Monday, May 26, 2014

Fears of Buyers and Sellers


Often the price battle between buyers and sellers is described as the battle between fear and greed. Currently I see the conflict as being between two vastly different sets of fears with very little greed motivation being shown. The focus is on not whether the proverbial glass is half full but rather, what will be the forces that change the water level? What is interesting is that both sides are being driven by fears.

Buyers’ fears

Today’s buyers are afraid of 2013. They are fearful that the near-term stock and bond markets will accelerate and once again they will be shut out of producing index-like returns. One can label this as a competitive threat that another period of underperformance will cause investor accounts to move. On a personal level the fear is the absence of bragging rights at the next gathering of smart people.

While in reality hedge funds are not a separate asset class, the popular image is that they represent highly sophisticated, smart, aggressive managers. In some cases this is an accurate description of managers who have richly rewarded good long-term records. The above average gains of the general markets in 2013 surprised many who significantly under performed. They don’t want this to happen to them again in 2014. This year the markets have incrementally advanced. Last week the S&P500 for the first time closed above 1900. To avoid a competitive repeat of 2013, certain managers are increasing their use of historically low interest rate leverage. We see this in the different directions of net flows in Exchange Traded Funds (ETFs) and similar portfolios of mutual funds. In April, equity ETFs attracted 17.6 billion compared to 12.6 in March, all of the gain was in World Equity ETFs.  

Large ETF positions in hedge funds include those that invest in emerging markets, gold and long-term bond indexes. (During the same periods Small Cap mutual funds saw over $2 billion in net redemptions as compared with net sales in March. Normally small caps are favored by some institutional investors, including hedge funds because it takes less money to move these stocks.) In the past the hedging method favored by some funds fearing price slumps in the S&P500 was the purchase of VIX contracts. In the latest week these contracts hit their low for the year, clearly indicating little fears of declines.

Adding to buyers’ fears, Germany’s DAX Index reached an all time high on the Monday holiday when the US markets were closed.

Sellers’ concerns

Normally buyers are more future-oriented than sellers. After all, since the beginning of the history of the Dow Jones Industrial Average the market has gone up two years out of three.  Thus for the buyers, when the future came it was positive. Today the sellers look at the future and see the past. They see many of the elements that led to the 2007-2009 financial markets crisis. They can be persuaded to slowly sell some of their long-term positions as market prices rotate upward.

Manipulation by governments and central banks

Once again we see activist governments and their central banks attempting to offset slowdowns in their general economies by pushing up the demand for housing. Just recently US federal agencies have been urging the lowering of the underwriting standards for residential mortgages. Combine this with artificially low interest rates and the result is the residential housing market getting injected with venom that can be dangerous to the markets as well as the whole society. Based on past experience it is reasonable to expect that an increasing number of these mortgages will default. When faced with large unpaid debts the past practice of these activist governments was to socialize the losses through various forms of bailouts financed through higher tax realizations. (They ignore past financial history that finds that after a collapse new and/or sounder financial organizations come into being to provide the necessary functions that lead to the overburdened debtors’ collapse.)

The fundamental problem with artificially low interest rates is that it underprices both credit and inflation risks. Within the payment of interest there should be, in effect, an insurance payment for slow to non-payment of the loan and interest. At the current low rates, credit risk premiums are not being effectively paid. They can get away with this for awhile as the huge underfunding of global retirement needs is driving savers into chasing for yield. (CCC-rated paper and bonds are being urgently sought after.) This is a long term problem with only an estimated one quarter of Americans saving for retirement.

Investors appear to be fearful that the central banks will eventually succeed in creating enough inflation that their nominal economies will expand at an acceptable rate. The goal of many central banks is to have a 2% or higher rate of inflation. To protect themselves, institutional and individual investors are plowing into TIPS (Treasury Inflation Protected Securities) to such a degree that the price on the 10 year TIPS is now yielding 0.297%. Clearly current interest rates are not covering credit and inflation concerns.

A Time Span Portfolio Solution

My favored approach is to divide the investment responsibilities into four time-spans based on funding needs and goals.

Under the current “new normal” interest rate environment, the shortest duration portfolio (the ‘Operating Portfolio’) will run out of money sooner than expected. The second portfolio, (the ‘Replenishment Portfolio’) has to carefully trade off liquidity for current yield. This could mean lengthening duration from three to five years. I recommend investors search for reasonably well protected and growing dividend streams. The third Time Span Portfolio,  (the ‘Legacy Portfolio’) should be all equity that can survive a normal recession and still build purchasing power in excess of spending. The fourth portfolio or (the ‘Endowment Portfolio’) should be positioned to recognize and take advantage of commercial disruptions that can lead to outsized returns after inflation, expense creep, and relevant taxes.

A question facing all of us

What are we going to do with the capital liberated by selling that won’t be sucked into either spending or chasing prices?

Memorial Day

This blog post has been delayed one day due to the Memorial Day weekend. 

On this day we are thankful for all of those who sacrificed their lives so that we may be free.
Did you miss Mike Lipper’s Blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of 

Copyright © 2008 - 2014
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Sunday, May 18, 2014

Are We Complacent or Petrified?


On my recent one day visit to San Francisco when I spent 12 hours on planes for a two hour meeting, I chatted briefly with what seemed to be an intelligent stewardess. She wanted to know whether any of the papers I was discarding would make her rich if she read them. I suggested that she should enter the pilots’ cabin and learn to become a flight captain. She demurred as her friends who were pilots were mostly bored when flying these airliners. (Of course, boredom can turn to panic when something goes wrong.) Her comment echoed in me when I read that Dave Tepper, the New Jersey-based, very successful hedge fund manager was quoted as saying the market had an air of complacency. Examining my own and others' current thinking, I believe our low level of activity could be that we have become petrified.

Why are we petrified?

Sir Isaac Newton introduced the concept that God was the watchmaker in the sky that kept all the physical forces in balance so it would appear that many countervailing forces were in balance. During this period of extremely low stock market volume we instinctively should be taking advantage of apparently reasonably priced securities. Except that our somewhat undefined fears or constraints are playing off against one another, so we are doing nothing.

What is the import of these messages for bonds?

Both German and more remarkably French 10 Year bonds are yielding below similar US Treasury bonds. The lower yields are caused by investors pushing prices up and therefore yields down as German and French bonds appear safer than those of the US.  At the same time the spreads on the five year TIPS have widened which is somewhat counterintuitive. If the dollar appreciates due to higher rates, in theory, both inflation and recession risks should decline according to Moody’s*. The desired loosening of underwriting standards for mortgages as dictated by the government brings fears that we are once again starting another residential housing bubble.

In terms of stocks: more confusion

One way to look at the stock market is to use a military approach. The large caps or if you will, the generals, are leading the grinding march upwards while the smaller caps are in retreat. In April, of the 10 S&P 500 stock sectors earning estimate revisions, telecom (+15.8%) was the only double digit gainer and discretionary (-10.2%) and financials (-11.0%) were the double digit losers. Five sectors were up and five were down which showed that within a relatively flat market there was a lot of selectivity. This selectivity was even more pronounced when one looks at movement within market capitalizations. In terms of price movements by sectors, eight of the large caps were up; led by energy (+5.11%) and utilities (+4.2%). In contrast for the S&P Small Cap 600, eight of the sectors declined, however the same two were the leading sectors but with much smaller gains of +1.84% and +1.08% respectively.

Thus hiding out in large caps has worked as it has in the past in a nervous, late stage bull market.

Better valuation methods

I am pleased that S&P is providing both reported estimated earnings price ratio and their estimate of changes in operating earnings. First, I have never been comfortable with the academically derived CAPE (Cyclically Adjusted Price to Earnings ratio) approach to valuation; i.e., accepting reported earnings as a basis for valuation. (Having run a company albeit a small private firm I am very conscious of the difference between operating earnings that one can spend and financial statements' bottom lines.) Second, the current market only looks reasonably cheap if one buys into the forward estimates. For example, the P/E for the S&P500 using 2013 earnings was 17.74x and 26.01x for the S&P600 (small cap) both declined using what looks to me a very generous estimate for 2014 price/earnings ratios of 15.1x and 17.99x respectively. The reason for my skepticism is based on S&P’s estimated gains in operating earnings, +17.51% for the 500 and +44.56% for the 600. In the latter case this is almost 3 times the operating estimate gain for 2013 of +15.96%.

The problem with too generous estimates

To my mind the overly generous estimate of operating earnings gains for small caps in 2014 is to some extent petrifying me in my investment management responsibilities. As regular readers of these posts know, I believe in utilizing time spans to segment portfolios. The longest time span is for a family fortune or an endowment for future users of an institution. Recognizing that a portion of the future belongs to those that successfully disrupt the markets of today, most often this kind of guts or perhaps desperation is found in smaller companies. Thus, smaller companies, particularly those found in small funds are a regular diet for most of our accounts. While I am looking for quintuples or “ten baggers” in this kind of merchandise, I can materially cut our returns by paying too high an initial price. Perhaps the very recent 10% correction in NASDAQ prices helps a little but not enough. I need a substantial discount in many of these biotech and new technology stocks which to use Warren Buffett’s term are beyond my circle of competence and thus I use appropriate mutual funds and related vehicles.

Count our blessings

The fashion of the times is moving away from the old numerical fads such as Modern Portfolio Theory (MPT) which was modern in the world of physics over one hundred years ago, had nothing to do with the construction of winning portfolios, and was a very much an unproven theory. During this current particular phase in the stock market as correlations within and among stock groups breakdown, we will need a new set of blankets to cover the different speeds the various proverbial horses are running. I would suggest two general approaches; the first has to do with operating results and second the nature of the ownership of the shares.

Correction: Last week I inadvertently gave a Caltech Degree to Charlie Munger which was not the case. He did get an education on meteorology from Caltech which probably helped him to become a very successful lawyer and investor as well as a partner in Berkshire Hathaway’s* operating and investment success.
*Owned personally and/or by my private financial services fund

Question: What are you looking at to characterize this market?
Did you miss Mike Lipper’s Blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of 

Copyright © 2008 - 2014
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Sunday, May 11, 2014

Three Warnings

1.)Bank Services Clients Should Be Wary
2.)Expected Interest Rate Increases in Second Half
3.)Short-Term Indicators Casting Shadows on Five-Year Investors


The job of a good securities analyst is to analyze and predict, not to extrapolate current trends. There is considerable career risk to those analysts and even greater career risk to the portfolio managers who buy into these predictions. The difficult issue is attempting to spot the peak in sufficient time to position the portfolio to avoid meaningful capital losses. Unless the decline comes after a long flat period, rather than a sharp peak, the career risk in repositioning is being premature. Unfortunately, in the eyes of too many clients, to be premature is to be wrong. The purpose of my three warnings is to identify three of the items I am watching to reduce being classified as being too premature.

Bank services clients should be wary

One of the reasons I focus my private fund on investing in financial services securities is that I believe that financial services are key to the growth of the global economy. Sometimes this sector will lead and at other times it will lag the general market, but not much progress in either direction is likely without some significant movements within the financial services sector.

One of the analytical requirements in looking at a company or sector is to understand the benefits and problems of the providers of critical services to the prime groups. Going back many years this was driven home to me as an analyst who had the responsibility to follow the “white goods” (refrigerators, washers, dryers and dishwashers) as well as the “brown goods” (radio and television). The most successful seller of white goods, at that time, was Sears Roebuck and another large department store group was the leader, with a much smaller share of market selling brown goods. One of the reasons Sears was so successful in what many outsiders considered a commodity type product was how it managed its supply chain. Sears insisted on quality and eventually price leadership.

In order to achieve these goals it in effect became a partner with its critical suppliers. In a number of cases Sears took a meaningful minority interest in the supplier’s stock. By doing so, it could help its supplier earn a respectable (but not extraordinary) return on investment at the same time producing for Sears and some others very high quality products. The original relationship was one of a handshake and I believe the first contract on paper came twenty or more years later. On the other hand, in selling brown goods other large retailing chains always insisted that they get the lowest price for the merchandise that they were going to sell. One hundred years later Sears is still selling white goods and it is difficult to buy television sets in most department stores.

As mentioned in last week’s post major banks, particularly large trust banks evolved into paper and data mills providing investment and administrative services along with their deposit and loan activities. For many clients a bank’s product quality and service is as important, if not more, than to the family buying critically important white goods. Last week I pointed out that banks in general have regulatory requirements that very much restrict their ability to make the kinds of returns that they used to. This week we are greeted with the news item that Bank of New York*, parent of Bank of New York/Mellon is contemplating selling its corporate trustee business to UFJ Mitsubishi. This follows by a few weeks JP Morgan* selling its pension fund record keeping business to Great-West Life*. Further, this week is the announcement that Barclays is going to lay off 7000 employees from the investment banking and related services activities. To the extent that this last move has to do with earnings from what the industry has dubbed “FICC” (Fixed Income Currencies and Commodities) this is going beyond reacting to reducing payroll, it has to do with escaping the capital requirements that most trust banks and other large banks are becoming burdened.

Why should I care as a customer of these banks? As operating profit margins are beginning to slip, there is a great drive to replace humans with machine driven functions. Computers are wonderful, but they lack a service capability to handle difficult or unusual needs of clients who are used to high touch relationships and have paid for it in the past by getting lower than street level interest rates on their balances. This is not a short-term problem which will go away when the economy is growing faster. There are two critical trends that will affect the banks:

At some point to reduce their labor cost including health costs, banks like many other US businesses will seek to employ workers less than 30 hours week, which is not likely to increase the quality of services provided. There is a second trend of some significance to those institutions that provide post-retirement services, which can be  profitable clients for many banking institutions. The trend is that the proportion of the population that will be retiring each year will grow much more slowly than the work force as noted by Goldman Sachs*.

One possible clue to the investment world’s view on the future for the trust banks is that they are selling in the marketplace at lower price/earnings ratio valuations than the more cyclical brokerage and asset management stocks.

Expected interest rate increases in second half. 

Moody’s * believes that by the end of the third quarter of this year that the consensus is that the 10 Year US Treasury will be yielding 3.06% compared with the current approximate level of 2.61%. I suspect that this increase will not be led by the Federal Reserve, but by both internal and external pressures. Most observers do not believe this expectation is already taken into consideration for the equity market. Moody’s joins others that believe that the current yield spread between treasuries and high yield is too narrow with inappropriate concern for expected increase in defaults.

Equity investors need to pay attention to the bond market for clues to future stock price levels.

Short-term indicators shadows on five year investors

I am trying to navigate between two forces that I have been reporting on in these recent posts. The first is my belief that long-term investors should sub-divide their portfolios on the basis of the time-spans that each segment needs to deliver adequate total reinvested returns. The second of the four time-spans contemplated is the current operational portfolio which in many cases addresses obligations over the next five years. This portfolio is designed to replenish the first portfolio after it has paid out all of its capital to meet current needs, hopefully for at least two years.

The second force that I am dealing with is my earnest belief that sometime over the next five years we will suffer a meaningful decline in stock and many bond prices. (While I have mentioned my concerns in prior posts, I would be happy to discuss my thinking privately with subscribers.)

As I have mentioned in the introduction, I am very concerned about urging premature actions that can cause career risk. Therefore, I scan both the long-term factors as well as the short-term factors to get ready to get into position to protect the five year-oriented account.

In looking at the short-term indicators, Steve Shelton of Cornerstone Global calls to my attention that option traders have opened a large number of call options on the VIX compared with put options. This group of traders is betting on a major increase in volatility, which has been at a remarkably low level in an aging bull market. Perhaps related to this view is the fact that as of April 30th, shares sold short on the NASDAQ Capital Market meaningfully expanded to 4.66 days of normal trading, as compared to just 3.31 days two weeks before, an increase of 41%. This is a measure of the number of days with normal volume required to buy back enough shares to close the short position.

These are among the indicators that I pay attention to in looking to avoid being too premature. Are there others I should follow? Please let me know.

* Indirectly or directly I have investments in these securities.
Did you miss Mike Lipper’s Blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of 

Copyright © 2008 - 2014
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.