Sunday, December 28, 2014

My Investment Worries


Essentially investment risk is not a number. The price of risk failure is the foregoing of important funding plans. In that light your risk is not the same as my risk. Not only because we have different financial and personality resources, but also different time frames, which is why I developed the TimeSpan L PortfoliosTM. These help isolate the impacts of risk failures; e.g., a disappointing short-term portfolio is different than one to help fund future generations.

No matter which is the planning time horizon of a portfolio there is another major difference between two similar portfolios. In this age of optimization many portfolios project funding out of resources with little to spare for unexpected mistakes. For many there are no reserves for mistakes because the investor or his/her manager has supposedly identified all possible disruptions. Thus, they have created an expectation risk. Thus, they need to examine what could go badly wrong with their expectations.

I suggest the biggest impact of an expectation risk is likely to be found in the very assets that most investors have the highest level of confidence. Not only by nature I am a contrarian, I am a student of history that gets uncomfortable when there is excessive enthusiasm. My current worry risk is as follows:
  • The US $
  • Large Cap Stocks
  • Treasuries-US and some Others
  • ETFs and other market structure changes

These worries are not generally recognized in market prices, which I think they should be. Therefore I perceive significant market price distortions that don’t recognize that in the future something could go wrong in most portfolios.

The worries

Part of my worries is that few if any professional investors are publicly concerned about the concerns that are on my list.

The (mighty) US Dollar

For those of us who live in a competitive price environment we are very much aware of the price spread for similar, usually not truly identical, items. There are always reasons why the bulk of buyers and sellers can identify with the current price; e.g., availability, ease of transaction, easy to service, and other qualities of merit. As an entrepreneur I always wanted to be the high priced service sold to discriminating, great capital sources. My approach was that my successful pricing was a badge of high quality. I was conscious that this policy was holding up an umbrella over cheaper competition, but in the institutional world quality usually trumps price, within reason.

Turning to the current valuation of the US$, the widening price spread versus all other major currencies suggests to me a leaky umbrella. Our current exalted position is not due to our virtuous qualities of protecting the purchasing power of our currency but rather it is due to the perceived decline in value of other currencies. Some of the weaknesses in other currencies are self imposed by the deliberate mercantile policies of governments to help sales of their exports to the US. In a period of increasingly unpopular governments within their countries and with their neighbors, people are choosing to store some of their wealth in the US, behind its supposed two ocean fortress sitting on valuable natural and human resources. Because the US monetary leadership is having enough trouble attempting to manage the domestic economy and a current Washington political establishment that would like to isolate the US from others’ problems, there is no desire to establish the US dollar as the single world currency. Thus, at some future point the unannounced but real weaker US dollar policy is likely.

In the future various economies will start growing again and become attractive places for investment both by the locals and those from outside. Therefore it would be wise to hedge one’s longer term portfolio against continued dollar strength. A number of mutual fund investors have been doing this for some time. With the exception of the five trading days ending December 24th, traditional US mutual fund investors have been adding to their non-domestic holdings while redeeming some of their domestic fund holdings. (The latter move could very well be a normal pattern of mutual fund investors exiting for retirement and other needs. In most cases the domestic funds are the oldest of their holdings.)

The leaky large-cap house

If the US dollar is being held up by a potentially leaky umbrella, the investment houses holding large-caps may start to leak soon. We acknowledged in last week’s post that in general large cap mutual funds in 2014 were performing materially better than smaller market capitalizations funds. At present and historically there is no solid evidence that large cap companies will do better than smaller caps. The foreword of Charlie Ellis’s book, What it Takes states that “None of the ten largest corporations in the U.S. economy in 1900 still ranked in the top ten 50 years later and indeed only three actually survived as companies.” In addition there is an article by JP Morgan Asset Management that since 1980 the S&P 500 has dropped 320 stocks or roughly 10 per year due to mergers, low volume, and an inversion of their tax headquarters. The problems that caused these results were more widespread with numerous large companies losing their advantage. Some possible victims of these deteriorations today might well be General Motors, IBM, and Citigroup among others.

Turning to the large-cap stocks as distinct from the companies themselves there are significant changes occurring. First the surge of stock price performance above the level of earnings progress may well be a warehouse effect. In the past when investment managers were concerned about not being invested in a market that was gently rising to flat before a perceived decline, they hid from their clients by investing in stocks of very large companies. AT&T was the best of the warehouses with its $9.00 predictable dividend which hadn’t changed for about 40 years. Today, many of the tactical players have shifted to using Exchange Traded Funds (ETFs). In the week ending Christmas Eve approximately $1 billion flowed into two S&P 500 ETFs (net of their redemptions) out of $23.7billion. Some of the inflows could be covering shorts. As of December 15th the SPDR S&P500 ETF had the second largest short position of 240 million shares. (The largest was our old warehouse name but applied to a different company, AT&T.) More on the changing market structure through ETFs and other derivatives below.

The current market sentiment may well be changing from complacency to belief in a general recovery starting in the US and haltingly going global. One clue that this could happen would be that in 2015 Small Market Capitalization stocks once against perform better than larger-caps. We could even see some flows from the larger caps into smaller cap funds. Due to ETF players who are mostly faster trading institutions we could see redemptions in various index funds as sentiment shifts from avoiding losses to picking exploding winners.

Treasuries discipline

Surprising the US deficit is declining due in part to the sequester in 2013, but it is still a deficit which does not include the off-balance sheet liabilities for various government programs. We have not taken the pledge that except in times of war to produce surpluses to retire our debt. One also needs to recognize our twin infrastructures in terms of roads and bridges as well as our growing educational deficit. We are not alone in our lack of discipline; most other countries are similarly addicted to deficit spending. For those of us who can choose not to invest in various governments’ securities this lack of discipline is an additional imponderable. However, for our banking institutions it should be a considerable issue as banks in most countries must own local government paper. Often the various authorities treat government paper more favorably than commercial paper in terms of the level of reserves required. Thus, to some extent our whole financial system is exposed to the level of discipline applied to our treasury deficit machine.

ETFs and other market structure changes

Students of warfare often note that changes of weaponry change how battles are fought and won. Clearly the introduction of the English Long Bow and the Aircraft are two examples. In the investment marketplace battles, some rely on the most current weapon which is often not fully tested. The 1987 market fall is a good example of a market collapse that was not tightly tied to an economic collapse. In a somewhat over priced market after a multi year rising market, many institutional investors felt secure because of their newly acquired weapon of “portfolio insurance.” This procedure was based on locked-in trades of securities and derivatives largely executed in Chicago. If markets were functioning normally with other investors using the various tactics of the past, a limited amount of portfolio insurance transactions apparently worked. However, as the decline accelerated many institutions and some trading organizations withdrew from the market and so the locked-in derivative trades were working against each other in driving prices into a free fall.

In 2014 and beyond the popularity of derivatives, particularly ETFs, have grown and now often represent the bulk of trading in an emotional period. To put the size of the ETF power into perspective the following points are worth noting:

  1. While the estimated net inflow into traditional US mutual funds for the Christmas Eve week was $12.8 billion the highest since March of 2000, almost twice as much ($23.7 billion net) came in through ETFs. As Blackrock’s Larry Fink has been warning for some time, institutions are using ETFs instead of futures to speculate. 
  2. There are roughly 250 authorized participants in the creation and redemption of ETFs. In many if not most cases these participants are acting for institutional clients. Some of the participants’ purchases may be to aid in setting up short positions or providing  securities to meet share lending requirements. To put the importance of the shorting of ETFs shares in perspective it is worth noting as of December 15th seven of the largest forty short positions on the New York Stock Exchange stocks were ETFs. As of the same day, nine of the thirty largest changes in short positions were for ETFs. Because of particular interest in the S&P Biotech ETF the short position would take 17 days to cover.
  3. The use of derivatives in both fixed income and currency trading is extensive.
  4. Some of the regulators and I are wondering whether several of these new weapons will blow up certain users and possible counterparties in the heat of battle.

How does one live with the worries?

One must recognize that probably there has never been or never will be a period without worries. Long-term investors need to be both flexible and diversified. In our four timespan portfolio structure, I suggest that the Operational Portfolio (1-2 years) stay tactical and not take large losses. In the Replenishment Portfolio (2-5 years) one should develop both tactics that can tolerate at least one to two poor years. The Endowment portfolio (5-10+ years) should shift to a more strategic view to take advantage of periodic declines. The Legacy Portfolio, needed to feed multiple future generations has a need to separate current fashionable thinking for expected future changes.

Question of the week:

Next week I would like to discuss opportunities for the Legacy Portfolio.  To do so I need reasons to believe positively.  Can you help me?

By the time I will be sending my first 2015 post, I hope that each and every one of my blog community has started a healthy and happy New Year.     
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A. Michael Lipper, C.F.A.,
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Sunday, December 21, 2014

The Worst Price and Long-Term Bargains

Professional investors and their political economies are very much interested in the price discovery functions of the securities and commodity markets. Prices translate into performance. Unfortunately, past performance leads to future individual investment decisions and asset allocations. In viewing the results for any given year, the last or terminal price plays an important role in the calculation of the resulting performance. Thus the December 31st (and to a much lesser extent June 30th) prices play a disproportionate role in the calculation that produces rankings, bonuses and job longevity. (Our actuarial friends would prefer multiple-date averaging calculations to “Last Trade on Last Day” as a better representative to what was happening.)

For 2014 in particular, I suspect the quality of the last prices will be weak. Due to restrictions as to the size and deployment of capital on various trading desks, the normal capital absorption capacity will be limited. Further, many organizations have already determined the size of gains and losses that they wish to sustain for the year. Thus there will be less buying power available on the last trading day of the year. Remember, the absolute final price on the last increment of trading will determine performance. In some prior years we saw a concerted effort on the part of performance players to ramp up prices of what they held in the last hour of trading. In some extreme cases there were efforts through short sales and other techniques to lower important prices for securities owned by specific competitors.

Ahead to December 31, 2014

At the moment I expect a slow Year-end day, but I am prepared for a spike in either direction on the last day which could be well reversed on the first trading day of 2015. In a relatively dull performance year the level of distortion is likely to be 1% or under.  From a performance analysis viewpoint I will pay more attention to year-to-date performance through November and/or the latest twelve month performance through the end of January, 2015. These mathematical machinations have some value in managing portfolios that have limited duration found in operational and some shorter-term replenishment portfolios. It should have no impact on decisions for endowment and legacy portfolios.  These refer to our Timespan L Portfolios™, which are segmented by investment period focus.

Better performance warnings

After a week when some of our holdings from bottom to top gained 5%+, for example T Rowe Price*, I start to get nervous about rising volume sucking in sidelined cash. (NASDAQ OMX* stock volume almost tripled from 773,829 shares to 2,225,599 shares in two days.)  These reactions need to be put into perspective. My old firm, now known as Lipper Inc., produces a daily index for each of 30 equity investment objectives. The components of these indices in the more numerous groups are the thirty largest funds.  In the smaller groups the number of components can be as small as ten. Examining the performance roster I noticed the Large-caps were up 10%, Multi-caps 9-10%, Mid-caps slightly under 8%, and the Small-caps 1.7%. What this suggests to me is that in a period of declining liquidity, institutional investors continued their Large-cap affection. Small-caps were the best performing investment objective asset based group in 2013, demonstrating their recovery potential.

The first warning in terms of a possible blow off will be when Small-caps become once again performance leaders and the investing public throws an extra $100 billion+ into Small caps which can happen.

The second warning is excessive focus on market capitalization as a screen for choosing investments. I note that on a five year compound annual growth rate basis there is little to separate the different investment objective groups’ performance; the entire range for these indices was a low of 13.92% for Large-cap Value, to a high of 15.77% for Multi-cap Growth funds. This narrow performance spread reminds me of one of the phrases that I learned at New York racetracks: one could throw a blanket over the leading horses at a heated finish line. In other words, even with all the traditional handicapping skills, the results of close races can not be successfully predicted. I would suggest that if in the future we have another five year like the last, investors should be pleased to be under the blanket of a 13.92% to 15.77% performance range, and not try too hard to pick the single best winner.

Target Date funds may not be optimal

There is another factor that may change the level of flows going into equities. The most popular inclusion in many 401(k) and similar plans are Target Date funds. The plans that are adopting these relatively new vehicles would be doing their beneficiaries a favor if they instead had chosen the mutual fund industry’s original product which was the Balanced fund where the managers made investment allocations between stocks, bonds and cash based on their outlook.

Lipper Inc. has 12 indices of Target Date funds broken down largely by maturity or retirement dates with performance on a year-to-date basis of +4 to +5%. None of them has done as well as the Lipper Balanced Fund Index gain of +7.03%. In the right hands, most potential retirees would be better off in a Balanced fund. Often the better performance of a Balanced fund is due to its investment into reasonably high quality equities.

Benefiting from discontinuous forecasting

I have often said that I can and want to learn from smart people, thus I read Howard Marks’s letters. Howard is the very smart Chairman of Oaktree Capital and an old friend. He devoted his latest insightful letter to what can be learned from the current decline in the price of oil. He focuses on the failure of most forecasts of the price of oil. These failures created what Wall Street Journal columnist Jason Zweig has called the “Petro Panic” which dropped stock and bond markets globally. Howard focused on the fact that oil price predictions were extrapolations of the past, adjusted perhaps by plus or minus 20%. This is similar to most predictions coming out of the financial community. I would suggest that these are not really helpful on two grounds. Most often the impact of the forecast is already in the price of the stock or bond in question. In addition, big money is only earned or lost when the old model is disrupted.

Three long-term items on my screen

In our Time Span Portfolios approaches, the final portfolio which is the Legacy Portfolio is expected to include securities from various successful disruptors. While there is a place at the right time and price for investing in secular growers, they are not usually the sources of extraordinary gains. These are what I like to find. I do not have the same scientific background as many of my fellow Caltech Trustees; therefore it is unlikely that I will invest client money on the basis of what is in a laboratory. I need to enter into the process later when my reading and some of my contacts can guide me in the right direction. Let me share three examples that I am looking into:

1.  The first is the global shortage of retirement vehicles. Almost no nation has sufficient retirement capital in private hands to meet the increasing retirement needs of large portions of its population. Europe is particularly troubled or should be with more people going into retirement, living longer, and fewer competent workers. I believe some of these needs can and hopefully will be met by mutual funds sold wisely to the public. Two of the investments in our financial services private fund portfolio address these needs. Both Franklin Resources* and Invesco* have strong retail and institutional distribution in Europe as well as in Asia. Their current stock prices are based on the perceived value of their present business and are paying little to nothing for their potential. At some point I believe either or both will show more earnings power internationally than domestically.
*Securities held personally and/or by the private financial services fund I manage

2.  The second item is one that I have only a tiny direct exposure; it is an expected exponential growth in the service sector within China and some of its neighbors.

3.  The third potential actually ties back to the concerns created by the Petro Panic that is the announced long-term strategy of Toyota to get rid of gasoline cars. I am trying to determine what else will be needed as people change their driving habits.
Question of the Week: Please share how far out are you looking and what are you seeing?
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Sunday, December 14, 2014

‘Tis the Season to Make Buy Lists


The shopping malls’ parking locations are increasingly crowded as shoppers are busy executing their Christmas and Chanukah gift lists being spurred on by the new discount levels of more than 50%. The shoppers look to be pleased with their purchases.

Perhaps my coincidence in the investment world which regularly rotates to being ahead or behind the world of retail sentiment,  recognizes this past week should call all serious investors to begin their research lists to examine the discounts from the peak stock price levels being offered to them. Please note I said research lists not an axiomatic buy list. There can be some long-term concerns that make current discounts not yet attractive.

This is an old exercise for me. As an analyst whenever there was a meaningful decline in the market I would make lists of stocks with future attractive price levels. The problem with these lists was that largely the stocks did not fall to really cheap prices, the equivalent to 60%+ discounts at the mall. Thus for all of my analytical skills, usually I did not execute as many buy orders as I should have. What I learned and now recommend is that instead of single price activators, one should develop a set of steps of declining prices combined with increasing levels of purchases. Buying more at cheaper prices is good as long as the declines are not in response to long-term changes in outlooks. The late and great Sir John Templeton and his chief investment officer Tom Hansberger made considerable fortunes for their clients always looking for better bargains than what was generally “on offer” in the market.

Some large and small examples:

The current apparent concern of the general stock and bond market is that the willingness to maintain supply levels of petroleum in the face of cyclical economic declines in Europe, Japan, and China is leading to lower trading prices for petroleum. I see little in the way of evidence of the relationship between the use of energy and a change in long-term economic growth. As a matter of fact, to the extent that energy prices remain low, the conservation efforts are likely to be reversed and we will probably become inefficient in our use of “low cost” energy.

I am addicted to being a long-term investor; I do not have the trading skills that others seem to possess. With that thought in mind, for an account with more than ample cash reserves held by an investment group of present and recently retired investment professionals, I recommended that the energy component be raised from 7% to 10%. In our energy basket we include various up, mid, and down stream petroleum and alternative fuel sources, rail tank car producers, railroads and various energy services suppliers. I am reasonably confident if the group averages down and holds for a long-term, the results will be pleasing. One of the smarter, large, (actually very large) investors today is Steve Schwarzman of Blackstone. He is now launching a multi-Billion dollar Energy Fund. He remembers when it was cheaper to find oil on the floor of the New York Stock Exchange than to drill for it. We are probably not there yet, but we are already seeing foreign buyers nosing around Canadian and US companies.

Mutual funds

Turning to an arena that I spend most of my waking time on, I believe there is a great trade opportunity presently. The year-to-date average performance of 24 commodity energy funds through last Thursday was down -25.99%. On the other hand the average for 88 Health/Biotech Funds for the same period was up +27.96%. (Friday was a bad day.) While we have benefited nicely from over-sized positions of Health/Biotech stocks in general diversified funds, I suspect that an energy-oriented portfolio will have better performance over the next two years than one heavily invested in Health/Biotech stocks.

In terms of my Time Span Fund Portfolios, this decision was for the operational time span portfolio (1-2 year duration) and the replenishment portfolio (up to five year duration), but not for the endowment portfolio (ten or more years) and certainly not for the legacy portfolio (for the benefit of future generations). For the longer term portfolios I recommended that at least one of the members of their investment steering committee have a background in commodities. I am not so bold as to suggest that commodity-oriented investments should be included today. I would want the committee to be aware of future commodity price moves. Rising commodity prices will affect food, transportation, manufacturing, energy, and financial services thus can be very important to most stock and bond portfolios.

Financial services

One of my lenses through which I examine the stock market is the holdings in the private financial services fund that I manage. Some of these stocks have been falling since the beginning of the current year after a generally good 2013. Others may have temporarily peaked in early December. In December through Friday, Moody’s* broke down from its $100 handle and now is down -7.46%. I perceive no change in the incredible need for income that is driving the issuance of more bonds and other financial instruments. However, the gain in the share price for the calendar year through the end of November was well over 20%.

A possible explanation

All stocks, particularly those with outsized gains, are subject to the practice of wealthy investors giving significantly appreciated shares to charitable organizations who immediately convert the gift to cash. This could be a possible explanation. Let me give a particular example of the stock price of T Rowe Price*. On Monday of last week on slightly under 900,000 shares being traded, the stock hit a high price of $85.45 closing at $84.80. At the end of the week on a pressured Friday the daily volume doubled to 2 million shares with a closing price of $82 near its low for the week of $81.97.
 *Shares held personally or in the private financial services fund I manage.

Longer term outlook

I was hoping to begin this week’s post with a headline “The Bad News is the Stock Market is Rising.” The reason for this contradictory thought was based on my often-expressed fear that growing enthusiasm was leading to a speculative, parabolic stock price rise; one of the remaining missing elements to be able to declare a major top. Luckily for all of us that this week’s decline activated a pressure release valve in the beginning to boil market. I should not have worried according to David Kotok the leader of Cumberland Advisors. In his December 12th commentary he noted the reactions to his talks with the analyst societies in Providence and Boston. He asked whether 18000 on the Dow Jones Industrial Average would be the break point and whether they thought that the closing one year from the day of his talk would be higher or lower. Almost half thought lower. That view was pleasing to him as he is fully invested in ETFs. I am also relieved because without the “professionals” leading or trying to get caught up with the charge, my feared final stage won’t happen. However, I am keeping my eye on the difference between redemptions of equity mutual funds and the purchases of stock Exchange Traded Funds. What I don’t know now is how much of the ETF purchases are from sharp investors like Cumberland or how much of the purchases are from approved participants that are buying shares of ETFs to facilitate their customers shorting these ETFs (either as a hedge versus their other holdings or expressing a view on future prices). Bottom line: many are confused about the outlook for the market. As a “registered contrarian” I am reasonably assured and only become deeply concerned when all of the market passengers move to one side of the boat.

Please share with me any evidence that you now have for materially changing your long-term views on stock and bond prices.
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Copyright © 2008 - 2014
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.