On To Stock Peak; Mild Danger - Weekly Blog # 497

Introduction

Gift buying is strong selectively in US and China this week. While political leaders emote, speculations in stocks are increasing and fixed income vehicles are displaying fault lines. Current concerns produce hurdles, not walls that can’t be breached. One of the benefits of segmenting portfolios into sub portfolios based on time horizons is to be able to focus on the impacts of various influences. This is the rationale for developing the TIMESPAN L Portfolios^® and how we look at the current picture.

Next Two Years

While most investors swear allegiance to being long-term investors, almost all that they consume in the way of views is what to do right now and that will be judged on the basis of the next month, quarter, current year and next year. They over emphasize whatever near-term payment concerns they have and ignore the impacts on longer term needs. If that is the tune that investors are currently dancing to, I will display what I believe to be relevant to this period’s dance.

In a consumer driven economy one should look at shoppers. At the local high end mall Saturday night it was crowded with people carrying a small number of shopping bags. We got the sense beyond buying, that  shoppers were examining prices, styles, quality, and inventory. At the crowded Apple^* store there were lines of buyers that began in the morning and were still present in the evening. What is on sale for shoppers are items that they could buy either at many stores, or they came to buy in one particular store, online or both - but they came to spend money. There were so many of them at three of the restaurants within the mall that the wait for tables stretched to an hour or beyond. 

In China the wonderfully manufactured Singles Day apparently once again produced record orders for merchandise and services. The purchases broadened out from buying for someone special to the buyer to the buyer herself or himself.

These controlled shopping frenzies were also present in the stock and bond markets. In the US, S&P^* has developed a quality ranking array which is different from its credit ratings. In the credit ranking array the objective is to gauge the odds on timely payment of future payments of principal and interest. Balance sheets and their future projections drive the credit ratings. On the other hand, the quality rankings are based on the income statements and the ability to grow them. In the last month particularly (and also for the latest twelve months) the companies with the low to lowest quality rankings had the stocks that appreciated the most. Obviously these stocks were perceived to have prices that deeply discounted their futures.

* I personally own shares in these stocks

Individual stock investors as measured by surveys of the American Association of Individual Investors (AAII) have a similar view as to the shoppers. In the last two weeks the percentage of those surveyed has dropped their bearish views from 33% to 23%. While this is a very volatile time series on the basis of casual conversations, it seems to be reflective of current thinking.

Equity Fund Leaders

In the week that ended Thursday, the weekly 14 of the top performing 25 performance leaders for the week were the Natural Resource and Energy Commodity funds. Six out of 10 losers for the week were with bank-heavy financial services funds. 

The enforced hotel “guests” in Saudi Arabia are probably a stimuli for the leaders. UBS points out that 70% of the world’s growth in GNP this year was caused by rising commodity prices both in energy and industrial metals. The decline in bank oriented funds could be an over-reaction from a view that materially lower US corporate taxes will be delayed and may be smaller than expected. On both the up and down sides of the week one can see the influence of news/rumor on near-term prices. I maintain the long-term trend of future energy prices were not changed by the Saudi arrests nor have the tax rates for banks changed the long-term generation of earnings and dividends of banks beyond perhaps a one time bump in 2018 or 2019. 

Fixed Income Markets Display Longer Term Concerns

Most often stock market declines are preceded by weakening fixed income markets. We are seeing some concerns being expressed in fixed income prices/yields. High Yield bond prices fell this week. Normally these, in effect, stocks with coupons which is what one wag called junk bonds, fall with the increase in the expected default rate or an actual unexpected default. Moody’s^** who typically has the best, but not a perfect record on expected defaults, is now expecting the stock market to rise because of low and declining expected default rates.

** Owned in a private financial services fund that I manage.

The fall in junk bond prices could be a reaction to the discussed restrictions on the tax deductability of interest charges to 70% of EBITDA, Earnings before interest, depreciation, and amortization.  A large amount of refinancing is expected over the next two years -  particularly by the mid to smaller energy companies that could be placed in jeopardy and possibly bring on defaults. 

Each week I look at the fixed income fund performance data from my old firm, now a part of Thomson Reuters. I have noticed for some time that US Treasury funds have consistently done better than US Government funds that often pay more interest than Treasuries. This has been true for at least five years for longer maturity funds and at least three years for the shorter ones. This must indicate that for some reason Treasuries are more valuable than higher earning agencies. I suggest one reason for this is that US Treasuries are being used as collateral for loans where agency paper is not as readily acceptable. Further I suspect that this collateral is backing loans for dealer and hedge fund securities which include positions in Exchange Traded Funds and Exchange Traded Portfolios. It is significant to point out as to the level of speculation in these markets that Deborah Fuhr  of ETFGI reports that globally this year, listed  funds that leverage have seen their assets grow 14% to $77 billion.

One of my market structure concerns is that financing inventory positions for market makers, authorized participants, hedge funds and brokerage firms is normally done with call-loans. A call-loan can be called with very little, if any, notice. Often when the loans are called the only way to pay it off is to sell some of the easily traded holdings. These are not price sensitive sales but are persistent. As in the past this can be a cause of an internal market panic. I do not rule out a recurrence of such an activity.

Endowment Period Concern

The focus has been first on low productivity of human labor. Next it has turned to capital productivity which is being addressed increasingly by additional leverage. I am now becoming more aware of research and development productivity. In each of the three productivity challenges part of the answer is better selectivity of people, projects, and research targets. All of these are being addressed, but with limited near term success.

Part of the problem is that there are shortages of attractive alternatives. Hiring more, poorly prepared laborers; committing more financial resources to low return ventures; not achieving technological breakthroughs in research; and utilizing the wrong scale for development won’t solve the problem. We need to both make smarter decisions and examine the structural impediments holding back productivity including education, appropriate returns for risk capital, and avoiding unwise intellectual property constraints. Some progress is likely in the very long-term. I just hope it arrives quickly enough to meet the retirement needs for today’s workers and students.

Misallocation of Capital

One of the advantages of focusing on Mutual Funds and ETFs is while they are large contributors of capital to our global society, they are also part of the institutional and individual mind set. For the latest twelve months looking at positive net flows of money coming into mutual funds with aggregate flows into investment categories, there are six each bringing in over $20 Billion. Five out of the six were bond funds which may do relatively little to address the productivity issues raised above. The more additive value to longer term corporate investment are equity funds. Unfortunately in spite of very good investment performance recently they are in heavy net redemptions with Large Cap Growth funds shedding $76 Billion and Large Cap Value funds $49 Billion. These net redemptions are almost actuarial in that they were purchased years ago to meet future needs which are now apparent. In the past redemptions were met by new sales. Currently it is more profitable for the financial community to redirect flows to other products. While some at the retail level is being directed into ETFs the bulk of their flows are from trading establishments that have short-term holding periods and rarely buy new IPOs. Nevertheless ETFs on many days have more net flows than the much larger mutual funds. Over the same twelve months previously mentioned, there were six ETF categories that generated over $20 Billion each. Five went into equities and one into bonds. Their flows are not likely to provide the long term risk capital that is needed for increased productivity of labor, capital and R&D.

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