Is There Enough Left on the Upside?

Introduction

One of the many necessary elements for a peak to occur is the belief that the current market rise will continue. This belief is nurtured by cheerleaders and there were two highly respected ones sharing their views with us this week. The first was in Mark Hulbert’s column, where Sam Eisenstadt, the former statistical genius of Value Line stated that he believes in the next six months the stock market will rise 8% as the leadership will shift to higher quality companies rather than the lower ones which have been the leaders. 

The second was an observation from U.S. Global Investors’ Investor Alert which quoted a study by BCA Research which examined the 30 years since 1870 when the market was up 25% or more. They found that in 23 years following the big gain that the market had an average gain of 12%. A number of Wall Street types are now hoping to split the difference and are looking for a 10% gain.

Is 8, 10, or 12% good enough?

On the one hand (as the economist would say) these gains are 2-4x the recovery high on the US Treasury 10 year note at just over the 3% yield achieved this Friday. On the other hand someone trained on using the odds of meaningful success would start to get cautious. Just five years ago the percentage decline in the market offered a potential recovery to the prior peak of 2-3x what is now being offered. This is not counting on going on to new highs. The question now is, are we about to enter Sir Isaac Newton’s “greater fool theory” trap? Remember he participated early in the run up of the infamous South Sea Bubble. He got out early, but got sucked back in when his friends were making more money faster than he did. When the bubble did break he lost all of his gains and more. What we have learned from the recent studies at Caltech is that some people don’t retreat when they sense danger, but stay involved believing that their sense of timing will take them out of danger. As I mentioned in prior posts, I learned about this as a junior analyst and it was called the greater fool theory. To believe that future big gains are possible after large gains are achieved does not show the level of caution that many successful long-term investors use.

I used to question why we researched bonds when I was studying Security Analysis at Columbia with Professor David Dodd.  The name of the class was the same as the title of the book that he co-wrote with Ben Graham. What became clear to them and reinforced in the recent mortgage market collapse beginning in 2005 and culminating in 2008, that at times the fixed-income markets are much more sensitive to credit conditions and therefore the eventual health of the economy than my fellow stock jockeys.

As mentioned above on Friday the ten year US Treasury bond’s yield rose to a psychologically important 3% from a low of 1.63%. This in turn caused bond prices to decline in absolute terms. I look at historic 10-year yields the following way:

• I view the normal yield for the ten year to be about 4%. 
• During abnormal times rates would be in the 6-8% range, which should meet the relatively few defined benefit pension funds' actuarial requirements.
• Under economically stressed periods one could see yields in the 9-12% range if not higher. 

The higher current yields would occur when there is greater demand for capital than what is immediately available, usually with both the private and public sectors needing money to meet their immediate and longer-term needs. We are currently far from these conditions now, but sound equity investors should be alert to credit conditions as both the private and public sectors are short of capital for long-term productive investments.

Is there too much asset allocation?

For far too long investment pundits and those who direct the construction of long-term portfolios have found comfort in diversification into many different asset classes; e.g., domestic stocks, international stocks, emerging market stocks and bonds and now stocks from frontier countries as well as similar fixed-income asset classes going from the most to the least secure. To these lists add private equity, commodities of different types, real estate, timber, and elements from the art worlds plus intellectual property. While not a separate asset class, hedge funds owning one or multiples of these classes are included in the array for diversified investing. Many of these types of investments have badly trailed the simple stock market and some for 2013 are likely to show negative results, such as commodities and volatility measures. I would suggest there are three lessons one should consider before deploying asset allocation.

The first is that in declining markets and particularly sharply declining markets, correlations will increase. Wherever there are pools of liquidity they will be drawn down. Assets that can be sold quickly will be. Second, when there are choices to be made and particularly in the early phases of a rally, selectivity will be important. Along with the skills of the selector it is important to understand the relative sizes of compensation of the intermediaries. Isn’t it strange the highly compensated products and intermediaries get the first mover advantage? The third clue (the most difficult one for those of us who are trained in complexity) is to keep the strategy simple where most of the time is spent on selectivity.  In his weekend column in The Wall Street Journal, Brent Arends quoted a study by Andrew Smithers, a well-known and highly respected British investment thinker, who in a study for the investment committee of a college at Cambridge University recommended that it should have only two asset classes, stocks and cash. Stocks could range from 60% to 100% based on the level of the market, utilizing some long-term ratios. In today’s world this simple but effective approach is making a lot of sense, at least until reset approaches coming off the next major bottom.

What is increasingly missing from our command structure?

As a US Marine Corps officer, we never really retire, we just change uniforms. Over the weekend I enjoyed an interview with Camille Paglia  where she is quoted as saying. “The entire elite class, now in finance, in politics and so on, none of them have military service, hardly anyone. These people don’t think in military ways. The politicians lack practical skills of analysis and construction.” She finds “no models of manhood except on Sports Radio.” (My friends at the National Football League and the NFL Players’ Association will be glad to hear that they are her models of manhood.) However, they are not alone seeing the benefits of military thinking, conditioning, focus, and street smarts for returning service men and women. Prudential Insurance and JP Morgan Chase are among the leaders in seeking out these returning heroes and heroines with job opportunities. I am guessing some of these people will rise to the top of our leading organizations. On a global basis the benefits of a well-spent military life could, and I believe should, give the US an advantage in our international competition. This alone may be a reason to be long-term bullish on America.

What are your thoughts?

Drop me a line.

I hope all of the members of this community will have a Healthy , Happy, and Prosperous 2014.     

_______________________

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

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

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?

_______________________

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

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission

Current Worries Obscure Long-Term Portfolio Thinking

There is too little enthusiasm about investments these days despite the fact that we have just slightly breached the old highs on the popular US stock market indexes. This weekend I seem to be besieged by too many worries to enjoy either my market price gains or a wonderful concert by the New Jersey Symphony Orchestra playing three Tchaikovsky pieces very well, plus a spirited encore. (As my wife Ruth is Co-Chair of the NJSO, it should have been exhilarating for me.) Somewhat like Tchaikovsky’s tragic to triumphant Fifth Symphony, my investment worries obscure the good results we and our clients have achieved, and what should be an attractive long-term future.

Worries

I find it difficult to rank worries as any one of them could be the proverbial canary in the mine shaft. Thus, I am just listing them in the order that they hit me.

1.    The demand for US $100 dollar bills is up, particularly in Europe. I take this to be showing a concern about the value of various European currencies rather than a money transfer tactic of the global underworld.

2.    Most of the financial press is devoted to the problems of Cyprus and some of the other peripheral economies rather than paying attention to the remaining parts of the world. China now has reserves of $3.44 Trillion which is about the same size of the entire economy of Germany. Interesting the last time China published its gold holdings was 2009.

3.    Due to the fact that governments are trying to dictate to their economies through the banking systems, financial transactions including loans are moving out of the depository banks and into “other’ financial institutions, often called the shadow banking sphere. In China for instance the growth in commercial and personal credit is greater than in the regulated banks. In the US a portfolio of bank stocks has been recovering, but is still behind the other financials’ stock price performance.

4.    The current chatter of the talking heads in the financial press is focused almost exclusively on the pace of the expanding economy. People seem to have forgotten that in every decade there is at least one economic recession and often two. Where this plays a role is in the “happy talk” emanating out of Washington about reaching a balanced budget over the next ten years. According to John Mauldin, there is not any suggestion that the period will include one or more recessions which could balloon government social spending.

5.    A recent census report adding all the levels of US government spending per household concluded that the average is approximately $50,000 and the median household income is about $49,000. No wonder that there is not enough consumer saving to pay for the physical infrastructure needs and intellectual infrastructure needs to create the knowledge and work habits to fuel this economy.

6.    The price, volume, and shorting actions in Exchange Traded Funds (ETFs) suggest to me that an important part of the trading in these vehicles is being conducted by short-term traders similar to hedge funds. If more individual investors were using them I would be worried by a recent study by Mark Hulbert as published online in Barron’s on Thursday. Mark compared the performance of a number of ETFs to actively managed funds within the same organization. He found that, on average, the active managers out-performed their less expensive stable mates. This may be particularly important in the next major market decline where the active managers can either raise some cash and/or get out of some of the larger volume stocks that are leading the market down. (Of course when there is a rally, as they say “cash is trash” and can hurt performance.)

7.    This weekend some of us will be watching the Asian markets and later the opening of the European markets to see what the price of gold will be doing after a major fall at the end of last week. As a well-known and respected non-gold bug said to me this weekend, “The reason to own gold, in some form, has to do with fundamental concerns about the continuing value of paper money; it is just as present today as it was last week month or year.”  The purpose of gold is as an insurance policy within a portfolio of other assets. For generations European private bankers have urged their wealthy clients to own 5-10% of their portfolios in some form of gold. Just as I don’t like to drive on the road with drivers that do not have appropriate auto insurance, I hope that a few do not use the drop in the price of gold as an excuse not to pay their “value of money insurance policy.”

Analyzing your long-term investments

As indicated, the list of worries above is obscuring what you and my fellow long-term investors should be focusing. I am an advocate of dividing one’s portfolio into different time horizon and special pocket investments. At the moment I want to focus on the longer-term time horizon bucket. This is the bucket to fund multi-generational needs for both families and charitable institutions. 

One useful exercise is to look at the current market weighting of each of your investments and assign them into these somewhat distinct categories:

Category one: The portion of your portfolio which is the result of the accident of gains. One never expected this to be such a big winner, even if it was the family company. Now one has a very large unrealized capital appreciation = tax and/or disposal issue.

Category two: Holdings that are selling at very deep discounts compared with other market indicators. The future price potential is large and if successful in later years could be moved up into category one.

Category three: Some investments that are selling substantially below what a knowledgeable buyer would pay for the company, particularly if a new management could be installed. Dell?

Category four: There are some very high quality companies whose shares most of the time reflects their quality, but not all the time. This weekend I read the very long proxy and annual report of Goldman Sachs, a stock that is owned in my private financial services fund. For some this may be a controversial firm, but I find in general in most of their varied businesses they do conduct their activities in a high quality fashion according to the ethics of the business. I own other high-quality names but I was using Goldman just as an example.

When you get all through assigning weights to these and/or other categories see whether they are in an appropriate mix for your long-term needs. I would be pleased to discuss this exercise with you if it helps to bring some additional clarity to your investing.

_________________________________

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.