Sunday, October 19, 2014

The Failure of Investment Failures


This past week I had several opportunities to chat with Tom Rosenbaum, the new president of Caltech; in one session he asked for suggestions as to what additional subjects should be taught. I suggested a course that covered most of the world’s major scientific failures. My thinking was that there may be a common theme to what has gone wrong. I later realized that this was a half-baked idea. On the one hand the very nature of most scientific discoveries is through experimentation. Some scientists however keep changing various elements until they get the result that they want to achieve or recognize that what they did produce is surprising and a good but unintended result. What is often missing from this application of the scientific method is that there is no attempt to learn from what went wrong or at least what did not turn out as expected. 

In the investment world we also examine why something doesn’t work out as expected. As many regular readers of these posts are aware I believe that essentially I learned security analysis at the race track. In some ways my most valuable time (after not cashing a winning ticket) was spent re-examining the prior records of both the winning horse and my losing bet as well the actual racing conditions. I often found that I had overlooked some critical set of facts and my expectations were sadly out of kilter. I humbly suggest that the 2014 investment performance through this week gives scope to look at a number of investment theories that have not produced the expected results. We should not fail to learn from these failures.

Friday's failures

After a week of significant global stock market losses, on Friday the Dow Jones Industrial Average (DJIA) rose +1.63% easily beating gains of +1.29% for the Standard & Poor's 500 and +0.97% for the NASDAQ. I believe the message from this data is that more of the gain was achieved in the indicator with the smaller number of securities which would demonstrate to me some lacking of enthusiasm for most securities. This view is reinforced by looking at one of the DJIA components, JPMorgan Chase*. On Wednesday the stock hit its low for the week at $54.26, on 37.9 million shares. On Friday the stock closed at $56.20 on 19.5 million shares or little more than half of its high volume day.  Don’t look at Friday’s rise as the beginning of a major recovery.
*Owned by me and/or by the financial services fund I manage

A number of my market analyst friends suggested that the pickup on Friday was to correct a significantly oversold condition and represents a sales opportunity rather than a buy opportunity. This pattern is present in numerous countries' stock markets. Those focusing on the US expect another test of the recent Standard & Poor's 500 lows. Nevertheless they perceive a good chance for a substantial rally in the winter; but a failure to go to a new high in late 2014 or early 2015 would suggest the potential for a major decline.

Mis-reading fund flows

Many market participants jump on aggregate net fund flow data to ascribe a level of demand for stocks and bonds without understanding the broader implications. First, the published data is often based in part on the net differences between fund purchases and sales. To me there is an analytical difference between a $10 Billion net inflow made up of gross income of $11 Billion and gross redemptions of $1 billion compared to a situation when $25 Billion is incoming and $15 Billion is leaving.

Further some analysts add the flows of Exchange Traded Funds (ETF) and conventional mutual funds together. There are two problems with their approach; the first is mutual funds are typically owned by individual investors directly or through financial  institutions that are long-term in nature, like the accounts that we manage, whereas many ETFs are owned by hedge funds and other short-term trading accounts. In the week ending October 15th, $17 Billion were invested net into equities by the ETFs. Of this, approximately $12 Billion were invested net in S&P500 ETFs. The analysts at my old firm Lipper, Inc. believe that a good bit of this inflow was created by the authorized participants who are largely brokerage firms and other institutions who offer these shares to short sellers in exchange for the interest earned on the short positions. The net effect of this activity is that a major portion of the supposedly supporting purchases to the broad market are betting on a decline.

US fund investors redeem domestic funds

For the last six months fund investors have been redeeming US oriented funds and buying International funds except those that focus on European investments. I believe that fund investors like much of corporate America are concerned about the near-term future for the country. The failure is to treat fund flows as a single-dimension.

Poor economic analysis

I write this post from Washington, DC, where the US Congress sits in the Capitol, a building whose inhabitants usually do not understand capital and the need to make it.

Some want to stimulate through throwing taxpayer money on infrastructure and other ways to fuel the US and other global economies. What they fail to understand is the only economic quantity that is of commercial concern to many of us is the opportunity to make money for beneficiaries. Both cash and credit are in surplus. If the politicians really want to invigorate the economy they should reduce the burdensome bureaucracy.

What are your investment failures?
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A. Michael Lipper, C.F.A.,
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