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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Sunday, July 23, 2017

Emotional Preparations for the Next Markets Using Top/Down and Bottom/Up Thinking


To some degree we are similar to a group like teenagers enjoying our first kiss. This communication skill has set us up to be exposed to other kisses. Turning to our social, political, and investment lives we are regularly being planted with kisses. Unfortunately those kisses are from those who wish us to part with our approval, votes and money. As they besiege us with kisses as translated from their sales training exercises “Keeping It Simple Stupid” (KISS).

I am particularly turned off by oversimplified presentations or sound bites by various sales types, be they be politicians, salespeople, and especially client portfolio managers and other types from wealth management organizations. It is normally a mistake to interrupt them as they have to go back to their opening line and repeat their pitch. Don’t ask too many detailed questions. By the time one gets to the third level of questions or cross examinations they are out of their depths. The good ones will stop there and change the subject to more familiar topics. The others will guess which “solutions” can be amusing but have little lasting value. Nevertheless, these presenters do have worthwhile value. They are excellent at summarization and generating memorable quotes.

Before I select a mutual fund for my clients I need to spend time with the fund's primary portfolio manager. I ask lots of questions, some they may have not addressed before. The purpose of the exercise is to assure me that the portfolio manager, perhaps aided by analysts, knows more than I do and has some different views than I do. I buy funds when it is clear to me that they bring materially added value. Often these portfolio managers are not as memorable or glib compared with their professional presenters. I still remember spending close to two hours with a well performing fund manager peppering him with lots of questions. At the end of the time allotted I looked at my list of questions and did not have any answers to my questions. What was clear: I did not understand him well enough other than to appreciate his good record. Subsequently when as all good managers do, he had some less than stellar performance, he left the large fund group with a couple of accounts as it became clear that the group was only interested in good performance not the reasons for it. It took many years for me to return to this particular shop. On return the new group of portfolio managers were good communicators of their bottoms up  analysis.

The Necessary Three Inputs

One of the better market analysts that I know is asking his clients to be emotionally ready and to be prepared to act in the future when the markets become much more cyclical with major changes of direction.

In order to prepare for these changes I believe a good investor will need three inputs. The first is understanding the “big picture” scenarios of the top/downers. The second are the contrary indications from the bottom/uppers. The third is an individual risk management levels for different components of one’s entire investment and career portfolio. In this stew one will need to be judicious in what one eats and when, without the tempting need to consume all that is “on offer.”

Top/Down Stock Market Views

Charles Schwab’s team is expecting a pull back from current levels. This is overdue in that the S&P500 has not had a 5% decline in over a year. The only strategy in using elements in the “500” to decline in the second quarter was the S&P500 High Beta sub index. It was the second highest performer in the twelve months through June which clearly demonstrates the rotational or cyclical nature of the market. The level of enthusiasm does not yet fulfill a prerequisite for a major top; the American Association of Individual Investors' (AAII) consensus in its weekly survey had a bullish jump to 35.5% from 28.2% the prior week and a bearish count of 25.8% from 29.6%. Clearly most participants have a neutral view. This and other sentiment indicators are worth watching at least as coincident measures and when they go to extremes as contradictory signals.

Bottom Up Inputs

Contrary to popular views of many of the various pundits, mutual funds are beating “the market.” Each week my old firm, now known as Lipper Inc., an affiliate of Thomson Reuters, tracks fund performances of mutual funds around the world. For investors in SEC registered funds, it divides its list into various investment objectives. In the latest week it is tracking 69 equity oriented fund objectives. For the year to date period ending Thursday the average performance in each equity oriented fund investment objective was better than the performance of the average S&P500 fund in 39 investment objectives or 56% of the universe.

In the US Diversified Equity (USDE) group there were five better performing objectives, four were growth funds of various market capitalization levels. There were 9 sector objective winners, in addition  25  of out 26 world equity fund objectives were also winners.

The latter is not surprising as fund investors and their advisors have been buying non domestic funds for over a year while their older and more long-term fund holders were completing their USDE voyages to meet educational, retirement and estate needs. What is interesting and historically surprising is in the same year to date period there are 27 fixed income investment objectives with fluctuating net asset values. Every one of these averages were positive. One of these, the Emerging Market Local Currency average (with a gain of 11.45%) did barely beat out the S&P500 gain of 11.39%.  Often when stocks go up, bond and other fixed income securities decline in price.

An Important Breakout Despite Clues of a So-Called “Likely” Pullback

Some of the leading technical market analysts are pointing to the fact that both the S&P500 and the NASDAQ Composite have twice broken out on the upside with gaps. These are usually filled in before there is an extended move. This is underpinning to the belief that a pull back is likely.

A reversal to the reversal may be imminent. In the backing and filling of the NASDAQ composite index, NASDAQ created a classic “head and shoulders” reversal pattern which often presages a reversal of the former pattern, which was rising. However, instead of declining, the index is rising - if it continues for a little bit more it could create a reversal to the prior reversal pattern and predict an important breakout for the NASDAQ. This is of great interest to small cap and technology investors and could stimulate even greater enthusiasm for their holdings.

The level of naivety expressed by much of the various talking heads about the changes in US regulations and taxes is a bit breathtaking. If Congress is instituting the changes it is likely that the bill will be hundreds of pages long. If that is not daunting enough, the number of pages of specifics including contradictions will be a multiple of the legislative documents. For instance the controversial and badly drafted Dodd Frank Act (DFA) was 848 pages and the subsequent regulations totaled 22,000 or a ratio of 25 pages of regulations for each page that was finally passed into law. Remember currently the bulk of the employees that will administer these regulations are not sympathetic to the current US Administration. Further, when the new laws and regulations come before the Supreme Court or possibly the lower courts, they will review the testimony given to the relevant Congressional committees.

Thus, when and if we get a major piece of “tax reform” enacted, my fear is that the amount of taxes that my clients and I will pay will go up not down as the reductions of deductions and permissible expenses will cancel out any tax rate reductions.

Emotional Preparations

First I accept that I will not perfectly predict the peak or the beginnings of a major decline. Hopefully I won’t be too premature or too late. My primary defense mechanism is my TIMESPAN L Portfolio® philosophy where I can expect to be able to be defensive in certain parts of our holdings and are willing to continue to hold other parts having our large gains converted into significant unrealized losses. One can accept these unhappy results if there is sufficient capital (largely cash) in the operating component. Without scaring them too much, I try to get clients to do the same. I accept a certain amount of substantial career risk and position myself to be able to pick up bargains during the chaos.
Question of the week: How are you emotionally preparing for future economic and market declines?  They will certainly occur, perhaps sooner than expected.

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Sunday, July 16, 2017

Individual Investors Should Worry Professionals


When I became a professional securities analyst in the 1960s there was a trend to have two separate research and marketing efforts of brokerage firms. A traditional effort to serve individual investors was joined by a second, and higher paid effort to serve institutional investors. Around the cyclical movements of the stock market, individuals and institutions invested differently and each fed off the other's transactions. Institutions were able to buy what they thought were cheap stocks from supposedly unsophisticated individual owners and sell into them when individuals were not well enough informed. Interesting this dichotomy did not work to the disadvantage of the individual investors as much as it may have seemed. Individual investors were not only net buyers, but for the most part long-term investors that often facilitated the more rapid turnover of the so-called professional investors.

This relationship is no longer the case. Because of the decision of the US government to introduce price competition in brokerage commissions (which led to a price war) the profitability of directly serving the individual long-term investor declined meaningfully. Today try to get a “full service” retail brokerage representative to be interested in opening an account to handle the sporadic purchase of a hundred shares of a NYSE traded securities. If the broker can’t get the customer to open a margin account, buy new issues, trade over-the -counter securities or place decision making judgment in a managed account or a packaged product or possibly an automated relationship with a call center, chances are he/she will not be interested in the relationship with the perspective customer. Only the alternatives just suggested are profitable for the firm and the individual broker. Thus relatively few individuals are directly active in today’s stock market. They are investors through their employers’ defined contribution plans, land stock purchase plans, and or mutual funds/variable annuities or in some cases stock options.

The plain truth on most days, particularly in the summer months, almost all the transactions come through various institutional channels. The market has become largely a game of professionals competing against each other for research and trades. In some respects the market has become more susceptible to sudden volatility within the trading day as the professionals in this interconnected world react to each incremental research element and price change. Thus, a different sort of market analysis is required to avoid being at a competitive disadvantage.

The Players

Exchange-Traded Funds (ETFs), and Exchange Traded Notes (ETNs), while relative small in terms of assets as compared with other institutions,  are selectively quite large in the intra-day markets. While the regulators believed that when they permitted the creation of these vehicles in the US and a number of other markets, that individual investors would benefit from their low cost and trading efficiency, they really created trading vehicles for fast trading professional investors including hedge funds, market makers, managed accounts of investment advisors, central banks (Tokyo), and other institutional players.

In many weeks the aggregate net transactions in ETFs is larger than those of conventional mutual funds, even though their assets are less than half of the assets of mutual funds. While there are thousands of ETF transactions in a given week, the vast majority of transactions are in a couple of products that professionals are using to invest or hedge with or without margin type leverage. According to my old firm, Lipper, Inc., for the week ending Wednesday there was $6.7 Billion in net purchases of equity ETFs; $4.4 Billion went into PowerShares QQQ Trust EFI, invested in the 100 largest NASDAQ stocks, and $1.2 Billion into the iShares Core MSCI EAFE Index fund or about 5.65% of that fund’s total net assets. This left approximately $100 million for net purchases of all other equity ETFs.

A similar pattern was present on the taxable fixed income side which had total net purchases in the week of $1.2 Billion, with $1.1 Billion into two funds, iShares 20+Year Treasury Bond ETF, and iShares Core Total U.S. Bond Market ETF.

All four of these funds could be used to fulfill the short-term trading needs of institutions. To get a feel as to how important the trading is in these products, one should look at the extreme volatility of the major stock and bond indices in the last ten minutes of a trading day as the Authorized Participants (APs) try to even up their trading books. On some days in the last few minutes the stock indices can move close to 1/3 of the daily price moves for the whole day up to 3:30. Sometimes some of the transactions in ETFs are on the short side. In October of 2016 the size of the short interest was at a record level on the SPDR S&P500 ETF. Currently it is at the lowest level in more than a year. Obviously some trading institutions were shorting due to their views on the US Election. They may have viewed this as a hedge against some long positions or it could have not been paired against other holdings.

Mutual Funds are Evolving

There is also something happening in conventional mutual fund transactions. Despite a current period of relatively good fund performance, funds are experiencing net redemptions. A careful analysis will reveal that this is not a signal of disappointment. Most of the redemptions are coming out of the Large Cap Growth and Growth and Income funds that were the major receivers of decades of inflows driven by commissioned sales people. The basic investment pitch to potential owners of funds was to provide retirement capital and to a lesser degree educational funding. On an actuarial basis a good bit of these redemptions are completions fulfilling their intended purposes. In prior decades we would not have seen net redemptions because the normal completions would have been offset by new sales of funds, except selling funds to individuals is far less profitable than it has been in part because the sale freezes the money in place for a number of years due to anti-churning rules and commissions on funds are no longer the highest level available to the salesperson.

There is another important trend that takes mutual fund dollars out of the US marketplace. While domestic funds in the week had net redemptions of $4.6 Billion, non- domestic funds had net sales of $2.6 Billion. This is understandable on two levels. The Financial Times data shows that there are eighteen national stock markets it tracks. Eight had gains of between twenty and twenty-six percent and only one of these (NASDAQ) was in the US. The IMF is forecasting only India and China will have GDP gains of more than 5%.

Chart Readers

All three of the major US stock market indices, Dow Jones Industrial Average, Standard & Poor's 500, and the NASDAQ composite started last week with a price upward gap. Often price gaps get filled before a major move occurs. In addition the NASDAQ composite daily price chart shows a reversal pattern called a “Head & Shoulders” which might be predicting a decline. As part of the market’s function to promote humility, this index is now rising near its former peak. The technical market analysts at Merrill Lynch stated that if the index breaks out on the upside it would be a failed Head & Shoulder pattern that is quite bullish. As usual there is an “on the other side” market research team at Charles Schwab that suggests that we should be prepared for a summer pull back.

Investment Conclusions

One of the reasons I came up with the TIMESPAN Lipper Portfolios® is to address this kind of situation, The second of the two portfolios, the Replenishment Portfolio, has a function of replenishing the Operating Portfolio which is designed to meet payment needs near term, or about  two years. The Replenishment Portfolio expects that over a market cycle it will be called to replenish the operating funds. This assumes that over a cycle (which typically takes four to seven years) there will be at least one down market. With this in mind Replenishment Portfolios should be examining their liquidity positions . This will be easier if they are in open end mutual funds that are not expected to “gate” or temporarily restrict redemptions in cash. In some cases large redemptions will be met with in-kind transfers. In most cases the transferred securities will be relatively easily sold.

The other two portfolios, Endowment and Legacy should not be disturbed. However if there was a serious decline one might want to switch. My data and consulting client, the late and great Sir John Templeton instructed to switch into better bargains when available.
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A. Michael Lipper, CFA
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Contact author for limited redistribution permission.