Could this Weekend be a Turning Point?

In the US, as in other countries on other days, Memorial Day is set aside to honor those that have sacrificed their lives in war to protect our nation and its citizens. In observance of Memorial Day, US financial markets are closed.

Watch global markets before US markets opens on Tuesday

As of this writing, the Japanese market is down -3.5%. One reason that the market is lower is that the Bank of Japan leader indicated it could tolerate a 3% yield.  Another reason the market is down is news that Chinese leaders have announced that they are willing to grow more slowly. At the moment, US futures and the price of gold are weakening slightly. Also the Australian dollar is weakening against the US dollar.

With the US markets closed on Monday and relatively thin trading in much of Asia, prices could trade freely with sharp moves both ways. Unless the afternoon session in Tokyo reverses direction, the results may not be pleasant by the time New York opens Tuesday morning.

Positive views

There are mixed implications derived from what I have seen this past week.  First, let me deal with the positives.

Shoppers shop

In almost all countries of the world retail shopping is by far the largest sport in terms of involvement and money transferred and thus well worth examining. The Memorial Day weekend is considered the unofficial kick-off to the summer shopping season in the US. In our community the weather on Saturday was cool and wet. When we went over to the Mall at Short Hills, a very glitzy place to do our indoor walking and getting a bite of lunch, parking was difficult. We encountered crowds with large shopping bags. (Other weekends some of the aisles within the enclosed mall and a few entire stores could have been profitably converted into bowling alleys.) We walked and had lunch and returned home for me to read. My champion “black belt” shopper of a wife went back to the Mall and ran into friends who were also shopping. When she left she should have auctioned off her parking space which was in great demand. Her competitive shopping eye reported that the crowd was approaching those at Christmas time. Perhaps it was the unseasonable weather or advertised sales prices from an investment viewpoint; the key was a lot of people were spending money at good prices.

Borrowers borrow

Another example of people making investment decisions is that the size of margin debt (borrowed money) has just exceeded the old record established in June, 2007. A number of retail brokerage firms have commented that the proceeds of this debt have not been put into additional securities investment. My guess is that an important portion has been in “non-purpose” loans, probably used for real estate purchases. The brokers point out that it is easier and involves less collateral to use futures, particularly on ETFs (Exchange Traded Funds). Nevertheless buyers are buying.

Cash is trash

One of the reasons people are being led into using securities for their spare cash or buying power is that cash has become increasingly considered trash in their minds. Almost every day I look at the average rate being paid on bank money market accounts. This week it dropped to the lowest level that I can remember of 0.46%. The central bank manipulators around the world are driving people into the market, but looking at the large amount invested in money market funds and bank accounts, there is a lot more remaining.

Incomplete gravity

After the considerable rise we have seen and benefitted from this year, many of us had expected a correction. Some have been waiting for this expected correction and keeping their trash/cash on the sidelines before committing to the pressures by the monetary authorities. Thus we had two consecutive down days on Wednesday and Thursday. But on Friday, with light volume, we had a minor up day. There are two remarkable observations to make. The first is that lower prices did not bring more sellers or an increase in buyers to the marketplace. The second item is we have not had three consecutive down days for the last 100 trading days. My friends at Caltech assure me that what goes up must come down according to laws of physics. Market technicians would generally expect a trading correction in the range of ten percent of the prior rise before a subsequent gain. For whatever reason investors, are not now ready to leave the party.

The best market timers are now bullish

In this week’s Barron’s my friend Mark Hulbert noted that in his long study of market timing newsletters the ones that have had the best record of correctly getting turns in the market remain very optimistic. From my standpoint what is more important is that the timers who have gotten the turns wrong are relatively reserved, with significant portions of their recommended portfolios out of the market. The reason I believe that being mindful of the laggards is more important than the good prognosticators being bullish is that in my continuing study of mutual funds and other managers it is not unusual to see good records lead to occasional bad results. There appears to be much more consistency in poor predictors staying bad. Finding negative predicators is very valuable indeed.

Mutual fund buyers are beginning to believe

My old firm, now known as Lipper Inc., which is an affiliate of Thomson Reuters, measures mutual fund performance and net sales around the world. Using the first quarter and reporting in euros, funds sold to Europeans in Europe had inflows of 116.5 billion compared with the US’s industry inflows of 155.4bn. Perhaps more important was the gain in Germany of 7.3bn which may be a retail leader for the continent. Large net inflows were seen in Thailand, 16.2bn and South Korea, 12.1bn (all in euros).

The first quarter numbers predate both the turbulence in the Tokyo market last week and the prior surge in Japan created by its adoption of a highly charged “QE” monetary policy, which in May probably brought a tidal wave of money into funds investing in Japan not only from within the country, but also from the US, Europe, and the rest of Asia. My guess is that judging by the rise in the Tokyo market (until this week) we are talking in excess of $50 billion in positive fund flows. All of these flows indicate that individual investors, along with institutional investors, recognize and want to participate in momentum wherever they sense it.

There are important negatives

When the Chairman of the Federal Reserve indicated that its staff has been directed to study ways it could ease off in its Quantitative Easing (QE) policies, the US markets caught a slight cold (under 2%), but the Tokyo market got pneumonia, falling 7% in one day.  This decline demonstrated how dependent Japan is on US Quantitative Easing and how thinly traded the Tokyo market is.

In his May 25^th long economic letter, John Mauldin focused on what the current government of Japan is attempting to do with its extreme QE policies, which until this week was working both in the local stock market and Japanese exports. Mauldin is a believer that QE won’t work in the long-term in that Japan has fired the first official shot in a currency war that will be met with Asian and perhaps other competitive devaluations. His real fear is that it will work for awhile and allow Japan’s share of the world’s wealth to get much larger on the back of absorbing all of the savings in Japan. When that is not sufficient to grow Japan out of its twenty year deflation and as its enlarged bubble bursts, it will materially hurt the US and others. The title of his piece sums up his views: “The Mother of All Painted-In Corners.”

“The Ghost of 1994 Haunts Financial Markets”

“The Ghost of 1994 Haunts Financial Markets” is the title of Moody’s latest capital market research report. In the piece Ben Garber reminds us what happened to the markets when the Federal Reserve unexpectedly and sharply raised interest rates. This led to some of the worst performance returns on record. While the Fed is conscious of this fear and that may be why the astute President of the New York Federal Reserve Bank is stating that it would take the Fed a number of months to decide to raise rates and a further number of months to effect the change. My concern and perhaps others fear that the need to make a change could be sprung on the Fed by unforeseen events, they do happen. Moody’s is also a bit skeptical as to whether Japan can accomplish what it needs to do to get some growth out of its economy without both a US GDP expansion and the cooperation of the currency markets. These are wise concerns.

What should we do now?

My recommendation is for long-term oriented investors to continue with their current policies. For those that believe in managing accounts through asset allocation changes, I would urge you to average in and out of positions. For those that have to report results this calendar-year, going to large cash position could be prudent. I believe we are in an emotional news cycle that can stampede markets on a daily basis without much total new movement this calendar year. The year 2014 also looks problematic until we see who will chair various committees in the US Senate plus the actual new policies by the leaders in Germany and China.

Do you have differing views?

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Another Victim of FICC Groups

• Where the Past Problems Generated Profits and Troubles
  
• Seven Immutable Laws of Investing
  
• The Currency Game
  
• The Interactions of Man and God
  
• Paper Money, Deficits and Hyperinflation
  
• We Are All Players-The Best Defense is a Good Offense

Where the Past Problems Generated Profits and Troubles

In an earlier era there was, in theory, a sharp distinction between brokers who were meant to act as un-conflicted agents and investment bankers and other dealers who were viewed as principals using their capital to enrich themselves. This theoretical distinction disappeared years ago, and its disappearance was reinforced by the combining of commercial banking activities with those of underwriting and market making. Out of this stew came the last financial crisis, through the sale and securitization of mortgages and similar debt instruments. The groups within the large financial conglomerates are labeled “FICC,” which stands for fixed income, currencies and commodities. Past blog posts have mentioned the growing attraction of the commodities segment to “investors” (really speculators) and the firms that service them. My concern with this blog are the $4 trillion dollar a day currency markets.

Seven Immutable Laws of Investing

This weekend I read an excellent piece by James Montier of GMO which many of us knew as Grantham, Mayo, Van Otterloo & Co. The seven laws are the following:

1. Always insist on a margin of safety
   
2. This time is never different
   
3. Be patient and wait for the fat pitch
   
4. Be contrarian
   
5. Risk is a permanent loss of capital, never a number
   
6. Be leery of leverage
   
7. Never invest in something you don’t understand

While we all should obey these seven laws all the time, for many of us this could lead to very little investing on our part. However, I urge all to apply these rules to their thinking when addressing the investment in currencies as an asset class.

Currencies can be traded by themselves in original form or through derivatives. This week, Barron’s published two articles that focused on currencies. The first piece focused on the growth of the market, some of the reasons for the growth and the use of ETFs to play the game. (An interesting point was made that it was better to short a currency ETF than to buy a bear-focused currency fund.) What the article did not stress was how much of the FX trade was leveraged by the use of various forms of derivatives or “margin” purchases. The second article was an interview with Ray Dalio of Bridgewater Associates, which has $90 billion under management. This interview focused on the difference between large deficit producing countries/currencies and those that have small deficits. Dalio favors the latter. I would suggest that unless you are in the FX markets everyday because you are hedging a stream of operating transactions, that currencies as a separate asset class fails the Seven Immutable Laws of Investing. Future exchange rates are not guaranteed or even have the same sense of reliability as do the maturity value of high quality bonds. Money has been traded around the world since the beginning of recorded time as noted in the Bible. Therefore, this time is not different.

One rarely sees a “fat pitch” (a perfect, or “too good to be true” pitch) that is advertised; note the FX dealer ads on the financial networks or popular press articles. The reason I mentioned shorting an ETF that is long a currency, is that is a contrarian move. From my own viewpoint, the short interest on the ETFs that hold Canadian and Australian dollars suggest that these may not be contrarian enough to be safe. Many of the academically trained participants in the market will look at the past movement of a currency and calculate the standard deviation around a 36 month trend line, and label this volatility as risk. Whereas risk is the permanent loss of capital, occurring when a government dramatically changes what its currency is tied to.

The second derivative of risk is not just the loss of capital, but the loss of the productive use of the capital. The problem with leverage, either through direct borrowing or through the use of derivatives, is that there is always a payment date that can be extremely inconvenient. Unless one clearly understands the real political pressures on the various central banks and how they in-turn apply pressure to their principal dealers, I would suggest that there is a lack of understanding that makes currency trading problematic.

The Interactions of Man and God

There are two old sayings that are worth remembering: “Man plans and God laughs” and “Man proposes and God disposes.” As long term investors, we try to think about the future, matching future streams of income with spending needs. In the past, many employers and their employees felt secure in terms of retirement on the basis of an average compound earnings rate on their capital of 8% or higher, with an inflation rate of 2%. That is not the world we live in today nor for the last several years. Not only were the forecasts very wrong, most investors did not have strategic reserves that could be applied to adjust the returns to meet some or most of their spending needs. The problem with reserves are that they don’t earn much money; effectively zero today, adjusting for published inflation. Even if we were smart enough to build strategic reserves, the removal of this capital from the higher earnings pools will reduce the overall return on the entire capital base and therefore a cut in spending plans will be required. That is an extremely difficult message for us to get accepted by various investment committees and wealthy families.

Paper Money, Deficits and Hyperinflation

One of the attractions of using currencies as an asset class is to escape too much reliance on any one currency, read US dollars. As most currencies today are not convertible into hard assets by their individual owners, the name of the game is to gravitate to those other paper currencies that have substantial excess earnings power that the issuing government is not spending. The current trends are not favorable either for the US or the UK, and many feel most of Europe, beyond Germany and Switzerland, is beyond hope. The US deficit is approaching the tipping point of 20% of federal government spending. Beyond 20% there is a very strong historic trend to go into hyperinflation, which will make most fixed income investments unsalable. (Thus, one can see why the FICC groups are building up their sales forces in the commodities and currency arenas.) If there is some chance of hyperinflation, one can see the investing public as reluctant to commit to what is probably a fairly priced, large capital equity market.

We Are All Players- The Best Defense is a Good Offense

In this blog, my intention is to cast doubt on adding to one’s present investments, suggesting the need for strategic reserves and altered planned spending. I further recognize that the earnings on today's strategic reserves don’t help the unavoidable spending needs. In response to these dilemmas, my training from the US Marine Corps makes me search for a good offense as a best defense. While I have some ideas to be shared at a later date with my clients first, I am not comfortable that these are the best or perhaps not even good moves on the offense.

I appeal to this blog community to suggest currently good long-term investments or sound strategic reserve elements that can be used for a narrow base of clients or shared with this entire blog community.

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Too Much Focus on Short Term Imponderables,Not Enough on Long Term Challenges and Opportunities

Unfortunately almost all attention is focused on the short to intermediate time horizons during this period when there is no sustained progress investing in large cap domestic stocks. These horizons are set by the patience of the most impatient member of each of our formal or informal investment committees. I noticed how conversations focus on the latest morsel of very current information, as if this will provide the answers to our long term investment needs.

MY WEEKEND READING “MORSELS”

• Chase is marketing a CMBS structured offering with a bottom traunch that has no credit rating and will be sold to hedge funds or swallowed themselves.
  
  
• CDO spreads show our fear levels, with Citi being at 327 bps, Goldman Sachs at 260, and JP Morgan at 138.
  
  
• Last week the Australian dollar rose vs. the US dollar 3.1%, the Canadian dollar 2.8%, the New Zealand dollar 2.75% and the Swiss franc 1.3%.
  
  
• The Barron’s Confidence Index (mentioned last week as an unusually bullish indicator) dropped some of the way back to its prior level.
  
  
• The Wall Street Journal suggested this is a time to use leverage.
  

All of the above elements are indicating that we are in a more normal or even a “new normal” period.

For my clients, family and the institutional investment committees that I serve, I try to focus on long term needs. Additional inputs that contribute to my long-term thinking are:

INPUTS FOR THE LONGER-TERM

• The state of Colorado after using a future investment returns assumption of 8.5% has recognized that if they lower their assumption to a somewhat more reasonable 7%, they will run out of money to pay pensions in 30 years.
  
  
• Jason Zweig in his always important but often controversial column in the Weekend edition of the WSJ (click here to read) compares the current difficulty of the DJIA to sustain a reading over 10,000 over the last ten years to the sixteen year period it took the index to sustainably rise over the 1000 level.
  
  
• Last year for the first time in perhaps thirty years, investors bought more gold than the jewelry trade. I have read that one gold ETF owns more gold in one London vault than all but a few central banks. Diamonds are also in significant demand. A high end Jeweler told me that he is having difficulty in obtaining serious diamonds caused in part by De Beers' control of the market. I also learned that in the US the retail price per carat is about $200, and in China over $1000.
  
  
• There is a new study that that suggests after a 10 year bull market in commodities, a 20 year bear market follows. (This makes sense to me in that higher prices bring into productions new mines and a major rise in capital expenditures, which we are seeing now.)
  

I maintain all of the above items are tactically important and are descriptive of the present moods. I would daresay that a consensus has been formed that the current markets do not offer any major opportunities to meet long term needs through investment gains.

BETTING ON NON-FAVORITES

My training at handicapping thoroughbred race horses holds that favorites, by definition consensus chosen, may win about a third of the time. When they do, the rewards are not enough to pay for the other losing tickets and their imbedded fees and taxes. The only to win money on balance is to selectively pick non-favorites. Almost by definition this process works on a different set of conditions occurring than those that have bet on the favorites.

THREE TENETS THAT LEAD TO CHANGE

I believe that future conditions which could start at any time will be viewed differently than those of today. As usual in these tautologies my beliefs are based on three growing forces. The first is innovation and technology. My Caltech bias may be showing, but long before joining their board I was a reasonably good electronics analyst. The second force is demographics as the growth both in numbers and drive for higher standards of living will raise the aggregate level of demand and to some degree where the supply will originate. (For the most part the countries in the northern hemisphere are facing a demographic time bomb of having too few workers to pay for those who are retired. The US is on the cusp of such dilemma. Our way out is to encourage the right sort of immigration and education.) The third force is very difficult: discipline. I have little faith in so-called reform measures imposed by governments without getting their own houses in order. I do believe that many people including business people, investors and loan officers have recognized some of their prior enthusiasm has led to bad decisions. Similarly, some of the losing teams in the World Cup will go home with an understanding that good intentions are not enough without the proper training and on-field discipline.

FOR INVESTMENT COMMITTEES:

The question before the formal and informal investment committees is how to structure for this expected change in conditions. Recently, I have advocated for a significant non-profit that the endowment be divided into three unequal parts. The first is to fund the current year’s needs as well as the next years’. (In other words, if the investment world collapses you have at least two years to live.) The second and the largest piece is to invest to meet the identified needs; which could be new facilities or sending Johnny to college. The third piece is to invest the needs beyond the identified horizon. We all have experience in our lives, both challenges and opportunities, that we did not expect. With the correct mind-set and a little bit of capital, these challenges can be opportunities. I will be the first to admit this three element strategy is easier to manage through the use of mutual funds or specifically designed separate accounts, than by choosing individual securities.

I am curious as to the reactions, comments and criticisms from the members of this Blog’s community, please let me know your thoughts.
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