Sunday, April 26, 2015

Investment Implications of the Week


Last week’s post listed a number of elements that could have caused the big sell off on Friday, April 17th. I questioned whether the relatively big decline was important. By this Friday the general equity market rallied back to the levels where the April 17th decline began. Thus the simple answer to my question is that the fall of the 17th was not important. As with most simple answers, they miss the point of relevance. Each of the five elements could become significant to the future value of our equity portfolios as discussed below:

1. The Chinese authorities expressed concern as to the level of speculation being done by somewhat affluent retail brokerage accounts which they were attempting to curtail.

(The prices of many Chinese stocks have doubled in a year while their economy is slowing. The strong desire of many Chinese is to get out of their large savings balances numerated in the Yuan. Securities makes sense for two reasons, first the government’s desire to moderate housing prices is driving the cost to borrow up and increasing the size of down payments. The second reason for the attraction of stocks is that they can now be sold through Hong Kong for HK dollars tied to the US dollar. The Chinese are thus joining the locals in many countries including the US wanting to partially escape their home currency and government control. This awareness of local concerns should not invite inflows into the markets where capital is being exported other than taking advantage of the late incomers.) 

2. Liquidity is becoming more scarce as capital requirements imposed on banking and other large financial concerns are limiting the ability of the traditional sources of liquidity to provide them to those in need at reasonable prices. Liquidity is not important, until you need it to exit or acquire a position quickly and discreetly.

(From a customer's viewpoint big is being viewed increasingly as muscle bound. Large players have had to deploy their capital against regulatory requirements leaving less and less capital to fund client needs or be able to quickly rescue a worthwhile competitor who is in dire straits. Thus there appears to be far less underpinning to current prices than what we used to have.)

3. The couple hour failure of the always reliable Bloomberg computer communications system highlighted how dependent many trading desks had become without sufficient alternatives to trade.

(For those of us who have relied on various machines to run our lives we are not totally surprised with occasional machine and people failures.)

For some, this week became a painful example of how one skilled computer operator can create short-term havoc for a brief period that was long enough to be a significant profit and loss opportunity in suburban London. Interesting, in all the talk about the flash crash, so far no one mentioned a similar occurrence in the US Treasury market. The longer term implications of these “sorcerers apprentice” actions drives home the fact that participants in the market should not count on various regulators understanding the current game or knowing who is playing what set of instruments. To some extent in the past we were better protected when marketplace members were the primary regulators. In a somewhat analogous situation described in Sunday’s New York Times, the diamond merchants have developed their own regulatory system with the main penalty for bad characters being that they won’t be welcome to trade.

4. Investors using academic models were not forewarned by the drop on April 17th . They had been taught at universities and promoters of various statistical services that standard deviation and other measures of volatility signified levels of price risk in various securities. Thus, these investors were surprised by the speed and size of the drop. A number of more seasoned investors were not particularly surprised due to the relative thinness of the volume on the way up and the lack of traditional price corrections. 

(The importance of this drop is to reinforce that risk is not volatility, but rather the penalty for bring wrong to the extent that long-term spending plans need to be curtailed. Periodic changes in the direction of prices are to be expected. When they do not come, changes are in effect delayed which can be made up quickly.)

5. At the end of the trading day a week ago, there was some price recovery. The critical question was: as the selling pressure lessened, was the buying from those that are trading oriented or new fundamental buyers? 

(The markets did rise last week with the NASDAQ index up every day to a new high along with a number of international markets. The question remains whether or not this is fresh money coming into the market now. I will discuss the importance of the answer to that question shortly.)

Bottom line, the price drop on April 17th was not immediately important, but it raised sufficient issues that should start investment policy reviews.

The oversupply opportunity

Commodities and industry capacity utilization are in ample supply which means that price inflation is a bit away. What are clearly needed are items that many people want to buy. I suggest that US-led companies as well as some others are brilliant at finding products that people and companies want to buy. In many ways, the US’s greatest natural resource is our advertising and marketing talent. We will be saved by our “Mad Men” and ladies. They not only create the initial demand but allow us to believe in continuing demand that will draw underutilized capital into the investment marketplace. All over the world people are desperately looking for investments in the private sector that can start to fill their retirement capital gap. The current incredible success of Apple* will not be a one off, as others find the need for new products and services not now present.
* I am long Apple Stock and have been for many years.

How do you balance your concerns and opportunities?

This question is exactly why I have developed this concept of Timespan Portfolios. The shorter term portfolios need to address the fact that the current regulatory picture is increasingly adverse to sound investing and so periodic and healthy drops may be more severe than history suggests. These will be corrected however, with different people in places of power.

The longer term portfolios will benefit from the successful mobilization of capital investing into more efficient companies, products and services.
I would be happy to discuss this dichotomy with our regular subscribers to see where the Timespan Portfolios work for you.

Question of the Week:

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Sunday, April 19, 2015

The Risk of Being Right and Other Lessons


I am dedicated to the mission of learning something every single day. Often I get a small insight into some relationship of minor long-term significance, but I never know its value either in the present or possibly in the future.

Was April 17, 2015 important?

One of my many advantages is that I am part of a loosely connected group of formerly senior securities analysts, portfolio managers, chief investment officers, institutional sales people and technical market analysts. We physically meet most months and we are in electronic communications daily. Last Friday, starting with the Chinese markets, global markets fell sharply. For a number of US portfolios the decline in one day wiped out the entire gain earned on a calendar year to date basis. I asked this group of former investment professionals if this drop was important or just a momentary blip. I broke the question into five parts which may or may not be related as follows:

1.  As we already knew many Chinese like to speculate, particularly with the new margin borrowing facilities. Can this kind of trading bring global markets down?

2.  Changing market regulation does not encourage liquidity when in short supply. Does the impact of various “To Big to Fail” measures to protect banks, and firms, (but not investors) actually raise transaction costs indirectly charged to investors? In periods of stress many deal with the absence of sufficient liquidity to bid for it by lowering offer prices contributing to the decline.

3.  There is no such thing as a totally fail-safe electronic system, no matter how many back ups. Those who were not too inconvenienced by the Bloomberg system being down for a few hours remembered how to use other devices; e.g., telephones, Reuters, and actual pencils and paper. Total reliance on new technology, as those of us why fly in planes know, can produce unhappy results. In the end and under stressed conditions the market has a place for human talent. Did the temporary halt of an electronic system materially hurt investors?

4.  The single day decline was not effectively captured by the volatility measures that some use as a measure of risk. Should investors not use volatility to measure the daily risk to their portfolios, but instead the depth of buy orders?

5.  Toward the end of the US trading day Friday, the size of the decline was cut significantly. Was it just a factor that there were not any new flows of sell orders hitting the market, or were there bargain hunters? Were buyers primarily long-term investors or just refreshed speculators?

Investment lessons from World War II

In a recent book review that covered the enormous contribution General George C. Marshall made to both the war effort and the European economic recovery after the war, there was a discussion that General Marshall, who at the time was US Army Chief of Staff, was not given the command to lead the allied forces for the European invasion.  There was no question by training and respect he was the logical choice, but FDR choose General Dwight Eisenhower*, a relatively junior officer for the job. There were lots of reasons for this choice, not the least is that Ike was more likely to be able to get along with the difficult British (then) General, later Field Marshall, Montgomery. Understanding this decision process I can appreciate Steve Jobs’ choice of Tim Cook to lead Apple** after he was not able to continue. Jobs did not choose someone with similar skills as his in terms of creative designs but rather someone who had a very different set of capabilities, which was the development and management of the supply chain.

* After the War and before he was President of the US, he became President of Columbia University where I graduated and received my commission in the USMC.

** I have holding in Apple.

Another lesson occurred to me last week. In reading the program for a concert by the Boston Symphony at Carnegie Hall that featured two pieces by Shostakovich, I learned how his music was evaluated by Stalin’s thought police/music critics when Stalin was alive and after his death. 

While not as draconian as Stalin’s control of the media and so called “intelligencia,” the current US Administration and much of the mainstream media have a single opinion on numerous issues including climate, inequality, economics, and foreign relations issues. Under varying political conditions it is reasonable to assume that popular opinion will change on some of these topics. The lesson for us as investors is that whenever there is a preponderance of opinion in one direction, it is likely to change in the future.  

No truer words

In his pensive column in this week's The Wall Street Journal, Jason Zweig quotes the late Peter Bernstein who I knew for many years. Peter said, “The riskiest moment is when you are right.” Not only does the correctness of the view breed arrogance, but it flies in the face of reality. No one is always right, excepting perhaps some favorite relatives. As with calling heads or tails on a flipped coin, after a correct call the odds on the next call being correct is 50/50 and certainly by subsequent calls there is substantial chances of being wrong. This awareness should prevent investors and manager selectors from being outcome-oriented. Picking winners eventually leads to losers. A better procedure is to pick managers that follow certain processes and procedures.

Two questions for the week:

1. What do you think Friday meant to your investments?
2. How do you pick winning managers?
Comment or email me a question to .

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Sunday, April 12, 2015

Unmeasured Risk


Volatility, which appears to be rising, is a mathematical measure of past price movements. The risks I am concerned with are future price movements, particularly those which are reactions to future actions which were not occurring in the past. There is a myth that the past is easy to use as a platform from which to extrapolate the future. The problem is similar to thinking about an intricate piece of music. Just looking at the score gives one a relatively flat projection, whereas when I listen to a familiar piece of classical music, including Bernstein, not only do I hear a much fuller rendition than what my mind can conjure up but I detect differences when the incomparable New Jersey Symphony Orchestra* plays under different conductors and soloists. In a similar fashion if I just look at past performance of prices of securities and/or funds I miss the color that helps me think about the future. Staying with this analogy, when I learn that we are going to hear a new piece of music, I become a little hesitant as to whether not only am I going to appreciate it but whether I would like to hear it again. My fear, turning to the investment world, is in the not too distant future we may well be dealing with situations that are not part of the historical past that is measured by volatility.
*My wife Ruth is Co-Chair of the Orchestra and therefore I know I will like each concert.

What are we missing?

In my opinion we are not fully equipped to deal with:

(a) Interfaces of changing market structures,

(b) Regulations to protect the regulators,

(c) Uneven technologies with some participants having distinct advantages over both others and the regulators, and

(d) Securities that can be traded in many different marketplaces in different regulatory environments.

In addition, legal and accounting regulations have forced companies to disclose more facts, but for me that is like reading a musical score but not hearing what is important that the gifted musicians (executives) are trying to deliver. For example, Saturday night for me was devoted to reading the 186 page annual report of Goldman Sachs** and the 58 page SEC Form 10-Q on Jefferies (100% owned by Leucadia**.)  These are very different investment banking/broker/dealer/asset managers with significant but currently unmarketable holdings of private companies. The annual report did give more color about the qualitative elements as to how Goldman is managed, but for understandable reasons did not dwell as to its views on the long-term future, which is what our long-term investment is based. The 10-Q on Jefferies was a legal and accounting document with little on how the firm makes its critically important decisions. Both firms, as well as the rest of the financial community are currently devoting a lot of time, money and effort to avoid regulatory problems and not looking at their investors’ problems in deciding how an investment in these two very, very smart firms will fulfill investors’ long-term needs.
**Goldman Sachs and Leucadia are positions in our private financial services fund and Leucadia is personally owned.

What are my worries?

Due to regulations, members of the financial community have had to augment their equity capital to such a degree that return on equity for example, has dropped from 30% to 11% for Goldman Sachs, which is materially better than most of its peers. Not only has capital been bulked up, but prices for their services have narrowed in part due to this low interest rate environment and compliance costs, which have skyrocketed. What to me is the real risk is that in the past when important firms got in trouble, shotgun mergers were quickly put into place; e.g., Bear Stearns and Merrill Lynch. While the remaining firms have more capital, they probably do not have sufficient capital to be an immediate suitor when, not if, the next important firm gets in deep financial trouble.

If I am correct that there will be future crises and it will be difficult to pull off quick marriages, bond and stock prices will react way out of proportion to their past, and volatility measures will be out of kilter. This in turn can cause those that use volatility as a trigger to immediately sell major positions. If this happens at the same time that there is a major run on liquidity (perhaps caused by disappearing liquidity) in the bond market due to capital or other issues for owners of ETFs, including their approved participants, we could have a substantial fall in market prices.

This is not to scare you out of the market, but to warn you that volatility is an after-the-fact measure, often based on only three years of monthly data.

We are not retreating from our equity exposure. One of the reasons to introduce to you our timespan portfolio concept is that building reserves is the better part of valor.  We will probably do the most reserve building in our Replenishment Portfolio. This portfolio is designed to replace the capital that has been spent from the Operational Portfolio, which in turn is meant to carry the investor through two years of spending. The Replenishment Portfolio, with a typical time horizon, assumes over its five year life that there will be at least one down-market phase. The other two portfolios, Endowment and Legacy should invest any cash flow into longer term equity holdings in periods of turmoil.

What to do while waiting?

Just as I spent Saturday night studying various documents, you should in effect look through the tea-leaves. In doing so, go to the original rather than press accounts or summaries. Let me give you an example. Last Monday, NY Federal Reserve Bank President Bill Dudley gave an early morning talk to a business group at the New Jersey Performing Arts Center. Both television and print media covered Bill’s talk, but focused almost exclusively on the timing of the expected interest rate increase, which he finely danced around, as expected by me. However, if that was all you got out of his talk and Q&A session you missed the following salient points:

1.  Debt de-leveraging has ended at the household level.
2.  Real wage gains are coming.
3.  The winter weather was 25% worse than trend.
4.  His personal terminal projection without a great deal of confidence is 3.5% for the ten year period.
5.  Middle Income jobs have been hollowed out.
6.  Much of the student loan debt is poor quality as the students did not understand the complexities of the loan. Many were taking out loans for academic programs that did not offer large enough compensation, if they could find a job to be able to pay off their loans.
7.  There is currently not enough pressure on resource prices to induce inflation.
8.  There are some small bubbles out there now, but they are not a major worry.
9.  The key for him is that when rates go up it will be a slow gradual trend.

Think about the various summaries that you may have read about his talk and see how many of the points I listed made it into the articles or the mouths of the talking heads. Thus I think it is appropriate for me and other professional investors to keep looking through documents and listening carefully to what is being said.

Question of the Week: What of significance are you seeing/hearing that others miss? 
Comment or email me a question to .

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Copyright © 2008 - 2015
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.