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.     
Comment or email me a question to .

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of 

Copyright © 2008 - 2014
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

No comments: