Enthusiasm Now, but Little Appreciation for the Long Term

Introduction

One of the reasons I developed the concept of the Timespan L Portfolios^® was to be armed with a tool kit for market conditions just as we are seeing now.

Whenever I am asked whether this the right time to buy or sell a security, my immediate responses is to inquire, “What is your time horizon and what is the benchmark that you will use to judge your success?” Depending on the answers I often try to help with suggested actions or at least elements for future consideration.

All too often securities analysts think of the future only in terms of the past. For periods of a month, the range of the vast majority of outcomes is roughly plus or minus twenty percent. If the measurement period is extended to a year the range of expectations could be bound by plus 100% and minus 50%. Over  longer periods, including average lifetimes, the extreme range is over +1000% to a total wipeout. Thus selecting your time frame or better yet the timespan of your controlled actions becomes critical as to how you organize and manage your investments.

Investment Satisfaction

In many ways the choice of appropriate benchmark has much more to do with your ultimate level of satisfaction than many of your other investment decisions. Your choice of benchmark comparisons will demonstrate the thoughtfulness that you apply to the investment decision-making process. All too often most people will compare their results against the unmanaged indices published in the media. They won’t understand the selection biases that are built into every index produced, including the ones that I created for much of the mutual fund industry. But the biggest fallacy in using securities indices is they don’t capture the investor’s expenses including an appropriate allowance for the individual’s time, expertise, and worries. These drawbacks are largely answered by using mutual fund indices that are also available in most professional media. Included in the fund indices are all of the costs of operating the funds that largely address the investor’s own costs of operating an individual security portfolio.

Within the Timespan L Portfolios often there is a mix of fixed income securities and stocks. That is why many of our managed accounts are primarily benchmarked against the Lipper Balanced Fund Index. For some investors who are managing their portfolios against specific spending plans, an absolute measure is useful; e.g., “Don’t lose money,” which was my informal instruction from the late Executive Director of the NFL Players Association in terms of their defined contribution assets. A further refinement to an absolute return requirement is one reasonably adjusted for long-term inflation.

Thus, I believe the selection of time periods and benchmarks are of critical importance. This brings me to my dilemma today, seeing risk and opportunity in different time frames.

Potentially Rewarding Long-Term

Various market commentators focus their comments on current valuations without regard to the flows into and out of the market. In effect, they are looking at the size and weight of a boat on the sea, whereas I believe they should include the long-term flows and evaporation of the water in their outlook. Some focus is currently being addressed to buy-backs, hopefully net of issuance expenses.

The principal reason that I am bullish in the long-term is the global deficit in retirement capital at the government, corporate, and individual levels. Using the US as a model (which is paralleled elsewhere in 2016) US corporations are expected to add $15.6 Billion to their pension plans. (I expect an even larger amount will flow into their defined contribution plans which are growing faster than their defined benefit pension plans.) The 2016 funding is under 4% of the S&P500 underfunded aggregate of $403 Billion.

Pension plans are shrinking as the major US corporations are not fully replacing retiring employees. A similar trend is likely to happen to the earlier adopters of 401(k) plans, but they will grow through market appreciation.

I expect that we will see some significant adjustments to both IRAs and 401(k) plans that will allow retirees to continue to accumulate assets in these vehicles on a tax deferred basis rather than mandatory distributions.

I also expect many governments around the world will move out of reliance on defined benefit pension plans and into defined contribution plans.

The political, social, and tax implications of creating a new class of focused investors could be a bigger benefit to all than the funding of defined contribution plans.

Short-Term Concerns may be Warranted Soon

After a very trying first six weeks of 2016, global stock markets have entered five surging weeks with current expectations of more to come in spite of the belief that market indices will have a decline in overall reported earnings per share in the first half of the year, including Energy. Current estimates for the S&P 500 as published by ThomsonReuters is for fourth quarter per share earnings to rise by +10.6% led by Financials +21.8, Materials +20.1%, Energy +11.9%. (I have some doubts about analysts’ estimates in general, particularly those that extend too far out.)

As some of the longer term readers of these blogs know, I was not concerned about a major market break because I did not see a great deal of enthusiasm being expressed for market prices. I am, however, starting to get a little bit nervous now. One of our holdings in our private Financial Services fund and personal accounts is the well respected T Rowe Price, a firm that has entered into something of a flat period. On March 14th the stock traded 1.05 million shares. By the end of the week the company traded 2.45 million shares. During this period closing prices went from $71.67 to $73.54. (I am detecting enthusiasm because I believe in the thesis that people and societies will address the retirement capital deficits. One of the logical solutions will be good for mutual fund management companies, however I am not beginning a gradual reduction program that I might do to be an inverse participant in the market.)

There are other signs of bullish market actions. Following a technique that friends of mine used during the Cold War to triangulate the truth they read in Pravda and the Christian Science Monitor, I read the New York Times and the Wall Street Journal. In the Sunday edition of the NYT on page 2 of the Business section there are two tables of interest which are quite bullish. In the first table of the twenty largest traded stocks, eleven were up on the year to date. On the negative side there was only one approaching the normal guideline suggested, -20%. The stock was Amazon ‑18.3%.

From my vantage point the second table of the fifteen largest mutual funds was more revealing. Nine out of the 15 were up on the year. Also nine were actively managed. Six actively managed funds were on both lists and if you include the two that were flat on the year, there were eight out of nine that showed progress or were flat. With all the media hype as well as various pundits pushing index funds, it is nice to see that some active managers are earning their fees in what has been a very difficult market.

Bottom Line

For our second or Replenishment Portfolio in the Timespan Portfolios I would start to plan gradual risk reductions in inverse proportion to signs of enthusiasm. For the Endowment and Legacy Portfolios I would continue to selectively add well managed funds and advisors.

Question of the week: What are your personal indicators of too much market enthusiasm?         

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

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Copyright © 2008 - 2016

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

Fixed Income Risk Hurts Alternative Funds

Introduction

Debt and equity are the two essential building blocks for all portfolios. With the current dichotomy between equity and debt indicators that were hinted at in last week’s post there appears to be more risk of capital loss in many alternative funds than investors perceive.

Surge in Introducing New Alternative Funds

As with most “new” ideas, nothing is rarely new, but a reworked old idea in new clothes, often the famed emperor’s new clothes. Early British Trusts as well as US vehicles were primary concerned with the preservation of capital for multiple generations; an idea that appeals to me and many of my investment accounts. The adopted solution used in many cases were the selection of investments that often move in inverse directions avoiding chances of complete destruction from a single event, think of Lloyd's Shipping syndicates. As these investment vehicles grew an additional defensive mechanism was added, diversification. Thus, in the US many of the first funds were balanced funds that held diversified bond and stock holdings. Still today many bank trust accounts as well as other institutional investors compare their investment performances to the Lipper Balanced Fund Index found in the Wall Street Journal and currently produced by my old firm. However, the traditional Balanced fund has been replaced by a whole category of Mixed Asset funds with current net assets of $2.2 Trillion or roughly equal to the total US hedge funds and in the same region of US listed ETFs (Exchange Traded Funds). In Canada Balanced funds are the single most popular fund type.

From this base many new funds were launched with the same desire; that is to offer to investors a less risky way to achieve good upside performance with controlled downside risk of loss. Right now there are approximately 500 of these products on offer in the US. Recent trips to Canada and Europe revealed that alternative funds have become a hot sales item. Almost all of the newer versions of Balanced funds in addition to stocks and bonds of various types include derivatives, private equity, venture capital, use of leverage, and selling short. In the past, there have been a handful of experts that have produced very worthwhile results individually with these types of investments.

There are two types of risks in these funds, the management company created risks and the inherent investment risk in the asset class. Many of these vehicles are being produced and sold by investment groups that have hungry indirect and direct sales forces for new products after several years of lackluster performance from their historic book of business. They either try to develop portfolio management talent internally or hire past winners in smaller shops with significant incentive contracts. Considering many of these firms past history to me either approach adds to the risk in their vehicles.  As we not only invest for clients and ourselves in many mutual funds, we also invest in many of the world’s publicly traded management company stocks. Thus we measure results from different vantage points. This is similar to a comment in the recent The Economist on celebrating the 100 anniversary of Einstein’s 10 equations where they said “What you measure depends on your vantage point.” To us the long term profitability of the management company contributes to the attractiveness of some of its investments, particularly in markets that are crowded with good competitors.

The inherent investment risk in most Alternative Investments is based on the structures of interest rates and credit conditions. Granting a huge assumption that the specific portfolio is not at risk as to what looks like significant changes coming, other portfolios will be at risk and that will cause prices and flows to change, perhaps in an unpredictable fashion.

Fixed Income Indicators of Investment Risks

The market speaks often in numbers and price movements not providing full explanations. For example:

Last week Barron’s measure of “Best Grade” bond yields declined 3 basis points to 3.75%. indicating an increase in popularity for high quality. In the same week its measure of yields for intermediate credits rose 6 basis points to 5.12% measuring some uneasiness about intermediate credits. (One might look at these relationships and postulate that the stock market is not in danger of losing assets to bonds until short-term rates run up to 3.75%  to 5.12%. I have always believed that the Bond Market is a better analyst than the stock market, as it has to be, for it has a lower upside potential.)

Last week one of the credit agencies noted that since there has already been 99 defaults this year, we will soon be in a triple digit period which is likely to grow.  Considering in general the relatively low revenue growth of non-energy companies, the odds favor more defaults and are the reason for the increasing of the yield spread on “junk bonds.” Stock funds including ETFs had inflows of $2.9 Billion and Bond Funds had net outflows of $2.8 Billion in the week ending before Thanksgiving.

By nature I am uncomfortable with crowded markets because the participants often accelerate their price/volume actions to get out of the crowd as fast as they can. Thus, I found of interest that Bank of America/Merrill Lynch produced a list of the four most crowded markets in the eyes of hedge funds:

 1. Long US Dollar

 2. Short Commodity Stocks

 3. Short Emerging Market Stocks

 4.  Long US Tech Stocks

If I had long-term risk capital, my instinct would be to take the opposite views of these hedge funds for the first three and possibly the fourth bet.

The three Alternative investment objective classification averages on a year to date basis are minimally above or below the average of US Diversified Equity funds and well below the average Large Cap Growth fund and other funds that own the “FANG” Group = Facebook, Amazon, Netflix, and Google or a slightly larger group known as the “Nifty Nine,” including the first four plus Priceline, eBay, Starbucks, Microsoft, and Salesforce. Both groups are up 60%.

Perhaps, the most salient point of analysis is that because of the other somewhat dour coverage I did not see the need to go over to the Mall at Short Hills to report “good, but not great” Black Friday. I will be interested to see how the merchants handle their inventory liquidation.

Question of the week: How much risk do you perceive in your bond holdings?     

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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.