Introduction
Contrarians
are useful even when they prove to be wrong. In forming an investment committee
for a non-profit institution of professional investors, I felt it was incumbent
on me to somewhat balance the committee, largely populated by generic
optimistic money managers with at least one contrarian that was well skilled in
finding good shorts. While it would have been inappropriate for this
institution to sell short betting on falling prices, the answering of some
bearish views were useful in appropriately constructing our long portfolio
which did well. We were better prepared to be long-term investors on the long
side for reviewing and appreciating contrarian views.
Current Thinking Process
Stock
markets around the world are rising well ahead of current sales and earnings, even
adjusted for modest growth projections. The buyers are enjoying what could be
called a “melt up.” Economic sentiments are moving higher.
While
I do not know how long these trends will last - be it a day or multiple years -
I believe it is critical to consider the potential risks that are currently
apparent to this long investor and manager.
First Risk: Simplistic Decisions
On
October 26th The Wall Street
Journal published a multi-page
critique entitled “Morningstar Mirage” which purported to show that the firm’s
various ratings were not helpful in making decisions as to what mutual funds to
buy. The article decried the marketing power of Morningstar’s ratings, not
recognizing that at least since the 1930s funds that performed well attracted
the most sales if they were known. In the same light there was no real
discussion of the questionable mathematical processes used to reach its
conclusions.
The
biggest risk to investors is not the Morningstar Mirage. The biggest risk is
that the financial community believes that investors want simple answers to
complex questions. Sales people who can get very limited time with both their
prospects and their accounts are trained to use the KISS principle, (Keep It
Simple Stupid)” in their communications. It has never been clear to me whether
the communicator or the investor was stupid.
Often
people spend more time at a sporting event or preparing a special meal then
they do making investing decisions which can have significant impact on their
lives and those of the beneficiaries. At the game each play, each course or
each critical ingredient is thought about deeply. As the readers may be aware I
learned the basis of securities analysis at the racetracks, spending hours on
each race. I am told that one of the most successful racehorse owners in the
last 30 years in the UK spends a great deal of time on the races and the
breeding of her horses. We should do no less than Her Majesty.
When
Hylton Phillips-Page, my VP of Fund Selection and I analyze a mutual fund we
spend a long time getting to understand how the fund, its managers, and
supporting organizations impact the past results. A much more difficult task is
guessing how we think the past will not be simply extrapolated into the
indefinite futures. The term futures is a recognition that there will be
interruptions of past trends as conditions change.
The
risk of simplistic decisions is much broader than choosing mutual funds. Not only investment decisions, but all types
of other decisions, including political, career, and other personal decisions
are put at risk when given only cursory attention. The past is useful as to
what happened and more importantly what didn’t. Most studies of human decision-making involve
a number of biological organs. The brain and our senses are very complex and
they interact differently when conditions change, and they are always changing.
Second Risk: Credit Withdrawals
In
each of the general write-ups of major stock market reversals almost all the
attention is devoted to stock prices. In truth almost every major stock market
decline was slightly preceded by the withdrawal of credit support. Since we are
not out of October, we should first start with October 28, 1929, the biggest
single day drop in the Dow Jones Industrial Average up to that point. On that
day, the index dropped 12%. Most recounts do not include the fact that the
market had been dropping since August and a good bit of the buying was done
with borrowed money called margin. The borrowed money came from the major banks
who issued it to the brokers, who in turn offered it to their clients on the
basis of their portfolios. The banks used call loans to the brokers using their
clients’ collateral. As the market declined in the late summer and early fall of
1929, the value of the collateral fell, reducing the safety for the banks that were
starting to call their loans. The brokers called their margin accounts to put
up more collateral which most didn’t (or were not able to) and were rapidly
sold out of their holdings. This is an example of a non-price sensitive
insistent seller.
A
similar thing happened in 1987 where in one day, October 19, 1987, the DJIA
fell 22.6%. European stocks were down about 10%. Portfolio insurance used
futures to hedge long institutional positions. Many of the futures contracts
were margined against the long positions owned by financial institutions. In
Chicago there was no requirement to be able to short on a price uptick as there
was in New York. When New York opened there was a wall of sell orders.
A
somewhat similar occurrence happened with the collapse of Lehman Brothers when
the “repo market” to finance its fixed income inventory was closed to Lehman due
to a different set of rules and expectations in London.
Trying
to avoid a future similar event, the Dodd Frank Act focused on what banks and
others owned, not the risk in their loans. I suspect that most of the inventory
owned by the Authorized Participants, (the market-makers for Exchange Traded
Funds and similar products) are highly margined. At some point the providers of
these loans may get nervous as to their collateral cushion and may want instant
repayment which could create a problem.
There
may be similar potential problems in both the US Treasury and Foreign Exchange
markets where high leverage is available.
Third Risk : Career Risk
If
investors are guilty of simplistic investment decisions, professionals live in
fear of being fired either by clients or employers, This is a particular risk
if someone needs to publicly report performance or work for publicly traded
companies. Thus, despite reasonable long-term results, near-term absolute and
even more importantly - relative results - drive terminations. This is normally
a mistake on the part of the terminator for two reasons. First, most of the
time there is a partial or complete recovery. Second, and much more dangerous
to the investor is the choice of the replacement, often a manager that has good
long-term results which are appropriate for a decline, but poor results in
expansions.
Bottom Line
Risk
is always with us and it is the highest when least expected. Drive on two-way
streets, they are safer.
__________
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Michael Lipper, CFA
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