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.

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