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? 
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