Hearing and Seeing Different Investment Views

Introduction

Having just spent the last eleven days in discussions with portfolio managers, CEOs of banks and other investment experts in London plus global stock exchange leaders in meetings in Barcelona, I have been trying to find some common theme among these bright men and women. The single most common theme is the complaint,  “The world is far from perfect and getting worse with almost every bit of news.” This feeling is felt widely, which I attribute to the rise of populism on both the right and left of the political spectrum.

All Cash To Escape the Complaint

In spite of their complaints, almost no one is just sitting in all cash, which is not what I am advocating. But to own anything we must have a belief that on a relative basis at least some assets will hold value and may increase in value. Thus, we must be relatively happy about something or some things. Interestingly we don't often proclaim our happiness. Perhaps, we fear if we brag about what we own, it will be taken away from us. Many in the or around the investment community want to appear to be sophisticated so that they may join in with their lists of complaints. Rarely is any time to devoted to those investments or conditions that make them relatively happy.


There are very few portfolios that have 20% in cash. A holding of 50% in cash within a fiduciary account might be considered imprudent before a probate judge. This is not to say that we should not prepared for periodic drops of equity prices in the range of 25% and once in a twenty five year generation of 50% decline.

Bottoms Good and Bad

The reason we limit our cash accumulation is that we have studied cash hoarding by mutual funds and individuals. In many minds, cash can become too comfortable because there could always be another major drop. Off of some bottoms, the first 10 to 20% is often viewed as a rally in a bear market when it is really the easiest earnings in a bull market. Many are frequently surprised by the strength of the new market leadership. Above all we need to remember that we can and will be wrong from time to time.

Interest Rate Hike to 4%?

My readers will not be surprised that I was disappointed by the Federal Reserve’s inaction last week, including what was said by the Chairwoman. I did not expect what is analytically needed. The best result would be a single immediate jump to 4%. Many will feel my call for 4% is extreme, but they should examine the last two studies of the so-called "dot-plots" by the members of the Federal Reserve's Open Market Committee. In each case the highest rate called for was 4% or even higher in the furthest out period. If some members believe that such a rate will be called for because of economic stresses within the next two years, why not be preemptive now?

By immediately raising interest rates we will probably reduce the intensity of the bad loans being made. We will also make saving attractive to those who need to begin a life long activity of building their capital for emergencies and retirement. A careful observer should note that, as usual, the Fed is late to changes in the market place. I believe one should look at Main Street as well as Wall Street. The average interest rate being offered by a large number of banks has risen from its lowest level of 25 basis points to 30 basis points. This demonstrates to me that local banks want to attract more deposits so they can make money on more loans.

While I believe both our monetary authorities and our courts should be guided by what is appropriate for this country, there are lessons that can be useful in assessing our own problems. Some of the observers of the surge of refugees streaming into Europe are suggesting that a significant number of these people are migrants for economic reasons not for political reasons. Applying that distinction when we look at a substantial number of immigrants to the United States (including some of our original founders) we learn they came to the US for economic opportunity reasons. If we want to see growing economic opportunities in the United States we should be constructing opportunities to save and to invest, activities that the current level of interest rates do not encourage.

Come what may, investment managers will find reasons to complain and keep their investments in equity mutual funds and stocks including those in the financial services arena. Many mutual fund and other portfolios that I examine have as their largest investment sector various financial services stocks. 

Question of the week: Next week I am contemplating addressing value investing. Please let me know what aspects of value investing you would like me to address.

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Stock Prices Up with Economists/Analysts Unconvinced

Introduction

There are no perfect rules about investing. Everything we think we know should carry with it a notation of a margin of error.

One of the advantages that I had growing up was to learn that one could have a winning day at the thoroughbred race track by cashing tickets only on one third of the races; in other words by picking one’s bets carefully and knowing when not to bet. The big advantage, in theory, that individual investors have over most fund managers is that individuals can be like me and not bet every race because of a lack of conviction as to its outcome or that the odds did not have an appropriate risk/reward ratio imbedded in the bet. My long-term analysis of the historical records of investors who stay in the game is that they are right on the order of 50% of the time and if they wind up by having more of their money on winning positions, can come away a monetary winner being right only 40% of the time. I believe most fund managers that have long-term records of ten or more years are right around 60% of individual quarters and years. The great ones are right perhaps two-thirds of the time.  With all that as a statistical prelude to indicate that being wrong is part of the game, I turn my attention to the remarkable first week of January trading. US stock prices were up roughly 5% in the four trading day week. One of the favorite market tales is that there is a “January Effect” which states that as January prices go, so goes the year. The believers in this theory are encouraged by the first day’s trading and the first week’s as well. Historically the “January Effect” does work, as do most months in most years. (The US market goes up over time most of the time.) There is some reasoning behind the belief in the “January Effect.” In early January many pension funds, 401(k) and similar plans get their money destined for the equity market and therefore they are buyers. Despite all the dour headlines and pundits’ chatter, the first week is actually a continuation of the halting rise in market prices that was evident in the fourth quarter of 2012. Nevertheless, the purpose of this post is not to jump on the momentum train, knowing full well about error rates and that optimism is contagious and often leads to unfulfilled results. The purpose of this week’s blog is to understand the dichotomy between the rising market prices and the very subdued comments of well-known and somewhat learned economists and investment strategists.

The focus of economists and analysts

1.    The recent tax bill is being celebrated by the media as saving the country from entering another recession. (My personal point of view is that it will hurt the economy long-term.) The tax bill did not address the causes for the deficit and actually added to the deficit. The real losers from this bill will be the lower and middle level income tax payers as well as those who pay no income taxes. All of them will suffer from an increase in the rate of inflation as capital owners will attempt to offset the increase in their tax costs through raising prices and slowing any hiring plans, particularly to reduce the impact of Obamacare on their income. What is probably the worst thing about the tax bill is a continuation (along with the central banks of the world) in attempts to manipulate the economy. After a generational expansion of the US economy, we need to materially improve the management of our own spending as well as to maximize our  productivity.  From time immemorial we have had economic cycles. Attempts to delay the cycle have often led eventually to a much worse result.)

2.    The tax bill included a number of benefits to particular special interest groups. This was evidently needed politically to get enough support or was a “due bill” to be paid. Mohamed A. El-Erian in his latest piece points out that politics drive economics in Italy, Japan, and the United States whereas in China, Egypt, Germany, and Greece economics drive politics. (I believe the second group are much closer to dealing with their structural problems than the first group.

3.    The US Federal Reserve, the Departments of Labor and Commerce, as well as the SEC have publically admitted that they do not have the correct statistical tools to fully understand what is happening within their specific areas of regulation. If they don’t have the right tools one has to fear their regulatory policies and recognize that it will be unlikely that the Congress or the White House can come up with appropriate policies.

4.    Some economists are pessimistic as to the long-term growth for the US. They cite the record levels of operating margins and expect less in the way of major economic benefits from innovation. (Ironically Professor Krugman believes that some are underestimating the growth potential from wider adoption of robotics.)

5.    Analysts have significantly lowered their current estimates of soon to be released 4^th quarter 2012 earnings, with particularly lower estimates for tech and financial companies.

6.    The expected growth within the US of electricity use is expected to be below 1% even with all the new electronic gadgets in-use. This is important for two reasons. First, if the electric utilities cannot grow their bottom lines they will be unable to directly pay for either major upgrades to their transmission grid systems or the new energy sources that the government is pushing. If these new expenses are to be mandated, either utility rates will have to rise and/or the government will have to subsidize these efforts. Neither will help the consumers or a struggling economy. The second reason is that slow growth in the US use of electricity is an issue for those of us who are concerned about the growth in China. One of the departing leaders from the top group of government officials publicly indicated that he felt the quality of the data for their own GDP calculation was “soft.” He preferred to use data on electricity usage and bank loans as more accurate indicators of their growth. If the Chinese eventually follow our pattern, their growth in the use of electricity per person will decline which may possibly hurt our ability to understand what is happening in what will be a major market for our goods, services and capital.

What do these market prices indicate?

1.    The first week’s surge, which cannot continue for long, may have had three unusual inputs. First, those with too much cash un-invested felt they had to get in, for the realization of the impact of the tax bill was turning their cash into trash. Second, those who had large accumulated losses without much near-term hope of getting even wanted to recognize their higher tax value losses. Third, US investors wanted to protect the dollar value of their portfolio by moving some of their money into multinational stocks.

2.    Lipper, Inc., now a part of Thomson Reuters has international, global, and largely domestic mutual fund categories for the various types of funds. On average the international funds performed better than the global funds which in term did better than the domestic oriented funds. Most of the superior results, particularly in the fourth quarter, were due to translation gains. The foreign currencies, euro, yen and pound, rose relative to the US dollar or if you prefer the dollar declined relative to its investment competitors, just as the Fed wanted.

3.    The yield spread between high yield bonds relative to treasuries of similar maturities is the narrowest on record, below 6%. The owners of these “junk bonds” are betting on an economic recovery with a relatively low default rate. As some of the buyers of this paper are essentially “yield hogs” rather than sophisticated analysts, this may be a danger signal. One indicator that I have quoted before may show the growing confidence in taking risk. The Barron’s Confidence Index published each week is a comparison of the yields of higher-quality bonds to mid-quality bonds. The index typically moves about 1% point a week, This week it rose  2 percentage points which normally is favorable for taking risks in stocks and therefore "junk bonds."

4.    The movements of the stocks of financial services companies are important to me for two reasons. First, in our global economy we transmit our wishes through financial channels; so the health of those channels is important. Second, as most of the readers know, I manage a private financial services fund along with much larger portfolios of mutual funds that I also manage. As mentioned above, some analysts significantly lowered their 4^th quarter earnings estimates for the financial stocks. The prices of these shares have been rising and particularly in the first week of the year. I believe one of the reasons for their gains is that the committee proclaiming the Basel III agreement has wisely become more flexible as to what is to be considered good capital for banks’ liquidity reserves and delayed its full implementation to 2019. (I suspect moving away from a reserve made up of sovereign bonds was viewed as slightly risky compared to a collection of high quality securities including some mortgages and even equity.)

5.    The markets reacted strongly to the publication of the latest Fed meeting minutes, where for the first time in the minutes (but not the first time in individual governor's speeches), there was concern expressed by some with the continuation of their various “quantitative easing” policies expanding their balance sheet. Possibly we won’t see their attempts to manipulate interest rates forever. As already mentioned, the Fed recognizes it may not possess the right tools to understand the economy. (I am wondering if in the future our “normal” level of unemployment will not be deemed to be closer to 7% with lower rates touching off higher inflation fears.) Further, I suspect that in examining the labor force participation one should look at six sub groups: employees at small, medium and large enterprises plus federal government workers, state and municipal workers excluding teachers. I would suggest that each of these groups have different needs and impacts on both our economy and more importantly our society.

6.    Later this coming  week my good friend Byron Wien will formally present his thinking about the surprises he expects for 2013. One of the reasons that I like Byron is that he has a strong streak of a contrarian in him, as many survivors do. He has a good batting average on being right on his surprises. As a contrarian myself, I hope that this year he will not do as well as usual, as many of his pre-published ‘surprises’ are already uncomfortable to me.

Please share with me how 2013 looks to you.

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Copyright © 2008 - 2013   A. Michael Lipper, C.F.A.  All Rights Reserved.

Financial Services Stocks: Separating the Walking Wounded from the “Zombies”

As regular members of this blog community know I am a “Civilian Marine” (the term used by the USMC Commandant to describe Marines no longer in uniform) and a manager of a private financial services fund. With these two inputs one can see how I tend to view last week’s news on financial services earnings.

Disappointing earnings for Financials

During the week, a number of large financial services companies reported their fourth quarter and calendar 2010 earnings. With the exception of Raymond James Financial, which we own, most observers were disappointed with the results. I was not disappointed as I did not have very high expectations for net interest income and retail volume. My modest views were due to the recognition that past battles have left deep scars that are now only slowly healing. But as an aftermath of prior battles, one can start to see the difference between the recovering walking wounded and the staggering lurches of what look like “zombies.”

The walking wounded

The recovering walking wounded members of the financial community are showing environmental scars of both low investor appetite for some of their products and services, as well as new wounds from less-than-helpful regulations. These firms will continue to recover as the global economy continues its progress. Their cultures are largely intact as are their senior managements who have worked successfully together for many years. Their survival is largely ensured.

The “zombies”

The “zombies” have not only suffered the same elements of damage that the walking wounded have suffered, but have also endured much more serious and perhaps life-threatening rescue acquisitions. The zombies have added failed cultures to their already weak cultures. In many cases they have had to import outside executives to fix their problems quickly. These are high risk maneuvers which did not play well on last week’s earnings pages.

The significance

Why should diversified portfolio investors pay attention to the financial services stocks? First, in a period of paucity of growth opportunities, much of the available merchandise is selling well below its prior peak prices. If one believes that we will eventually equal or surpass past market prices, then large segments of the market are reasonable candidates for current purchase. The S&P 500 Financial Index is selling under half of its former peak levels. Last week’s decline of 1.66%, gives an interesting window. Second, a bull market not including financials is difficult to imagine. This is particularly true in most of the developed markets, where the financials are the largest single market cap components.

As the fog of past battles (read mistakes) lifts the separation of the walking wounded vs. the zombies, the prudent long term investor may receive an unusual opportunity.

What do you think?

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