Introduction
Even long-term
investors like me need to pay attention to near-term information. Often I have
said the critical price risks to investors are their fellow holders. At
critical times the first ones to sell get materially better prices than those
that follow. Early last week quick sellers did better, but paid the price
later.
Trading Speed
In last week’s blog I
briefly listed what many consider the 4 most crowded trades. They are: (1) Long
US Dollar, (2) Short Commodity Stocks, (3) Short Emerging Market Stocks and (4) Long US Tech Stocks. These are sizable
positions relative to current marketability in large hedge funds and other
trading accounts. All of these led the parade of falling prices. While one
could argue about the investment merits of these positions, what was clear by being
on the most crowded list is that there was limited near-term liquidity in these
trades. In order to get out of the way of the falling prices, the players had to
accept lower prices quickly. For some time many of us have been pointing to
the shrinkage of commercial and investment banks’ capital devoted to market
making activities. What we saw early is that the total dollars of the sellers
overwhelmed the dollars of the buyers. (When similar markets occurred in the
old days when I had a small trading desk reporting to me my instructions were to
back away and let the energy of the moment exhaust itself before we entered the
market at calmer prices.)
The intensity of the
selling was apparently driven by disappointments caused by statements made by
the central banks of Europe and the US. Because the world is so interconnected,
in a nanosecond the sellers lined up and started to compete for exit prices and
volumes. Some may wish to lay additional blame beyond reduced market making
capital on the current era of accelerating speed of information flow. The
Economist, like some politicians, comes down squarely on both sides of the
issue. It points to in an article entitled “The Creed of Speed” that reports Apple*
customers download an App every millisecond, which demonstrates the growing
interconnections and thus reaction times to news. On the other hand it points
out that active mutual funds have almost doubled their patience by holding
stocks for almost two years, which shows a portion of the active market is
taking its time on sell decisions compared with the turnover in the S&P 500
which is under one year.
*Held
personally and/or in the private financial services fund I manage
Before turning to an
important cause for the rapid decline and even more rapid recovery on Friday, I will alert you as to possible future extreme intraday and single day price
changes. The most popular price index and the one with the longest history is
the Dow Jones Industrial Average. I should point out that on the day in 1929
when the DJIA collapsed, it fell by 13%.
Most people focus on this market break and neglect to point out that by
December of that year the index rallied to its former levels, just as we saw
the rally on Friday when the DJIA made up all the ground lost earlier in the
week. What is critical is that in 1929 the average non- index stock did not
recover to former peak levels. This lack of full market representation by most
indices raises questions as to their utility for sole decision making (more on
this later). Having warned you as to the utility of using an index for decision
making, I should also warn you about my statistical, not investment view, as to a
potentially huge one day move in the DJIA. Because the market structure has
changed since 1929 and due to worsened regulation in addition to the abolition
of floor specialists and reduced capital devoted to market making, I suggest
that a 10 to 15% move measuring from the low to high price on a crisis day is more
than possible. While this might make the news and give the pundits a lot to
talk about, it may signify far less than it appears at the time.
The Real Cause for
Concern
As a card carrying
Chartered Financial Analyst (CFA) and someone who learned analysis at the
racetrack, I have never had enough numbers. People in the global investment
community use numbers to build models of
what has happened and our best guesses of the future. In truth we create
statistical abstractions. I would like to have all the money that has been bet
on the “best horse or stock in the race.” Not too often do we get our numbers
individually wrong, more often we get the weighting of the inputs wrong. Most
of the big errors come from not understanding the human equations of the
managements in depth as well as the critical group of customers. In addition
there is the Mark Twain quote of what will hurt us is what we know is not true.
Combine this with the ever present quantity of racing luck covering the
unknowable. Thus, to me the sole or main reliance on statistical measures can
produce small gains and big losses, particularly losses of opportunities.
As an example I
recently heard about a fund group that we think highly of losing an
institutional client because the client’s consultant didn’t like that the fund
group’s stock selection did not look like the average fund of that type. This
is a statistical comparison, not an investment judgment. I could see redeeming
the fund if an examination of its portfolio led to the conclusion that the fund
managers did not have sufficient skill to pick sound investments. In this case
a recent visit with both fund managers and their analysts produced the opposite
conclusion.
Trading Speed vs. Sound
Investing
This week’s price volatility
largely shows the results of making very rapid statistical comparisons. I
believe there are a very limited number of skilled artists that can play that
game well consistently. For long-term investors looking to see their capital
grow in the decades ahead to meet funding requirements from current needs all
the way out to those who want to meet perpetual needs, I believe that they
should rely on the combination of wisdom and future judgment. Wisdom is the sum
total of past experience that can be learned as well as experienced. For
example, the brief discussion above about the 1929 DJIA performance is part of
the wisdom data bank which should include a great amount of historical inputs
and personal learning, including acknowledged mistakes. The purpose of wisdom
is to understand the range of what has happened. When I look through my wisdom
bank, the main lessons are not from some statistical array, but from what
various people through the ages accomplished in spite of identifiable mistakes and
hurdles.
As important as wisdom
is, investment judgment is more important. Wisdom is in effect our memory
drive, where judgment is our investment plans for the future. Authors and
historians make up good stories about people. Almost always they make the
individual they are portraying to have a singleness of mind, knowing exactly
what they want to accomplish and how they are going to do it precisely. I have
yet to study such a person in reality. Judgment comes from making decisions
while in motion not at the beginning. There is an expression in the US Marine
Corps that it taught junior officers: in a combat situation you will never be
judged on Plan A, but on Plans B,C, all the way to Plan Z. This is exactly why
I divide my clients’ portfolios into sub groups.
As an entrepreneur with
limited capital I had to “bet the farm” on a sole product and then on a very
limited number of products, however that is not how I now invest as a fiduciary. I put a portion of my
resources in direct confrontation with selective elements of the market. Some
resources are held back to add when the front line elements get tired through
losses and need time to rejuvenate. Finally I try to develop specific talents
that can leap frog over today’s leaders to find new ones. The key to evolving
judgment is to know when to regroup. This is very strange for me to say, but I
do not use investment performance as my principal decision tool. Primarily I
look to whether my people judgments were correct. If I get my people judgments
correct in time, stock prices will reflect it.
Proper Traits of
Professional Investors
In searching for good
portfolio managers and advisors of all types there are some basic
characteristics for which I look. The first is the thirst for knowledge; in the
modern world something new is happening every day. The next in this lawsuit-prone
world is judicial temperament. Does the individual carry on his/her activity in
the light of possible challenge? Does the individual know, particularly in the
world of many ethical challenges, how to distinguish his or her role as an
agent and as a principal? A good person can play both roles carefully. Notice I
did not require mastery of various types of securities. Those are mechanical
skills which lead to continual usage even when they are no longer the most
suitable.
When developing the
Lipper Mutual Fund Performance Analysis we said the service was for analysis
not for fund selection. The funds were broken down into investment objectives
of what they were trying to accomplish not what they contained. The latter was
an outgrowth of how Marine Corps officers were instructed to give orders to
their senior non-commissioned officers; which was to state the objective and
what resources they had to accomplish the mission, not specifically how to get
the job done. (This is a very different approach than saying you had to look
like the rest.) In my latest endeavor, the TIMESPAN L PORTFOLIOS®,
we assign assets to specific timespans, but the instruments that can be used
include mutual funds, commingled funds, separately managed accounts, individual
stocks and bonds or some combination.
Question of the week:
What are the chances of new index high in 2015? Will a new high be achieved in
2016?
Question of the month: Do you react to investment tweets?
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Copyright © 2008 - 2015
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.
All Rights Reserved.
Contact author for limited redistribution permission.
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