Two Reversible Negatives

Introduction

For some time I have been worried about a market top in stocks. In a classic sense, a major decline is less likely today for structural reasons than I had previously thought. Two obstacles to higher stock prices are Politicians and Commodities.  Both of  these drawbacks are reversible, but could cause the “once in a generation fall” of my fears.

The Enemy = Politicians

All politicians, as distinct from statesmen or stateswomen, wish to avoid being tagged with unpopular political decisions. The very nature of human and animal life is one of periodic successes and failures. A student of financial history recognizes peaks and valleys. The current crop of political leaders recognize that job preservation and job creation are critical to their reelection. To deliver on these goals they have adopted a policy of bailing out large employers who have sufficiently poor financial conditions that there is fear of substantial job losses. Such bailouts ignore the historical fact that it is natural for businesses to expand and contract, and in many cases particularly good for their customers. When a significantly large number of voters in key areas are employed by a company that is in distress, the modern reaction is to bailout the troubled company or industry with taxpayer money.

The recognized problems of late 2007 and 2008 in the US led to massive bailouts of both major auto makers and very large financial institutions. The public was revolted by this use of its hard earned money in the face of needs for spending on infrastructure, education, and defense. To avoid future bailouts and to protect themselves, the politicians came up with the doctrine of preventing large corporations from becoming “too big to fail” so that the government would be politically forced to bail them out. From the standpoint of protecting the politicians, the various “reforms” such as the Dodd Frank legislation appear to be doing a good job currently, as we have not had a major failure since the financial crisis.

The Price

To fund the bailouts, the Federal Reserve bought almost all of the debt the federal government put out and in so doing increased money supply which led to materially lower interest rates, particularly hurting the retired population, living on fixed income returns from their savings and pensions.

As harmful as that policy was to an important part of the population, a much bigger price was paid by the retail investor. Over the five years that the Dodd Frank bill has been operating there has been a withdrawal from individuals buying individual stocks. This has been caused by two simultaneous elements. The first by making the investment community seem to be the sole source of the financial crisis without regard for the contributions of government policies, labor unions, and inappropriate education.  By demonizing the financial community many otherwise rational investors voted with their feet. In the past, this kind of withdrawal would have brought a response from the financial community.

Because of greatly increased regulation on large financial institutions they needed to add highly paid compliance people and capital buffers that made the cost of serving the middle income public sky-rocket.

For many brokerage firms, the retail cash agency business has become unprofitable. This in turn has led to a change in the nature of the sales force serving the public. They have shifted into selling packaged products that have higher margins and often include borrowing (leverage). This shift has led to a number of the older and more trusted sales people leaving to become fee-paid advisors, replaced with younger sales people with increased sales quotas (this did not sit well with established clients or younger would be-investors). The net result is that far too many investors did not benefit from the doubling of market prices over the last five years. Their absence is being felt today by their lack of enthusiasm for investing to meet long term retirement needs.

Despite various politicians’ beliefs, human nature has not been repealed. Eventually the animal instincts will drive greed over fears and we will get enthusiasm for risk taking. While it is likely to be more muted than what we have seen in China, it will become a force that will override the damage to investors’ psyche caused by the Dodd Frank bill.  (Retail investors own 80% of the small Chinese market often with substantial margin debt. The Asian institutional market is a heavy user of equity derivatives which did not help in the last couple of weeks.)

Commodities, the Second Reversible

I have not owned any commodity future for more than thirty years. Nevertheless, whenever I see the media coverage of a major decline with the expressed view that it will continue, my investment instinct is to look for exhaustion on the part of the late sellers which will create a bottom. To most investors, commodities and particularly futures are of little importance in developing longer term investment policies. With high quality interest rates being manipulated by the central banks, I wonder whether the fixed income market will continue to serve its historic role of alerting the equity market of on-coming problems. If that is the case I am beginning to examine whether there is useful information in commodity prices.

According to Calafia Beach Pundit, while commodity prices are down they are still substantially up from their bottom. For example, Copper, often called Dr. Copper because of its economic ties, is down 40% from it peak but still 290% above its 2001 bottom. The price of commodities is a function of perceived and actual scarcity. One of the students of commodities recognized that in truth, the only scarcity of mankind is “human ingenuity.” Over time technology has eaten away at the use of any commodity through improved mining and manufacturing techniques plus growing substitution of less expensive elements. Also history reminds us that higher prices bring out more supply including new discoveries.

This is not going to become a “gold letter” for I believe that there are a different set of constraints on gold than on other commodities. Nevertheless, the price of gold hugged the CRB Raw Industrials Index in lock-step from 2001 to about 2007-2008. At that point the industrial commodities declined in sympathy to the then economic slowdown. Gold continued to rise until 2011. One might suggest it is when those that view gold not primarily as a commodity but a hedge against the decline in the value of currency became the dominant buyer as the US entered various phases of “quantitative easing.” Since that peak the price of the metal has had a parallel decline to the industrial materials. Gold bullion may have suffered the ultimate substitution by the increase use of “paper gold” in the form of futures and Exchange Traded Funds (ETFs) which absorbed some of the demand for currency safety.

China has become the pivot for commodity prices including grains. The command society shift from manufactured exports and internal infrastructure to consummation of goods and services has changed the global demand for industrial commodities. At some point this shift will meet its logical end and we will see growth in commodity imports into China. In the meantime the other developing economies will need to import commodities to fill the needs of their growing populations.

I do not know when commodity prices will turn upward, but as a student of history, I believe they will. If that happens at the same time as the lust to own securities deemed in short supply, we could have one enormous market rise which we will need before we have a generational type of decline.

Question of the week: Where are you seeing signs of growing demand? (The Mall at Short Hills was crowded on a warm and clear Sunday, today.) 

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A. Michael Lipper, C.F.A.,
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Now, The Most Dangerous Time to Trade

Introduction

Some pseudo-sophisticate might say the most dangerous time to trade any market is when it is open for trading. For traders initiating a trade that can be costly to unwind, there is no worse time than when the market is slow, with little volume and in a long, flat pattern. The very trap of being the worse time could also be the best time for investors.

For Traders

For many years I have watched the actions of traders on various broker/dealer trading desks. At times their biggest risk is boredom. In a slow, flat market (which we have had for some time) watching their screens, reporting only minor price changes can drive these activists crazy. To create some action they find prices that they follow closely which they believe they understand better than the market and create a long position or in a minor number of cases a short position. Because the traders need to earn more than the cost of capital assigned to them they multiply the small expected moves by the use of borrowed capital in some form. A swift breakout or breakdown from the price level of their position can have a dramatic impact on the value of their positions, the bonuses, and ultimately their employment. In the current environment the trading desks staffed with portfolio managers at hedge funds play similar games as the old dealer desks, except with more modern training they are likely to use derivatives as their medium.

For Investors

Perhaps the key difference between a trader and an investor is the time to success (or failure). The trader is short-term oriented in terms of hours, days, or possibly weeks. An investor is much more concerned in terms of years, often a number of years, which is why we developed the Lipper Time Span Portfolios^TM concept. We manage money for the long-term, and in some cases beyond one’s lifetime. However, the long-term starts with now, at today’s price.

Jumping Off Point

We have written in past posts that it is somewhat natural to be in a reasonably flat stock price picture. Equity prices have raced ahead of the slow, uncertain economic factors that are producing limited gains in top line revenues. Current prices reflect largely present and expected earnings gains coming from profit margin increases due to low commodity prices, more efficient use of labor, foreign earnings translated into US dollars, and buy-backs. Without future revenue gains much of the above-earnings increase elements will eventually reverse.

Two Bullish Strategies

The strategists at Charles Schwab believe that we will enjoy a grinding higher stock market. With core inflation, excluding food and energy, growing at a current 2.3% rate, Schwab and most of the rest of the strategists are looking forward to the early stages of an interest rate rise. Also the sentiment index of home builders is rising at a faster rate than new starts.

The strategists at JP Morgan proclaim that they are global investors to some degree, escaping the geographic labeling in asset allocation. Nevertheless, they point out that for many of the normal investment measures, US stocks are priced above their ten-year averages. On the other hand they point out that the Asian Emerging Market stocks are selling below their ten year averages in terms of forward price/earnings ratios, price/book value, and price/cash flow. This Asian bias is similar to our own which favors Asia over Europe, even though a number of the funds we use are currently betting in favor of Europe.

Two Causes of Concern

The first is Moody’s has raised its forward looking ratio of default frequencies for US and Canadian High Yield issues. From an abnormally low level the expected rate increase is back in the more normal range. This could be influenced by a concern for the oil and gas High Yield paper or  too accommodative underwriting standards in the past. I tend to pay attention to the fixed income market from the perspective of an equity investor. Often the risk avoidance mechanisms of bond holders and traders act as the canary in the stock market.

The second cause for concern is much more complex and controversial. It starts with the relief rally the world stock markets delivered for the week ending July 15^th  as reported by The Economist. All 44 of markets it tracks rose for the week in US dollar terms. Only 9 declined in local currency terms. As a contrarian, any time I see all of the passengers in a boat on one side I fear a collapse. Many market participants view the news of the week positive from Greece, China, and Iran. Perhaps, the US Mutual Fund and Exchange Traded Fund investors were using the relief rallies to be net redeemers of both domestic and international funds for the first time. Maybe they are right or at least raising the same questions that I do in terms of Greece, China, and Iran.

The decision to fund Greece’s place in the euro with German money in the long run, in my opinion weakens the euro and will not correct the larger than treaty permitted deficits for a number of European countries. The cost of losing Greece for awhile is much smaller than the damage in keeping it.

In many ways the current Chinese government is the most effective government in the world. This may be true due to its command structure or the skills of the present leadership learned at the party’s political school. I am afraid what has been taught is the use of socially determined bailout mechanisms. Bailouts perpetuate poor behavior and in the end prove to be more costly to the society than letting failures occur. In quick order they will be replaced by newer and sounder forces.

In terms of the agreement with Iran, my fear is that we have seen this movie before in terms of our experiences in and after WWI and the creation of WWII.

Once again we are experiencing the power and “wisdom” of an unelected woman in terms of the second Mrs. Wilson (VJ) and the lack of understanding by Neville Chamberlin (VJ and crew). The temporary avoidance of conflict comes at a much larger price of future innocent deaths.

As we have not yet raised cash, and since Gold and TIPS are not rising in price, let us hope that I am wrong.

Questions of the week:

1. How are you going to “play” the change in direction of the current market? 

Question 2: What are your long term investment worries? 

__________   

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Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2015

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Leaders vs. Managers

Introduction

In building a portfolio of funds for clients, essentially the choices are to choose leaders, managers or a mix.

Leaders

This last weekend may show my inclination. We spent the weekend with our enlarged family group of forty-seven, some or all participated in visits to George Washington's home in Mount Vernon, the US Marine Corps oldest base at 8th and I street in Washington for the sunset parade and silent drill team demonstration, and the National Museum of the Marine Corps.

One could build an entire leadership course based on George Washington's life and pursuits. While much has already been written on these topics, for us involved with investing, two themes merit our review. The first is aggressiveness. Before and after his military battles during the American Revolution Washington was an aggressive investor in land. At the time of his death he owned some 70,000 acres all the way into the Ohio Valley. Many of the land parcels he had surveyed years before, but some were virgin territory for him. Unfortunately while he believed in both physical as well as financial planning, he died with lots of land and some debts and very little cash, thus much of his assets had to be liquidated without further development in order to meet his debts. As with most leaders he was ahead of his time focusing on the potential of future development. (He could have used a more competent cash manager.)

Discipline

I have often written about the second important aspect of Washington’s leadership, discipline, which I have learned from my active duty service in the US Marine Corps. On this trip the skills and bravery of the individual Marine was an important focus. The National Museum of the Marine Corps in their displays depicted the bravery and fighting skills of individual Marines. In addition to listening to the very talented Marine Band and the Drum & Bugle Corps, one of the highlights was watching the silent drill team's parade. This  platoon of perfectly selected young Marines go through their routines with no audio commands issued. Their memory of endless rehearsals and the discipline to follow ingrown procedures produced a striking tableau. In addition to the Marine Corps Commandant, the honored guests included  a sizable number of members of Congress who one point wore the US Marine uniform. Perhaps it was no accident that the current Commandant, General Joseph Dunford has been nominated to be the Chairman of the Joint Chiefs of Staff  pending the approval of the US Senate. In that role he will become the chief military advisor to the US President.

At the end of the evening the Commissioned Officers marched away and were replaced by the leading Non-Commissioned Officers to march off the troops returning to the barracks. These NCOs are the real managers of the infantry. They get the job done accomplishing the officers’ orders.


Do you want Leaders or Managers Managing Your Portfolio?

I sit on a number of investment committees as well as managing discretionary accounts of portfolios of funds. One of the characteristics of investment committees is that there is a strong desire for them to reach unanimous decisions. Often there are official or unofficial benchmarks that become performance targets. All too many investment committees react politically by agreeing to the least aggressive strategy, with emphasis on beating a benchmark regardless of the nature of the account or composition and management of the benchmark. By adopting this strategy they are really making the decision in favor of managers who will be graded on how close they come over time to the benchmark. As all too often the benchmark is of individual securities that are assembled without management and trading expenses they are also without the auditing standards normally used by professional organizations. In addition, not much attention is paid to component weights and methodology and the timing of additions and deletions. The drags caused by expenses and the desirability for some operating cash makes it quite difficult for most managers over time to beat securities benchmarks.

If you wish to have superior results from specific portfolios which do not have the low expense ability and/or the need for operational cash, one should take the risks of going with leaders. Leaders are managers doing some things differently than the normal (not currently the best) performers. Because of their relative isolation, leaders can often be strong personalities with some missionary zeal. A complicating factor in choosing  a potential future leader is that often they are not the smooth presenting managers that garner so much of the institutional money. Further, most of the time they have little or uneven performance records. The key to their selection rests on their well thought-out, but different investment approaches.

What Do We Do?

We build a mix of managers and leaders. The managers are selected on the basis of their expense control and their ability to reasonably hug the benchmark. These are then combined with managers that we believe will have a good chance to be future performance leaders.

Question of the week:  Can we discuss our approach with you as applied to your investments?

__________   

Did you miss my blog last week?  Click here to read.

Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2015

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.