Sunday, August 13, 2017

Managing for the Next Decline - Weekly Blog # 484


In order to ease indexing, I have added the blog sequence number to my weekly posts.


All life is cyclical going from good periods to poorer periods. No one has repeatedly been able to predict the tops and bottoms on a regular basis. Unlike actuaries, those who learn the basis of analysis at the racetrack assume that they will be wrong some of the time. There are two keys to investor survival, the first is to be selective in which races to bet on. The second is to change the levels of the bet based on both the intensity of the conviction and to a lesser degree the need to preserve some wealth. At least this is how I look at the markets and manage the money for which I am responsible.

Any survey of known history identifies periods of rising and falling prices as human emotions react to changes in perceived conditions. From a portfolio management perspective, to me the odds favor a meaningful decline between now and probably the time of the next US Presidential election. The decline will be measured in terms of prices of securities and/or general economic data; e.g., Gross Domestic Product (GDP). There have been times when individual markets or economies have fallen and occasionally both at roughly the same time.

The problem is that few investors have had a good record of timing these declines. My life-long study of mutual fund performance suggests that winners in a particular phase who raise a lot of cash on the downslope are not very successful at recommitting the cash on the way up and often over long periods of time underperform those that accept the pains of declines, but in general remain largely fully invested in equities and especially in well managed equity funds. This is less true in bonds and commodities.

To attempt to answer the questions as to selectivity, weighting, timing, and turnover, I have developed the concept of Timespan investing. Thus, today I look at the future through the filters of at least four different Timespan Portfolios.

Short-Term Operational Portfolios

At the moment these are the most price sensitive portfolios because these have near-term payment responsibilities. For some non-profit institutions and active families the next several years can be particularly stressful. Not only that the odds favor some price disruptions in most securities and commodities markets, but there are the new imponderables of net federal and state tax payments. At the very same time as we may be experiencing a cyclical decline, calling for more contributions to those who are suffering, but a high likelihood that those of wealth will be paying more taxes as forgone taxable deductions will have greater impact than a decline in federal tax rates. In addition, in many states and local communities taxes will go up to fill some of the smaller grants from the federal government.

Often these short-term portfolios are made up of income-producing securities. As corporations see new opportunities to profitably invest in capital expenditures (even as they may reduce buy-backs) the rate of dividend increases may slow. Depending on the depth of the decline, markets may fear that there will be reductions in some dividends.

To balance the stock risks in these portfolios often a significant part of the money is invested in a variety of credit instruments. Historically the prices of these instruments did not move much. There is however a good chance that some of these will become much more volatile. Over the last couple of years many institutional investors with a primary background in stocks have offered to their clients new Credit funds. (In some cases to improve their yields these portfolios are leveraged with borrowed money.) One might be concerned with the impacts of a rumor on the credit worthiness of any of these instruments creating volatile prices which will surprise some holders.

To those that are funding some non-profits and/or family spending, they may be caught in a squeeze as inflation rises. I tend not to give too much credence to government produced inflation figures. For those who have borrowed on the doubling of LIBOR levels in the last year as it moves closer to the mythical 2%, it could be driving costs up for some people. Interestingly there is a real dichotomy on savings rates offered by institutions who are paying LIBOR or higher rates, while the average money market deposit rate has dropped to 0.29%.

Limits on Upside Removed

Now that the price gaps have been filled in by the recent declines, the limitation on further price appreciation has been probably eliminated. This elimination does not guaranty gains, it is just more likely to occur than recently.

Bottom line: shorter-term portfolios will require more than custodial attention.

Intermediate or Replenishment Portfolios

These are the portfolios that are meant to replenish the operating portfolio’s payments. The duration of these portfolios should be tied to the internal policies of the account. One guide may be the period that the chair of the company or investment committee is likely to be in place. From a stock market vantage point it would be wise to consider that the period should include an expected market cycle.

As I have worked with funds advising on incentive compensation, I have favored four to seven years to set the target period of a portfolio manager’s performance pay. I am particularly concerned about the use of three-year periods, because they can be one directional and not show important elements of a full cycle. Over the last fifty years in the US 37% of the time there has been a down quarter which means 63% of the time the stock market has risen and therefore there is no institution-wide experience in down markets. This may be of real significance today as there has been only 15% of the quarters in decline since the first quarter of 2007. We could well see a major rise in down quarters to bring the current 15% closer to the historical rate of 63%.

Portfolios often own both growth and cyclical stocks. Almost all companies are affected by the cyclicality of the economy and various segments. If one could count on the bouncing ball type of behavior of a cyclical market to come back to prior levels, a buy and hold strategy would work fine. This is particularly true if the dividend is maintained through the cycle. However, in some cases former performance is not repeated. For example investments in telephone companies largely dependent on physical long lines in the age of the internet are unlikely to reach their old levels of profitability. For years there has been the substitution of aluminum and plastics for steel in cars and trucks which suggests that despite what happens on the tariff front it is unlikely that many steel companies will return to their old levels of profitability and employment.

Bond Downgrades, Reality or Rumor

Without signs of great enthusiasm for stocks, any cyclicality is likely to be limited to a decline in the twenty percent range which is a difficult arena to successfully raise cash and redeploy fast enough to beat many buy and hold quality stocks. This is not true on the bond side as there has been too much money coming into the bond markets at current prices and yields. At some point rising interest rates will drive bond prices down. It is quite possible some of those who purchased their positions with leverage will be forced to sell out into an illiquid market. A credit rating drop from investment grade BAA down two levels to B increases the expected default rates for maturities of five years from 1.67% to 22.06%, In other words the rumor or the fact of downgrade could raise the possibility of losing over one-fifth of the par value of the bond.

Long-Term Aspects of the Endowment Portfolio

Our Endowment portfolio is meant to fund the expected needs of those currently alive and thus expected to live through numerous cycles. Quite properly long-term investors should be concerned about a major market decline. In the past approximately once a generation there have been a period, usually quite short, of a 50% decline. All investors at all times should be on the lookout for the bubbles that lead to theses declines. Bubbles are created by human nature when greed relegates fear to a forgotten corner of the mind. Those of us who dwell in the world of numbers will often be very premature, that is wrong, in spotting bubbles through the use of market or economic statistics. The more useful guide is to listen to the level of enthusiasm both the professionals and the public express. Some of the attributes of past bubbles are as follows:

- A new discovery that is expected to bring wealth to many.
- Apparent liquid markets, often one-sided in reality.
- Easy and cheap credit.

At the moment in terms of stocks I don’t yet see signs of a bubble which means that long-term endowment accounts should stay reasonably well invested in stocks now.

Legacy Portfolio Items

Periodically equity market prices are focused predominately on near term results which are often troubled. At the very same time these enterprises are developing not just the products and services that will be in great demand in the future, but more importantly a cadre of managers that can bring a lot of the potential to fruition. To an important degree it is like looking at young racehorses who are expected not only to have winning records but to be successful breeders. Not easy to find, but worthwhile. Currently perhaps the best returns in these searches may be found in frontier and emerging market investing. All of these opportunities will experience some turmoil during their development. One needs very skilled analysts and portfolio managers to find these opportunities and enough patience to hold them.


What are you going to do in the next decline?
Have you been able to identify desirable Legacy investments?
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A. Michael Lipper, CFA
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Sunday, August 6, 2017

Look to London When Seeking Global Views


Too many American investors and managers do not search for investment wisdom beyond their national borders. For years Byron Wien wrote about "the world's smartest investor who has passed away.”

 I do not have the skill to identify the smartest investor. For decades I have been calling on some very smart investors in London. Some of these were clients of various fund data services and resulting consulting. Others were leading investment shops or investment trusts. I continue this journey.

This last week I accompanied my wife Ruth to London to hear our New Jersey Symphony Orchestra's wonderful music director, Xian Zhang conduct a superb concert at The Proms, held in the Royal Albert Hall. I took a ‘busman’s holiday’ and spent the rest of the week speaking with a number of great money managers, corporate leaders, old friends and former associates. As usual our far ranging conversations covered both the current global investment environment through to multi-generational investing.

Shakedown Cruise

Most of my British friends don't know what to make of President Trump. He is a definite interruption of the past policies and trends that they had become accustomed. The only way I could help them with their concerns was to explain that the current occupants of the White House have embarked on what the US Navy does immediately after it launches a ship. The Navy conducts a "shakedown cruise" where the crew learns how to handle as many of the problems that might occur in carrying out their missions. From a training viewpoint, the more problems the better. Over time they learn to solve most of the problems. At the beginning of the cruise the crew does not know how long the shakedown effort will last.

I reminded my hosts that the President learned command at military school. He is a product of a Queens County, New York real estate family. Using his threatening negotiating skills, he successfully attacked other New York City boroughs and regulators to accomplish his business goals.  

President Trump is going to be different. The intramural battles in Washington are what the founding fathers expected. They did not want an imperial king. We all are going to have to learn the new dance steps to unfamiliar music.

International Investors and the US Markets

For international investors putting money into the US, it is a double bet on the dollar and local stock prices. In the past these moved in the same direction which increased their total returns. More recently while share prices were rising, the value of the dollar was dropping. (One good technical market analyst believes the dollar is "bottoming" and will rise to new highs.) Due to a left leaning press, many in London tie it to Mr. Trump. I see it very differently.

To me the dollar should not have been strong for a number of years, which in part was a contributor to the 2016 Republican electoral wave, all the way down to state legislatures and counties. The reason the dollar was strong until recently was that almost all other currencies were weak in view of their own problems. The prospects in many of these countries are sufficiently improving to a point that the locals are reducing their conversions into dollars. (I have not yet seen a reversal where there is significant selling, just less buying.) This phenomenon is being recognized by US investors who have been replacing some of their domestically-oriented mutual funds with international funds, a trend that has been going on for many years. We are also participating in this trend for our accounts.

When I see very successful multi-generational families, I look at their investment portfolios and philosophies. Most of the positions in the trust-quality portfolios are not likely to be top performers, near term.  Thus, they won’t make the lists, to use a British expression, of the “Tops of the Pops.”  As it is almost impossible to always be in the most popular successful stocks, there will be times when these former leaders will under-perform. Thus their records will appear to be more cyclical than the somewhat slower moving secular growers.

Harking back to my first professional investment job at a trust bank, the multi-generational families opted for quality of management and products. Today the long-term concerns of multi-generational investors remain focused on quality and selectivity. We seek to answer these issues in the Endowment and Legacy segments of  TIMESPAN L Portfolios®, though these portfolios may contain other instruments that are more price-sensitive as well.

Interesting enough, the striving for quality has a place in their portfolio investing in under-served markets and these exist in all societies. The keys to these investments is to be providing uplifting services to the underserved.

The new European regulations coming into effect in January, MiFid II will raise the costs of both investors and brokers, which will lead to a reduction of investment industry capacity and is likely in the short-term to reduce the support for smaller and many mid-sized stocks.

There is recognition of the large and growing global retirement capital deficit, but at the moment no one is addressing it in a major way.

Short-Term Concern

While we focus long-term, we do not ignore short-term. One of the short-term factors that we look at is the relative yield dispersion, what Barron’s calls Best Bond and Intermediate Bonds, based on credit quality ratings.  In the last week, the demand for Best Bonds drove their yields down by 12 basis points, and prices up,  whereas the Intermediate Bonds’ yields dropped by 5bps.  The increase in price of the Best Bonds relative to the Intermediates is viewed by some as a bearish signal for stocks.  
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Sunday, July 30, 2017

(1.) Future Investment Success Depends on Productivity, (2.) A Possible Re-play of Sub Prime Crisis


Often a publicized trend enters into private conversations. During the summer two day meeting of the Board of Trustees of the California Institute of Technology, there is a dinner with selected undergraduate, graduate, and post docs with some of their professors. At the dinner last week, we were sitting at a table with other trustees, some of the students and a very prominent young professor. She turned to the trustees present and asked. “What should Caltech focus on in the future?”

The initial reply was from a trustee who has earned all three of his degrees from Caltech. His answer was that Caltech should continue to seek to hire the very best professors which would attract the very best students. I applaud this continuing goal set, and I suggested that for the future there should be an additional goal. This goal should be to increase the productivity of the professors, students, and staff, and therefore society.

As a board member and contributor to a number of other non-profits, I am seeing this need in lots of places throughout our global society. I suspect that future structural improvements in productivity will be led by a combination of commercial interests and a few non-profit leaders.

Economic and Business Trends

One of the best commentators on these trends is my Securities Analyst Society friend, Byron Wien. In his latest publication for Blackstone he laments that one of the biggest risks is “the inadequate investors’ attention to productivity.” He points out that productivity has been declining since it peaked globally in the 1996-2005 period, except in China and India (increasing areas of investment interest in the funds in our clients’ portfolios). He further points out that the number of new companies has declined by 50% and the number is about equal to the numbers of companies that disappear. (Many of those that disappear are doing it voluntarily through the richness of M&A activity, lack of family interest to continue to work hard as the founders, and tax considerations.) He  suggests that since the development of the internet and smart phones there have not been significant productivity inducers. He laments the decline in high school students mathematical capabilities.

On this topic, I applaud the generous gift by Ronald and Maxine Linde that re-purposed the Caltech mathematics  building into the Ronald and Maxine Linde Laboratory of Mathematics and Physics.

To focus on the significance of the productivity problem, I wonder whether more attention should be given to a statistic I used as an analyst which was the ratio of revenue and costs per employee. In both the profit and non-profit arenas the additional costs of compliance and welfare oriented employees may be causing these ratios to narrow and thus the number of employees, I did not say workers, is a useful statistic.

Actually part of the productivity problem has more to do with personalities than pure analytical ratios. While profit margins are expanding due to higher returns from capital expenditures than employees, it is understandable these margins are hiding the very pedestrian growth in top line revenues adjusted for price increase. Too often sales are fulfilling only existing demand, not in problem-solving or creating new demand. In many companies and non-profit agencies clients are only to be tolerated, not cherished as the real assets of the activity.

Help is on the way. Currently the best performing fund in our clients’ portfolio has changed its name and focus to Innovators Fund Investment.

Perhaps the most bullish area that is benefitting from global attention is consumer spending and activity. In many of our homes and lives we still do things the way we did years ago. But today we can utilize the internet to search and buy items we did not have. We are already benefitting from the delivery of medical services through electronic communication. The race is on to remotely automate elements within our home for higher functionality than what we had in the past. The question is how we are going to use the time efficiency in our personal rising productivity, which is not in the published productivity numbers?

There are some reasons to be positive long-term.

Are Sub-Prime Type Risks Lurking?

One of the key responsibilities of prudent analysts and portfolio managers is to worry, particularly when others don’t. Many of the worries about the future do not come to pass, but some do. A full ten years has elapsed since the public recognition of the problems created by the excessive use of sub-prime residential mortgages. Are there similar type risks today? One should remember the old quote about history not fully repeating, but rhyming with the past. To me the keys to these concerns are not in the instruments but in the behaviors that are similar from one era to others. In an over-simplification, a list of some behaviors shown below could be useful in identifying future problems:

1.  Reliance on the predictability of long-term trends
2.  Investment vehicles that can be leveraged
3.  Inexperienced investors and advisors
4.  New entrants, some from well-known organizations facing slow downs
5.  Media cheerleaders
6.  Few skeptics
7.  Things not what they seem
8.  The deep linkage with the larger financial community
9.  Lack of specific regulatory oversight
10. Global activity

Some may feel the current wave of enthusiasm for Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs) apparently has some of the similar characteristics experienced in the sub-prime era. The results don’t have to turn out the same way, but prudent investors should consider the parallels and make their own judgments.

The underlying statistical trend that made mortgages attractive was that housing prices always went up, though the careful student of long-term history could point out some long periods when this was not the case. The possible equivalent today is that active managers on average can’t beat the popular market averages, but it is happening in 2017.

It is cheaper to use ETFs and ETNs to leverage market bets than the purchase of futures contracts. Thus traders of all types including hedge funds are rapidly moving in and out of these products either to express a short-term market view or as part of a hedging operation on the long or short side.

Utilizing information that was called to my attention by Lilia and Leo Clemente, illustrates the rapidity of these flows in a particular week’s net flows as a percent of the aggregate assets in a specific fund.

Exchange Traded Funds are a fast changing market as they evolve into increasingly a trading market.  One measure of the manic weekly inflows is to measure the net weekly flow for a specific fund, as a percent of the asset under management in the fund. 
Net Flows
AUM % Change
Goldman Sachs Treasury Access 0-1 Year
83.07 %
iShares MSCI Japan Small Cap
13.35 %
Kramer Shares CSI China Internet
8.80 %
SPDR Bloomberg Barclays High Yield Bond
8.68 %
iShares Short Treasury Bond
7.89 %

These weekly net flows are in USD millions and we don't know the size of the gross numbers, but clearly the aggregate size of the trading would represent a larger share of the assets under management.

I suspect most of these transactions were by trading activities, including fee paid discretionary investment advisors.

The size and volatility suggests to me that there are speculative forces at work. 

I am seeing many traditional active mutual fund and brokerage shops entering the ETF and ETN markets. In terms of details and the personalities in the market place, they are quite different than the market participants that were successful in the past. Since many of the ETF and ETN manufacturers advertise heavily, there are few media skeptics.

Many of the users of these products have not taken the time and the continuing effort to understand the construction of these portfolios and the mechanisms for change. Also some of these products have built-in, larger than normal fees.

Most of the transactions in these products are conducted through “authorized participants” (AP) these are largely dealers who utilize their undeclared capital for all of their trading activities. Goldman Sachs* has recently withdrawn from being an AP. Goldman is an intelligent prudent risk seeker. For them to withdraw could be indicative of either too high risk or too low profitability. Due to the linkage, largely through counterparts leverage, a problem in these markets can generate rumors of bigger financial community problems.
*Owned personally or by the private financial services fund I manage

These products do not have a specific regulator but are overseen by numerous securities and financial regulators some of whom are thinly staffed.

In many countries that have a viable, active, securities markets there are either locally manufactured or globally traded ETFs and ETNs with different degrees of intelligent regulation.

Just be careful .   
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Copyright ©  2008 - 2017

A. Michael Lipper, CFA
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Contact author for limited redistribution permission.