Sunday, February 7, 2016

Long-Term Investors’ Telescope vs. Traders’ Microscope


“It is a puzzlement” reminds me of a phrase from the wonderful stage show “The King and I.” With so much negative market news, I find it easy to close my eyes to my professional responsibilities (which is to produce at least acceptable results for many years in the future). Perhaps like the King of Siam in the musical I should be conscious of Chinese culture and its messages. In the Chinese calendar we are entering the Year of the Monkey. This is the year that we are to be confident as well as curious and the year is to be a great problem solver. Further this year is the year of the Fire Monkey who is strong and resilient. I will try to utilize these traits as I look through the traders’ microscopic focus to set up the intuitive leap to use the long-term investors’ telescope.

Microscopic Attention

Many published pundits are using the falling stock markets in both the US and China as leading indicators of an oncoming recession, forgetting Professor Paul Samuelson’s quip that the stock market has forecasted nine of the last five recessions. Globally, purchasing managers are reporting more strength than weakness. Nevertheless, stock prices for large-cap stocks, with the exception of utilities (+ 8%), have fallen mid to high single digits through Friday. Smaller market capitalization stocks  have declined greater, Russell 2000 ‑13%, NASDAQ Composite ‑13%,  and the KBW Bank Stock Index ‑16%. What is causing these double digit declines if not a rapidly oncoming recession?

One of the lessons we learned from  the surprise of an earlier default of Russian treasury paper was that firms whose trading capital fell had to quickly reconfigure their trading books to fill the vacuum caused by the absence of value in their Russian holdings. This was called contagion. I believe that today we are experiencing a form of contagion. When energy and other materials stocks cratered, many portfolios found that the percentage in equities was above their mandated limits so they became price-insensitive sellers. They sold what they could which started with their most liquid stocks, but if they had to sell the smaller cap stocks because of the Volcker rule they found many formerly large dealers could not provide liquidity for many of their less favored customers at prices without further discounts. Until a bottom is achieved discounts tend to produce more discounts. In a similar fashion contagion is now a world wide phenomena.

Thus whether we like it or not, all of us are global investors as almost all of our economic activities are affected by foreign supply and demand for goods and services including securities beyond our home markets. Fidelity is running an ad for its international funds where it proclaims that only 26% of the world’s publicly traded companies are in the US and 80% of global GDP comes from non-US countries. Because of these concerns I look at numerous local markets first to see if they are opportunities and second how they are impacting my home market. The Shanghai Composite Index on a year to date basis is publishing a 22% decline. (I wonder what will be the value of the companies that have had their stocks suspended or what might happen to prices when the institutions can break loose from their restrictions on selling?) Nevertheless, there are apparently some more attractive markets than the US; Mexico is up 0.6% and Korea is only down ‑2.2%.

In terms of potential direct impact on US stocks in the financial sector, I am noting that in London Life Insurance stocks are down 17%, Banks
‑17% and non life insurance stocks ‑7%. I suspect that we will see more transatlantic deals like ACE and Chubb with or without tax inversions.

Long-Term Investors’ Telescope

For many long-term investors the 2015-2016 market decline is giving back some of the house’s money which has been gained over the last five and ten years if not longer. Even at today’s prices many long-term investors are sitting with doubles or more on their purchase price. Some of these investors have net cash flows into their portfolios or some disappointing positions. If their successful holdings still double, but are down measurably from peak prices, it might be quite prudent for these long-term investors to add to their winners. If they have too many opportunities relative to their ability to buy, they may want to examine the currently published results of the stocks in the S&P500. According to the S&P Index service while 8 of the 10 sectors reported better than estimated revenues only 3 reported “beats” in terms of per share earnings. In order of their % gains, they were Technology, Health Care, and Financials.

Four bulge bracket investment banks reported to a credit rating agency that they expected a healthy bond issuance in 2016 because the companies were borrowing money for buybacks and paying dividends. Most of the issuers have more than enough cash already to pay for these, but they do not want to pay additional taxes on repatriating the money. From my standpoint as a long-term investor I would prefer them to modernize and expand their capacity to improve both their volume and productivity. Thus, I believe there is sufficient available capital to build another leg on our economic growth. This is not to say that between now and the expansion we could not have a down
because as one of the writer’s in the UK’s Telegraph remarked, “Someone actually could know something about a near-term recession.”

Question of the week: In which of the next 12 quarters will the recession start and end?    
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A. Michael Lipper, CFA,
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