Sunday, November 30, 2014

Thanksgiving and Investment Performance


Most cultures have a harvest festival where people give thanks for what they have gathered. I am particularly blessed by the opportunity to communicate with such intelligent people globally through both this blog as well as through my investment responsibilities. One of my investment blessings is uncertainty as to the future. Contrary to many people’s belief, uncertainty is the arena where most investment gains are made; as various elements sort themselves out prices will react appropriately. However once things become crystal clear the vast majority of the price movement has been achieved. Thus I am thankful for levels of uncertainty as I attempt to deal intelligently with expectations.


Faithful readers of these posts know that I visit the nearby Mall at Short Hills each Thanksgiving weekend. My report this year is mixed. By far the biggest attraction with long lines of grandparents, parents, and children was an expansive display of products and photos based on Disney’s “Frozen.” I marvel as how successful the “House of Mickey” has been with a product that was in public domain that they didn’t invent, but brilliantly promoted. The other big winner was apparently the iPhone and related merchandise. The large Apple* store was jammed, but did not have outside lines. A much smaller Verizon store was quite crowded. AT&T’s much too large store had a sprinkling of people within it. While this mall ranges from mid price points to high prices, the high-end stores looked quite empty. My walking conclusion is that it will be a good season for Apple and not so good for high-end shops. I do not have a big feel for the purchases over the Internet. Some retail groups have jumped on to it, Macy’s claims that it is the fifth largest seller on the net.
*Owned by me personally and/or by the financial services fund I manage

From an economic viewpoint the absence of many “must have” purchases may mean that the savings (not spending) ratio will not retreat from its current 5% level. The use of debit cards is probably not going to soar.

Liquidity concerns

One set of expectations on the part of members of the SEC is the rapid redemptions in bond funds and ETFs when interest rates begin their “inevitable” rise. Quietly they are asking leading fund groups and their independent boards about plans to handle the expected tidal wave. Curious to me they do not appear to be as concerned about equity liquidity which I believe under the present shortage of trading desk capital could react just as quickly. In terms of investment performance in both the debt and equity markets, it has paid off to invest in large, but illiquid positions. We will be watching intently as to how those portfolios that have been more illiquid than others handle any significant squeeze on liquidity. (More on this relating to performance below.)

Longer term economic expectations

Pensions & Investments magazine (P&I) and Aberdeen Research conducted a poll on Macroeconomic expectations over the next ten years by region. The majority of respondents would improve as shown in the following ratios of improvement vs. decline:              

Market Location
vs. decline
Emerging Markets
47% vs.13%
Frontier Markets
36% vs.
33% vs.
31% vs.
16% vs.
non-US dev.
11% vs.
9% vs.

Other major regions including US, UK, and Europe were expected to have deteriorating macroeconomics over the ten year period. I have little confidence that these projections will work out as expected. However, I believe that they are useful in understanding current price/earnings ratios in these markets.

Performance analysis

One of the elements that I am thankful for this holiday is that we are in deep discussion about managing one particular new account’s money. A vital key to a high level of satisfaction is to agree as to what is important to be measured. I have difficulty determining a worse measure to make decisions as to hiring or firing a manager than raw absolute performance or even relative performance to some securities index. These are not the primary tools we use in selecting funds for a portfolio of funds. As J.P. Morgan himself stated, he only loaned money on the basis of the borrower’s character. Thus we want to understand the managers as individuals.

We also recognize the need to be patient and that is why we look at long-term developments.

There have always been some spectacularly performing managers often with very successful sales people attached that I do not believe. Many times when I dig into their records I find a particular, undisclosed relationship that is the main engine of their success. Some of these engines can keep functioning for a number of years until they are found to be wanting. One of the keys to our analysis is to try to determine where the good and bad performance come from. In some cases all of the extreme performance comes from a limited number of securities. I remember one quite ordinary fund with a skilled portfolio manager salesman touting its good performance. When I looked further into the fund’s performance I noticed that all of the truly great performance was coming from a single analyst. I suspected that he would quickly find better employment elsewhere. When that happened the air was let out of the fund’s good numbers which eventually led to the sale of the management company.

The significance of turnover and fund flows

A rapid turnover producing a good record is not as valuable to me as one whose portfolio is turned over more slowly. The first fund may possess trading skills which are often relatively transitory while the second one may have real selection skills. As even the best investment managers have periods of significant underperformance, we need to understand both the causes of the underperformance and what the manager does about it. The impact of cash flows and how they impact the portfolio has a distinct implication to evaluating the result. Often a surge of money coming in can overwhelm either the position size or the number of holdings. (An important corollary of the surge is what the organization does with its increased profitability. Does it change the life style of the key investment personnel?) Withdrawals or redemptions can reverse some of the behavior changes. However, we are not disturbed by the outflows. I have never seen a portfolio that couldn’t benefit from some pruning.

The question that I am currently grappling with is how to introduce sound judgment into the investment performance question. With the large group of very intelligent investment professionals and sound investors reading these words, I appeal to you for help. Your assistance will give my accounts and me something to be thankful for.
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Sunday, November 23, 2014

Markets Misread the Medicine


Perhaps because of my cold I am more conscious than at other times to medicine. With all the wonders of modern science there is no sure fire way to cure the common cold, yet the market for cold remedies is very large and present in every country. We all want to get better quickly and will try any so-called remedies.

Wrong medicine sends markets higher

This week we have seen several examples of governments and/or their central banks prescribing the wrong medicine to the welcoming stock markets. The sugar pills that are being rammed down our throats are various forms of Quantitative Easing.

Perhaps exporting our problems helps

The US used to be accused of exporting our home grown inflation. At other times we were criticized for our declared strong but actual weak dollar policy. But now we are exporting a bigger fallacy. The recently retired chair of the Federal Reserve Board and mentor to the current chair in his continued advocacy of Quantitative Easing (QE) has quipped that in practice it worked, but in theory it shouldn’t. Further, he said “We were never concerned about [inflation]. Inflation was never a risk and inflation is not a risk now.” This is from a man that did not see the many precursors that multiplied and helped created the housing bubble.

The evidence of the lowering of underwriting mortgage standards was reported on within the Fed’s own documents. The comment about no inflation now is particularly inappropriate when using core inflation, the Fed’s preferred measure, which over the last twelve months has risen to 1.8%.  These mental lapses are acceptable for a busy ex-Princeton professor who was not challenged in the commercial world. His real crime against the US economy and now his followers in the central canks of the world is the belief that QE worked. There appears to be a loose correlation that the first dose of QE was stimulating. Those of us who follow the performance of securities prices have learned that correlation does not equal causation. The proof is that in this market additional doses have had increasingly less impact.

Japan’s experience revealing

Our Japanese friends have relatively quickly observed their own evidence when much stronger QE medicine was applied to their economy: it has led to them falling back into recession. On the weight of the evidence I believe we can conclude that QE is a poor if not bad medicine for economies, but not stock markets who need to believe. Thus this week’s Euro propaganda by the ECB buying bonds as they launch their latest QE attempt was good for their local stock markets, but is in and of itself unlikely to materially help the various economies.

The "Third Arrow" could really help

After fiscal and monetary changes in Japan, the “third arrow” was a deep and sustained reform movement which included removing many government imposed controls, including immigration.

Perhaps if the third arrow is successful, both the US and Europe could follow Japan’s lead. In the US, federal tax regulations are spread over approximately 79,000 pages. Renewed faith in the marketplace to provide much of the regulation with appropriate oversight would energize each economy. All one needs to do is to array the starting date of various industries along with the anticipated level of regulation to see where economic productivity is likely to occur.

What won’t help

Reliance on old economic theory and practice is not the answer to today’s problems. I won’t go on paraphrasing  Mark Anthony about coming to bury Keynesian thoughts. I am concerned more about an eighteenth century ghost of mercantilism. Today, as in the past, governments are trying to aid their exporters to earn increased amounts of currency.  The European governments of past eras were attempting the same maneuver by lowering the value of their own currency versus their competitors. This created an era of competitive devaluations. 

Both our Japanese and European friends are trying to accomplish the same thing today. This will set off a race to the bottom and deprive their homelands of more expensive imports. In terms of quality of life, cheaper goods often means items of less value to the user. To defend themselves, much of the wealthy classes are now exchanging their own currency for foreign luxury goods as a way to protect their own real wealth. Some of the preferred goods are securities. The $1 trillion dollar Japanese Government Pension Plan has doubled its commitments to both domestic and international stocks, each to 25% of their total responsibility. This surge is helping the Japanese market and I suspect is playing a role in the US as well.

What may be the root cause of the problems?

The as usual intriguing John Authers in the Financial Times has produced an article that may explain the unanimity of central bank thinking. In the article under the column head of “The Long View,” he has a title of  “Why we need to break the white male grip on the markets.” In the article he focuses on group thinking. The bottom line in the article is homogeneity makes a group overconfident. 

Most central bankers are learned economists. Most economists spend most of their time on macro-economic studies, in other words top/down. Coming from a securities analyst and race track handicapper my instinct is for micro- economics and focus on details that make something standout. I also learned at the track and in the marketplace to challenge the consensus thinking which is right some of the time, but wrong at other times. When right things go as planned, no problem; but when wrong they can be disruptive. Central bankers like most boards of directors and investment committees are made up of polite people that may occasionally question but rarely challenge the perceived truth. To have all the major central banks going the same way is an example of extreme consensus thinking which could well be risky.

Are good stock markets worrisome?

One of my individual high net worth clients reminds me that while he is delighted with the performance of his account, the pain of loss would be twice as large as the pleasure of his gains. He has his pleasure/pain calculus right even though over time a continuously invested stock portfolio has absorbed major market calamities with an average annual gain going back to 1871 of 6.8%. Nevertheless, if the medicine that we are swallowing is giving us sugar highs we need to be wary. The Lipper Balanced (Mutual) Fund Index is slightly elevated at 7.47% for the year-to-date. The index is benefiting from its ownership of large cap core equities that as a stand alone is up 11.42% in 2014. Neither of these numbers is of the nose bleed size, but after a remarkably strong 2013, we need to watch closely.

There are two indicators that we are watching. The first is the ratio of the purchase of call options as compared with the number of put options owned. This ratio is historically low and on this measure the market is not looking frothy. However, Friday’s stock price movements are a flashing cautionary signal. On the New York Stock Exchange 219 stocks hit new highs and only 15 hit new lows. This may show that the large amounts of institutional cash reserves are being committed. The reason for this belief is that on the NASDAQ there were only134 new highs, but 48 new lows. Often the NASDAQ is a more speculative market.

The patient is recovering

As my cold is leaving my body this evening I regain some perspective having recovered from the medicine I took. The issues in counseling my nervous client are the time horizons of his concerns. Clearly the US market could fall at any time in view of its long recovery. While the recovery has been long, it is not particularly robust. On a historical basis, we could see a possible 25% fall which could be recovered in perhaps five or so years. We are prepared for that potential. However, there is a bigger risk and it is on the upside. 

We may be in a period that many investors seeing the current gains and the popular belief in QE and other government remedies quickly re-enter the market and not in the large markets for companies like Berkshire Hathaway*, IBM, Procter & Gamble as recommended by Goldman Sachs*, but in much more speculative NASDAQ stocks and call options. This kind of surge could produce parabolic price patterns as we head to some predictions in the years ahead of 3000 on the S&P 500, but perhaps much sooner than expected. This kind of enthusiasm could set up my feared spike which could lead to a generational decline on the order of 50% like we saw in 2008. Normally the next big drop would be further in the future, but we can not count on it.
*Owned by me personally and/or by the financial services fund I manage.

The key for my client mentioned above is what level and duration is his discomfort. He could experience pain as those around him in the short run make a pile of money before they lose most or all of it. My task is to be conscious of his pleasure/pain calculus as well as his longer-term performance.

Question of the Week: Where are you on your Pain/Pleasure investor calculus?
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