Sunday, June 26, 2016

Europeans Win, Experts Lose, Trading Opportunity vs.1848


The essential difference between market followers and sound analysts is the former follow short-term momentum and the latter long-term directional changes. I embrace the second responsibility. Brexit, in my opinion, is the beginning milestone on the march to an era of more freedom of consumption and investment which will lead to better lives for many Europeans. Note I am focusing on people not present political countries.

The Perils of Over-Confidence

The focus on the needs and desires of most people is exactly what the expert class was not doing. They did not see or hear what the working class and much of the middle class were saying. The colossal surprise of the upset is only a surprise in that the expert classes of economists, political scientists, politicians, portfolio managers, senior investment people and media pundits had never considered that they were wrong. They had no plan “B.” In the US Marine Corps young officers are instructed you will only be judged on what you execute which will largely be plans “B,C,D, E, or F.”

This tendency of overconfidence will be part of a panel discussion this week at the New York Society of Securities Analysts celebrating the work of Benjamin Graham, the father of value investing. At the meeting I will be focusing on mistakes investors make keying off some of the mistakes that Berkshire Hathaway has made over the years. I have been asked about the single biggest cause of professional investment mistakes. I will discuss the overconfidence which has led to sizable losses. A similar pattern was in evidence in the London approach to Brexit. 

What Actually Happened: A tale of Three Countries

In Great Britain the London-centric experts thought the campaign would be won focusing on the fear of economic disruption. They were not listening to the people of the North of England and Wales who were primarily concerned with the loss of national sovereignty in terms of immigration and Brussels’ determined justice and procedures. These working classes and much of the middle class were fed up with what they perceived was likely to happen to them.  

One of the signs of this great division with those who wished to remain is the number of voting districts where the winning side polled more than 60%. We are used to seeing a split in many voting areas similar to the final 52/48%. The wider spread indicates to me that both sides were effectively only talking to their own and not engaging with the sizable undecided or opposed. The London-centric people initially bet over 90% of the money with the book makers that they would win only in the last few hours of the referendum, bet 90% on Brexit. (Too bad the Londoners didn’t know their history. More on that later.) Since the bulk of the more active institutional and trading money is intellectually based in London, over the preceding days they were heavily buying securities and sending similar thoughts to other markets. Interesting when the shock of the results became clear, the UK stock market declined one of the smaller falls in the world in part because only 35.5% of the indices’ revenues were domestic to the UK.

German investors suffered a 12% decline in part because 72.4% of their revenues are international in scope. One corollary measure is in the US, the Vanguard Europe ETF fell 11.3% as noted by my friend Jason Zweig.

In the US with approximately 70% of our revenues produced domestically, the main stock averages fell in the neighborhood of 3%.

This needs to be put into perspective. First, the decline essentially corrected the last several days’ rise based on our trading fraternity believing what they were hearing from London as well as significant short covering by hedge funds and similar traders. I believe the over 600 point fall in the Dow Jones Industrial Average was caused by the absence of short covering and algorithm-driven quant funds that sold as various price levels were violated. People at JP Morgan believe that from this source some $25 billion dollars were thrown on the market. If there is a continuation of the sharp decline they are looking for up to $300 billion more to be added to the market.

For those of a trading mentality I suggest at some point a near-term bottom will be reached, possibly on Monday. Current prices for many securities are back down to the bottom of their recent trading ranges which could well hold. If these trading bottoms do not hold further, declines will find other bottoms. Whenever the bottoms are found, subsequent rises could be dramatic because of the absence of positioning capital on trading desks.

While I recognize a potential trading opportunity, at the moment I do not see a substantial reason to change fundamental investment strategy. In terms of our four chamber TIMESPAN L PORTFOLIOS® I might adjust the second chamber or the Replenishment Portfolio’s equity trading account to either take advantage of some cheaper merchandise or reducing risk if there are more violations of support levels. I would not change either the Endowment or Legacy Portfolios.

Londoners Had the Answer

The intelligentsia in London had the answer if they knew where to look. I do not know whether or not the restaurant that was in the downstairs floor of the residence of Karl Marx is still functioning. One evening my wife Ruth and I climbed the rickety stairs to his apartment which still had no electricity. At the request of the German Communist Party, Karl Marx authored the Communist Manifesto in early 1848. (A side note: because of his subversive activities in Europe he was never allowed to become an English citizen even though he was buried there.) He believed that it was in England that the revolution of the proletariat would begin because of its class structure.


The main reason to focus on Karl Marx is the year 1848. This was the year of some 50 revolts by the working and middle classes throughout Europe and Latin America. These brought down a number of governments including in France. There was widespread dissatisfaction with the political leadership. Nationalism was on the rise in France, Germany, Netherlands, Denmark and Italy among other places. The violence of the revolts and the desperation of the people led to massive migration into “the new world” which in one generation proved to be a major brain drain. Lenin summed up what happened. “There are decades when nothing happens and there are weeks when decades happen.” (Courtesy of John Mauldin)

Perhaps the bureaucrats in Brussels and the current political leaders on the Continent are now seeing the risk to their structure. As is natural their first instinct is to punish the interloper, the second is to become defensive and the third hopefully to negotiate and evolve. Possibly Dr. Brendan Brown of Mitsubishi UFJ Securities is correct when he says. “The referendum result marks the start of A European journey out of a failed EU.  Britain is in the lead…There are serious grounds for hope (for) greater economic and political freedoms, prosperity and European harmony.” Greater Europe has for centuries developed official and more informal trade patterns that has produced satisfactory results both in peace and war and I would expect that to continue. In that light I believe that Europeans need the British as much if not more than the British need various European elected and non-elected states.

What to Do?

Many of the better US managed international funds have significant portions of their portfolios invested in Europe. I suspect over time these will be good investments and could find places within sound Endowment and Legacy Portfolios. For those whose preference is individual financial services securities, on a long-term basis they may wish to examine INVESCO, Franklin Resources, and Goldman Sachs all three are long term positions in our private financial services funds and have been under pressure recently. There are similar long-term attractive non-US domiciled financial service companies that I will be happy to discuss with our readers.

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Sunday, June 19, 2016

Be Aware of History


My basic belief is that you can scratch an analyst and a historian will bleed. The good professors and scientists at Caltech tell me that our memories are a critical decision-making part of our brain. Thus each of us are to some extent historians. On this weekend before the historic Brexit referendum I thought it would be useful to selectively search history for clues as to future wise investment moves.

Lowest Interest Rates in 5000 Years

In Mesopotamia about the first recorded interest rate was 20%. That was the same rate charged in Babylon in 1772 BC as well in Italian cities about 1150 AD. The highest recorded rate was in 539 BC of 40+% at the time of King Cyrus taking Babylon. What may have been a spur to colonization of the US, English interest rates were 9.92% in the 1700s. To show the volatility in the US, our rates were about 1.85% during WWII. By the 1980s rates rose to 15.84% compared to the 0.25-.50% the Fed is using currently. The sources for this and other similar data are the Bank of England, Global Financial Data and a book by Homer and Sylla entitled “A History of Interest Rates.” Dick Sylla an NYU professor for many years has been the chair of the Museum of American Finance whose board I served on. The purpose of showing the historic swings in rates is to alert investors that a future surge in rates may not peak in the mid single digit range.

One of the very best chart readers I know suggested to me that the continuously offered 30 year US Treasury Bond has possibly reached a thirty-five year peak in a move that began in 1981. I am conscious that Treasury officials, the SEC, and various hedge fund operators are concerned about the illiquidity in portions of the Treasury market. This may well be the reason that the Treasury is not materially expanding the duration of the US Government Debt structure. As investor for clients and my family in equity funds I find that any potential disruption in the most senior market can be unnerving. The modern theory of equity investing is based on the floor created by the risk free interest rate on US Treasuries. Perhaps it could be suggesting that we should be looking for a sub-basement below the floor!

Historic Perspective on Brexit

I do not know which way the vote will go, but the way I look at the polls as of now the “leaves” appear to be winning. Regardless on the outcome unless there is at a least ten point spread, it is my belief there will be other elections in the UK and Europe both for leaving and joining. From a historic point of view one can see that Common Market is just another attempt at European unity which goes back to the time of Julius Caesar. All of these have failed in the end for two intertwined reasons, (1) lack of confidence in the leadership particularly and (2) the provision of defense of the life of the homeland. During the Spanish Civil War there was great fear of the “fifth column” of enemies in civilian clothes creating great damage. Today throughout the world this fear is again present in the inability to properly screen immigrants or perhaps their children.

In the developed world these fears (along with concerns about the future economic outlook) are leading to a decline in the rate of marriage as well as fertility. Demographic trends take a long time to develop and change slowly. In time these trends play a political role and the referendum and the coming US elections could be influenced beyond the political leadership’s expectations.

Risk Management

On a recent trip to Europe one of my good analytical friends who is now a US citizen but was born elsewhere was anxious to return to the US, a land of risk-takers. By implication he was decrying that most of the Europeans that he was talking with were not attuned to taking risks. I believe that the US has benefited from the fact that many of our ancestors had to take big risks to get here. But we are not as much gamblers as other people are. What we risk is our hard labor against long-term goals.

One liberal arts university whose board I sat on recognized the need to offer business related courses to keep its attendance up to the level that they could afford the professors and staff. The would-be business professors came to the board and were outlining what they wanted to teach. In one case they wished to teach risk avoidance. I demurred. To me they should teach risk assumption and therefore risk management. Our whole private and public equity culture is based on wisely seeking risk assumption at the right price and conditions. To an important degree this drive is missing in many countries, but not others -  particularly in Asia.

Getting Bullish

The essence of risk management is to take on risk when others shed it as much as possible or are reluctant to commit to a future. While both Brexit and the high quality bond market may prove to be hurdles, they are not absolute impregnable walls. When too many are in their foxholes or trenches, this could be the time to advance. Clearly if bad things happen there could be cheaper entry points if one is not too petrified to move. Thus, I would urge long-term oriented investors to begin or increase their equity investing. If they are having trouble finding the appropriate funds to use, I will be glad to help for awhile.

Question of the week: Will the outcome of Brexit change your equity allocation by more than 20%? 
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Sunday, June 12, 2016

Investing with the Uncertainty Principle


Valuable insights can be derived from the same principle when making decisions for investing in securities and betting at the race track. While I am a senior trustee at Caltech, I do not claim to understand quantum mechanics. What I do recognize is that in 1927 Werner Heisenberg identified a way of thinking now called the Uncertainty Principle. He found that there is a fundamental limit to the precision of measuring unequal objects. Stripping out all the math, which is beyond me, the mere act of measuring the difference changes its precision. Translating this to my dollars and sense world means that the value of a comparison in terms of utility declines the more it is measured. In effect the more popular an analytical relationship becomes the less valuable it is.

One Successful Asset Manager’s Application

Marathon Asset Management of London starts a section in its well-written monthly report entitled: TOO MUCH INFORMATION, with a quote from T.S. Eliot. “Where is the wisdom we have lost in knowledge? Where is the knowledge we have lost in information?”

What Marathon is decrying is the frequency that the modern publicly traded company is supplying information to the market directly or through analysts and the media. This flow of information is augmented by trade associations and others’ intra-period industry data. Market prices move in the direction of the perceived value of the information only to be reversed often on the interpretation of the next morsel of information. This leads to stocks turning over much more rapidly than in the past. I have noted that the increase in individual stock turnover has led to a general increase in active mutual fund turnover. Unfortunately, this trend has not added to investment returns. 

Through June 9th on a year to date basis in the fund asset class identified as US Diversified Equity funds - with one exception - the two best performing groups were the Mid-Cap Value funds + 7.80% and Small- Cap Value funds +7.68% (S&P500 Index funds were up +4.23). What is more interesting to me is an almost double gain from the one exception of +13.00% for Equity Leverage funds. This suggests to me it is not the fund’s selection skills but the use of borrowings (margin) and derivatives. One would think we are describing hedge funds. However, two others fund performance statistics tell a more complete story: Dedicated Short Bias funds -14.20% and Alternative Long/Short Equity funds -0.10%. I have now transmitted to you too much information.

Marathon would believe that the information above is a dump not a filter in terms of data discrimination, giving equal weight to each factor. There was no attempt to fathom what is missing. (I have often found that what is missing from an investment proposal is more important than what is provided.) The frequency of information input or overload leaves little time for deep thinking and pondering not only what is missing, but what weight one puts on each factor considered and how much to value what is unknown. The last exercise is critical to avoid the single biggest contributor to large losses, overconfidence. The last step often leads to a decision not to do something. While not axiomatic, lower turnover funds produce higher on average results over long-term investment periods that we favor.

Unfolding Brexit Pictures

We have one more weekend before the referendum. I hope in next week's blog post to devote more space to its impact and probabilities. However, in reaction to last week’s blog plus some conversations I had at a meeting sponsored by the London Stock Exchange on the value of listing funds at that exchange, there are three thoughts that I would like to share:

1. Unless the spread between the Remain and the Leaves is greater than 10 percentage points, the odds favor other elections on this and related topics in the UK and within the EU.

2. Regardless of the result, the 2017 elections in both Germany and France will be impacted possibly in different directions.

3. The use of foreign political leaders and foreign media comments can prove that such outside influences are counter-productive to the mass of voters.

Has the Commodity Cycle Bottomed?

As noted above, the US Diversified Equity funds have produced low to middle single digit returns year to date. There are ten sector funds that are showing on average double digit returns. Not only are these Precious Metals funds +88.89% but also Energy, Base Metals, Agriculture and Infrastructure funds. Clearly these are recovering from deep multi-year bottoms. But when the average Sector fund is up+9.58% compared with the US Diversified funds’ gain of 3.26%  are the markets telling us something? This is exactly the kind of question that Marathon and I are both calling for some deep thinking. The data above was compiled by my old firm, Lipper, Inc., part of Thomson Reuters.

A Professional Analytical Pause

On most weekends I draft these posts on Sunday, but this week because a significant concert of the New Jersey Symphony Orchestra, I am beginning to draft Saturday afternoon. But I am going to suspend my scribing to watch the 148th running of the Belmont Stakes. For many track followers this is the single most important race for three year-olds. Its importance is similar to the senior prom in many US high schools. In both cases this one event will be remembered for a lifetime and a point of passage for these equine adolescents. In almost all cases this is the only time they will be asked to race for a mile and a half. The winner will initially be highly valued as a sire of future champions.

I will be watching not only from a racing standpoint, but also from an analytical viewpoint. Earlier in the week the weather looked for rain at race time. In theory this would have helped the favorite who has won in the rain several times in the past. The backers of the favorite were hoping for a repeat set of conditions and therefore results. This may be like picking a fund on the basis of superior past performance in down markets. But in each case for the very moment the question is how will the candidate do with a change in conditions?

Conclusions After the Belmont

As is often the case, lessons from one field have application in others. The race was won by a long shot meaning the experts and the bulk of the betters were mistaken. The interesting thing for me is the application of the Uncertainty Principle. It did rain right after the race, but that did not appear to be the deciding factor why the favorite (while close during the race) faded at the end of the race to finish almost last. If one filtered all of the past performance data and only looked at what could have been expected to be the interim best time at each leadership position, one could have deducted that this year’s Belmont Stakes had too much early speed and took the favorite too much effort to get to the front and couldn’t easily overcome the early leaders. In addition, there were a couple of fresher closers at the end.

From an investment point of view there were some lessons:
Past performance needs to be carefully analyzed and broken into components. The weight of past victories in terms of money earned was not a deciding factor. Finally, betting on future trends even when right, (the rain), the timing can be slightly off and not workout as forecasted.

In Summary

We should recognize that we live and must invest in an uncertain world. We need to focus on critical subsets of information. Finally our confidence should be measured to avoid overconfidence.

What do you think?
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Sunday, June 5, 2016

Pivoting Season: Be Careful


We are entering the Pivoting Season. Some investors will succeed and others won’t. One needs to understand both the successful and unsuccessful pivots in history and at present to be able to pivot successfully in the future.

Current Pivot Attempts

For some time the “Jarrett Administration,” otherwise known as the Obama Government, has been attempting to execute a Pacific Pivot without meaningful success.

Another pivot is the coming “Brexit” referendum with the base arguments shifting away from London-oriented economics toward social and defense concerns. The continent can not progress economically without Britain, but Britain can survive and even progress without Europe, albeit with some near-term difficulty. In my humble opinion, the momentum will be for the UK to leave.

In the run-up to the US Presidential elections we traditionally enter the period of pivoting to the center and escaping from the strident extremes. This year, due to the length of the primary season and the shift away from network news to the Internet, the movement toward the center is going to be much more difficult unless there are surprises.

With this focus on pivoting it is natural for investors to also think deeply about pivoting their portfolio into more winning structures. Based on my study of history and racehorses, my instinct is not to try it unless you use appropriate, professional talent and then restrict the pivoting to only sections of the portfolio. Our goal is to execute a pivot if certain conditions are met (such as those passed on from Lincoln to Generals Grant and Sherman) as described further below.

The Most Successful Pivot

When President Abraham Lincoln changed focus from defeating the Confederate armies in battle to winning the war, he picked different leaders and different battles. He shifted from primarily fighting in Virginia and Pennsylvania to Missouri and Tennessee. His leadership changed from generals who graduated at the top of West Point to those at the bottom of the Class; from officers that were accustomed to riding horses to ones who in Grant’s case, only made a modest living driving mule chains.

Ulysses S. Grant built his campaign from the shores of the Mississippi River down through the tough terrain of Missouri through to the western side of Tennessee. The Confederate high command took this as a continuation of the North pushing southerly with the ultimate political goal of seizing the political center in Alabama.

At this point Grant ordered General Sherman to execute the pivot. Instead of a north to south-oriented drive, Sherman executed from the west in his ‘March to the Sea’ (Atlantic Ocean).  His target was to knock out the logistic center of the Atlanta rail head. The battle shifted from political targets to a war-making capability. 

Because of the speed of execution and the destruction of property along the way, Sherman was able to survive a two front exposure (from the north and the south) when the Confederates reacted with underwhelming force. In the end the pivot brought the US Civil War to an end many years before the old, politically-oriented strategy would have.  In terms of the conditions for a successful pivot, Lincoln had chosen the right leaders, the right time, and the right place.

Both Napoleon and Hitler also made pivots from the west to the east into Russia and failed miserably because they did not have the same right leaders, time, and space.

Is this the Right Time to Pivot?

Are we at a similar point as was Mr. Lincoln, when the top strategists are wrong? Let’s look at the results this year from the standpoint of large stock and bond portfolio investors.

High Quality Corporate Bonds and US Treasuries are meant to be risk absorbers as they no longer can produce income above actuarial assumptions. They are not meant to be performance vehicles. The S&P500 has a Corporate Bond index that seeks to replicate components of the S&P500. Through the first five months of 2016 this bond-only index was up +4.99%, after being the only major asset class to show positive results earlier in the year.  The problem for most investors is they didn’t own enough of this dull instrument during this period because they were not being advocated by the ‘top of the class strategists.’

What is even worse is that most large investors owned the wrong stock sectors. In the five month period ending May 31st, the S&P 500 stock index gained 2.59%. During the same time period the healthcare sector was down -0.3% and the financials -0.74% of the stocks within the index. These two sectors were heavily owned within institutional portfolios and favored by most strategists. What really hurt the pride of portfolio managers and the pocketbook of investors is that there were three large sectors producing double digit returns: Utilities +12.80%, Telecommunication Services +11.45% and Energy + 10.73%. My guess is that the first two sectors were only slightly owned  by institutional accounts (with the exception of  Verizon and AT&T which was held for yield). The third was shorted by the hedge fund community.

After a period of disappointment with market and performance leadership, performance-addicted investors are ready to switch horses. Should they? Do they currently have the right generals and right locations?

The Lessons from the Track

As my regular readers may know, I have learned many analytical approaches in attempting to analyze the past performance at racetracks. I have previously written that there are “Horses for Courses and more importantly that the changing conditions of each race should impact the probabilities as to the ultimate results.

There are other factors that should also be considered. These start with the racing history of the particular horse and those of its family, including the sire, the dam, and their families. Plus a similar review is required of the past success of the jockeys, trainers, and stables. The challenge for both the track and security investor is that there are very few winning teams that have a good record under all conditions. Under the pressure of the laws of economics, most of the better teams are under contract to rich players. In our investment account world, this often means high-fee hedge or private funds.

While we look to find consistently superior teams and horses, they are hard to find. Thus, we tend to match the available talent to the expected conditions.

Right Battlefield Locations

One the first major distinctions a good handicapper or track analyst focuses on is the length of the race. The length often determines the racing strategy and betting (or if you prefer, allocation strategy). In short races opening speed is very important as there is little opportunity to recover from a slow start. In longer races there is both the opportunity and risk of recovery. Stamina and the ability to handle change in leadership becomes important.

It was the thinking expressed above that was a critical element in our development of the TIMESPAN L PORTFOLIOS®. In this structure we divide the portfolio responsibility into at least four different timespans.

The first or Operational Portfolio is to fund the cash needs for the next two years. From a manager, fund, or security selection standpoint, capital risk is paramount.

The next three of the portfolios should have different representations of investment styles (growth, GARP and value) and talents (technological, turnaround and management assessment). This is a real mix and match effort, which is based on the individual needs of the account.

The second or Replenishment Portfolio is designed to recapitalize the Operational Portfolio. Often the duration of this portfolio is five years or a capital cycle. From a selector’s viewpoint the cycle is presumed to have at least one down year and some recovery.  In the first two portfolios liquidity is very important and expensive however is less important in the final two portfolios.

The third portfolio (Endowment Portfolio) is designed to meet the longer term funding needs often tied to the expected length of service of the CEO, Investment Committee Chair or Chief Investment Officer. This portfolio is expected to last through a few cycles and can accept some risk of loss capital if it has a positive cash flow.

The final portfolio or Legacy Portfolio is the funding vehicle meant to endure beyond the current sets of management and is designed to successfully tolerate a number of disruptions while still provide funding to meet very long-term needs.

Where Are The Generals?

In the US Marines I attained the rank of Captain, however I have devoted my adult life to studying various generals, both investment as well as military.

As a General, U.S. Grant handled numerous setbacks just as a competent securities selector is able to survive the unexpected and not lock into positions where there is little prospect of recovery.

Question of the Month:

Do you have or want the right generals?
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