Introduction
One
of the signs of a truly expert professional is the recognition that he/she
could be wrong. This question should come up to those of us that have to
develop a view on a series of futures. We should recognize that the only
consistent product of following the swings in the market is humility. Actually
I learned this first at the New York racetracks where it became obvious one
could not pick the winner of every race and it was rare to be right even
half the time. I learned that the real object of betting is to come away a net
winner. Thus by proper picking, which we call analysis, and prudent handling of
money, one could accomplish the goal by cashing winning tickets one-third of the
time. Actually there are much bigger winnings to be had. The bigger winnings in
the future come from examining one’s losing bets. Over time it becomes clear
that there are a limited number of patterns to the losses which drive the
analytical imperative to see whether repeated losses stem from a faulty system
of analysis.
With
that series of doubts in mind I am now rethinking my assurance in last
week’s blog that any forthcoming market decline
will be one of normal proportions and not the “Big One.” Because we think
in numerical terms, a normal decline is between 10% and 25% and the “Big One”
is more likely to be 50% or more and come around once within a generation.
Modeling
“The Big One”
In
last week’s blog I listed seven characteristics that described the lead up to
one of the most famous market collapses, “The South Sea Bubble.” Summarizing
the seven steps as follows:
- Displacement
- Credit and Monetary Expansion
- Overtrading
- Financial Distress
- Fraud/ Malfeasance
- Widespread Mistrust and Revulsion
- Panic Selling
Looking
at the current stock markets around the world with particular emphasis on the
US, I only saw elements of the first two steps to a South Sea kind of collapse.
This is particularly true with the lack of enthusiasm for most US stocks and
equity funds. Even with Byron Wien and Bill McNabb, the retiring CEO of
Vanguard lengthening the earnings forecast period to pull down the market
price/earnings ratio to more attractive levels, most investors are using
shorter time periods. (When I came into the professionals’ markets in the 1960s
and early 1970s it was not unusual to be quoted five forward year P/Es.) Without
this stimulus there is no need to fear a major decline and periodic declines
will be of normal size. During normal declines, most high-quality long-term
portfolios should be maintained in place.
However
harking back to my education at the track, maybe I am missing some other
patterns which could lead to different conclusions. Perhaps I should be looking
at what is happening in the bond market. This won’t be easy for me. In a study
of single portfolio manager Balance funds it became clear to me that, with rare
exceptions, the managers that performed well did so with only a portion of
their portfolios. They were either good at stocks or bonds. This finding
suggests that stock and bond mavens speak in different languages and don’t
communicate well to the other side. (I am experienced as a stock fund and
individual stock picker and rarely voluntarily use individual bonds.)
Are
Bond Prices Peaking?
For
more than a year the most favored type of mutual funds have been bond funds,
with Intermediate Maturity Corporate Bond funds alone receiving $ 93 Billion on
a year to date basis. This flow could well be the missing level of enthusiasm
on the road to the South Sea list. This could also be moderating this past
week. According to my old firm, this last week was the first week in thirty
seven when there were net outflows in High Grade Corporate Bond funds.
Corporate treasurers and investment bankers are counting on this demand, as
2017 expectations is for issuance to top $ 1 Trillion. If accomplished
it would fulfill the second item on the list of expansion of credit. With a
reasonable outlook that the US and other national governments will be running deficits
this year, there will be an additional monetary expansion.
Perhaps
the most intriguing element on the march to the South Sea is displacement. On
the equity side I counted on the internet filling that role. With my eyes now
focused on the debt markets I see a much more structural set of changes which
are not obvious to most investors, individual or professionals. The first and
biggest change is the role of collateral for speculative loans.
Years
ago the brokerage industry could make a reasonable profit through simply
charging commissions. It has been many years since equity agency brokerage
business was profitable. A number of different financial products replaced traditional
stock brokerage business by the larger firms. By far the biggest was the margin
loan business where a brokerage house extended credit to an investor at a
relatively attractive interest rate. In turn the brokerage firm borrowed money
from a bank against the collateral that the borrower put up. With the decline
in retail interest in trading stocks this source of revenues shrank. However,
it has been replaced by supplying credit to various trading entities; e.g.,
Hedge funds. The most favored collateral for these loans is US Treasuries. The
demand for treasuries is so high that the current yields average 1.77% and according
to Eaton Vance their average performance on a year to date basis is 3.15%,
which is materially better than similar performance for US agencies (a gain of
2.56%). In theory, the full faith and credit of the US Treasury is a bit better
than those of US Agencies therefore the yields should be lower for the
treasuries and generate slightly better performance. Thus one can believe that
the treasury market is experiencing some displacement.
I
suspect globally one form of displacement is in the nature of the collateral
that is borrowed against. Moody’s* has noted that its
Base Metals Price Index has gained 29% this year. It suggests that these gains
may be due to an increased level of speculation rather than surge in user
demand. Copper has risen 50% in this period. I believe that one has seen the top
of the use of futures on iron ore and copper as collateral by various merchants
around the world and particularly in the Far East. By the way there is a slight
negative correlation over the last five years between a large basket of
commodities and US stocks.
*Held
in the private financial services fund I manage
There
is still one other displacement element and that is Emerging Market Local
Currency bonds and funds. This is the best single type of fixed income fund for
the last three years and doing very well this year in part because a number of
commodity producers are located in emerging markets. The number one ranking for
three years may need to have a warning label attached to it. The single worst
performance period to extrapolate into the future for investment purposes is
three years. In a period as short as three years often the market is going in
one direction. Going back to my race track experience the odds of continuing
winning after three years is remote.
Two
Possible Signs of a Bond Top
This
week the iShares 20+ Years Treasury Bond ETF had a year-to-date gain of 10%, that
is unlikely to continue. The 10 year US Treasury yield hit a low of 2.02%
closing at 2.06%. To me these represent unsustainable
levels.
My
Concerns
I
believe a good bit the high quality fixed income trading is on borrowed money
from the banks. This is akin to the period immediately before the Lehman crisis. The abrupt liquidation of fixed income collateral spread to credit
concerns in the equity market, leading to a stock price decline. While the
overall level of leverage in the system is probably less, so is the flexibility
of both the majors and the regulators to act.
Please
Help
Communicate
with me and assure me that I don’t have to worry now.
__________
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Michael Lipper, CFA
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