More Opportunities from Disruption + Confusion

Introduction

One of the relatively consistent habits of people in the global financial community is an insatiable focus on the current price trends and almost no focus on factors that may reshape their workplace. I see this right now, but I should admit by nature I am a contrarian and that I often focus on what I see coming over the horizon.

Financial Services Employment

Knowing people within the financial community I am conscious of an increasing number of senior employed executives looking for new opportunities and those recently “at liberty.”

Over the years this has happened a few other times and in most cases my friends have found new and profitable activities. During these periods I have said that based on the available people, on paper, I could form one of the best financial groups in the business. (The reason for the “on paper” caveat is knowing the personalities, I am not sure all of these experienced people could work well together.)

I perceive we have entered another and perhaps much larger such period. Recently I have had conversations with presidents of large and small investment funds groups, senior traders, strategists of various types, etc. Part of this personnel reduction is due to present and projected profitability squeezes. Part may be due to low (relative to the past) prices for financial organizations. As an investor in financial services stocks I am used to seeing this kind of cyclical behavior. Too many people within the financial community believe that their own value is similar to whatever is the current growth stock leader.

The problem of risk management is tied to the growing illiquidity in the markets which is addressed by Jamie Dimon on pages 19 and 20 in the JP Morgan Chase annual report^*. With his personal worry about abrupt rise in interest rates, it is likely that markets will become more illiquid and some traders and investors will be shouldering more risk.

^*A personal holding. I will be happy to send those copyrighted pages to subscribers who contact me. 

Using the often used phrase “This time is different,” I think we may be entering a new phase. For many years we have been going through a concentration phase largely through mergers or acquisitions. This trend could well see a reversal in the next couple of years and the individual investor could be the loser.

Government Interference in Compensation

On both sides of the Atlantic as well in selected Asian countries governments are interfering in the compensation practices of large financial organizations. Officially the politicians drive is to reduce the risk taking that leads to government bailouts. (A far better way to do this is to prohibit such rescues by the politicians in governments and particularly in their central bank dependents in sponsoring bailouts.) The latest action by the US government is to require those in senior jobs or those in a position to assume risk to have the bulk of their income to come from deferred equity ownership that will vest in 4 to 7 years and be available for recapture for cause.

New Enhanced Trading Groups

I suspect the real motivation on the part of these bureaucrats is to address their concerns for wealth inequality both on the personal and corporate levels. The initial rules are built on a scale with the greater the assets owned the more draconian the implications. The focus is on principal trading. If these regulations are fully implemented it is where the job and profit opportunities will be created. Instead of the bulk of trading being conducted on exchanges and by the members of the concentrated players, it will shift to smaller asset owners who control large amounts of clients’ money; e.g., Hedge Funds or similar non-deposit taking groups. These groups will have no obligations to the marketplace and/or to provide service to individuals. In effect we will have reinforced the kind of private markets that currently run most of the commodity and real estate markets. The new enhanced trading groups will need research for both decision-making and institutional marketing. Some of these groups will gather money through accounts, others may use private vehicles that that have similar characteristics to mutual funds.

Historically any attempts to legislate risk has only shifted to other locations including beyond borders. Thus the aggregate total of risks assumed is unlikely to change. People’s business cards and the location of some of their computer servers accessing the Cloud will change. By the way, the biggest source of risk for most citizens is the induced risk that is inherent in current government practices; for instance deficits, unfunded liabilities, and unaccounted for contingent risks.

The Enthusiasm Watch

As repeatedly set forth, I am on the watch for growing enthusiasm for stock prices as a warning device of a major top. Here are three cautionary signs:

• Only three of forty-four markets tracked by The Economist declined in the week ending April 20^th.

• Both in the US and Europe mutual fund investors are putting money into Fixed Income funds and out of Money Market funds showing a lack of Jamie Dimon’s concern about rising rates.

• Barron’s Big Money Poll of global money managers has 35% bullish and only 16% bearish with 49% neutral. However 59% are bullish on commodities. (They must have high confidence in their individual selection skills for their outlook for corporate profits this year is under 5% and under 10% in 2017. This suggests reliance on concentrated, less diversified portfolios.)

Standard Approach to Look for New Winners

One of the lessons I learned from an old market pro was to search the new low list for future winners. This is why I insisted on showing the lagging funds much to the annoyance of fund managements when I was publishing Mutual Fund Performance. I still believe it is a good exercise in the search of future winners. This view was reinforced with the arrival of Dimensional Fund Advisors' Matrix Book.

Near the very end of this interesting compendium were two pages that looked at twenty years of relative performance of developed and emerging markets which I found to be instructive. Below is a table for the last six years of the best and worst performing countries in these two universes:

Year	Developed		Emerging
	Best	Worst	Best	Worst
2015	Denmark	Canada	Hungary	Colombia
2014	USA	Austria	Egypt	Russia
2013	USA	Singapore	Taiwan	Peru
2012	Belgium	Spain	Turkey	Morocco
2011	New Zealand	Austria	Indonesia	Egypt
2010	Sweden	Spain	Thailand	Hungary

My data analysis points out how rare there is a repeat with only USA having a next year winning repeat and Austria and Spain repeating on the downside later.

Much more important in the emerging market lead, both Hungary and Egypt went from the worst to the best in a few years time.

Using the Hungary/Egyptian model I would be looking for opportunity in both Canada and Singapore.

Question of the week: How do you search for future winners?     

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Copyright © 2008 - 2016

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

Beware of ‘Risk On’ Enthusiasm

Introduction

Confidentially I will let you in on a big secret as long as you don’t tell anyone. The secret is that I can not predict the future and have serious doubts that others can sequentially. I view my responsibility as an investment manager is to review the possibilities of future events and attempt to refine them into logical probabilities and to determine whether these opportunities are priced rationally. I try to follow the precepts of strategic military intelligence, if that is not an oxymoronic belief. A strategic as well as a tactical commander should be supplied with an array of potential future events. The commander then makes the judgment as to which are probable and makes his/her plans accordingly.

Enthusiasm Risk

As regular readers of these blog posts may recall, I have taken the position that most stock markets top out with a demonstration of excessive enthusiasm. As we have not seen an example of this for some time, I have not been worried about a strategic decline. Historically these happen once in a generation and cause the general stock market levels to fall by 50% from their peak. For my long-term oriented accounts I have witnessed several tactical declines every decade in the order of 25%.

Too many of us think about only stock markets. This often is a mistake. Historically, elements of the bond market have performed the ‘canary in the mine’ function of warning about oncoming stock declines. Possibly a chirp could be heard this week. Having observed estimated weekly net flows by mutual funds and ETFs, I can see substantial inflows into both High Grade Corporate and High Yield (Junk) bond funds. In light of both the popular view of an eventual rise in interest rates when we exhaust the lower for longer phase plus current corporate operating data, bond investors could be subscribing to more risk which will be discussed more fully shortly.

This week on the equity side of the ledger there were also signs of growing enthusiasm. Forty out of forty-four global markets tracked weekly by The Economist showed gains. Further, the transacted volume of JP Morgan Chase^* shot up from 17.7 million shares on average in the first two days of the week to 27 million shares on average in the last three days of the week.  One important element of caution for novice investors in bank shares is there is a second way to read the apparent discount between a bank’s stock price and its tangible book value. The market may be suggesting that the historic tangible book value is overstated. A proper analysis of a bank’s assets and liabilities, including contingent liabilities, could mean that current prices of many banks are appropriately priced and are not the bargain that the discount implies.

^* Shares owned personally.

There may be another class of enthusiasm that should be identified. For about a year the US auto industry has been reporting close to historic sales levels of 20 million units. Even at last month’s rate of about 17 million, some of these gains are due to the fact that the average car on the road is 11 years old and the average light truck is 13 years old. However, some industry and financial professionals point out that the decline in gas prices has helped to fund purchases and many do not expect lower prices. At the same time the length of both leases and sales contracts have lengthened beyond past levels. Part of the growth for these has been characterized as sub-prime loans. The smarter banks have been cutting back on these loans. If one switches to sales dollars as distinct from unit sales the increases in SUV and light trucks has been meaningful and possibly replacements for lower priced and lower profit margin sedans.  (One of our two cars is an SUV purchased more than five years ago.) The car buying public has shown a bullish belief in our future.

Capacity Utilization and Productivity Warnings

At the same time that the level of industrial production is published each month another statistic is released and may have more impact on future profitability than production numbers. Capacity utilization measures how much of a plant’s capacity is utilized in that month’s production. The latest reading is 74.8%. This is 5% below the monthly average since 1972. This is significant for many plants an 80% utilization generates optimum operating margins. (Higher utilization rates will produce larger aggregate profits, but the last bits of capacity often are outmoded and produce lower margins.)

Profits are the direct result of the level of production and the productivity of labor. The risk to bond holders and particularly high yield holders is that revenues are currently growing at best very slowly if at all and wages are starting to rise. Moody’s believes that the default rate on non-energy High Yield bonds will rise this year as some of these companies’ profits will be squeezed between flat sales and rising wages.

Why are wages rising for new employees?  In order to survive, companies have been replacing manual labor with machine labor and in many cases not using outmoded plant capacity, which is written off when the plants are closed rather than on a contemporaneous basis. Regardless of the accounting niceties, the new machines require more skilled labor. These as a class are in short supply and hence result in high hiring costs.

Part of the reason for the shortage of highly skilled labor is the failure of our educational system, starting with the home and going all the way to the formal educational system including our PhD programs at elite universities. We are producing students who not only don’t possess adequate knowledge, more importantly many job seekers don’t have the right attitudes. They are not prepared for the workplace culture of integrity and cooperation. We are not producing people who are skilled at reading others in a group or individual basis, so they lack sales ability. (In any group of two or more, sales ability is needed to get optimum results.)

What to do?

Since I have let you in my secret, here is what I recommend for your portfolio under the current circumstances:

First, I recommend for consideration the development of timespan buckets or portfolios similar to the TIMESPAN L Portfolios^®.

Second, one should make small and somewhat frequent portfolio changes, perhaps in one timespan bucket at a time.

Third, have sufficient diversification so one has appropriate hedges, in case some of the expected future trends don’t work out as expected.

Fourth, we live in a global world, whether we like it or not. As we can not escape from many global trends, keep that in mind in your selections of managers and securities.

Fifth, continue your learning process as we are trapped in a dynamically changing world and we need to wisely adapt.      

Question of the Week: Are you watching bonds to help with your stocks?

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

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2016

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

Fiduciaries, Expenses, ETFs and Timespans

Introduction

Apparently the favorite interview press query at the Academy Awards is “what are you wearing?” The answer, according to script is the designer’s name. However, this is an incomplete description of the garment. The question and answer works in a sound bite commercial world for some but does not tell us anything as to the talent of the actress (or actor), the role portrayed, and most importantly how the performance worked. This is an example as to how we use labels to convey a familiarity of topic knowledge and “being in the know” exclusivity. The media, government agencies, and some investors also use labels in the same way and these could be traps in terms of making sound long-term investment decisions.

Fiduciary

This week the US Department of Labor produced a 208 page document which I actually read. The full title is “Fiduciary”; Conflict of Interest Rule - Retirement Investment Advice. In brief summary the document mostly discusses the appropriate disclosure of compensation arrangements by various investment intermediaries. As both a registered investment advisor and an employer of other fiduciaries, I read this as a cynical document. One of the definitions of a cynic is that he or she knows the price of everything and the value of nothing.

The investment process at the professional level is long and often difficult in terms of coming to present conclusions from past performance and the surrounding analysis. (It is worthwhile that the Securities and Exchange Commission requires a cautionary statement to be appended to investment performance claims that past performance does not guaranty future performance.) I am sympathetic to the government’s desire to help investors, in particular ones investing for retirement. They believe that disclosing various ways that the investment system has found to receive compensation is useful. This is like the true statement that at some future point we all will meet our maker.

The real problem is that the professional community has been unable to fully identify the system-wide cost of investing, from securing a relationship, lifetime training and servicing, all of the administrative expenses including legal and tax professionals, as well some recognition of the standby costs to have these services available for when they are needed. In aggregate, I don’t know  what the real costs are. 

For many individuals the biggest single investment in their lifetime is the purchase of a home. Before the pressure of competitive pricing, the “going in” costs are quoted at 6% + closing costs. (I have often said “protect me from a ready to move-in house.” Within the first couple years of ownership perhaps another 10% or more may be spent converting the home to what we really want.) Thus realistically I view the true cost of a new home as the transaction price plus 10-20% a few years out. I suggest that the true cost of the time and efforts of all professionals dealing with your retirement capital is probably in the same order of magnitude on a much larger amount.

With the exception of performance fees, no one attempts to recapture these kinds of costs on the surface when investing retirement money. This does not mean that these service provider costs are not there or that they are a great deal lower than residential real estate transaction costs. Traditionally the investment community has recognized that there was a customer barrier to charging up front the lifetime expenses of a transaction. Thus, the favored way to earn compensation is first to receive annual payments which if the accounts stay with them long enough; e.g., 10-20 years, payments may reach equivalent to residential real estate expenses. The second way is to have many more transactions than the average real estate broker, which in turn probably means a significant increase in marketing costs.

The hope of the financial community is that investing for an individual’s retirement is a long-term effort and can receive periodic payments to make the effort worthwhile. Getting back to the cynic (who similar to the Department of Labor, is focusing on price disclosure) like many in the investment community wants to be paid on the basis of value received. Financial professionals have not been very good at demonstrating the value received beyond relatively few performance fee contracts which often are counterproductive by emphasizing shorter term performance. Without this ability, all too often the investment community charges relatively nominal amounts on the surface and has found methods to get additional compensation other ways. The DoL wants these to be fully disclosed. Good luck. The hope is that analyzing fully identified expenses will become the model of retirement investing behavior.

As a continuing student of investing and the investment communities, I think there is a substantial chance that when one restricts the price of a service the value provided in that service declines. What may happen is that instead of the title of fiduciary being something of an honorific, it will identify those that can’t make enough money by being good investors. If there is any chance that I am correct, those with small amounts, albeit growing, of retirement capital will find it difficult to get a high level of service. (Under these conditions some employer-sponsored savings plans; e.g., 401(k), 403b, and 457 plans may be modified to accept additional investments from existing and retired employees who will be able to keep their retirement capital relatively safe within their plans for their lifetimes. We would be interested in working with them on that prospect.) 

Exchange Traded Funds (ETFs)

Many people throw around this term, but don’t understand the differences between these vehicles. Most of the money in ETFs is in beta-matching products attempting to replicate various published indices. These indices were never designed to be prudent portfolios or to  meet specific investment needs. A smaller group (in terms of assets) but much larger in terms of numbers of funds are indexed to various sectors or in some cases to various investment factors. These presuppose that the creators of these profits selected correctly those stocks (or in some cases bonds) that will now and in the future capture the essence of the sector or factor. I question whether anyone can predict the future well enough to lock into future investments. Finally there are ETFs and ETNs (Exchange Traded Notes) that are “super-securities” used as a way to capture the general movement of items that don’t trade frequently or have enough liquidity; for example bonds of various qualities and duration, very small companies, emerging market securities, and commodities. As one can easily see, each different type of ETF or ETN is sufficiently different that labeling the same thing can be misleading. At some future date I will discuss the practice of managing accounts exclusively with these products.

TIMESPAN L Portfolios

          Regular readers of this blog are aware of my TIMESPAN L Portfolios^®.  A unique benefit of this construct is its ability to enable the management of capital through single-purpose beneficiary portfolios that allocate investments over specific timeframes and risk tolerances.  TIMESPAN L Portfolios can be a suitable strategy for defined contribution retirement plans, non-profit organizations and family wealth. 

          A visual example and description of TIMESPAN L Portfolios is available in hard-copy.  Qualified institutional investors: Please send me your mailing address and a brief description of your interest to aml@lipperadvising.com .

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

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2016

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