Re-Risking with Bonds, China Near-Term

Introduction

I have learned that one of the most risky periods to trade is when the market is open. Without the regular flow of transaction prices, one doesn't know if one is winning or losing. Thus, during all trading hours one is at risk to a significant price adjustment. Or to the contrary: opportunities to recognize investment profits. But some periods have been more prone than others to substantial price moves. We may be in such a period after a light volume expansion which appears to have topped out, and at the same time little in the way of successful shorting  and low volatility.

Re-Risking with Bonds

After 35 years of substantial gains, bond prices for high-quality paper experienced some falls. By year end it appears that the declines have just about slowed to a gentle fall, at least temporarily. Bond trading has attracted hedge funds and other speculative players. Many of these have taken losses as markets have signaled higher interest rates. These losses were  relatively small for un-leveraged portfolios, many portfolio managers feel that they have been insulted by "Mr. Market." They plan to get even with the market by re-risking their portfolios utilizing below-investment grade paper,  be it floating rate paper, loans, or high yield bonds. One can be concerned that they are creating the next large bubble. We should pay attention to that great portfolio manager William Shakespeare when he wrote the following words for the witches in Macbeth:

"Double, double, toil and trouble, fire burn, cauldron bubble...."

The re-risking has already begun with high yield bonds gaining +17.18% and floating rate paper +10.57% compared to 5.98% for the bonds issued by the S&P 500 participants. For a number of mutual fund management companies the appeal of this paper hopefully will add to their dominant bond funds which could be very useful to the groups, but particularly Eaton Vance^*, Franklin Resources^*, and T Rowe Price^* among others. The flows are presumed to come from new shareholders who wish to participate in the rising interest rate phenomena. One sign of the popularity of intermediate quality bonds is that their average yield for the week fell 23 basis points vs. a fall of only 7 basis points for the previous week, according to Barron's. If interest and inflation rates grow slowly, and stay below a pre-determined yield point, many bond investors will not focus on the decline in the price of their bonds.

 At this point that breakaway yield is probably about 4%. Another concern is the likely default rate that is expected on this paper. Moody's^* believes that currently the bid/ask spread on speculative issues is 60 basis points too narrow or phrased another way, Moody's expects greater default rate than the market does.

^* Personally owned  or through a private financial services fund that I manage.

Must be in the China Funds Business

On the fifth of January two of the global fund industry’s leading groups announced long term commitments to the Chinese mutual fund business. Fidelity was given permission to establish a wholly owned fund management subsidiary in China. On the very same day it was announced that two arms of the Power Corporation of Canada^* would become the second largest owners of the largest mutual fund company in China. Both of these two groups are long-term strategic thinkers that have successfully entered markets beyond their home and appear to the locals that they are local themselves. (Fidelity is one of the largest fund providers in the UK, Hong Kong, and Japan among others. Power Corp. has big positions in Great West Life both in Canada and US as well as Putnam and substantial investments within Europe.) While I don't know whether these Chinese ventures plan to offer domestic and international funds in China, I am impressed with the commitment these two giants have to their long-term expansion plans. Each has benefitted from multiple generations of their senior management families who have worked their way up to their current command positions. On the basis of my respect for these families and their companies, I feel in the future one can not afford to disregard China and the Chinese investors as even more portent powers in the fund business globally.

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A. Michael Lipper, C.F.A.,
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Labels Can Be Dangerous to Your Wealth

Introduction

In our modern lives we are inundated with information. To avoid chaos we organize information in silos and give each of the silos a label. Unfortunately we (the universities, the governments, media)  rarely ever examine whether we have misfiled the information or whether those informational relationships have changed. If so, the current label on the current fact is often misleading.

One of the few benefits of long plane rides is that I get to read the news of the day more thoroughly and from many different sources. As I read these pieces, different relationships between the elements of information and some important investment implications occasionally come into focus.

How and where do we shop?

On October 18 in the London edition of the Financial Times there was a front page article headlined “Retailers Shut 20 Stores Each Day.” The article was based on research conducted by the accounting firm PricewaterhouseCoopers. In a study of 500 UK cities/towns, PwC found that in the first half of the current year some 953 stores were closed, compared to 174 in a similar period in 2011. (While I don’t have data on the US and other countries, I suspect that the trends are roughly parallel.)  Computer game stores, toy shops, clothes shops, gift shops, jewelers, card/poster shops and furniture stores were hit the hardest. Places offering check-cashing, pawnbrokers, discount and convenience stores, coffee shops, currency changers (and wire sites) and charity shops were far less effected. After reading the article, the analyst in me had three different thoughts that bumped heads with the traditionally-labeled silos.

First, did the UK statistical offices note the change in the mix of retail activity? Second, the realization that we are seeing marked changes in behavior. Trading down from higher-priced merchandise and conversion of assets to various forms of money, replacing merchandise spending for service spending are all important changes. Third, the data is incomplete, I am guessing a good bit of the store traffic has been lost to the Internet.

In my recent discussions with UK portfolio managers, no one directly discussed these changes, however many held Internet-oriented stocks as long as they were moving higher in price. National governments do not seem to be aware of these changes. Local governments around the world are very conscious of disappearing storefronts and therefore employment, but seem powerless to stimulate sales on their High (Main) Streets.

Does the US have the same labeling problem?

The labeling of various stocks as consumer staples or consumer discretionary is misleading.  These are terms from outmoded economists based on the goods and services once sold, not how they are bought today. Amazon and similar online merchants have changed the world and both investors and policy makers need to catch up.

Another example of mislabeling

In a recent conversation with a very intelligent mother of children who are now in the workplace, I was told that she educated her children as they were growing up at various ages by the stocks she bought for their accounts. At an early age she bought McDonald’s for them, as it was the place they went to get rewards for good behavior and good marks. I am delighted that it worked out well for the family. She followed that thinking and at some point bought shares in Apple for them. (I suggested that now as they are in the workplace she might look to buying some of the recruiting firms. In the past they have not been big winners as stocks but are very much leveraged to mid to high-income employment growth.)

All of the stocks mentioned appealed to her and her lucky children because they knew of the companies and their products. But in each case these are globally-oriented companies. It would probably surprise her and many Americans to learn that McDonald’s has more sales in Europe than it does in the US. (Interestingly there are more Burger Kings in Barcelona than McDonald’s even though McDonald’s has the Airport location beyond security.) In a similar fashion, Apple’s future is very dependent upon both production in China and whether the iPhone 5 will increase the potential market from 17 million users to 200 million users.

The fastest growth for many recruiters is their foreign placements. Not only are local offices around the world filling local needs with local talent, they are searching for qualified US talent to work overseas. These are examples of stocks that are labeled as US domestic because they are legally domiciled here. Most portfolios owned by US institutions and individuals need to recognize the global nature of their holdings and adjust to the world not as it is, but how it is likely to be.

Fidelity has come up with some very important numbers

Following the trail of the now grown up children mentioned above, they and their cohorts need to start to think about their retirement capital needs NOW!  In an article  in the October Financial Advisor magazine, Fidelity Investments has laid out the math for meeting a working person’s retirement needs which I have outlined below. (Bear in mind that Fidelity is the largest factor in the 401(k) market.)    

1.     To reach 85% of final salary level at age 67 retirement, including social security, one needs retirement capital of eight times the ending salary. They assume the age at death is 92.

2.     To reach this goal one needs to enroll in a 401(k) at age 25 and make continuous contributions beginning at 6% and raise it 1% each year until it reaches 12%. (This plan presumes an employer contribution of 3% p.a.)

3.     The intermediate benchmarks would be an account equal to one year’s income by age 35, three times by age 45, and five times by age 55.

4.     The underlying investment assumptions are a 5.5% rate of return, the employee’s income grows by 1.5% p.a. more than inflation and no breaks in employment or savings.

There are very few people that I know that are on this track (excluding those who have access to outside capital) and most workers won’t get to these numbers. Thus, we need to come up with a new label for the period of our lives beyond our primary employment.

Can we discuss your retirement planning?

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