Sunday, June 28, 2015

Do Minor Price Changes Lead to Major Moves?

The Risk that Greece Will Not Leave the Euro

While much of the world worried about “Grexit” and its impact on the world’s economies and markets, much larger risks loom if the central banks continue to ignore the fundamentals, allowing governments in stress to thumb their noses at the laws of supply and demand and other realities faced by the rest of the world. My historical reaction is that if Greece remains in the Eurozone, it may mean the “Fall of France” eventually out of the Euro along with a couple of others that consistently run large deficits that threaten the value of the central currency. One could envision with France and possibly others out of the Euro, it will look like the old Hanseatic League. Led by German Baltic ports and allied with England, the Hanseatic League dominated free trade in northern Europe for the years between the late Middle Ages and the 1700’s.

Factors Behind Declining Interest Rates

Interest rates being quoted on US Money Market Deposit Accounts (MMDA) declined to a low of 0.31% and a weekend rate of 0.34% vs. 0.36% a week ago. Could this be that a number of banks don’t want to show “excess” deposits on June 30th reports? Perhaps these rates are dropping  because some banks do not want to have too much in the way of excess deposits as they might be of interest to an unwanted acquirer. Or is there a recent drop-off in the demand for short-term loans, as the average short/intermediate US Government & Treasury mutual fund dropped ‑0.14% for the week when the average general domestic taxable fixed income fund was flat on the week? The only major fixed income fund category to gain was the High Yield funds +0.11%.

Equity Funds Show Divergent Trends

The only domestic funds that showed gains in the week ending June 25th were Financial Services +0.09% and Health/Biotech +0.07% among the majors, plus Dedicated Short Bias funds +1.41% and Alternative Equity Market Neutral funds +0.14%. All the other domestic equity funds showed declines as somewhat predicted by the continued net redemptions of domestic equity funds. In contrast, every global and international fund posted gains for the week led by the average Indian fund rising in US dollar terms +2.36%.  In spite of the attention to the Greek stand off, international markets in local currency terms showed gains for the week of +3.9% for the Nikkei 225 and +3.36% for the Xetra DAX.  

While this was happening the internal Chinese market was crashing and had entered at least a correction (­­‑10%) or a bear market after a one year bull market gain in excess of +100%. Morgan Stanley is publicly telling its clients not to buy into this particular dip. Early Monday morning prices are down in Asia reacting perhaps to Greece. But more likely it is the need of the Chinese authorities to liberalize bank reserves and lower interest rates to stop the slide in their stock market. Some have even suggested restricting buying on margin. As a reaction to these moves on Sunday night in the US, the DJIA futures are being quoted off some 260 points.    

To some degree what didn’t happen was the most interesting occurrence of the week. Friday was the day when the annual reconstruction of the Russell indices took place with the DJIA going up marginally, the broader S&P 500 and the NASDAQ declining marginally.

Apparent Conservative Funds may be Risky

For the last seven weeks the oldest form of mutual fund,  the Balanced fund has seen net additions, with $1.6 Billion net coming in for the week alone. Is this just a sign of confusion as to direction or conservatism? Possibly the rise is due to 401k and similar defined contribution plans for employees being treated as mixed asset funds (bonds and stocks) which are somewhat more modern Balanced funds. If that is the case I hope that fiduciaries supervising these accounts have sufficient memory and education to recognize the risks of underperformance of mixed asset portfolios in sharply rising and falling markets. The Investment Company Institute, the fund business’s trade association, indicated that there were $741 Billion in retirement target date funds and another $400 Billion in somewhat similar “lifestyle” funds at the end of the first quarter. Under the correct personal conditions and understandings these vehicles might prove to be satisfactory; for others they may in the future prove to be problematic as these funds will own fixed income securities which may not perform well (as discussed below).

Fixed Income Risks

John Authers of the Financial Times had a very thought provoking column on Thursday exploring the “Bondification” movement to address the fundamental concerns that have led bond fund managements to under-perform. Most bond investors start with the assumption of a “risk free” interest rate based on local country Treasury yields. The problem is that with various bouts of qualitative easing as managed by many central banks, these interest rates have proven to be quite volatile. In my opinion, the restructuring of bond markets in a period of diminished capital on trading desks makes bonds anything but stable. The bond professionals have responded by developing a culture of unconstrained fixed income portfolios that allow managers ultimate flexibility in terms of maturity, credit quality and inclusions of derivatives and in some cases commodities. While this flexibility can, if well executed, produce good relative results, they bring into question how bonds should be used to provide some risk-dampening to a mixed asset portfolio. I hope the owners of target date funds and lifestyle funds understand these changes from past performance records.

Liquidity Concerns

Exchange Traded Funds (ETFs) have become an important institutional trading device; the US Securities & Exchange Commission (SEC) is showing concerns as to the use of derivatives both within ETFs and their marketing partners. For the most part institutions and individuals buy and sell ETFs through market makers called Authorized Participants (APs). When a buyer or seller of an ETF operates through the limited number of APs, they are utilizing the liquidity of the AP for each ETF. Some of this liquidity is in the form of derivatives. The SEC and other analysts would like to understand the size and nature of the liquidity that exists for specific ETFs. My particular concern is primarily based on sector and some single country vehicles. We will see whether the SEC will get the details on a timely basis and make them publicly available.

The use of public disclosure of how various funds manage their portfolios can add some reassurance. For example, the National Economic Research Association (NERA) has published a white paper examining if a fund broke any of the constraints being applied to Money Market funds. Among their findings was a theoretical conclusion that at worst there may be a temporary 1-3% break from the dollar NAV with most of that happening in the first two days followed by a recovery likely by the end of the first ten days. I hope that they are correct as I have regularly used Money Market funds to hold required firm capital.

Outliving Retirement Capital

Many people are  living longer. As a group, they have not changed their spending and savings habits. Also, governments have not fully recognized these implications. Both the workplace and retail distributors are behind in adjusting to this reality.

GDP for the first quarter in the US was revised to a decline of only 0.2% from 0.7% as originally reported. As previously pointed out in these posts the change was not a surprise. In this case the markets were a better forecaster than government agencies. The size of the adjustment is too large for those who steer our ship of state to put reliance on their own statistical collection approaches.

Question of the Week:  Based upon the week’s news, do you remain a Bull or a Bear?
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Sunday, June 21, 2015

Future Father’s Day Fears

In the US, commercial interests have created a day to celebrate Fathers. For me, Father’s Day has been a day of getting together with parts of my nuclear family. Some are from great distances including Singapore. Close friends that feel a family-like cohesion with my wife Ruth and I phone in or send cards. At the moment, all appear to be well and progressing with their lives. While I am enjoying all this goodwill among our extended family, my first fear is that it can’t last.

Uncertain future

The future is and always has been uncertain, it seems particularly uncertain now. While as a human and an investor, I can handle that; what I find unnerving is that far too few people are planning to handle future problems which include opportunities. Today, there are two elements to my concern - terminal values and flight capital.

Terminal values

The purpose of not spending all of our current income and capital is to provide for future spending. As both a Father, Grandfather and surprising at least to me, Great-Grandfather, as well as a trustee for a number of organizations that are chartered for perpetuity, I should be thinking about the ending piles of dollars and other currencies to meet future needs. While it is true that this is not a unique concern of mine, notice that most all of the focus of the investment world is the present relative price of assets and liabilities. Regularly we are told that an asset is attractive because the current price on a relative basis is cheaper than other assets. There is a presumption that the particular price will rise and fill the gap compared with other assets. In my US Marine Corps days I would label that as a tactical movement. Tactics are important in the battle for investment survival, but rarely accomplish the strategic mission of winning the war and creating a lasting peace.

The first major fear

This week’s piece from John Mauldin is about the large and growing underfunding of state and large city pensions. Various governments, both in the US and elsewhere (Greece and most other countries), appear not willing to close this retirement funding gap. There are two issues with this incipient failure to keep the promises made to both government employees and their supporting tax payers. First is that future contracts to deliver pensions appears to be based on what is now clearly false assumptions as to rates of investment returns and the willingness of politicians to get taxpayers to close the funding gap. This present dilemma has three probable impacts on me and our investments that could be beyond our current plans:

a.  Our tax burden will go up.
b. The services we expect from government will decline.
c.  New money that must be invested will likely push markets higher.

I started this discussion about the lack of focus on the terminal value of investments, which I find to be disappointing. However, the discussion above about the pension gap is a clear example of an attempt to project terminal values. Many, but not all private organizations also have granted their employees pensions, and appear to be able to meet their obligations to the older employees and retirees. (Some have reduced their exposures by Pension Risk Transfer contracting with Prudential and other insurance companies.) The larger approach is to put as many of the employees into defined contribution plans; e.g., 401k or similar plans. In these plans normally both the employer and the employee contribute to the plans and have a number of choices of investments products available to select. The employee is at risk to choose the vehicles that will produce the best return based on personal and investment factors. Some will choose well and others won’t. In most plans the choices are institutional grade mutual funds. We can testify that in one case, The Second Career Savings Plan of the National Football League and the NFL Players Association that it has worked out. For the last two calendar years BrightScope has found this plan to be the Number One of large 401k plans. While the criteria for that ranking does not directly include investment performance, without reasonably good investment results for the players the plan would not have grown as it did with Lipper Advisory Services as its investment advisor.

Nevertheless, the individual players and their families are at risk as to the uncertain value of their terminal accounts. I have the very same problem when I invest for my family’s future. I can not honestly say what will be the ending value of their investment accounts. What I can do in my selection of mutual funds and individual securities is in my own mind to focus my selection based on what I believe are likely future values, at least on a relative basis. I believe that more of us professional investors should be focusing on expected terminal values.

Second major fear

This week is the twentieth straight week with net redemptions in equity funds. When looking at the underlying details, the redemptions are largely in domestically-oriented funds which are importantly offset by purchases of International funds. I find a similar pattern in most countries with the main exception of China. When people switch out of their local currency into other currencies it is traditionally a sign of expected trouble in a country. Are they doing this now through their International fund purchases? They may be seeing higher terminal values beyond their borders. As this is a global pattern, one might say the money class of investors is hedging its bets.

Question of the week:
What are your longer term fears?
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Sunday, June 14, 2015

GDP Now Poor Investment Guide


Have you noticed that almost all top-down investment theses start with the US Gross Domestic Product (GDP) as the base for their recommendations? Often these extensions have proven to be considerably wide of the mark in terms of predicting equity markets' price movements.

I suggest that the fault is not in the stars, as a modern day Cassius might say to Brutus according to Shakespeare, but in their numbers. As a professional securities analyst I have never seen a number that is sufficient in and of itself for decision-making. To make money one should dig deeper into the numbers to find value. This is similar to last week’s post where I pointed out that there was a lower risk way to earn the same return as on the winner of The Belmont Stakes by betting on the second placed horse to place.

1st Quarter 2015

Turning to the GDP releases, the pundits jump on the first or flash release of quarterly progress of the Gross Domestic Product numbers for their prognostications. By the time the final of four quarterly releases the number may well have meaningfully shifted. The first quarter of 2015 was reported to be -0.7% down. The next release expected to be issued on June 24th could very well show the first quarter was about flat. This should not come as a surprise, as perhaps with the handling of your betting on The Belmont, if you looked at the numbers in some detail. The two double digit declines in GDP reported were -20.8% in non-residential structures fixed investment and -14% decline in export of goods. From my handicapping (racing analysis) days I would have thrown both of those out as significant future indicators. The severe winter weather probably delayed building construction and the US West Coast dock strikes hindered our exports, probably more than our imports which could find other ways to deliver.

For those who follow the GDP carefully they would have also recognized that the recovery in March counted for only 1/9th of the quarterly ratios according to the construction methodology used - with the earlier months of the quarter counting for more than the last month; with the worst of the winter storms occurring in the first half of the period, the better results were not as significant.

More reliable indicators

As often stated I tend to look at investments through the lens of mutual funds. One of my developments in terms of fund data before I sold my firm’s data activity to Reuters, now ThomsonReuters, was the development of 31 investment objective indices tracking the performance of the largest funds in each of the major equity investment objectives.   

Health/Biotech and European Funds are up double digits for the year to June 11th . Utility and Real Estate funds are slightly negative, all the rest are showing gains. This indicates to me that the market prices in the vast majority of stock portfolios are gaining ground a bit. On further analysis the Small Market Capitalization and Mid-Cap funds are doing better rather consistently than the Large Cap funds. For example, in terms of growth funds, Large-Cap +6.03%, Mid-Cap +6.96% and Small-Cap Growth +8.09%.  This suggests to me, despite consistent net redemptions from domestic-oriented funds for the year, investors are making money in US-oriented stocks. If they are fearful of a final negative GDP report for the first quarter, that might trigger a fear that it would be followed by a second quarter of decline for the GDP that would qualify as a recession. 

Beyond the US

Each week The Economist publishes the performance of 43 markets both in terms of local currency as well as in US dollars. As of the moment there are only seven that are showing declines in terms of US dollars as well in their local currency. This suggests to me that these markets are expressing some longer term concerns which could trigger future political and/or currency actions. Three of the largest declines are in the Mediterranean:




The second largest year-to-date decline is in Colombia -18%. The other three are geographically close to one another:
-18.0 %

To the global investor using US dollars as their measure, these seven are probably more risky than the stock markets that are not down in local currencies but are down in US dollar terms. There are eight of these. Avoiding  both sets showing declines, there are 28 markets that are showing positive results which suggests that as of the moment carefully chosen global investing is relatively safe for now.

Bottom lines

Be careful in utilizing top-down GDP focused investment recommendations. Careful analysis of any set of numbers offered as a foundation for an investment action should require deeper study by professional investors.

Question of the week:
Please share with me your favorite indicators so that I can improve my clients' results.
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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.