Sunday, September 25, 2016

Don’t Let Your Current Perplexity Slip You Into a Comfort Zone


One of the better market analysts (who like the rest of us analysts, can chant history) just sent me an email saying that the current market conditions are not like those of our fathers or grandfathers but more like that those that faced the founding fathers of the US. I interpret this reference to be understanding that we are now in a period of great experimentation, unlike anything in history. It also means that there are opportunities both to lose a lot of money/purchasing power or to make a great amount for ourselves and heirs, be they be personal and/or institutional.

Having my first lessons of analysis attempting to figure out at the New York racetracks, l am continuously looking how to improve my odds of both surviving and winning.

Rules to Survive

1.  Get over your successes. Many years ago as a young security analyst, I had a great year. I published six stock reports all of them significant winners. Institutional clients of the brokerage firm for whom I was working were bypassing my senior analyst and wanted to talk with me directly and wanted to compensate me for my ideas. I did not fully appreciate both how politically unwise this was and the minimal odds that I could keep the streak going. I should have fully remembered that at the "track" and various professional sports arenas all streaks come to an end. Mine did and I learned to compete again at other firms.

2.  Like all streaks, the status quo also does not last. Today bond buyers around the world are believing that the "lower for longer" in terms of interest rates will persist, and/or that they can jump out and avoid the losses when bond prices fall.

3.  Not to believe that you know everything worth knowing. Recently not only did the "experts" get the Brexit vote wrong, but many also did not recognize that the new smart phone from Apple could have market-moving positives. We should always expect to be surprised and to be alert to elements that could prove that our beliefs in our superior knowledge are less than what we tell ourselves.

Rules for Success

In his most recent weekly blog post Teddy Lamade (who also advises clients) has listed very sensible suggestions for investors who wish to be successful. These are as follows:
1.          Resist the temptation to sell.
2.          Control spending to build predictable cash flow for investing.
3.          Be willing to look different than peers.
4.          Be comfortable with a concentrated portfolio and accept more volatility.

The Big Elephant in our Room: Lack of Sufficient Retirement Capital

This is not a new topic for our discussions, but one with some additional information. The current issue of The Economist quotes a study by Citigroup. In this study of twenty OECD countries, the size of the public unfunded pension liabilities is $ 78 Trillion. Nine of these twenty have a liability in excess of 300% of their GDP. (The liability is a multiple year obligation whereas the GDP is an annual estimate of a country's production of goods and services or an income account where the pension liability is a balance sheet obligation. All of these governments have assets that could be used to pay partially or all of the obligation which may be what has to happen as the net savings of these countries could probably not pay off the obligation in under fifty years.) With the success of medical science and modern agriculture, people are living longer. An average 65 year old man in 1960 had a life expectancy of eleven to thirteen years, now his life's expectancy is 18 to 19 years more. Women's life expectancy has been extended by twenty to twenty-four years. Several CEOs of life insurance companies have told me that there are some people already alive that have a life expectancy of 125 years.

In most large population countries during this election season, it is wise to remember that many of the young don't vote, but their grandparents do.

You can see my motivation in creating the TIMESPAN L Portfolios® to meet these and other needs.

In Conclusion

We will be dealing with different strains and opportunities sooner than what may be comfortable for investors. We will need to free our thinking from our experienced-driven mind set to survive and eventually profit.
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A. Michael Lipper, C.F.A.,
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Sunday, September 18, 2016

Not Complacent, Not Petrified but Perplexed: Is Cash Being Downgraded?


 Far too many previously successful portfolio managers and savvy investors are not currently performing well. Their portfolios are essentially frozen in place with very little in the way of transactions. Why is this? Some say that they have yielded to complacency. They are far too unhappy to be considered complacent. I originally thought that they were petrified to make a major decision. As these people have been historically action-oriented people, I now reject that is the cause of their inactivity. During their investment careers they have made a number of mistakes and survived rather well either by reversing some transaction or having the rest of their portfolio pick up the slack in terms of generating good long-term performance. Then, what is it?


I am privileged to have a wide circle of professional friends. In the last two weeks I have been in contact with a very good retired institutional investor, a vice chair, ex analyst/portfolio manager of a giant investment group, a very successful global private investor, a former NYSE specialist, and a well respected trust and estates attorney - each of them were deeply concerned about the outlook for their own personal investments. In so many words they felt that we are facing a political/economic/market environment that they had not seen before. Add to these concerns the following quotes:

"Americans are losing faith in institutions and are concerned about government intrusion." (He mentioned the message sent by UK Brexit voters) 
"America is middle aged, out of shape, and overweight."
"Central Banks’ interest rate manipulation is not working."

Many market valuation metrics suggest that the market prices are above average with one exception. Price divided by free net cash flow is trading below average. Either the market is doubting the soundness of the financial statements or the market is suggesting that cash is less valuable than it was in the past. The latter view might suggest that other assets are more valuable than cash to both stock and company buyers. The former doubt as to the quality of the net free cash flow calculations, which is worthy of study because of the widening gap between the price earnings ratios attached to published earnings and the more conservatively constructed GAAP earnings determined according to strict accounting rules. Confidence is critical to most investors.

The Probable Answer

Listening to the neuro-economists at Caltech I have learned that our brains are wired to use our memory as a critical filter in making judgments. To all of us who have served in the investment wars, our memory does not recognize the current situation. We are perplexed. When people are perplexed their action orientation tends to shut down until a new, somewhat familiar, pathway is found.

My Pathway

In understanding my approach one needs to identify the three inputs.

1.  The first was learned from betting on horses at the racetrack. Pick a limited number of races, because if one bets on every race, one can't escape the expenses of the universe. Also stay away from the favorites, in other words, bet against the crowds.

2.  The second input is what was taught to me in the US Marine Corps, which is the best defense is a well chosen offense.

3.  The third professional input is “if you slice a securities analyst a historian will bleed.” The long history of humans is one of uneven progress which often comes when least expected. This week the average net worth of US residents was published. Most articles focused on whether net worth exceeded the level immediately before the financial crisis. The analyst/historian in me focused on the growth since 1950’s, adjusted for published inflation of 2.4%. Since we have been generating net worth at a slower rate, I believe it is reasonable to expect a higher rate of gain to bring us back to that average over some extended period of time. Thus, I believe for investment periods of ten or more years one should be slowly increasing one's equity allocation. This would include the third and fourth portfolios in the TIMESPAN L Portfolios®.

Question of the Week:
Are you perplexed or are you doing something?
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A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Sunday, September 11, 2016

Is 2% the Investment Solution?


Friday saw the popular US securities industry fall between 2 and 3%. In the week through Thursday over half of the equity-oriented mutual fund averages gained over 1% and over 12% of the performance averages were up over 3%. It was also a week where there were discussions by institutional investors as to the appropriateness of management fees between 1 and 2%.

Every Model is Flawed

As a “card-carrying” securities analyst I have never seen a statistic that I didn’t like. But also I have never seen a statistic that I didn’t ask for more as well - as in more understanding of what was behind “the number.” During the week I was at a presentation by an academic who based his pitch on statistics. I almost believed him because he admitted to what I believe, in that every model is flawed.

The difference between a reporter reporting ‘the facts” and a real analyst is that the analyst attempts to get behind the proclaimed number and more importantly put this particular insight into the constellation of factors leading to a tentative conclusion. The tentativeness of the conclusion is that there are always more “facts” which are revealed and sentiments change.

The Classic Definition of a Market Top

One of the best comments I read this week was that risk aversion is not a constant. The perception of risk of loss of capital and reputation is cyclical. Actually it is contra-cyclical. The definition of a market top is when risk aversion is low, when it should be high and the reverse at the bottom. At the moment unless there is a great follow-through of Friday’s drop, risk aversion appears to me to be in the mid range.

Unless Friday triggers massive selling in the weeks and months ahead, investors appear to me too petrified to grossly change their allocations to equities and fixed income securities. The classic definition of a market top is when there is no more cash that can be “sucked” into the market. 

In my judgment there is still a lot of potential money that could come into the equity market. Some of this is in portfolios that have an unnaturally large commitment to fixed income. After all, in 2015 one of the best places to have money was in long-term US Government bond funds. Nevertheless market history suggests that a temporary decline in stock prices could be on the order of 10%. Further I recognize that at least once every ten years there can be an equity decline of about 25%. Without more risk aversion disappearing and becoming enthusiasm, I am not worried about a once in a generation drop of 50%. However, my accounts invested in mutual funds would have better liquidity exits than many stock and bond portfolios.

Examining Friday’s Stock Market Numbers

The array of one-day performance of the popular market indices is instructive as shown below:

Dow Jones Industrial Average
-2.13 %
S&P 500   
-2.45 %
-2.54 %
S&P 400 (Midcap)
-2.92 %
S&P 600 (Small cap)
-2.97 %
-1.85 %
-1.01 %

On a market capitalization weighted basis the Dow Jones has less of the growth oriented company stocks than the S&P 500. The latter have much bigger derivative and ETF drivers than the old DJIA. The NASDAQ marketplace is more lively than the old exchange-oriented markets as can be seen on the NYSE on Friday: only 5.5% of the stocks rose in price whereas 13.6% of the stocks rose on the NASDAQ. The greater declines suffered by the Midcaps and Small Caps were due, in my opinion to much smaller capital commitment by the dealers making markets in those stocks.

The smaller decline in the financials in general and specifically in the larger banks is due to the fact that their prices are still being penalized for perceived sins of the financial crisis. (Strangely, we don’t penalize the Congress and the GSEs!)

I am particularly sensitive to the financial sector as I manage a private financial services fund.

Mutual Fund Performance Ending Thursday

There are 96 equity related mutual fund investment objectives tracked by my old firm Lipper, Inc. a subsidiary of ThomsonReuters. Last week, 55 of the peer group averages were up over 1%, most of the gains in sector and world equity groups (22 categories) gained over 2% and 12 were over 3%. The latter group was mostly natural resource and commodity based. With the exception of the High Yield Bond funds, none of the fixed income categories were up 1% or more.

I suspect most of the buyers of equity-related mutual funds already assumed that both interest rates would rise and the central banks would be forced to recognize that their collective monetary experiments weren’t working. Further, that a rise in rates to meet commercial and savers’ demands was a positive development. One should expect narrowly based sector funds to be more volatile than Diversified funds. The increase in volatility that is expected by some may scare more money into the Diversified funds than the Sector funds. We should watch both broad groups in terms of performance and flows.

Putting Management Fees into Perspective

While various pundits stress the importance of fees in investment selection, management fee is a number like any other number and should be put into proper perspective. Friday’s decline was greater or equal to many investment advisor management fees. However, the performance of most equity funds and many separately managed accounts in just the two months of July and August were greater than their annual fees. In most cases these equity accounts are showing positive results for the year.

There is much enthusiasm for Index funds on the basis of their fees being lower than actively managed portfolios. As with any number it needs to be examined. I believe in many, if not most cases, the currently superior results of selected Index funds to certain actively managed portfolios has to do with other factors. Most importantly Index funds carry little in the way of cash in their portfolios where it is not unusual to see an active manager with 4-10% of the portfolio in cash and cash equivalents. The use of these reserves are to meet redemptions/grants and to be a tactical reserve for future purchases. Many Index funds are not worried about redemptions and will tolerate bad exit prices that active managers would not. Many market dealers offer Index funds with lower commissions/spreads than active funds as they treat an Index fund as an information-less trade. On the other hand the dealer is afraid that the active manager is ahead of the market’s realization as to dramatically changed information. Dealers want additional income on these trades to offset these risks. Many Index funds have positions above 5% of their portfolios, largely due to market appreciation. These big name stocks are the very ones that active traders will be dumping in an aggressive declines.

Buyer Beware

As long as Index fund buyers understand the risks that come with their lower fees they can celebrate their lower fees; but be careful of going to the lowest priced brain surgeon.

My own view is that the greater the proportion of the trades that are done by price-insensitive transactors, there is more room for bargain hunters who are the type of managers we favor.

Is 2% the Investment Solution?

Two percent is just a number like any other number, which needs to be evaluated.  Most importantly, 2% is a small number relative to the long-term expected movement of your money, and therefore we don’t think 2% an important element of an investment decision.  What do you think?

Question of the week: Did Friday’s price action cause you to materially change your asset allocation plans?
Did you miss my blog last week?  Click here to read.

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Copyright © 2008 - 2016
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.