Three Warnings

1.)Bank Services Clients Should Be Wary
2.)Expected Interest Rate Increases in Second Half
3.)Short-Term Indicators Casting Shadows on Five-Year Investors

Introduction

The job of a good securities analyst is to analyze and predict, not to extrapolate current trends. There is considerable career risk to those analysts and even greater career risk to the portfolio managers who buy into these predictions. The difficult issue is attempting to spot the peak in sufficient time to position the portfolio to avoid meaningful capital losses. Unless the decline comes after a long flat period, rather than a sharp peak, the career risk in repositioning is being premature. Unfortunately, in the eyes of too many clients, to be premature is to be wrong. The purpose of my three warnings is to identify three of the items I am watching to reduce being classified as being too premature.

Bank services clients should be wary

One of the reasons I focus my private fund on investing in financial services securities is that I believe that financial services are key to the growth of the global economy. Sometimes this sector will lead and at other times it will lag the general market, but not much progress in either direction is likely without some significant movements within the financial services sector.

One of the analytical requirements in looking at a company or sector is to understand the benefits and problems of the providers of critical services to the prime groups. Going back many years this was driven home to me as an analyst who had the responsibility to follow the “white goods” (refrigerators, washers, dryers and dishwashers) as well as the “brown goods” (radio and television). The most successful seller of white goods, at that time, was Sears Roebuck and another large department store group was the leader, with a much smaller share of market selling brown goods. One of the reasons Sears was so successful in what many outsiders considered a commodity type product was how it managed its supply chain. Sears insisted on quality and eventually price leadership.

In order to achieve these goals it in effect became a partner with its critical suppliers. In a number of cases Sears took a meaningful minority interest in the supplier’s stock. By doing so, it could help its supplier earn a respectable (but not extraordinary) return on investment at the same time producing for Sears and some others very high quality products. The original relationship was one of a handshake and I believe the first contract on paper came twenty or more years later. On the other hand, in selling brown goods other large retailing chains always insisted that they get the lowest price for the merchandise that they were going to sell. One hundred years later Sears is still selling white goods and it is difficult to buy television sets in most department stores.

As mentioned in last week’s post major banks, particularly large trust banks evolved into paper and data mills providing investment and administrative services along with their deposit and loan activities. For many clients a bank’s product quality and service is as important, if not more, than to the family buying critically important white goods. Last week I pointed out that banks in general have regulatory requirements that very much restrict their ability to make the kinds of returns that they used to. This week we are greeted with the news item that Bank of New York^*, parent of Bank of New York/Mellon is contemplating selling its corporate trustee business to UFJ Mitsubishi. This follows by a few weeks JP Morgan^* selling its pension fund record keeping business to Great-West Life^*. Further, this week is the announcement that Barclays is going to lay off 7000 employees from the investment banking and related services activities. To the extent that this last move has to do with earnings from what the industry has dubbed “FICC” (Fixed Income Currencies and Commodities) this is going beyond reacting to reducing payroll, it has to do with escaping the capital requirements that most trust banks and other large banks are becoming burdened.

Why should I care as a customer of these banks? As operating profit margins are beginning to slip, there is a great drive to replace humans with machine driven functions. Computers are wonderful, but they lack a service capability to handle difficult or unusual needs of clients who are used to high touch relationships and have paid for it in the past by getting lower than street level interest rates on their balances. This is not a short-term problem which will go away when the economy is growing faster. There are two critical trends that will affect the banks:

At some point to reduce their labor cost including health costs, banks like many other US businesses will seek to employ workers less than 30 hours week, which is not likely to increase the quality of services provided. There is a second trend of some significance to those institutions that provide post-retirement services, which can be  profitable clients for many banking institutions. The trend is that the proportion of the population that will be retiring each year will grow much more slowly than the work force as noted by Goldman Sachs^*.

One possible clue to the investment world’s view on the future for the trust banks is that they are selling in the marketplace at lower price/earnings ratio valuations than the more cyclical brokerage and asset management stocks.

Expected interest rate increases in second half. 

Moody’s ^* believes that by the end of the third quarter of this year that the consensus is that the 10 Year US Treasury will be yielding 3.06% compared with the current approximate level of 2.61%. I suspect that this increase will not be led by the Federal Reserve, but by both internal and external pressures. Most observers do not believe this expectation is already taken into consideration for the equity market. Moody’s joins others that believe that the current yield spread between treasuries and high yield is too narrow with inappropriate concern for expected increase in defaults.

Equity investors need to pay attention to the bond market for clues to future stock price levels.

Short-term indicators shadows on five year investors

I am trying to navigate between two forces that I have been reporting on in these recent posts. The first is my belief that long-term investors should sub-divide their portfolios on the basis of the time-spans that each segment needs to deliver adequate total reinvested returns. The second of the four time-spans contemplated is the current operational portfolio which in many cases addresses obligations over the next five years. This portfolio is designed to replenish the first portfolio after it has paid out all of its capital to meet current needs, hopefully for at least two years.

The second force that I am dealing with is my earnest belief that sometime over the next five years we will suffer a meaningful decline in stock and many bond prices. (While I have mentioned my concerns in prior posts, I would be happy to discuss my thinking privately with subscribers.)

As I have mentioned in the introduction, I am very concerned about urging premature actions that can cause career risk. Therefore, I scan both the long-term factors as well as the short-term factors to get ready to get into position to protect the five year-oriented account.

In looking at the short-term indicators, Steve Shelton of Cornerstone Global calls to my attention that option traders have opened a large number of call options on the VIX compared with put options. This group of traders is betting on a major increase in volatility, which has been at a remarkably low level in an aging bull market. Perhaps related to this view is the fact that as of April 30^th, shares sold short on the NASDAQ Capital Market meaningfully expanded to 4.66 days of normal trading, as compared to just 3.31 days two weeks before, an increase of 41%. This is a measure of the number of days with normal volume required to buy back enough shares to close the short position.

These are among the indicators that I pay attention to in looking to avoid being too premature. Are there others I should follow? Please let me know.

^* Indirectly or directly I have investments in these securities.

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The Investment Danger in Models

I have spent a good bit of time over the last decade conversing with portfolio managers with good to great long-term records. But their current performances are far from stellar. What has happened?  I might stretch to answer with a paraphrase from Shakespeare, “Aren’t they honorable men (women)?”

Last week’s blog focused on the way most of our brains work, relying on short-term memory to make current decisions. Those who have had damage to the frontopolar cortex portion of the brain rely on longer term experiences. This dichotomy has made me wonder how we think throughout life. As a baby we find food and compassion wonderful and wish to obtain more. We learn to quickly translate the specific pleasure to an expected generalized pleasure. Our formal education continues to use the appeal of future benefits as a reward. By the time we formally learn about finance and investing we are hooked on the generalized rewards that can be programmed into our actions. Particularly in schools of so-called higher learning we are introduced to mathematical models. In effect, the models substitute for the reality that is available for inspection.

Time pressure

In college and graduate school as well as most entry level jobs in the financial community, we must immediately start plugging numbers into the models provided to be one of the first to solve the problem in the expected way. Rarely do we take the time to understand the historic development of the model and how the immediate conditions are different from those present at the foundation of the model.

Libor

Bankers, borrowers, and other lenders took the published Libor rate as the price for high-quality borrowers.  In terms of the US dollar Libor, they did not focus on the fact that this was a private collection of expectations of sixteen banks set in London. On many days during the crisis of 2007-2008 there may not have been a single loan at the expected rate. Further, the calculation excluded the four highest and the four lowest expectations. If one wanted to manipulate the rate one had to “reach” the middle eight to rig expectations and these middle eight could change every day. During this period there was practically no confidence on the parts of banks that other banks would repay the loans promptly. Thus the conditions that led to the creation of the model were very different than the conditions during this current bank crisis. A prudent person should not have looked to Libor as a reliable rate-setting mechanism. In a moral sense the criminals in this situation were those that used the mechanism without comprehending and revealing its frailty.

Euro

The establishment of “The Single Currency” was an attempt by Western (Continental) European governments to replace the US dollar as a reserve currency for intra-European trade. The single currency was meant to be followed by a series of additional political, economic, and legal moves. These provisions would provide backing for the currency. Long before the current problems with the PIIGS, (Portugal, Italy, Ireland, Greece, and Spain) there was a strong clue that the people of Europe did not truly support their intended union. The politicians wanted to stop the bloodshed in the Balkans, calling for NATO to provide the muscle to end the conflict. The only problem was that the various countries would not tax their populations enough in money and manpower to bring a military victory. In the end the US had to provide the additional muscle that was needed. There is an important lesson here. With rare exception, a permanently strong currency rests on both a sound economy and the bayonets that are willing to enforce the government’s will. (Perhaps I have had too much US Marine Corps training.)

I do not know if the recent brave statement by the ECB will temporarily turn the tide. Similar statements “of whatever it takes” have been an invitation to hedge funds and other speculators to move against the currency. Remember, speculators can leverage more en masse than central banks can. Stopping the run on the currency without permanently addressing the deficit will be insufficient to hold the euro up. (I hope our European brethren do find a way to address their deficits as we in the US will need an inspiration.) However at this point, if pressed, one would have to say the euro model is failing.

Indexed ETFs

While it is too early to call Indexed ETFs a failure, I am beginning to see some early warning signs that investors are not paying attention. Recently I was with the senior investment officer of a multi-billion dollar fund with a small but ample staff. I was concerned that he had a considerable number of investment funds in which the group was invested. My concern was even with his staff, did he have enough professional help? He felt he did, in that he did not have to devote much time to his index funds. At the moment he could be correct. However, I see two areas of concern. First the change in the weighting of individual stocks within an index. Within the S&P 500 one can see the rapid escalation of the weight of Apple and the decreasing weight of the older “Blue Chips.” Second, at some point these changes may call into question whether or not the index is an appropriate measure for various institutional needs. If that were to happen quickly, there might be some pressure on ETF liquidity considering the large hedge fund holdings in many ETFs.

Looking beyond the models

The current models in many shops today call primarily for US cyclical and recovery stocks.  As you might suspect, I will be looking for something different. In my quest for long-term investment additions to the accounts of my clients and family, I seek inputs from a variety of sources. If you have any insights to deliver to me privately, please do so.  I would also be happy to talk if you would like to join our growth adventure.

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