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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