Sunday, August 30, 2015

Price Insensitive Sellers Pay A Big Price


Price insensitive sellers are forced to sell at whatever prices they can get. Emotionally they feel that they have no alternative than to convert their assets into immediate cash to meet pressing needs. On the other side of the trade are buyers who have innumerable choices both in terms of what assets to buy and what prices they are willing to accommodate the driven sellers. This is one of the two big lessons from last week's market turmoil. The other lesson are the answers to “what did we learn  about ourselves as investors?”  I plan to explore that subject in next week’s post.

Co-Venture Risk

One of the big failures in teaching investments is only using quantitative analysis of price, cash flow, earnings and book value. The approach  assumes that these factors, or if you prefer estimates, are operating in suspended animation from what else is happening in the real world. To me the real risk in a traded investment is not my changing perception of price, but what is happening to the thinking and actions of others who own a holding in the same or allied securities. Due to my more contemplative nature I make decisions slower than the quickest "gun" in the market. My method might be deadly in a gun fight, but it is not too dangerous if I am early and take cover while transacting.

Fundamental and Emotional Perceptions

In attempting this very difficult analysis of guessing the cards of the players opposite me at the gaming table, I find it useful to divide the effort into two parts. The first and easier of the two is what would cause the co-venturer to change his or her perception of our shared investment; e.g., a view on the appropriateness of management's actions, or a similar point. The second and more difficult effort is to attempt to fathom out changes in the financial or emotional needs of the co-owner who becomes highly motivated by internal pressures to sell for reasons other than price. In other words, what would cause my co-venturer to become an immediate price insensitive seller?

Two Price Insensitive but Understandable Sellers

As a manager of institutional and high net worth accounts, I am well aware of planned and unplanned needs for money. On any given day there are other investors that are meeting similar needs, but for the most part these transactions are relatively small in scope and do not have price moving impacts. When a very large or a group of large players come to the table for immediate action regardless of price, they temporarily become the dominant players in the market and therefore the settlers of price reactions.

To put last week's price movement into some perspective, instead of looking at market indices, I looked at the prices of some very high quality stocks and their prices to gauge the intensity of the sell-off. For illustrative purposes I will use a personal holding in JPMorgan Chase. On Monday the 24th  of August it opened down from the prior Friday's close at $59.29 and quickly sold-off to $50.07 and to finish the day at $60.25 and the week at $64.13. The drop early on Monday was part of the rattling 1000 point fall in the readings of the Dow Jones Industrial Average.

While I am not a full time bank analyst, I saw nothing on Monday that would have dictated that kind of price action on relatively high volume. As a matter of fact I am beginning to think that banks’ exposure from loans to highly leveraged domestic oil and gas producers could be a problem. Accepting the questionable assumption that these loans will be defaulted, the issuer will go bankrupt. Thus the lenders will be forced to take over the borrowers temporarily. Due to substantial operating cost reductions, the banks are likely to find that the underlying equity to be sold to surviving energy companies will more than pay off the prime loans owned by most banks. Therefore, to my mind, the risk to most major banks' balance sheets is reduced. This is a classic example of an insistent seller meeting an immediate need for cash regardless of price. The seller could have been liquidating a margin call. (Under prior market regulations the stock specialist on the floor is responsible for maintaining orderly markets and would have to explain to the Exchange and possibly the SEC why it should not receive a large fine and lose the right to make that market on the floor.)
Another technique to understand what happened last week is to view the world (as I do) through the lens of  mutual fund performance. For the week ending Thursday August 27th , there were only two types of fixed income mutual funds declining 1% or more, US General Treasury funds -1.3% and Emerging Market Local Currency Debt funds, also declining 1.3%.

The Chinese Government, the Big Seller

I have maintained for a long time that whether one invests directly into China or not the actions of what happens within China will be the single largest impact on global markets. This last week underlined the importance of China to our markets.

Excess cash has been flowing out of China from wealthy individuals pursuing various activities. At the same time, exports from China are growing more slowly. The combination of the slowing global economy and rising labor costs within the country, means that China is earning less than it did to fund infrastructure, food, and health requirements to sustain the ruling party in power. In order to meet these pressing needs the government has been selling down its huge hoard of US Treasuries and at the same time slightly devalued its currency. One needs to remember that short-term US Treasuries are an important collateral for many market sensitive loans. Any pressure on Treasury prices can and probably did drive some margin calls.

What most financial analysts focused on in terms of China were its financial assets and liabilities. They should have looked deeper into the generator of these elements which is the nature of its exports and imports. China’s favorable trade balance was shrinking at the very same time that the US swung to its own favorable trade balance in the second quarter, after two quarters of being unfavorable. Thus for the aware, the actions of the Chinese leadership should not have been a total surprise.

The Second Price Insensitive Seller

While the primary depressant last week was the actions that emanated from Beijing, the second insistent sellers were traders that had or were about to receive margin calls on their Exchange Traded Funds (ETFs). When looking for hedging devices hedge funds and others  have determined it was cheaper to use ETFs than to use futures. In the lackluster, thin market that had many stocks declining and only a relatively few momentum stocks rising there was an increasing need to hedge. In a period of low returns which we have been going through for more than a year, leveraging becomes attractive with its low manipulated interest rates. On Monday due to changes in market rules and some lack of demand in late August, approximately 1300 stocks on the floor of the New York Stock Exchange either could not open or had to be temporarily suspended. Approximately 500 of these were ETFs. One extreme example is an equally weighted S&P 500 index fund which in the first hour of trading was only open three minutes.

To take a somewhat longer term view of the impact of ETFs on the general market remember the performance of thee three general market indexes: S&P 500 -2.36%, DJIA -1.98% and NASDAQ -1.33%. There is substantially more invested in ETFs that track the S&P 500 than the other two measures. The 1% difference between the S&P and NASDAQ is of particular interest because in most market declines one sees greater falls in the over the counter market than the listed market, however the NASDAQ index had been stronger recently. Based on history one would have expected the prices on NASDAQ to fall the most, followed by the DJIA due to its heavier industry orientation and the least decline should have been the market weighted S&P 500. I believe the difference was the amount of money invested in ETFs  in the S&P compared to others.

Why did some of the ETFs momentarily perform worse than the indices or their related mutual funds?  Mutual funds have only one transaction price per day which is the closing price. ETFs are traded on the open market throughout the trading day. When one is dealing with the mutual fund it is a direct purchase or sale. With ETFs one goes through an Authorized Participant (AP). The APs are floor dealers that create or redeem $250,000 chunks of the fund. They get frequent intra day net asset values for the underlining fund. They use this to make bids and offers for those who wish to transact. Under normal market conditions the price differentials from the last known NAV is small, in part because there are other competitive APs. On Monday with a large number of large company stocks not open for trading there were not good NAVs to trade against. As a risk control measure the APs widened their bid/offer spreads and reacted to incoming orders. The price insensitive sellers were desperate to get immediate executions which used up much of the capital of the APs who could not off-load the redemptions  fast enough to stay within their own capital constraints. Later in the day trading returned  to more normal, but high volume day patterns.

In Summary

1. Be aware of co- venturers and the risks of them getting through the door first.

2. Understand the market mechanisms of what you own.

Next Week

I am currently planning on discussing what we learned about ourselves as investors last week.

Post-Script:  According to Blooomberg TV, Asian markets opened down, with DJIA futures off 214.

Question of the Week: What did you learn last week?   

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A. Michael Lipper, C.F.A.,
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Sunday, August 23, 2015

Awareness Risks and Opportunities:
The Search for Outliers


After stock prices slumped last week, particularly Thursday and Friday, we should be aware that our judgments are far from perfect. To help us in our deliberations, I am calling up our top strategy team, RT&E. Let me introduce the team: they are more formally known as Donald Rumsfeld, Mark Twain, and Albert Einstein. Rumsfeld divided knowledge into “Known Knowns,” “Known Unknowns,” and “Unknown Unknowns.” Mark Twain cautioned us as to what we “know” that is just not true. Einstein, a three-time visiting professor at Caltech, told us “Everyone sits in the prison of his own ideas, he must burst it open.” He suggested that we must think differently to produce different results. We should always be aware of risks and opportunities including those that we create by our own narrow thinking.

Known Knowns

1.      In the modern era, where the leading academic institutions teach the unsuspecting students a top/down view of the world in order to put the academics near the top of the power structure, they teach that markets are primarily driven by monetary policies implemented by the Fed and other central banks.

2.      The best examples are China and Russia, both are command economies and therefore the governments can totally deliver what they want.

3.      Price momentum leads to further price momentum for stock prices.
(see table below).

Known Unknowns

Each of the “knowns” are macro trends, or if you prefer, gross understandings that can be transmitted to the audience in sound bites up to 40 minutes of class time.  These averaging or actuarial approaches to human behavior lead to surprises or counter developments that are derived from the study of micro trends which when netted against the gross trends cause periodic reversals. This may well have been what happened last week with the gross beliefs being carried beyond their “sell date.”

For some time it has been reported that most publicly traded stocks in the US were falling, but the popular market averages were being held up by a couple handfuls of favored shares. Many of these favored stocks prices in one day fell into a correction (10%) or a full bear market (20%).

Filtering the largest dollar volume declines on NASDAQ the following names could lead a major price trend change list:

These stocks have preformed very well in the past, but the unknown element is when would they give some back, and how quickly would it occur.

(I am not commenting on the attractiveness of these names, but the surprising rapidity of their decline in high dollar volume which up to last week was unknown.) 

Unknown Unknowns

The “knowns” are premised on “all other things being equal.” We live in a world of small and occasionally large changes daily. Strange as it may seem, each day we grow older and perhaps wiser, but not definitively different than the day before in terms of our attitudes and mental and physical health. Not only are we changing, but we are experiencing the never-ending changes caused by technology.   Because of cell phones, billions of people are now aware almost instantaneously of any important news item, interesting rumor, or critical price change. Markets move with the speed of electronics; in many respects for major “chunks” of money no market is closed.

Teenagers’ buying habits and other consumer demand swings occur rapidly, responding to perceived models can lead to major changes in distribution chains globally, with much unsold inventory.

The Known is Untrue

While I am a professional analyst and money manager at my core I am also a student. Thus each day I am aware that some of my rock-solid facts are going to be challenged. Many of these “facts” come from respected sources. The best of which are my own experiences and yet some of these are extrapolated too far to be general cases and not just specific relationships. For example, for many years I have been following the weekly Barron’s Confidence Index which measures selected Intermediate-rated bond yields compared to a selection of High Grade yields. When the yields of the High Grades go down relative to the Intermediate Grade, which means that high grade prices are raising at a faster rate than the lesser quality is a measure of risk coming off for bonds, which often is indicative of current attitudes toward stocks. Most weeks the change in relative yields is under 1%. This week the move itself was 3.7 percentage points which is the most dramatic change I can remember and signifies a major risk aversion. Whenever some ratio goes to a historic level most people believe it is a confirmation of a trend. My training from the racetrack is to either doubt the mechanics or believe it is less reliable in terms of the future because it represents an extreme. At the moment I am being cautious and doubting the validity of the ratio, but I can be wrong.

Dr. Einstein’s Prison Breakout

We all like the past because we know what happens. The future is uncertain and we need to learn when to jump off the comfort of extrapolating the past. One of the advantages of my practice is that regularly I can examine extreme performance both good and bad. I would be a poor analyst if I assumed that these extremes would continue. The odds are that there will be some reversals where a poor performing fund will do much better than average in some future period. Often this happens because the portfolio manager or the CEO of a company sees something in a different light than the rest of the pack. My job is to find these rare reversal types and get enough confidence in their approach to follow them. The nice part of our portfolios is that almost always there can be room for an unusual approach as they breakout of the conventional prisons.

Question of the week:
Which managers are doing unconventional things that we should study?
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A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.