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.
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