Introduction
Investing is an art not a science. In science the search is for a repeatable answer under every identified condition. As strong as it may seem to many, the search is not in the end the largest performance number. The search is the delivery of the required funds to meet the accepted needs of the beneficiaries; be they institutions or individuals investing within the realms of prudence. Thus, the investment manager’s primary function is to aid in the feeling of the well-being of the beneficiary. According to a recent report on happiness as applied to nations, well-being is based on income, healthy life expectancy, social support, freedom, trust, and generosity. It is far easier to contribute to well-being through sound investing. I believe our clients hire us to provide sound investments for them in order to accomplish their well-being. Thus far I have been able to deliver. But much of this is not based on the certainty of math and science that I learned in school and university, but as a handicapper at the New York racetracks. From an investment standpoint what I learned at the track that is useful can be summarized as follows:
1. The objective is not to win every race but to finish the day as a winner (including expenses).
2. Don’t bet on every race, there could even be days when no bets are made as the payoff odds are not appropriate to the probabilities foreseen.
3. Occasionally the most popular bet is logical in terms of expected results, but the payoffs are too low because it doesn’t take into consideration what can be called “racing luck.” At these times it could make sense to invest in the second or third most logical horse if they are being offered at reasonable odds for second or third place and turn into larger money makers if racing luck overcomes the favorite. This is a good bet as favorites rarely win, even half the time.
4. After concluding the most logical result, the real analysis begins, which is how much should be bet on this horse in this race? Weighting one’s bets can make the difference of a nice win vs loss record and walking away as a winner for the day.
5. Accepting that I was wrong an uncomfortable number of times, but learning from the experience by re-examining both my analysis and how I handled my money and to a lesser degree my expenses.
Thus, I believe that, like other investors, I will be wrong in terms of market direction, sectors, “factors” and selections. To defend our beneficiaries’ interests I have adopted a policy of having a number of different bets at the same time, but with the recognition that unlike at the track where races end, the investment process continues through many cyclical periods.
“Goldilocks” May Be Leaving
Liz Ann Sonders of Charles Schwab among others is raising concerns about the future. After all, for at least nine years it has been somewhat easy to ride the secular rise in the US stock market. (Shorter periods for other stock markets.) This issue brings up a number of questions: evidence of impending change and what should be the correct investment policy going forward. In terms of evidence of impending change there are two important elements: flows into stocks are from traders not investors and credits may be mispriced leading to fixed income not providing stable values. This week some in the press for the first time are heralding significant flows into the equity market from “funds”, which shows the Public is buying the current conditions. The truth, according to Thomson Reuters’ Lipper Inc., is that $20.4 Billion came in net, but $18.7 Billion went into domestic oriented ETFs with $8.2 Billion going into the SPDR S&P 500 and $3.1 Billion into PowerShares (Invesco*) QQQ. Both of these are favorites of hedge funds and other traders. In numerous cases ETFs and ETNs are being used by these players as substitutes for futures which are more expensive. I am noting that a number of investors have sold short some ETFs that represent over 10% of their assets and in at least one case over 100%. What may be more disturbing is that a number of independent investment advisors and a number of advisors working through brokerage firms are managing discretionary accounts exclusively in ETFs/ETNs. Some of these are probably good, but I suspect many do not have any successful background in market trends, sectors, “factors” and the selection of individual securities. They may be, along with others, contributing to a much higher turnover rate in ETF/ETN portfolios than conventional mutual funds.
*Invesco is held in a private Financial services fund and personal accounts that I manage.
Credit Concerns
Remember that most significant stock market declines begin after a period of fixed income market declines. Through March 15th most bond funds are showing a slightly negative total return, which includes both their income and their market movement. The only domestic groups that are not negative are loan participation funds, some specialized credit vehicles, and ultra short maturity funds. I don’t know when the next recession will commence, but I expect it will be within this first term of the President. I do know that during a recession bankruptcies and other financial difficulties occur and they are not being priced into the market. Institutional term loans are being priced at only 3.2% above prime corporates, compared with 3.1 % before the crisis that began in 2007-8. Further, while banks have much more capital than they did before the last crisis, their book of derivatives is somewhat higher.
In a talk at a Futures conference last week, my old friend Tom Russo, formerly General Counsel to Lehman Brothers, mentioned that when a counter-party believes it was duped, the entire class may be considered illegal as an auditor will have difficulty claiming the asset is worth 100 cents on the dollar. He said, according to the Financial Times, that “when you owe a little bit you call your bank - when you owe a lot you call your lawyer. “A good bit of derivatives are directly or indirectly financed through the credit market.
What Should Investors Be Doing Now?
There is no special reason for long-term investment policy to be changed as long as it contemplates that there will be periodic market declines. This is similar to money that is invested in what we label Legacy and Endowment Timespan L Portfolios®. For those with a shorter focus of at least five years, they should be making two lists of equities and equity managers.
The first list should be of items that at higher prices would become risky if the general stock market rises at a rapid rate. (There is some chance of this happening as new money rushes in on the basis of buy-the-dip or FOMO fear of missing out.) The risk is that such a surge most often leads to a major fall, which could lead to structural changes. The second list should be labeled “Hopefully not to be used, but probably will be.” It is a list of sound companies and managers who may be slightly damaged in a decline but will survive and prosper. Both of these lists should have names and prices scaled to avoid emotional price reactions. Five or ten price points could be prudent.
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A. Michael Lipper, CFA
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