Introduction
I
attempt to learn every single day. Further, as a disciple of betting on
racehorses, I am always searching for the potentially successful contrarian bet.
Contrarians perceive potential future developments different than the crowd.
Thus, they almost always are premature and often wrong. However, since
contrarians by definition have fewer followers when they are wrong (or too
premature) losses are relatively small.
Normal
Stock Markets Decline
Anyone
that has studied the laws of gravity or were a ground-crunching US Marine, is
used to a long march up a hill or a stock chart followed an accelerating
decline. We should have expected it because of the length of the past
performance streak.
For
the last ten years earnings growth has been declining and most of the time
operating earnings have been growing in the mid-single digit range. On the
other hand, due to the central banks/governments’ manipulation of interest
rates, risk assets mainly stocks, attracted inflows. Using the average US
Diversified Equity Mutual Fund investment
performance for periods ending at the end of January produced the following
results:
Average US Diversified Equity Fund Performance
Period Length
|
% Total Reinvested Return
|
One Year
|
+21.34%
|
Two Year
|
+ 20.96%
|
Three Year
|
+ 11.12%
|
Five Year
|
+ 12.53%
|
Ten Year
|
+ 8.12%
|
Any
follower of statistical streaks, e.g., Super Bowl winners, election victories,
or rainy days would doubt the continuation of a streak. Despite the Atlanta
Fed’s latest forecast of GDP 2018 growth of 5.4%, streaks end often to the disbelief of the crowd.
First
Contrarian Concern
The stock
market structure has changed and some
very successful people are betting on further changes.
A
strategist at JP Morgan* has noted that there has been massive redemptions by
commodity trading advisors and risk parity pools. Charles Schwab* has noted massive
unwinding of “short vol” and other positions to meet margin calls. In the
latest week, according to my old firm, conventional equity mutual funds had net
redemptions of $3.1 Billion and equity ETFs had net redemptions of $ 20.8
Billion. While there may be some double counting in these observations, what is
clear to me is that the trading community reacted much more and faster than the
longer-term investment community. (We can discuss privately whether we are
seeing modern day Sir Issac Newtons at work.)
From a
longer term point of view I am much more concerned in watching three of our
most prominent investment leaders adding dramatically new (to them) investment
activities. Goldman Sachs* going into consumer small loan business through
Marcus. Black Rock announcing that it wishes to raise $10 Billion to
permanently invest in long-term minority positions similar to Warren Buffett
and Charlie Munger at Berkshire Hathaway* and some of their other holdings.
Blackstone becoming the 55% partner in ThomsonReuters* financial services,
currently managed by Reuters.
*Owned in a private
financial services fund or in personal accounts
Each
of these may make sense, but requires the use of talents that they may not have
already.
What is much more significant
to me as a stock market investor is that they are saying that their existing
businesses are insufficient to produce enough of the expected profits. When a crowd moves to a different casino
table or shrinks around a trading post on the floor of a stock exchange, one
has to wonder whether these bright people are saying something very
fundamental to which we should be paying attention.
Second Contrarian Concern
One of
the reasons for the victory in the last Super Bowl was the winner had better
defenses than the loser. When Marines are forced to go into a defensive
position they continue to examine it for possible weaknesses. Most defenses are
based on an orderly collection of principles. The two main fixed income
considerations are duration/maturity and credit quality.
Around the world the
search for somewhat acceptable yield has led to record sales of bond funds and
other credit bearing devices. Due to low and
until very recently declining yields, investors have been lengthening their
duration to get higher yields even though central banks/ governments are
raising rates. The traditional ethos of investing in fixed income is that one
makes money through receiving interest payments and hopefully reinvesting them
wisely if they are not consumed. Most of the time investors are not concerned
about losing principal as the bonds promise to pay off at par. Great theory,
but when rates change and fixed income prices decline, bond fund net asset
values decline. This is what has opened in the year 2018 up to February 8th.
The average Core Bond fund on a total return basis declined-1.67%. This is the
largest category for retail investors. Even more disheartening was the performance
of the general US Government funds -3.83%. This demonstrates when rates move up
a small amount investors can lose money. One needs to remember that there have
been periods when high quality rates reached into the double digit range.
My real concern is the
possibility of some credit instruments not paying off in full or on time. As someone that sits on investment
committees that are besieged by the newest and latest credit instrument vehicles,
my guess is that many will be okay, but some may not. For example, a credit fund
for a management group that has had prior trouble announces its week even; with
40% in cash they have felt it needed to reduce its net asset valuation in half.
Many of the new credit vehicles in the US and other markets are
staffed by bright people who believe in the numbers provided and their derived
algorithms. As interest rates move higher, integrity throughout the system may
not.
While one can certainly
lose more money in stocks than fixed income securities,
the expectations are different. In fixed, one expects most of the time is
disappointment with the smallness of the gains. Most investors do not expect to
have any loses in fixed income. At this point in the cycle, one should be aware
that there can be losses and on an emotional basis of disappointment there can
be more risk in fixed income than in recognizable volatile equities.
Question of the Week:
What are you watching for in terms of fixed income risk?
__________
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- 2018
A. Michael Lipper,
CFA
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