Sunday, April 17, 2016

Beware of ‘Risk On’ Enthusiasm


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.      

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A. Michael Lipper, C.F.A.,
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