Now, The Most Dangerous Time to Trade

Introduction

Some pseudo-sophisticate might say the most dangerous time to trade any market is when it is open for trading. For traders initiating a trade that can be costly to unwind, there is no worse time than when the market is slow, with little volume and in a long, flat pattern. The very trap of being the worse time could also be the best time for investors.

For Traders

For many years I have watched the actions of traders on various broker/dealer trading desks. At times their biggest risk is boredom. In a slow, flat market (which we have had for some time) watching their screens, reporting only minor price changes can drive these activists crazy. To create some action they find prices that they follow closely which they believe they understand better than the market and create a long position or in a minor number of cases a short position. Because the traders need to earn more than the cost of capital assigned to them they multiply the small expected moves by the use of borrowed capital in some form. A swift breakout or breakdown from the price level of their position can have a dramatic impact on the value of their positions, the bonuses, and ultimately their employment. In the current environment the trading desks staffed with portfolio managers at hedge funds play similar games as the old dealer desks, except with more modern training they are likely to use derivatives as their medium.

For Investors

Perhaps the key difference between a trader and an investor is the time to success (or failure). The trader is short-term oriented in terms of hours, days, or possibly weeks. An investor is much more concerned in terms of years, often a number of years, which is why we developed the Lipper Time Span Portfolios^TM concept. We manage money for the long-term, and in some cases beyond one’s lifetime. However, the long-term starts with now, at today’s price.

Jumping Off Point

We have written in past posts that it is somewhat natural to be in a reasonably flat stock price picture. Equity prices have raced ahead of the slow, uncertain economic factors that are producing limited gains in top line revenues. Current prices reflect largely present and expected earnings gains coming from profit margin increases due to low commodity prices, more efficient use of labor, foreign earnings translated into US dollars, and buy-backs. Without future revenue gains much of the above-earnings increase elements will eventually reverse.

Two Bullish Strategies

The strategists at Charles Schwab believe that we will enjoy a grinding higher stock market. With core inflation, excluding food and energy, growing at a current 2.3% rate, Schwab and most of the rest of the strategists are looking forward to the early stages of an interest rate rise. Also the sentiment index of home builders is rising at a faster rate than new starts.

The strategists at JP Morgan proclaim that they are global investors to some degree, escaping the geographic labeling in asset allocation. Nevertheless, they point out that for many of the normal investment measures, US stocks are priced above their ten-year averages. On the other hand they point out that the Asian Emerging Market stocks are selling below their ten year averages in terms of forward price/earnings ratios, price/book value, and price/cash flow. This Asian bias is similar to our own which favors Asia over Europe, even though a number of the funds we use are currently betting in favor of Europe.

Two Causes of Concern

The first is Moody’s has raised its forward looking ratio of default frequencies for US and Canadian High Yield issues. From an abnormally low level the expected rate increase is back in the more normal range. This could be influenced by a concern for the oil and gas High Yield paper or  too accommodative underwriting standards in the past. I tend to pay attention to the fixed income market from the perspective of an equity investor. Often the risk avoidance mechanisms of bond holders and traders act as the canary in the stock market.

The second cause for concern is much more complex and controversial. It starts with the relief rally the world stock markets delivered for the week ending July 15^th  as reported by The Economist. All 44 of markets it tracks rose for the week in US dollar terms. Only 9 declined in local currency terms. As a contrarian, any time I see all of the passengers in a boat on one side I fear a collapse. Many market participants view the news of the week positive from Greece, China, and Iran. Perhaps, the US Mutual Fund and Exchange Traded Fund investors were using the relief rallies to be net redeemers of both domestic and international funds for the first time. Maybe they are right or at least raising the same questions that I do in terms of Greece, China, and Iran.

The decision to fund Greece’s place in the euro with German money in the long run, in my opinion weakens the euro and will not correct the larger than treaty permitted deficits for a number of European countries. The cost of losing Greece for awhile is much smaller than the damage in keeping it.

In many ways the current Chinese government is the most effective government in the world. This may be true due to its command structure or the skills of the present leadership learned at the party’s political school. I am afraid what has been taught is the use of socially determined bailout mechanisms. Bailouts perpetuate poor behavior and in the end prove to be more costly to the society than letting failures occur. In quick order they will be replaced by newer and sounder forces.

In terms of the agreement with Iran, my fear is that we have seen this movie before in terms of our experiences in and after WWI and the creation of WWII.

Once again we are experiencing the power and “wisdom” of an unelected woman in terms of the second Mrs. Wilson (VJ) and the lack of understanding by Neville Chamberlin (VJ and crew). The temporary avoidance of conflict comes at a much larger price of future innocent deaths.

As we have not yet raised cash, and since Gold and TIPS are not rising in price, let us hope that I am wrong.

Questions of the week:

1. How are you going to “play” the change in direction of the current market? 

Question 2: What are your long term investment worries? 

__________   

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Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2015

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Watching Investment Paint Dry

Introduction

For many mutual fund investors owning domestic stock and bond funds, the first half of 2015 while volatile on a week to week basis, for the six months performance was as exciting as watching paint dry. For these investors the net result was minor gains or losses in an essentially flat period. (We will discuss the positive results for international investments below.)

Different Speeds Create the Gap

Ever since the bottom of the last economic cycle, the domestic stock and bond markets have been producing worthwhile capital appreciation. The markets have been so much better than the economy that a valuation gap may have been created. One can say that some or the entire gap was formed by the combination with the Federal Reserve’s manipulated-low interest policy that there were insufficient returns in savings vehicles, thus money went into investing. At the very same time the main vehicles for investing in stocks have been shrinking. The combination of buy-backs and cash paid for mergers has reduced the number of shares available. The net result is that we have had a shortage of satisfactory investment vehicles. Shortages are cured by either new supply, higher prices, or both. Valuations rose in the face of shortages of investments at reasonable prices in spite of only pedestrian growth.

Closing the Gap

Often when a valuation gap appears it leads to a price correction. As noted by many, we have not had a domestic market correction which is normally translated as a 10% drop since the 2009 bottom.  There is a second way the gap can close, which is that over time the earnings production grows within a flat price environment. In addition to a sharp increase of new equity underwritings including IPOs, supply is increasing. Thus the gap is structurally closing.  Perhaps, flat is good for awhile.

Double Digit International Returns

As this post is being written the final performance returns for funds during the first half are not yet available. Nevertheless, I do have fund performance data through June 25^th which shows a substantial number of International funds producing double digit returns. The best returns were coming from China and Japan. Undoubtedly some of the gains were given back since then, particularly for domestic Chinese portfolios.

This phenomenon has been understood by mutual fund investors who have been adding to their non-domestic holdings practically every week this year while redeeming their domestic stock funds. Is this just performance chasing?  All too often this is a practice of unsophisticated investors in a bull market which is often labeled momentum investing. Only a few can execute a withdrawal from momentum investing successfully.

Another Possible Explanation

We have seen a similar pattern in just about every mutual fund arena around the world. More and more people globally have noticed that their governments and central banks are in effect devaluing their local purchasing powers. While this pattern is global in nature, for many investors it is wise to invest some of their wealth, perhaps 25-50% beyond their home countries, as a form of diversification. In the case of US investors, there are some relatively bargain priced securities available outside of the US. If this trend becomes too strong it could be another example of the smart locals offloading their own securities onto the gullible foreigners, so caution is urged.

Implications of the Greek Vote

Now that the population of Greece has voted “No,” there is an improved chance that the euro will last longer than had the vote been reversed. There are increased odds that agreements having to do with the level of deficits will be kept. Thus those that remain within a smaller central currency will have a stronger currency to deal with the dollar and yuan.

The Meaning of Fund Redemptions

With every purchase of mutual fund shares, redemption is set up. What is purchased must be sold eventually to capture the full value of the investment. Historically it is a mistake to view gross redemptions as a sign of dissatisfaction. Post-redemption surveys indicate that for the most part investors are cashing out of various funds which have met their needs. Investors need the money for retirement or other needs where aggressive investing may be unsuitable.  Sometimes they switch to lower volatile funds to meet their new needs.

Most fund sales people and many investors focus on relatively near‑term past performance. They do not wish to buy into past poor performance, ignoring the principle of buying low and selling high. Thus there is relatively little in the way of fund purchases to meet normal, often actuarial based, redemptions. We are currently seeing this pattern increasing in importance due to changes in market structures, particularly by relatively inexperienced investors.

Unprofitable Investors’ Mechanistic Solutions

Frequently it has been said that mutual funds and some other investments are not bought, but are sold. The reason behind this statement is that investing is complex and difficult to do well. Earlier I alluded to momentum investing which is essentially jumping on a speeding train. The basic view is that gains of yesterday will be repeated tomorrow ad infinitum.  If this always works, almost any upward sloping mechanical strategy would work. Many are available through the wonders of the Internet world.

Increasingly, fees and commissions for investment products and services are controlled by regulatory bodies. In their minds, by definition, lower fees are better than higher fees without regard to quality of service and lifetime support. This view has led to little to no upfront charges and various ingenious ways to generate other revenues for the distribution and management entities. Thus, the number of full time mutual fund salespeople making a living providing services to investors has declined. Some of their efforts have been redirected to other packaged products, including unregistered offerings. Thus, with the number of peddlers down, the sales of open-end funds is not what it used to be.

There is some Help

Today’s younger investors are not facing their investment future alone.  Many of them are employees of companies, government bodies, schools and universities that offer salary reduction programs to supplement or replace defined benefit pension plans. As an investment advisor to some of these, where appropriate, I created a series of portfolios of funds. When I began with these I was concerned that the employees would pick out one of the better performing funds in the mix for their own after-tax account. To counteract such an undiversified approach, I captioned our reports with a cautionary label that individual funds used in the plans were not necessarily a good personal investment, or similar words. 

Even though one of the plans that we were the advisor to was judged to be the best large 401(k) plan for the past two years in a row, I saw no large scale use of the particular funds in the plan in the personal accounts, except by some of the people administering the plan. Evidently the high income participants separated their retirement money from their personal, and I presume more aggressive money. Thus in this case they did achieve reasonable diversification which should help them in the long run. In industry statistics the 401(k) and similar plans are considered institutions because of how they are sold, serviced, and priced, even though their ultimate beneficiaries are individual people who, over time, would have their own redemption patterns.

Question of the Week:

When you close out an investment, do you enter a similar investment or readjust your portfolio with the proceeds?

__________   

Did you miss my blog last week?  Click here to read.

Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2015

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Investing in World Equity?

Introduction

A study of flows within the global mutual fund business shows that money is flowing into investments outside of one’s own country at a faster rate than being invested internally within the home country. This is not a new phenomenon. For probably the first 200 hundred or so years the US was being built with capital from overseas. Even in the 1920s, I am told that my Grandfather’s firm had one or more branch offices or correspondents in Europe to service European investors and traveling Americans who wished access to the US markets.

A lot of money has been made investing outside of the US in 2015. This is particularly true in local currency terms. According to The Economist, eight separate markets have gained more than 20%, compared with 3% in the US.  The reason this is important to US investors is at the bottom of the market, the locals will set the terminal prices.

My early career exposure to overseas investment

As a trust bank trainee, one of my jobs was counting the foreign stock certificates behind each of the American Deposit Receipts (ADRs) that the bank was issuing for foreign corporations to US investors. One of my mates at the counting table said that we were both likely to be involved with international investing later. He became the research partner for a highly respected London headquartered fixed income shop and at an early career opportunity I joined a small splinter analyst group focused on international investing. My next job was with a brokerage firm that among other things was institutionalizing some foreign corporations to the US market. At the time, while I was following what we called electronics companies, I was asked to sit in on the internal discussions on a major European electronics company. One of the things that hit me as odd was that every morning my firm was buying shares in the company’s local market to sell to Americans. I kept on asking if this is such a good deal for American investors why are the locals selling? Initially it turns out that I was correct. The locals were reducing their holdings in a stock that periodically had falling spells. Perhaps with the proceeds of their sales they were buying some shares of the companies that I favored in the US. This particular dichotomy of judgments is driving this post.

My mutual fund lens

Subsequent to my time at the brokerage firm, I spent my career focusing on mutual funds registered with the US Securities & Exchange Commission as well as in other major countries. Initially my focus was as sales targets for my industrial company research. Later on I focused on selling performance, fee and expense data to the funds. This in turn led to a consulting practice largely focused on boards of directors, including CEOs. In order to understand my clients more fully I bought small amounts of the publicly traded shares of mutual fund management companies mostly in the US and in the English speaking world. Many of these shares are in the portfolio of the private financial services fund that I manage. Thus, I study the fund business on a regular basis.

Utilizing data from the Investment Company Institute (ICI), I have seen that the retail fund investor since 2001 through April of this year has multiplied their investments in World Equity funds almost 4X (to $1.54 trillion) compared with an almost double in Total Return equity funds ($ 3.25 trillion) and about 1.5X for Capital Appreciation funds. It is quite possible that some of the more speculative money in the Capital Appreciation funds chose to speculate in World Equity funds. Institutions using institutionally priced mutual funds have built their world equity positions much faster than the retail investor, multiplying their 2001 base 13.56 X to a $ 749 Billion at the end of April 2015. Thus as far as the US fund business is concerned, approximately 1/3 of World Equity funds are owned in institutional funds.

Is institutional ownership good for world equity owners?

That depends on the dichotomy mentioned in my prior research experience. The retail investor has been reducing his/her more speculative exposure by being net redemption for at least 15 years in terms of Capital Appreciation funds. For their retirement and more conservative investing they have been redeeming only since 2007. What is more difficult to fathom is their behavior in World Equity funds. In 2006 they added $121 billion and $115 billion, in the following year only to be followed with a net withdrawal of $85 billion in 2008. This seesaw pattern was repeated in net redemptions in 2011, -$43 billion and $31 billion in 2012 which was followed by net purchases of $56 billion in 2013. These repeated swings could well be tied to dramatic changes in the value of the US dollar and gold. What is more hopeful is that over the entire period institutional World Equity funds had positive net flows.

Year	World Equity funds Flow (in $ Billions)
2006	+ $121
2007	+ $115
2008	-  $ 85
2011	- $ 43
2012	- $31
2013	+$56

Mutual recognition of mutual funds in China and HK will allow the sale of locally-registered funds in each market.  This may have an impact of bringing more money to be invested in China.

What the gyrations of net flows on the retail side may be focused on are the short-term views of some brokers or registered investment advisors. I believe that the institutions were focusing on both longer term timespans and lower valuations, ex-US. What buttresses this view is when I look at what is happening in the non-US fund business, I see that investors are investing beyond their home markets. Part of this is practicing sound global diversification. Part may be in recognition that in general, the rich in any country tolerate their governments, but it is difficult to find a country that is happy with their present government. The current one is better than alternative for the most part.

What should be done now?

To some degree any domestic or foreign investment in the summer of 2015 should have a view on Germany, China, and India. On my recent trip to Germany I was impressed with the feeling of orderliness and a very strong desire for control. Many of their businesses have the attitude that they will not put a product on the market unless it is the best that can be produced within a price/quality range. There is not the rush to gain the first movers’ sole position in the race. If they can maintain control, investing in Germany (particularly in its middle market size companies) should be comfortable. The issue of control of Germany’s environment is critical. German investors’ fears are three. The first is to keep the Euro reasonably intact. The absence of a central currency will drive a huge flow into a German currency which will create an unmanageable inflation. The second is to keep Russia and the sanctions directed to it in proportion. A collapse of the Russian economy would hurt German companies as well as raise potential military stress. The third is to continue to keep ethnic unemployment low enough to prevent civil strife. Can they succeed with their three challenges? They have, but that is not a guarantee of the future.

I have said for some time that China is the single biggest economic/financial issue facing the world for the rest of this century. While the US, Japan, and Europe may think they are being bold with their levels of monetary experiments, China has many more moving parts to manage. Some of these are demographics. The one child policy means that their supply of cheap labor has peaked. The rapid urbanization to succeed required large scale infrastructure spending and an increase in the number of jobs with wages appropriate for urban living. The size of the provincial debt along with debts of government controlled banks will take great skill to avoid a financial collapse. The military/naval machine will need to be fed to avoid political problems. Solutions for ethnic and ecological problems can’t wait much longer. The enormous size of China’s internal market and their own trade ambitions are creating substantial opportunities for the world to participate in its growth. Simply put China can not be ignored.

On a gross basis India is growing faster than China. Whether the year-old government can encourage an in increase in productivity is critical. Skipping the landline phase in telecommunications will help as will some technological improvements in terms of electricity and drug production that need to be accelerated. Higher productivity requires lower levels of corruption and governmental controls. India already has the world’s largest middle class and an increasing number of highly educated workers.

Portfolio advice

Each investment activity that I analyze has a global aspect to it. Increasingly I segment portfolios into different risk classes, bearing in mind that risk is the size of the penalty for being wrong which affects future spending plans. If we live in an increasingly dynamic world we should be investing in securities that can manage change. While this favors stocks over bonds, it also introduces a bias in favor of mid to small companies that can make changes more rapidly than large companies that are too risk averse.

Question of the week:

Which are the companies that are likely to handle future change the best?     

 

__________   

Did you miss my blog last week?  Click here to read.

Comment or email me a question to MikeLipper@Gmail.com .

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2015

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.