Misunderstanding Technology Can Be Dangerous - Weekly Blog # 507

Introduction

Investors do not understand the current stock markets. Globally most stock markets are rising and most have reported record highs in spite of political instability. The driving forces are both normal and novel. In many economies we are experiencing a normal cyclical recovery as both confidence is rising and memories of past crises are receding. What is more novel is the exponential growth in the use of technology to address many problems.

One of the advantages of being part of this blog community is that we have a large number of thoughtful members. One of the most responsive members has called to my attention a Financial Times article by Jim McCaughan, the CEO of Principal Group Investors with the intriguing title “Investors must get to grips with impact of technology.” While contemplating this article I examined a report on the S&P and the Dow Jones Sharia indices. These various stock market measures show that in many of the emerging markets and frontier markets that cater to those who wish to follow the Sharia laws for investing, that information technology is the best performing segment. This is appropriate because the growth of technology is accelerating economic growth. When illiterate farmers can price quotes and weather forecasts daily on their cell phones, they will manage their own economics better. Their families will also benefit when they can react with professional medical and nutritional experts. Perhaps these advantages will become the most effective birth control devices the developing world has ever seen.

In my continuing search for understanding why so many very intelligent people continually make more economic and perhaps political decisions that prove to be unfortunate, I suspect that they are using faulty memories of incomplete and in some cases faulty data. It almost seems the more PhDs and other credentialed “experts” that analyze a problem the odds of finding the “Aha moment” decreases.

Measuring The Impact of Technology

I suspect that no class of financial institutions has more learned PhDs than the central banks, particularly the Federal Reserve System. Yet as a mass they have been surprisingly unsuccessful in predicting inflation as it drives their policies. For example they rely on payroll data and other information from the IRS. There is little attempt to capture unreported income. In many countries the “informal economy” is of sufficient size to question the aggregate, growth, and relative ranking in global tables.

Perhaps the biggest failure to capture the economic reality is in the measurement of consumer and commercial prices. On the surface it is reasonable to assume that technology is deflationary otherwise it wouldn’t be bought. The deflation is not just in reported prices, but more significantly the added value that brought through technology. For instance how much are we better off in general with cell phones than landlines? What is the net benefit of shorter transportation time due to speed and safety of mass transit? These are not easy calculations but suggest that the real economy has been growing faster than realized due to the deflationary technological input. Is this the reason that no developed country has hit the 2% desired inflation target identified by the New Zealand central bank?

On the other hand we should also be measuring and understanding the disruption that technology has caused in terms of unemployment and wasted capital resources. Hopefully, we will see more re-engineering and rebirth of former sites. For example some shopping malls are becoming education, health, and service providers. Once services providers can demonstrate value added through sales and retention skills, these wages will move back to old industrial levels. They will accomplish this through smart applications with personal choices through the use of technology.

What Does The Future Hold for Investors? Avoid Reliance on Numbers

First, the question is flawed. The biggest single mistake most individual and institutional investors make is to think of the future as a singular event. One of the reasons we have evolved our TIMESPAN L Portfolios® is to force investors to allocate their resources to different timespans based on their own needs and proclivities. The allocation of capital and intellectual resources is the single most effective method to reach most goals.

Second, is how to handle the various types of price declines (seasonal, cyclical, secular, normal, abnormal). As we can’t avoid them, we need to set some policy goals as to which we “grin and bear it,” make partial adjustments, radical change, or more appropriately different actions for different timespan portfolios and/or different levels of fiduciary and commercial responsibilities.

Third, questioning to perceived wisdom based on unadjusted history. For instance, searching for persistence. Looking backwards for various periods of time which are heavily influenced by beginning and ending conditions there appears simplistically little persistence particularly in top quartile performance rankings. Most individual and institutional investors are goal oriented not ranking oriented. History suggests that the main value to an investor is the timing of the initial investment as well as flows into and out of the account. By definition the biggest gains come from buying into a lowly regarded price and selling into excessive enthusiastic prices. Persistence is rarely found in humans, sports teams, and political leaders. Allow me to demonstrate with the use of fund performance statistics from my former firm, Lipper, Inc., now part of Thomson Reuters.

For the five years ending Jan 18th, 2018 the average S&P 500 Index fund had a compound growth rate of 15.36%. Not only is this way above a historical average it is better than all other mutual fund investment objectives except five, including Large-Cap Growth which had a 77 basis point better return. This may show the advantage that we have maintained for a long time that for some remaining fund holders net redemptions can be a positive, as all portfolios can use some pruning. More importantly, performance while it does impact sales, is not particularly related to redemptions which are more time based. Referring back to the main topic of this week’s blog: technology, the best single performance group was the Global Science/Technology fund which gained 22.09% vs. the average S&P500 fund that gained 15.36%. While I don’t know who will be the winners for the next five years, I think it won’t be the S&P500 index or the Global Science/Technology funds.

Some Straws in the Wind

Before a significant storm often, there are some straws in the wind. The following anomalies are noted:

Barron’s Best Grade Corporate Bonds yields went up last week 8 basis points which means their prices went down a proportionate amount. However a similar index of intermediate credit grade bonds yields only went up 4 basis points. Typically high grade investors are more safety oriented and credit investors more income focused. The possible importance of these observations is to not worry about the safety of high grade corporates paying off their obligations in a timely manner. I believe the significance of the price decline is that these investors and their dealers are worried about their near-term bond prices because of a surge in the supply of high credit bonds. If these fears grow it can create instability in the bond market which could impact the stock market either because a change in outlook or a credit shortage supporting the stock market,

The AAII bulls are running again with 54% of their weekly sample bullish compared with the pull back experienced the prior week of 49%. The bears pulled in their teeth with a reading of 21% compared 25% the prior week. Momentum is continuing.

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A. Michael Lipper, CFA

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Could this Weekend be a Turning Point?

In the US, as in other countries on other days, Memorial Day is set aside to honor those that have sacrificed their lives in war to protect our nation and its citizens. In observance of Memorial Day, US financial markets are closed.

Watch global markets before US markets opens on Tuesday

As of this writing, the Japanese market is down -3.5%. One reason that the market is lower is that the Bank of Japan leader indicated it could tolerate a 3% yield.  Another reason the market is down is news that Chinese leaders have announced that they are willing to grow more slowly. At the moment, US futures and the price of gold are weakening slightly. Also the Australian dollar is weakening against the US dollar.

With the US markets closed on Monday and relatively thin trading in much of Asia, prices could trade freely with sharp moves both ways. Unless the afternoon session in Tokyo reverses direction, the results may not be pleasant by the time New York opens Tuesday morning.

Positive views

There are mixed implications derived from what I have seen this past week.  First, let me deal with the positives.

Shoppers shop

In almost all countries of the world retail shopping is by far the largest sport in terms of involvement and money transferred and thus well worth examining. The Memorial Day weekend is considered the unofficial kick-off to the summer shopping season in the US. In our community the weather on Saturday was cool and wet. When we went over to the Mall at Short Hills, a very glitzy place to do our indoor walking and getting a bite of lunch, parking was difficult. We encountered crowds with large shopping bags. (Other weekends some of the aisles within the enclosed mall and a few entire stores could have been profitably converted into bowling alleys.) We walked and had lunch and returned home for me to read. My champion “black belt” shopper of a wife went back to the Mall and ran into friends who were also shopping. When she left she should have auctioned off her parking space which was in great demand. Her competitive shopping eye reported that the crowd was approaching those at Christmas time. Perhaps it was the unseasonable weather or advertised sales prices from an investment viewpoint; the key was a lot of people were spending money at good prices.

Borrowers borrow

Another example of people making investment decisions is that the size of margin debt (borrowed money) has just exceeded the old record established in June, 2007. A number of retail brokerage firms have commented that the proceeds of this debt have not been put into additional securities investment. My guess is that an important portion has been in “non-purpose” loans, probably used for real estate purchases. The brokers point out that it is easier and involves less collateral to use futures, particularly on ETFs (Exchange Traded Funds). Nevertheless buyers are buying.

Cash is trash

One of the reasons people are being led into using securities for their spare cash or buying power is that cash has become increasingly considered trash in their minds. Almost every day I look at the average rate being paid on bank money market accounts. This week it dropped to the lowest level that I can remember of 0.46%. The central bank manipulators around the world are driving people into the market, but looking at the large amount invested in money market funds and bank accounts, there is a lot more remaining.

Incomplete gravity

After the considerable rise we have seen and benefitted from this year, many of us had expected a correction. Some have been waiting for this expected correction and keeping their trash/cash on the sidelines before committing to the pressures by the monetary authorities. Thus we had two consecutive down days on Wednesday and Thursday. But on Friday, with light volume, we had a minor up day. There are two remarkable observations to make. The first is that lower prices did not bring more sellers or an increase in buyers to the marketplace. The second item is we have not had three consecutive down days for the last 100 trading days. My friends at Caltech assure me that what goes up must come down according to laws of physics. Market technicians would generally expect a trading correction in the range of ten percent of the prior rise before a subsequent gain. For whatever reason investors, are not now ready to leave the party.

The best market timers are now bullish

In this week’s Barron’s my friend Mark Hulbert noted that in his long study of market timing newsletters the ones that have had the best record of correctly getting turns in the market remain very optimistic. From my standpoint what is more important is that the timers who have gotten the turns wrong are relatively reserved, with significant portions of their recommended portfolios out of the market. The reason I believe that being mindful of the laggards is more important than the good prognosticators being bullish is that in my continuing study of mutual funds and other managers it is not unusual to see good records lead to occasional bad results. There appears to be much more consistency in poor predictors staying bad. Finding negative predicators is very valuable indeed.

Mutual fund buyers are beginning to believe

My old firm, now known as Lipper Inc., which is an affiliate of Thomson Reuters, measures mutual fund performance and net sales around the world. Using the first quarter and reporting in euros, funds sold to Europeans in Europe had inflows of 116.5 billion compared with the US’s industry inflows of 155.4bn. Perhaps more important was the gain in Germany of 7.3bn which may be a retail leader for the continent. Large net inflows were seen in Thailand, 16.2bn and South Korea, 12.1bn (all in euros).

The first quarter numbers predate both the turbulence in the Tokyo market last week and the prior surge in Japan created by its adoption of a highly charged “QE” monetary policy, which in May probably brought a tidal wave of money into funds investing in Japan not only from within the country, but also from the US, Europe, and the rest of Asia. My guess is that judging by the rise in the Tokyo market (until this week) we are talking in excess of $50 billion in positive fund flows. All of these flows indicate that individual investors, along with institutional investors, recognize and want to participate in momentum wherever they sense it.

There are important negatives

When the Chairman of the Federal Reserve indicated that its staff has been directed to study ways it could ease off in its Quantitative Easing (QE) policies, the US markets caught a slight cold (under 2%), but the Tokyo market got pneumonia, falling 7% in one day.  This decline demonstrated how dependent Japan is on US Quantitative Easing and how thinly traded the Tokyo market is.

In his May 25^th long economic letter, John Mauldin focused on what the current government of Japan is attempting to do with its extreme QE policies, which until this week was working both in the local stock market and Japanese exports. Mauldin is a believer that QE won’t work in the long-term in that Japan has fired the first official shot in a currency war that will be met with Asian and perhaps other competitive devaluations. His real fear is that it will work for awhile and allow Japan’s share of the world’s wealth to get much larger on the back of absorbing all of the savings in Japan. When that is not sufficient to grow Japan out of its twenty year deflation and as its enlarged bubble bursts, it will materially hurt the US and others. The title of his piece sums up his views: “The Mother of All Painted-In Corners.”

“The Ghost of 1994 Haunts Financial Markets”

“The Ghost of 1994 Haunts Financial Markets” is the title of Moody’s latest capital market research report. In the piece Ben Garber reminds us what happened to the markets when the Federal Reserve unexpectedly and sharply raised interest rates. This led to some of the worst performance returns on record. While the Fed is conscious of this fear and that may be why the astute President of the New York Federal Reserve Bank is stating that it would take the Fed a number of months to decide to raise rates and a further number of months to effect the change. My concern and perhaps others fear that the need to make a change could be sprung on the Fed by unforeseen events, they do happen. Moody’s is also a bit skeptical as to whether Japan can accomplish what it needs to do to get some growth out of its economy without both a US GDP expansion and the cooperation of the currency markets. These are wise concerns.

What should we do now?

My recommendation is for long-term oriented investors to continue with their current policies. For those that believe in managing accounts through asset allocation changes, I would urge you to average in and out of positions. For those that have to report results this calendar-year, going to large cash position could be prudent. I believe we are in an emotional news cycle that can stampede markets on a daily basis without much total new movement this calendar year. The year 2014 also looks problematic until we see who will chair various committees in the US Senate plus the actual new policies by the leaders in Germany and China.

Do you have differing views?

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Did you miss Mike Lipper’s Blog last week?  Click here to read.

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 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission

Should We Appreciate Bonds? Part II

Cocktail parties for charities often reveal more investment concerns than those expressed in an organization’s formal meetings with investment advisers or investment committee members. In this age of unusually high fixed income yields and low total returns from common stocks, taking advantage of spreads for capital appreciation, not primarily income and capital preservation, can be unnerving. The question of whether this new approach is a sound one for a fiduciary has been expressed by members of several charity boards and committees.

As many of our regular readers know “Monday Morning Musings” is written largely on Sunday evening. As some also may know, on Sundays I spend time with Barron’s, the oldest and (and in my view) the finest statistical package of data. I also use the weekend to peruse my old mutual fund analysis reports, now produced by Lipper, Inc. With these resources in hand I can more fully address the propriety of using credits, in this case corporate bonds, to make money for fiduciary accounts.

Each week Barron’s publishes a list of the 40 corporate bonds with highest estimated trading volume for the week. One of the most useful columns in this display is the estimated spread between the current yield and those of US Treasuries of similar maturities. As there are all kinds of buyers of bonds in the secondary market, these spreads vary widely from the lowest, 79 basis points (0.79% of 1.00%) to 1175 basis points. The suggested strategy is to buy investment quality corporate bonds whose spreads with treasuries are 300 to 400 basis points above a more “normal” spread of 100 basis points. In examining the April 17th list, I found there were seven bonds with a 400 point spread, and eight with a 500 point spread. The proposed strategy presumes a mini-portfolio of about four bonds, so there are a sufficient number of candidates in the most liquid of cases.

A more difficult question as to what is the “normal” spread, sent me to look up the data from the year-end Lipper Fixed Income Fund Performance Analysis Report Certificate Edition for 2006. The data is somewhat like comparing apples with oranges as to their weight and caloric content. Nevertheless, this was all that was available to me over the weekend. There are three distinct mutual fund peer groups which can be compared: General US Treasury Bond Funds, Corporate Bond Funds - A Rated and Corporate Bond Funds – BBB rated. As distinct from the proposed strategy that only includes four issues, each bond fund in the peer group may own more than 100 individual bonds. Each fund only has to assure the SEC and my old firm that the majority of its holdings meet the minimum credit rating in the title of the peer group assigned to them.

Another complication is that funds have expenses which are deducted before the yield and total returns are calculated. By adding back the average total expense ratio to the reported yield, we get the average gross yield in the average portfolio. As of the end of March 2009, the adjusted yield spreads compared with treasuries were 246 basis points for the “A” rated Bond Funds, and 327 basis points for the “BBB” rated Funds. Using the same approach for year-end 2006, the spreads were 174 basis points for the “A” rated and 231 basis points for the “BBB” rated funds. Therefore there appears to be the historic possibility of a 96 basis point pick up using funds alone, which leaves no room for security selection skill.

While we professional investors fixate on relative performance and yields, our clients spend actual dollars, not basis points, so absolute return becomes critical to them.

At the time when one expects to use an investment, a decline in the absolute is extremely painful. So what can go wrong with the proposed strategy? The credit quality of the owned bonds can decline. (In theory, this is answered by the chosen manager following both the issued bond and the underlying stock on a day-to-day basis.) The next major risk, and one that I feel is much more likely, is that inflation and not deflation becomes the problem, causing investors to demand and get higher yields on new issues of US Treasuries. The higher yields on the new issues will drive the yields on existing bonds higher and therefore prices lower. While the spreads could questionably narrow, the prices of the bonds will decline under those circumstances. (One possible counter argument is that a balanced portfolio with a majority of equity investments, often drive equity prices higher initially.)

The fundamental question facing the fiduciary is whether the odds on tightening in the near term future far outweigh the longer term risk of specific credit problems and/or rapid inflation. My attitude is that the strategy could work well in the hands of a skilled active manager of selected bonds, but not a strategy to be recommended for individual investors or most institutional investors. The next cocktail party questions should be around demonstrable skills, not investment policies.

(This post is a follow up to my March 30, 2009 Blog entitled,
“Should We Appreciate Bonds?”)