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.
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