Sunday, June 29, 2014

How to Survive Banner Headlines


Investors and the public in general tend to believe in big headlines and invest in the direction of the headlines. Often this is a mistake. On the front page of The Wall Street Journal last week there was a five column banner headline trumpeting “Broad Gains Power Historic Rally.” A sub headline stated that for the first time since 1993 that six closely watched indexes rose in the first half of the year. (The indexes were two from Dow Jones - DJIA and Commodities; two from MSCI - World Stocks and Emerging Markets Stocks;  as well as indexes for Gold and Bonds.)

The financially sound investor would quickly point out that the flow into tradable elements was caused by people getting out of cash money. Institutions and individuals were recognizing that excessive borrowing to meet or prolong deficits and the central banks manipulating interest rates has caused a twenty year recognition that in today’s world cash is trash.

Those of us who have any knowledge of how people (particularly investors and voters) react will recognize that when there is a large imbalance of opinion that the majority will win for a relatively short while to be followed by major disappointments. Such may well be the case this time.

How do I know? Years ago I learned from a very sound investor who happened to be one of my accounting professors that I should read financial statements from the back forward. I should spend as much time reading the footnotes and auditor’s certificate as I would in reading the CEO’s comments even though the CEO’s comments were designed to be more easily understood. I suggest that all who wish to be informed and to have the ability to change one’s views to read the small articles at the end of the pages in most newspapers. If you do you might come up with what I am seeing.

Bits of information important to me

1.      In the last week the average interest rate paid on bank deposit accounts (MMDA) went from 0.37% to 0.43%. In most weeks there is no change or only minor moves of .01%. This 16% move could be for some technical reason or could be that banks, mostly retail banks, are starting to make loans and need more deposits.

2.      The five month increase in CCC (low credit quality) loans is up 17.2%.  At the same time there was a decrease in high quality loans being sold.

3.      Moody’s * is concerned that the combination of below trend profit growth and above trend borrowing will lead to an increase in defaults.

4.      Two very respected investors from quite different vantage points, Stephen Roach and Wilbur Ross, are worried about too much easy money. Steve is one of the leading experts on investing in China and Wilbur Ross has had a very successful career investing in distressed securities both in the US and elsewhere.

5.      Bank for International Settlements (BIS) which is the international bank that provides credit to banks globally is warning about “euphoric markets.”

Applying concerns to portfolios

As a professional investment advisor I need to be concerned each day as to how the accounts that I am responsible for are positioned. In almost all cases these accounts must be in the market to meet their long-term needs. Today, with interest rates in the range of perceived long-term inflation, (if not lower, as shown by the WSJ banner headline), the bulk of the accounts are balanced accounts with a preponderance in equities.

Regular readers of these posts have learned that I am worried about a major, once in a generation, drop in equity prices. Up to now I have been focusing on stock prices to generate sell signals. Increasingly I believe I should focus much more attention on fixed-income markets. The triggers to the last major declines were caused by the failure of Lehman Brothers ability to finance itself and the widespread fears of residential mortgage defaults. These were fixed-income problems that severely impacted stock prices.

I want to learn from other investors and investment managers. This is why I prefer in most instances to invest through funds managed by bright people. This week someone sent to me a copy of Schroders* latest investment letter. In the letter Schroders divides its outlook for the future of its accounts into scenarios. The most probable is an extrapolation of present trends. However, the letter mentions seven other scenarios which could be important. I have listed them in order of their probability according to Schroders:

  • Capacity Limits
  • G7 boom
  • China Hard Landing (Steve Roach believes the increasing codependence on China could hurt the US if we don’t come to a better relationship.)
  • Secular Stagnation
  • Eurozone Deflation
  • Trade War
  • Russian Rumble

*Owned by me personally and/or by the private financial services fund I manage

While each of these could be the problem that sets off the market decline, to me the key is the proportion that Schroders gives to the most probable outcome, the essential “muddle through” scenario which is at 65%.

Why I am limiting equity exposure

Coincidentally because of my concerns after five good market years and below average economic years, I think it would be wise to limit equity exposure in a conservative balanced account to 65%. While I expect we could have one more major, almost skyrocket selected stock price move, I would be moving lower in terms of equities, if I could find some reasonably safe fixed-income alternatives producing above inflation rates of return.

The equity exposure mentioned is for those accounts that will have funding responsibilities in the next five years. Longer-term accounts could selectively be higher, except I am beginning to worry about long-term endowment type accounts. In the past I felt that this account should be invested all in equities as the best way to get the benefits of disruptive technology and favorable demographics. I am beginning to worry that pricing competition could be too fierce. 

In terms of demographics, I believe that the US will accept more legal and if not illegal immigration. My concern is as to the quality of our young labor force today. I find it disturbing that in the US Army’s reported view, only 29% of the population could be accepted. (I don’t know what the experience is for the US Marines, but we only wanted “the few”). Without the right people our long-term returns will not match our needs.

Please share with me your views.   
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A. Michael Lipper, C.F.A.,
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Sunday, June 22, 2014

Be Vigilant when Relying on Patterns


In last week’s post I discussed that many investors are only interested in outcomes and not the causes of the outcomes. These investors search for repeated results and expect the same patterns to be continued into the future. For the last two weeks I have been drawing lessons from California Chrome’s losing the Belmont Stakes, and stated that it was a bad bet. Those who wagered on that result were betting that the colt’s past pattern would continue in this most difficult race for three year olds.

Those who follow history of sports, politics (Eric Cantor), theater, and human emotions all have experienced disappointment when the winning streak is not continued. The reason I said that the bet on California Chrome was a bad bet was that the betting odds were odds on, putting up more ($5) to win less ($4). This assumed a much higher degree of certainty than warranted on a young, head strong colt in the spring of the year.

Keynes lost several fortunes following patterns

In the June edition of the Financial Advisor Magazine there is a good article on John Maynard Keynes and his investment experience. There is no question that this Cambridge University don was exceedingly bright and had all kinds of ambitions. As an economist he was also a researcher and looked for patterns in commodities and currencies as well as US and UK common stocks. Each failed to produce a winning result every year and also led to large, (but less than market) losses in 1931. He did beat the UK market in 12 out of 18 years, which is exactly the ratio one would normally expect from a very good professional investor. The sad part of this experience in terms of the rest of the world is that various governments took his economic theories to be unassailable laws. If people only would have used the concept of applying a winning percentage to absolute belief in his economic laws, the world would have been a better place. Instead we had a Republican President of the United States intoning “We are all Keynesian Now.” This was almost exactly at the very moment of history when the US allowed its budget to get out of hand and began peace time deficits that continue to this day, which has led to a relative decline in the US standard of living.

Favorable patterns that may not hold up.

All humans look for patterns in everything they do. Even well-trained analysts look for what they hope for is certainty in patterns. Being a contrarian by nature I look for a reversal of trends, but currently markets are accepting the following patterns:

1.  On a year to date performance basis the Dow Jones Industrial Average is up +2.2% and its Utility average is up + 15.5%. This suggests that focusing on sectors is more important than the level of markets.

2.  Many portfolios are centered on various market capitalization levels which S&P provides. However the best performing S&P level is its 500 Index up +6.2%, and its worst is its Small Cap Index +2.1%. This suggests that market caps are relatively insignificant. We will see if this is true in the next major moves, particularly on the down side.

3.  Low perceived quality as measured by those stocks listed on the American Stock Exchange gained + 16.3% compared with those of the New York Stock Exchange + 5.5%. In 2014 (and for the last several years) higher quality, particularly of balance sheets has hurt relative performance. I doubt this trend will continue in an economic downturn. (Keep an eye on the default rate in high yield bonds.)

4.  Enthusiasm for various political leaders’ statements as to the future of their economies going through restructuring has driven their markets to possibly unsustainable comparisons. The Indian Sensex index is up +18.6% and the Japan’s Nikkei is down -3.5%.

5.  David Herro in his search for economic trends noted that the old indicator, an increase in lipstick sales, is being replaced by an increase in nail polish as an indicator.

6.  The trouble with following patterns slavishly is there is no room for a “black swan” occurrence.

Pattern Analysis can be useful

In a recent report Standard & Poor’s compared the performance of Large-Cap mutual funds to their respective S&P Benchmarks, showing in each of the last six years that the majority of funds beat the indices. The range of beats goes from 81% in 2011 to 51% in 2009. I found this data set interesting in that it shows actively managed funds can perform as well as the benchmarks. More significant to me is the extremes of performance. The low number occurred in a sharply rising market and the high number in a market that was declining in many sectors. My explanation for this result is that the indexes do not hold cash reserves where mutual funds do. Coming off a bottom, “cash is trash” and hurts performance, whereas in a falling market cash acts as a cushion. As I believe that this pattern will continue in our managed accounts, I have been cutting back on our use of index funds as a preparatory move for a future decline. (The impact of this move is to slightly raise our overall expense ratio.)

Moody’s*  believes “Exceptionally thin spreads typically credit cycle slumps.” As the yield spread is historically small between low credit instruments and high quality ones, I believe that this is a pattern worth noting. This is particularly true as we are seeing a concerted push on the part of both mutual fund houses and brokers to invest in unconstrained fixed- income funds. Even various government agencies are concerned and have discussed an idea of trying to put some redemption constraints on bond funds, which I do not believe will happen politically. Further to the discussion is a comment by a former Federal Reserve Governor in referring to bond fund redemptions as “liquid claims on illiquid assets.”

*Owned by me personally and/or by the private financial services fund I manage

Perhaps, my searching for the top of the stock market that precedes a major decline is misplaced, possibly the top will be caused by a malfunctioning fixed-income market. After all, the last major decline was caused by Lehman’s inability to fund itself in the short-term market. 

What patterns do you use?  
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A. Michael Lipper, C.F.A.,
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Sunday, June 15, 2014

Good Investment Outcomes Can Lead to Poor Investment Results


In last week's post I mentioned that much of what I have learned about investment analysis I learned at the racetrack, and that a bet on California Chrome while understandable, was a bad bet from a rate of return basis. Some have asked me what about handicapping, the term used for analyzing horse races that I find so appealing. My initial response was that within the half hour between races one could make a thought-out decision and shortly thereafter you learned whether you were right.

As with most rapid response answers this one was not fully responsive for it focused only on results. The real benefit from handicapping races at the track, particularly with knowledgeable other people, is not about their choices but rather observing their well-reasoned thinking. After the race there was often a post-mortem on what we did not fully appreciate in the past performance tables we studied. In the case of the Belmont Stakes the very fast workout a few days before the race by California Chrome was combined with the fact that the eventual winner was more rested than the favorite, as it did not run in the Kentucky Derby. Another item that should have factored in the analysis was that there were a few more horses entered in the race than normal for the Belmont.

The above elements give greater depth to the results. Many who will follow the favorite's future races will focus only on the disappointing results or blame the jockey for a bad ride; for instance California Chrome’s jockey who described his colt as "empty" when he urged a final stretch run. I would suggest that when rested at equal weights California Chrome will be difficult to beat in the future. (Until we get more current information.)

The failure to separate outcomes from critical analysis   

A quick focus on outcomes is often used to confirm one's own thinking without looking at it as an opportunity to search for other elements of useful wisdom. One of the differences between a number of investment committees and professional investors is that investment committees want simple definitive answers that they can extrapolate into the future. The manager or fund that did not meet or beat the assigned benchmark failed, and should be replaced in favor of more promising candidates. Races are often won or lost due to the unexpected element of “racing luck” which is unlikely to be repeated in the future.

Avoiding habit-based decisions

In the current market environment of an aging bull market (980 trading days without a 10% correction), “racing luck” might be attributed to an unexpected merger or acquisition announcement. Just as a professional jockey keeps his mount out of trouble and does not fruitlessly exhaust his/her horse, a prudent portfolio manager exercises appropriate risk management. Good jockeys don't run every race the same way. They avoid habit-based decisions in trying to find new ways to win races.

In looking at various races one should be looking for what is the preferred length of the race for each horse in the race. Some are very good at short distances and try to hold on for mid distance races. Others are using a race as a warm up for a richer, longer race in the future.

Parsing the analyses

As subscribers to these posts have learned, I am a believer in breaking up a single portfolio into at least four sub-portfolios based on the expected time-span to meet the investor’s and particularly the institution's needs.

The definitions to the four Time-span Fund Portfolios are listed in my blog post last week, click here to read.

If one assigns each position to one of the sub portfolios then one can make a more incisive analysis as to whether the securities’ results are likely to be delivered against the needs of the account. Just as at the track one should separate sprinters from middle distant and longer race horses.

Another factor that one can take away from the track (particularly when looking at fillies and mares) is whether they may be good brood mares. Many believe that the male line provides the stamina and the female line the racing ability. Numerous individual and institutional investors want to hire a manager that will work with them for many years or a couple of generations. Thus, they should look at the ability to develop replacements for their key players which should include portfolio managers, analysts, traders, critical administrative personnel, and beyond.   

Other sources of good and bad investment results

If the only source of investment expertise is distilled from going to the races, there would be huge crowds at all the tracks all the time rather than the sparse crowds that normally show up. One contribution to another important element can be gleaned from a Barron's
article by Stephen Mauzy, who I don't know. In his article he describes investing as entrepreneurial rather than formula driven. He suggests while risk could be considered probabilistic, uncertainty is where the opportunities lie. The entrepreneur type of mind is used to dealing with uncertainty and the good ones thrive on it. We prefer, when possible, to invest with managers that are entrepreneurial in nature and in shops of a similar nature.

The source of what may turn out badly are some very bright people who are quite numeric, according to a New York Times interview, where the subject stated, "There's a lot of behavioral psychology around the fact that the smarter you are, the easier it is for you to make up metrics that make you think you are doing the right thing.” 

The biggest risk: the Operational (Cash) Portfolio

There is not meant to be any risk or at least very little in the most secure of the four Time-span Portfolios, the Operational Cash Portfolio. While we are used to taking risks in venture or disruptive type equity portfolios, we believe that our operational needs are completely secure in the portfolio that is set-up to fund immediate needs. The problem is as long as the Federal Reserve and other Central Banks keep manipulating interest rates so short-term interest rates are close to nil, there will be experimentation at getting elevated rates on this supposedly secure money. Probably nothing will happen, but even a potential loss of one to five cents on the dollar will cause a great deal of stress on the operating people in the family or non-profit institution. The stress from this disappointment is likely to be more intensively felt than the satisfaction from prior gains achieved from stretching. In the real world this is the difference between genuine analysis and outcome focus. So be careful, particularly now.

Whether your observe Fathers Day or not, as with horses we all have gotten a great deal from our fathers which I hope you celebrate. 

How are you safe-guarding your short-term capital accounts? 
Comment or email me a question to .

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.