt that the yield spread versus the poor performing treasuries was too narrow. All of these results suggest to me that the fixed income and commodity investor was acting cautiously, but was questioning the value of the US government’s paper as well as the reality of inflation production.

The equity funds also sent out mixed and not very strong signals. Of the 31 equity investment objective classifications tracked by my old firm, now known as Lipper, Inc., four produced slightly negative results and five positive results. The losers were hurt by disenchantment with growth regardless of size (Small-Cap Growth -0.47%  and Large-Cap Growth -0.11%). The gainers were led by two traditional bets against the future lower value to the US dollar and/or increased inflation. The average Precious Metals fund was up +12.28% but still down -29.29% for the trailing twelve months. The second best was the Real Estate funds +8.13%. From a macro point of view the most surprising performance was from the average Utility funds +6.69%. This result was clearly better than any bond category. Often utilities are viewed as bond substitutes. The fourth best was Health/Biotech at 6.69%. The fifth best was the Mid-Cap Value funds up +3.14%. The other twenty two equity funds had gains below 3% or under the results for both bonds and commodities.

The ends of March

As indicated in last week’s post I detected a significant change in equity leadership. This change is better defined when one examines the month of March performance. The four worst performers were the Precious Metals funds -7.82% giving up some of their recovery, Health/Biotech funds -5.30%, Large Cap growth -3.22% (all of the growth fund categories declined in March). A good further explanation for their declines was the fall of -2.67%
in the Science & Technology classification.  Science and Technology has driven a good bit of the Growth funds' performance. Clearly the old war horses of the 2013 leadership in healthcare and technology were no longer producing bigger dreams for their owners. The new leaders seem to be very specific in terms of their own merits even though there appears to be greater attraction to value-oriented portfolios (see April observations below). British funds seem to be reading from the same playbook being used in the US.

If one is following the script of an aging bull market the switch to larger caps that have perceived value safety nets beneath them makes sense. However, if the next market collapse proves to be spectacular, we will need to have sudden, sharp, parabolic price explosion on the upside. That kind of performance is normally needed for a 50% decline. Without such a runup, the next decline is more likely to be in the neighborhood of  25% which is not enough to dislodge sound long-term investment portfolios.

Early April flows and ratings pluses

Being indebted to my old firm for flow data,  I can see some interesting cross trends if I parse the data carefully. The traditional equity mutual fund had net estimated inflows for the week ending on Wednesday of $2.2 billion; however $1.6 billion were non-domestic stock funds. This would indicate that only about $600 million was betting along with the Administration that good things are in the offering for the US economy. Some of the money leaving the US may be going to Europe on the basis that Moody’s is regularly raising western European credit ratings, that business is improving and the price/earnings discounts to comparable US stocks makes them attractive. I suspect a smaller piece is going out to buy Asian stocks that are recovering somewhat from their prior fall. In term of investment objectives, the traditional mutual funds buyer put the bulk of their net money in Large Cap core funds which category included index and closet index funds. Some of that money probably came from the $429 million net outflows from the Large Cap growth funds. These shifts were aligned with our prior observations.

What are most interesting are the flows into the ETFs. Their assets are considerably smaller than the traditional mutual funds, but they managed to put more money, $3.2 billion into their equity funds of which $2.5 billion were in non-domestic portfolios. The domestic fund investment benefited from a $941 million flow into a large S&P 500 index fund which appears to be a “parking lot” type of investment, rather than a long-term commitment.

Why focus on mutual funds?

First, mutual funds around the world, according to the Investment Company Institute (ICI) have $30 trillion dollars under management. In many markets they are the most transparent institutional investor. Often some of the 76,200 funds are managed in the same fashion as the other institutional accounts in their shops. Thus an analysis of what mutual funds are doing gives one useful intelligence as to what is happening in both the institutional mind set as well as the general investing public.

Second, I spend most of my working hours focused on the proper selection of funds for clients as well as our extensive charitable activities. Third we eat our own cooking, as we invest in these funds for my family along with a private fund that invests in mutual fund management company stocks and other financial services providers.

My question for the week is:

How prepared is your thinking for the next market decline? Please let me know, for General Mundy would expect me to look at any moving object that was somewhat visible.

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