From One Week to Eternity with Reason - Weekly Blog # 543

Mike Lipper’s Monday Morning Musings

From One Week to Eternity with Reason

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

Investors’ Dilemma
“Buy and hold forever” is an easy and dangerous command that investors’ issue to themselves. The one guaranteed aspect of life and investing is that conditions change, often in surprising ways. Because making investment decision is frightening, there is a natural tendency to make as few decisions as possible, recognizing that we might be wrong. This ignores that everyday an action is not taken is a decision in itself. The one sure bet is that the conditions that underlie any decision are likely to change, both for the investor and the investments, be they individuals or institutions.

One way to deal with a big problem is to break it up into a series of smaller problems. That is why I trademarked the TIMESPAN Lipper Portfolios TM. This approach allows the individual and portfolio manager to select the appropriate strategy and tactics for each important time slice. (I would be pleased to discuss this application to subscribers’ own needs.)


Professional Portfolio Managers’ Commercial Dilemma
Professionals are hired to think about and do something with the money entrusted to them. Since thoughts can’t in and of themselves be measured, many investors evaluate their investment advisers solely or largely on the activity of buying and selling in their accounts, when at times it makes more sense to do nothing. (Dividing the long-term records into high and low turnover managers, the low turnover managers tend to produce better investment performance records.)


What to Act on and When?
The key is in the straw, that is the final straw that breaks the camel’s back. The more risk averse among us may prefer to wait to a time closer to the final collapse. Again, both the professional and individual investor should be conscious of impending changes to the investors’ condition.

Evaluating the changing conditions of the underlying investments each week, I peruse lots of hard and soft data in an attempt to understand their implications for the various time spans for which we are responsible. The rest of this blog is devoted to what I looked at in the latest week and why they might have longer term implications. 


Markets

• US stocks appear for the second consecutive year to outperform US Treasuries. This is the longest such period since 1922-28. (Caution warranted)

• The six largest countries (G6) are again spending a smaller portion of their GDP this year than they did in 1948. (We won’t be able to fulfill the population’s demands if we can’t deliver goods, services, and people inexpensively and efficiently. This could be an opportunity.)

• By 2050 the cohort of 65+ will more than triple. (Potentially important for both the real work force and healthcare). Adding to these trends is the likelihood that babies born today will be alive for one hundred years.

• Each week The Wall Street Journal publishes weekly price changes for stock indices, currencies, commodities, and Exchange Traded funds. In the latest week, the top three performers that all rose approximately 7% were commodity related and were down considerably earlier in the year. The next three largest gainers were foreign stock markets that likewise were recovering from earlier declines. (I am wondering how much of these extraordinary gains are from short covering. The general characteristics of the six are sudden/rapid changes in perception, low level of present market liquidity, and the availability of margin to support derivatives.)

• NASDAQ(*) reported that the trader who defaulted on $134 million of derivatives will pay back the default. (This probably reassured the derivative market that we aren’t facing a mini repeat of the Long-Term Capital Management insolvency). 

• There is a published market rumor that Mass Mutual Insurance is selling Oppenheimer Management for approximately $5 billion, which would equate to 2% on assets under management. This would be considered a good price in today’s market. (If the rumor is accurate, the buyer is also in the business and can use some of the investment and marketing talent. Insurance companies have regularly entered and left the mutual fund business. Cross-selling is more difficult to do well, resulting in volatility and risk)

• The Dow Jones Industrial Average and the S&P 500 developed price gaps. Most of the time prices can’t move much until these gaps are filled. (Short-term caution) 

• The market was unexpectedly kind to my examples of the type of stocks that would be suitable for adult children that are not focused on investing (Berkshire Hathaway (*) and those suitable for grandchildren as a long-term change agent BYD (*)  

Bonds

• According to a Barron’s, an index of high-quality corporate bond yields has broken through 4% vs. 3.19% a year ago. According to the perceptive Marcus Ashworth of Bloomberg, this could be caused by there not being enough high-quality European debt to meet the demand in a period when European companies are growing at half the rate of those in the US. In addition, it is expected that for the next several years there will be little to no net new German government issues. (If this is correct there are two likely results. The first is greater demand by Europeans for US debt and second that US companies will issue Euro backed debt. American companies have substantial European operations and sales.)

• The Financial Times devoted a full page to large private equity shops that have become even larger factors in the private debt market. These and other non-bank credit providers have taken significant market share from the traditional bank lenders by employing heavyweight deal makers, thus improving the certainty of closing with less stringent terms (covenant-lite) in exchange for higher interest charges, which in some cases are floating rates. Moody’s (*) has noted that 80% of the currently marketed issues are covenant-lite. Howard Marks is quoted as saying “The seven worst words in the world are: Too much money chasing too few deals.” (If there is an actual or rumored sudden credit market problem involving leverage or derivatives, it is very likely that the stock market will feel it.)

Trade

• The three fastest growing export markets for the US since 2001 are: China 580%, Hong Kong 140%, and Mexico 140%. (In looking at the three leaders I wonder how the transshipment numbers are handled. The whole practice of global supply chains makes looking at national data questionable, at least to me. Are Apple (*) cell phones US, Chinese, Korean, Taiwanese, or Japanese products?

• In 2016 Asia outpaced North America in patent filings by more than 3 to 1. (There is a legitimate question as to the commercial value of some of these patents.)

Mutual Funds

• Utilizing the Lipper Investment Objective Fund Indices for the week ended Thursday, the leading categories were: Precious Metals +4.59%, Global Natural Resource +3.15%, European Funds +2.60%, Financial Services +2.37%, Pacific Region +2.32%, and Emerging Markets Stock funds +2.05%. In each case these categories are recovering from earlier poor performance. Not a single one of these categories beat the S&P 500 Funds Index +10.83% on a year to date basis. Small-Cap Growth +21.48% and Health/Biotech +20.64% almost doubled the market measure, but they are also playing catching up for longer periods of underperformance. (There appears to be much greater selectivity required to come up with a top performing investment objective. This suggest narrowness of leadership, which is more prevalent around peaks.)

• The dominance of very selective ETFs is probably due to a relatively small number of trading organizations like hedge funds or leveraged investment advisors. For example, one ETF drew in more net inflows than all other equity ETFs. The SPDR S&P 500 took in $2.7 billion for the week compared to a total net equity fund inflow of $2 billion. The figures are from my old firm, now a part of Thomson Reuters.

Working Conclusion
There are short-term trading opportunities and after at least a measurable downturn, longer-term opportunities.


(*) A position in these securities are owned in the private Financial Services fund that I manage and/or I own personally.
       

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

Did someone forward you this blog? To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA
All rights reserved

Contact author for limited redistribution permission.

Will Monday Morning Show More Blood in the Streets and Contagion?

Most of the time writing a blog on a Sunday for Monday consumption is a relatively low risk endeavor. Not today. The riots in Egypt (with some echoes in other Arab countries) are building to a climax that can frighten or relieve market participants Monday morning. More likely the surface political issues will not be settled and the underlying causes of unrest will not be really addressed. Nevertheless, those of us in this blog community have an obligation to act responsibly for our portfolios. Perhaps one of the few benefits from these events is to follow the dictum of the President of Caltech and others, not to waste a crisis as a motivator for fundamental change.

What have we learned?

Ever since Vietnam, the ultimate outcomes of war have been manipulated (or if you prefer, directed) by people viewing various actions on their home screens. In this more modern age, the home screen is increasingly a computer or smartphone screen. The regime in Egypt is probably mindful that the Iranian revolution was sparked by smuggled audio tapes imported surreptitiously and played in darkened rooms which spurred the unhappy into action. Today’s response is to pull down the country’s Internet and social network sites, rallying many young people to stream into the streets and squares.

The first lesson here is to more fully appreciate how electronic communication is reshaping our world politically as well as economically. For us in the investment world, we should understand that the Internet and smartphones are the new electric and gas utilities of our era, as their services have become essential to billions of people. While some of the providers run significant technological risks, there is little risk that the demand for communication services will decline. This suggests that there is some form of guaranty of activity similar to what made electric transmission and gas pipeline stocks and bonds more attractive than their industrial competitors for investors’ capital.

The second thing that I learned on Friday is that not a single market pundit that I know identified a general market risk of a disruption in Cairo. Risk managers were once again unaware of these risks. True, many of us were nervous as to the acceleration of bullish statements being issued by many pundits. Some of us were nervous and curtailed purchases, but none that I know accelerated sell programs. From a technical viewpoint, the January gains masked some deterioration.

A similar situation occurred in the week before the assassination of JFK. The internal structure of the market was weak due to fears of additional brokerage firm failures coming from the Salad Oil Scandal. When the announcement of the tragedy in Dallas was made, buyers disappeared except for some brave and foolhardy specialists on the floor. Sellers dumped positions fearing a possible coup d’état. Following a nervous weekend, the markets rallied.

Asset allocation in times of crisis

If there is a bad perceived outcome on Monday, most portfolios will decline in value and the correlation (at least in terms of direction of the various allocations) will be similar. The appeal to most investors of asset allocation is that it creates diversification, which is meant to lower the overall risk of the investor. One of the lessons of the sharp market movements over the last two years is that price movements of many different types of assets moved somewhat in lockstep. I suggest that normal asset allocation today is not a major help in risk reduction. What may well be of better use is the selection of advisors and analysts that see the future quite differently. Some bearish inputs can help a long biased portfolio. In theory, this is one of the benefits that could be derived from various long/short hedge funds. My problem with the execution of this strategy by many managers is that the bull and bear segments’ price movements go in the same direction, perhaps at different speeds. In the equity world I have seen very few short portfolios producing worthwhile gains in down markets. (This is not necessarily the case in the fixed income world.)

Most investors find it difficult to hold contrary points of view within a single managed portfolio. One of the advantages of investing in different types of mutual funds within a client portfolio is that we can have extreme portfolios within a single account and vary the commitments to the extreme in anticipation of future market moves.

What will we be looking for on Monday?

One of the quotes attributed to Lord Rothschild is the time to invest is when there is “blood in the streets.” We will see whether there is a large coterie of opportunist buyers snatching up bargains in various, largely Middle Eastern markets. On the other side of the coin is the possibility of repeating the experience from the Russian defaults on treasuries that tipped over Long Term Capital Management and potentially much of the Wall Street trading community. Emerging Market traders who quickly needed to restore their capital balances after the recognition of the Russian losses, sold whatever they could out of their other emerging market portfolios. Thus, the Russian default led to slumps or collapses in many Latin American markets. The term for this rapid transmission of risk is contagion. This brings up a need to avoid investing in markets that are dominated in terms of trading from the same sources. When we wake up on Monday, I will be curious as to what level of contagion is visible in the Far Eastern markets, who will have a half trading day advantage over the Mid Eastern markets and a full day on the US markets.

What are your thoughts and learned lessons from the streets of Cairo?

P.S.: “Egypt Today, What it says about the region”

As few securities analysts read the Marine Corps Gazette, I would like to pass on a few of the points made in an article from the February edition, as it explains a number of the reasons we saw the five days of rage in Cairo. In the article by Lt. Col. Edwin O. Rueda, the following points were made:

1. The perceived stronger, better Arab armies in the 1967 war with Israel lost because of the Arabs' “lack of religious fervor.”
   
   
2. There is a sense that Egypt is the center of the Middle East both geographically and politically. It should be treated that way. There is the perception that the United States does not seek Egypt’s advice in dealing with the Arab world.
   
   
3. Many people admire the western model and would like to move closer to the west, but they are afraid of not supporting the Egyptian way.
   
   
4. There is an enormous economic gap between the wealthy and the poor.
   
   
5. An enormous part of the population is without hope of anything better for them.
   
   
6. “Loss of face” is critical in Egypt’s machismo society.
   
   
7. Arguments/discussions are based on perceptions, often sourced from “word of mouth” or Arab media. No credence is giving to “facts” as we know them.

I will be happy to email the full article if you contact me.
_____________________________________________
To Members of Mike Lipper's Blog Community:

For readers who would like to stay current on my uncommon perspectives regarding investing and world markets, join the community by subscribing, at no monetary cost, just your time and interest as well as occasional responses. Simply click the "To Receive Blog via Email" box on the left-side of the screen.

For those already receiving my blog by email, if you would like to recommend this blog to a relative, friend or colleague, the sign-up is located on the left-hand portion of the screen at www.MikeLipper.blogspot.com.

Can China Be Hedged?

There is a difference between people and markets. While both have histories, they are portrayed differently. The experience of people is recorded with lots of emotions, thought processes and personalities. We record market movements whether they are for securities, commodities, real estate or objets d’art in two dimensions, up or down. I believe the study of both are essential for any successful investor. However, the study of people should serve as alerts to those who focus on the history of markets.

Calamities Travel

Once in a while the single tree falling in a forest or an insect flapping her wings could be the start of a world-wide calamity. There are two relatively recent examples that I saw early, but did not fully comprehend until much later, to my accounts’ disadvantage. The first was the collapse of a Greenwich, Connecticut based hedge fund firm called Long Term Capital Management (LTCM). Actually before the founding of LTCM, I was exposed to one of its widely proclaimed “geniuses.” This learned academic gentleman believed that market-based statistics could be used to predict future market prices. He was correct in many instances, but not in each and every instance. He and his associates applied their mathematical skills to foreign treasury instruments with considerable leverage. They were totally “blindsided” when the Russians defaulted on their treasury issues. My mistake was I did not fully understand the implications of this collapse, after all none of my accounts were exposed to Russian paper. Initially I missed two knock on relationships. The first was the contagion effect. LTCM and other leveraged players (more on this shortly) needed to quickly restore their capital base. They quickly sold their other emerging market positions. (I did not foresee how a Russian default would be the cause of Mexican market decline.)

The second relationship, or if you prefer the second order problem that I missed, was the nature of the trading community. LTCM was one of the largest customers of many fixed income trading desks on “The Street.” Initially these desks merely filled the order of their customer rapidly, perhaps in some cases they sold short the securities as part of filling the order. Soon they saw how successful LTCM was and they followed its trading patterns and in some cases put money into LTCM’s funds. The size of these actual or potential losses would have been very large for the trading community if all of The Street’s trading positions had to be liquidated quickly when LTCM problems became known. Unlike the more recent cases of Bear Stearns and Merrill Lynch, the government recognized the problem early, but the Fed did not ride to the rescue of LTCM with saddle bags full of money. The Federal Reserve Bank of New York convened a meeting of all the principal players including a very reluctant Bear Stearns and would not let the participants out of the meeting until they agreed to loan enough money to LTCM so it could be prudently liquidated. Thus Wall Street was saved from its own potential collapse. (In this instance the FRB of New York played the role of J.P. Morgan when he helped end the “Money Panic of 1907,” before the Federal Reserve was created.) Thus, the tree falling in Moscow almost took down the entire trading market in the US and probably elsewhere as well.

The Sub Prime Calamity

While I recognized that far too many people were speculating in real estate and that amateurs often lose to professionals in the market place, I did not appreciate who the real losers would be. (The providers of credit all the way along the line were the losers.) Initially, people began writing about the ballooning sub prime and the “Alt A” mortgages and that they would lead to bankruptcies and a slowdown on the building of new homes. While this was serious, at the time it was not of monumental importance, as new house construction is a small part of our expanding economy. Once again I was not sufficiently conscious of significant changes and how the market place was operating. I did not fully comprehend that the major investment banking houses had become the center of the mortgage origination casino to feed their securitization sales forces. This process was replicated in the UK, Australia, and elsewhere and the resulting production of mortgage slices were owned throughout the world, including places as distant as Norway and China. While in the case of LTCM the infusion of leverage was at the so-called professional level, at almost every stage of the housing chain leverage was induced so there were many more losers, including those living on fixed income from these mortgage tranches. When the various governments started to get inklings as to the size of the looming debt on the way to non-payment status, the governments rode to the rescue to save at least their financial communities, if not their economies. (We can debate whether the rescue attempt was ham-handed and whether the private sector should have been let to sort out the problem, as Mr. Morgan forced in 1907.)

Is China A Potential Calamity?

Recently I spent time thinking about conventional asset allocation strategies. In almost all cases, institutions are attempting to broadly diversify their assets. Often the categories they use are as follows:

• emerging market equity and debt
  
• developed market equity and debt
  
• domestic equity and debt
  
• commodities including timber
  
• domestic and foreign real estate
  

My unanswered concern is that these diversification attempts are making a common bet and therefore do not have the diversification against a major risk, which suggests there exists a potential for a major dislocation. All of these classes are exposed to China in one way or another. Most emerging markets are increasing their trade with China. General Motors sells more cars in China than the US. Proctor & Gamble, Coca Cola, Microsoft and soon Apple, have important sales and/or facilities in China. “The Middle Kingdom” is the swing buyer or seller of most non-agricultural commodities in the world. Almost all bonds are priced in relationship to US Treasury issues of similar maturities. The Chinese convert much of their trade surplus with the US into the purchase of US bonds, which helps to absorb our increasing deficits. A significant slowdown in China’s purchases, let alone its absence from the market, could send most bond prices down around the world.

I am not an expert on China. I have a great deal of respect for its economic leadership so far. Perhaps these “experts” will continue to manage the population’s needs and desires as they have done in the past, but each year it becomes more difficult. China has replaced the US as the locomotive for global growth. This is not a prediction but an observation that at some point it is conceivable that the engine will perceptively slow down or even temporarily go off its planned track. With so much of the world dependent on the continued growth of the Chinese economy, a slight flicker or a rumor of an unexpected result could cause all markets to react.

How Does One Hedge The Chinese Risk?

Granted we don’t know for sure that there is such a risk, but we should have learned from the LTCM and sub prime examples that calamities can happen. As a professional investor I would like to identify a satisfactory hedge against the possibility of a Chinese calamity. I would like to do this on two counts. First, I am in the market for some insurance. Second, if there was a recognized hedge, its price action could be a clue to a the current market’s perception of the risk.

I have reviewed all of the current asset allocation categories and have found to varying degrees each is dependent on developments within China. At the moment I can not find an independent hedge. Perhaps you will share your thoughts with me on such a hedge or at least your leading indicator of Chinese problems.


____________________________________________
To Members of Mike Lipper's Blog Community:

For readers who would like to stay current on my uncommon perspectives regarding investing and world markets, join the community by subscribing, at no monetary cost, just your time and interest as well as occasional responses. Simply click the "To Receive Blog via Email" box on the left-side of the screen.

For those already receiving my blog by email, if you would like to recommend this blog to a relative, friend or colleague, the sign-up is located on the left-hand portion of the screen at www.MikeLipper.blogspot.com.

“Stop the World, I Want to Get Off,” I Don’t Want to be Global

Some may remember the Broadway musical, “Stop the World, I Want to Get Off.” The title’s message, also found in the Bible, is that the world is too much for us. Today almost every activity we do is the result of product, services, influences or fears of the same from beyond our borders. The very act of watching the Super Bowl is being done on television sets that are made totally or in part from overseas. The commercials that bring us the game are largely from global companies selling globally. If the commercials are animated, the odds are that the animations, at least in part, were not done in this country. A few of the players were born outside of the fifty states. Much of the clothing worn at the game and a good bit of the clothing worn by the larger electronic audience was produced overseas. One quickly recognizes that if America’s most iconic event, the Super Bowl, has gone global, so has most of the rest of our lives. Shouldn’t our investments recognize that we live in One World? (One World is the name of the book written by Wendell Willkie summarizing his thinking after his defeated presidential campaign against FDR. My mother was one of his assistants.)

The next-to-last financial crisis that faced this country was when Russia defaulted on its own treasury paper. This sent Long Term Capital Management, a very large, professional hedge fund managed by Nobel Prize winning economists and formerly brilliant traders, into a tail spin that threatened other Wall Street participants with similar holdings. The real damage was not done by the Russian default, but by the frantic urge to sell other emerging market debt to raise capital to avoid bankruptcy driven by margin calls. The rapid selling of other government debt and some equity was contagion, as particularly Latin American and Southeastern Asian markets collapsed. While there was no economic connection between Russia and Argentina and Thailand, there was a market connection in that some of the same owners panicked.

This weekend, while watching the football battle in south Florida, there is another financial battle occurring. The question at the moment is whether the government workers in Greece and Portugal will strike over wage cuts and lay offs that were designed to prevent sovereign defaults. Why should we care if Greece goes down? After all, it has been reported that Greece has been in default 105 years of its 200 year history as a modern nation. Throw Greece, Portugal, Spain, Ireland and Latvia together, they are smaller than one of our states, California. (For the sake of brevity I will ignore the dangerous combination that high government debt and large government work force has on the long term health of an economy.) If these are relatively small national economies, why are the various stock and bond markets around the world nervous and pausing during the slow recovery that is underway?

Is the pause just a reaction to the financial and business press? I don’t think so. I do not see recognition on the part of regulators or legislators as to the critical connection of potential foreign losses and the domestic economy. The connection that eludes most of these non-business politicians is the type of loans that are currently in use. With the exception of mortgage loans, most loans in the United States for individuals and businesses, particularly small businesses, are “call loans.” Like margin debt, these loans can be called for immediate repayment, without cause. Simply, the bank or broker wants its money back. (Only the large and /or public entities can borrow on a fixed term basis.) If the banks or brokers believe that they will sustain large losses in their foreign loan books, they will search for capital from all of their sources. Thus, I believe there is a fear that problems on the streets of Athens or Lisbon could cause problems for the Main Street borrowers in Baltimore, Cleveland and Denver as well as smaller towns.

As much as we would like to be isolated from problems, particularly from those generated beyond our borders, we can not. The Super Bowl can not be a purely domestic game; in reality neither can our own financial posture be without foreign perspective. As with many nervous, I would say prudent, investors, we keep our reserves in US Treasuries directly or through money market funds. We have been trained that these are the most secure of all investments. However, it would be naïve on my part not to recognize that foreigners, particularly their central banks, are very important participants in the markets for US Government paper of all sorts. Thus, to some extent, this most domestic of all securities investments is, in reality, globally influenced paper.

The segmentation of investments into international (ex-US) and domestic is the favored technique of consultants and brokers. At one point in time the differences between these two general classes were real and there was major difference in their performance. Today it is less true and will probably be an artifact in the future. While we will continue to report to our investment management clients the way they are used to seeing reports (bifurcating US and non-US investments), my thinking is evolving beyond those distinctions. First, I tend to look at who are the major buyers of various securities, e.g. international institutions, domestic institutions, wealthy domestic families, or the general public served by brokerage firms. Second, where is the source of expected earnings growth? Third, what is the nature of law and regulation governing the securities and their issuers?

I would be pleased to discuss this different way of looking at your portfolio.