Re-Risking with Bonds, China Near-Term

Introduction

I have learned that one of the most risky periods to trade is when the market is open. Without the regular flow of transaction prices, one doesn't know if one is winning or losing. Thus, during all trading hours one is at risk to a significant price adjustment. Or to the contrary: opportunities to recognize investment profits. But some periods have been more prone than others to substantial price moves. We may be in such a period after a light volume expansion which appears to have topped out, and at the same time little in the way of successful shorting  and low volatility.

Re-Risking with Bonds

After 35 years of substantial gains, bond prices for high-quality paper experienced some falls. By year end it appears that the declines have just about slowed to a gentle fall, at least temporarily. Bond trading has attracted hedge funds and other speculative players. Many of these have taken losses as markets have signaled higher interest rates. These losses were  relatively small for un-leveraged portfolios, many portfolio managers feel that they have been insulted by "Mr. Market." They plan to get even with the market by re-risking their portfolios utilizing below-investment grade paper,  be it floating rate paper, loans, or high yield bonds. One can be concerned that they are creating the next large bubble. We should pay attention to that great portfolio manager William Shakespeare when he wrote the following words for the witches in Macbeth:

"Double, double, toil and trouble, fire burn, cauldron bubble...."

The re-risking has already begun with high yield bonds gaining +17.18% and floating rate paper +10.57% compared to 5.98% for the bonds issued by the S&P 500 participants. For a number of mutual fund management companies the appeal of this paper hopefully will add to their dominant bond funds which could be very useful to the groups, but particularly Eaton Vance^*, Franklin Resources^*, and T Rowe Price^* among others. The flows are presumed to come from new shareholders who wish to participate in the rising interest rate phenomena. One sign of the popularity of intermediate quality bonds is that their average yield for the week fell 23 basis points vs. a fall of only 7 basis points for the previous week, according to Barron's. If interest and inflation rates grow slowly, and stay below a pre-determined yield point, many bond investors will not focus on the decline in the price of their bonds.

 At this point that breakaway yield is probably about 4%. Another concern is the likely default rate that is expected on this paper. Moody's^* believes that currently the bid/ask spread on speculative issues is 60 basis points too narrow or phrased another way, Moody's expects greater default rate than the market does.

^* Personally owned  or through a private financial services fund that I manage.

Must be in the China Funds Business

On the fifth of January two of the global fund industry’s leading groups announced long term commitments to the Chinese mutual fund business. Fidelity was given permission to establish a wholly owned fund management subsidiary in China. On the very same day it was announced that two arms of the Power Corporation of Canada^* would become the second largest owners of the largest mutual fund company in China. Both of these two groups are long-term strategic thinkers that have successfully entered markets beyond their home and appear to the locals that they are local themselves. (Fidelity is one of the largest fund providers in the UK, Hong Kong, and Japan among others. Power Corp. has big positions in Great West Life both in Canada and US as well as Putnam and substantial investments within Europe.) While I don't know whether these Chinese ventures plan to offer domestic and international funds in China, I am impressed with the commitment these two giants have to their long-term expansion plans. Each has benefitted from multiple generations of their senior management families who have worked their way up to their current command positions. On the basis of my respect for these families and their companies, I feel in the future one can not afford to disregard China and the Chinese investors as even more portent powers in the fund business globally.

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Shorter-Term Worries, Longer-Term Opportunities

Introduction

We are not enjoying complacency about securities' prices, we are suffering from petrification. One of the supposed benefits of holidays be they secular such as Labor Day, bank holidays or religious fast days, is it gives investors and those who are dependent upon investors a chance for introspection.

On the surface we are experiencing relative calm with the month of August posting the second lowest volatility in a decade of S &P 500 performance. I have yet to meet any professional or individual investor who is happy with the markets - stock, bond, or commodity. The relative lack of movement is anything but creating complacency but rather a deep seated fear of being wrongly positioned for the next market. Until magically they see further into the future than they are now, investors are petrified to act.

Short-Term Worries

Several new books and other long treatises can drone on as to all of the problems facing our global societies, economies, political leadership and securities markets. I am going to list a number of concerns that occurred to me over this three day weekend and it is not an exhaustive list:

1.  Over-valuation of leading components of popular securities indices due to flows into passive portfolios, including ETFs. These buyers are participators not evaluators.

2.  A record level of long contracts on the Dow Jones Industrial Average. (This level of speculation is normally wrong. However, in today's world I wonder how many of these contracts are paired with shorts on individual stocks.)

3.  Moody's^* warns "take cover if defaults climb through 2017."

4.  John Authers of the FT in suggesting rules for investing success, recommends the need to be humble as the markets are not perfectly efficient and the greater the price paid for a security the lower the potential return.

5.  In a recasting of the famous economist's view of a “Minsky  Moment,” the illusion of control encourages risk-taking behavior. Much of what is being pitched these days is expressed as low risk due to the fact that they are government actions and in the past history few things have gone bad.

*Held in the private fund I manage.

In the latest Marathon Asset Management Global Investment Review, the London-based firm tells the story of a famed Soviet professor of statistics who regularly did not take shelter during the Moscow air raids in World War II. When asked, he pointed out that there were seven million people living in the city and one elephant living in the Moscow Zoo. Thus he felt comfortable not going into the shelters until one night he showed up at a shelter. He then announced that the prior night they killed the lone elephant. The message: Change when the facts change.

Longer-Term Opportunities

This weekend I sat next to another guest at a wedding; she had worked in development at Yale before it was famed for extraordinary investment performance, but during the period that it was building that record. We chatted about the Chief Investment Officer who had introduced alternatives to stock and bond portfolios. We concluded that one of the reasons for Yale's success during that time was that few or any of its major academic competitors were taking advantages of these opportunities.

During the current period of complacency/petrification I see a similar opportunity. Too many very bright investors are focusing on the current (apparently insurmountable) problems and not at the opportunities that always exist but too often are hidden to us because of our perception deficits.

Keith Ambachtsteer contributed an article to the FT entitled "Long-term thinking will lead the way to improved returns." He knows by experience in affecting a number of Canadian and to a lesser degree, US pension funds. His focus is to keep the attention on the long-term and not get bogged down in the short-term.

If one does focus on the longer-term, an investor has two mathematical advantages working in his/her favor. The first is the compounding impact of reinvesting income. Over the last five years the reinvestment of distributions from the stocks in the Dow Jones Industrial Average raised the DJIA total return by 33.85% over its simple price change gain. The second mathematical power going for investors in the long run is that almost all of our lives we have been in a period of secular growth with both demographics and technology helping to enlarge the demand for what we produce.

During a period when the negatives are being accentuated, too few people are searching for positive opportunities. In the US and some other countries, we will have both new political leaders as well, I believe, quite different legislative bodies. Perhaps we will also have some movement in the judiciaries. As much as many would like, they are not going to be able to slavishly copy what was done in the past. Even slight changes will create opportunities for those who are looking for them. Major changes can create major opportunities. I believe we will see many. 

While it may be too early to tell, one should look for ways to foresee changes in both the labor and consumer markets. As an example, keying off this weekend's news of the poor showing of Germany’s ruling party in Angela Merkel’s own district due to the rise of an anti-immigrant party that has potential implications in Germany, the rest of Europe and possibly the US.

How to Play

During these uncertain times I believe our preferred structure of sub portfolios addressed to specific time spans can be of particular value. Regular readers may be familiar with my TIMESPAN L Portfolios^®.  I would suggest that the need to meet payment requirements over the next couple of years will require close, very short-term management that is extremely sensitive to changes of credit conditions and shifting short-term interest rates. (The first, or Operational Portfolio.)

The replenishment requirements of the expended operational funds (the second or Replenishment Portfolio) probably need to deal with at least one down market year before the new government leaders leave office. On the other hand, investing for endowment (the third portfolio in the series) and other intermediate and long-term money have a great opportunity to invest wisely in less popular investments. For the truly long-term investor there will be ample opportunities to invest in both new and established disrupters.

Question of the week: Please help me find disrupters, what are your current favorites? 

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Copyright © 2008 - 2016

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

Do You Need to Update Your Thinking?

Introduction

Many institutional and individual investors are frustrated by the current levels of stock, bond, and commodity markets. These frustrations have led to inaction in addition to a state of anxiety. Most professional investors and many individual investors have had direct academic training and they and wealthy individual investors have had indirect or passed-along academic investment theories. With the major central bankers of the world experimenting with various forms of quantitative easing (QE) which has not had the desired effect, most of the reliable past investment measures have not been working.

As part of our responsibilities for managing accounts investing in mutual funds, we regularly have discussions with fund portfolio managers. Recently I had an in-depth conversation with the lead portfolio manager in a group that I have visited with since the 1960s. In discussing her financial services holdings she used the very same ratios and thinking that I have heard from this group for more than fifty years. I was struck that the fund's great long-term success was based on a very traditional approach that predates the current QE era and may explain why it is not enjoying its normal performance leadership position.

Recently Michael Mauboussin, now with Credit Suisse, published a list of ten attributes of successful investors which I have further edited:

1.  Be numerate (understand accounting)

2.  Understand value (present value of future net cash flow)

3.  Think probabilistically (nothing is absolutely certain)

4.  Update views

5.  Beware of behavioral biases

6.  Know the difference between information and influence

7.  Position sizing

Analysis of Financial Services Opportunities

Almost all financial services stocks are selling below their book value per share, and so the argument goes they are cheap now and will go up in price in the future. Under the current environment I am much more inclined to view their value is what they are selling for, as many traders believe. Book value is not a valuation metric but a reflection of historical costs of tangible assets. In the destructive era of QE some portion of loans not yet non-performing will become non-performing and thus their historic asset value is less by some to-be-determined amount.

The managers and owners of financial services companies claim that since the financial crisis the firms have added to their capital base and improved their efficiency and credit controls but their valuations have not improved since the crisis, even though their returns on assets and capital has. When interest rates normalize (read higher) their returns will rise, but probably won't get back to historic levels. Putting all of the current factors together these stocks are probably worth what they are selling for at the moment. However, under a higher interest rate scenario these earnings could be substantially higher. My view is that the current owners have in effect an option to benefit from normalization of economic conditions. Thus, the shares are priced right for the current environment, but with a potential "kicker" for the future.

One of the problems in using a balance sheet/book value approach is one is only dealing with tangible assets. As both a buyer and a seller of financial services companies, I recognize that the intangible assets are often worth as much if not more than the tangible. Think of this as "brand value." Among financial services stocks in the publicly traded market, I suggest that JP Morgan^* has brand value and Bank of America^* and Citi^* do not. I would clearly pay for JP Morgan without its balance sheet, but wouldn't for the other two. Even Chase's^* credit card business has brand value. Goldman Sachs^* has brand value in excess of its balance sheet. Just track how well quite a number of ex-partners and senior managers have done in raising money for their new ventures after leaving Goldman. I find it difficult to say the same thing for other firms, with limited exceptions for Morgan Stanley^*.

 Opportunities for Financial Services

Anytime there is a flow of money, there is an opportunity for some financial services organization to make or to lose money. Currently there are concerns as suggested by Moody's* that aggregate corporate earnings in the US is unlikely to top the record 2014 level until 2018. John Authers of the FT suggests that if one wants earnings growth, one should escape reliance on US sources. Fund money is already following fund performance. For the year 2016 through last Thursday, Emerging Market Equity mutual funds’ average is up + 18.50%, Emerging Market Local Currency Debt funds +16.62% and Emerging Market Debt funds in hard currency +13.56%. This is a worldwide trend with the second largest sales of ETFs based in Europe pouring into Emerging Markets. Cross border trades create a need for foreign exchange transactions which can be very profitable for financial services firms. In terms of the growth in emerging market debt, professional buyers conduct these through carry trades with US Treasuries and other elements as well as substantial use of margin. Most of the Emerging Market activities have been in Latin America +36.7% (Brazil + 68.4%) and the following list of countries all with gains exceeding + 20% : Russia, Colombia, Thailand, Indonesia, Hungary, Pakistan, and Chile.

* Owned personally or in a financial services fund I manage.

Perhaps the biggest opportunity for financial services organizations may occur with a new Administration in Washington. While one is reluctant to believe any of the political rhetoric from any politician, it does seem that it is likely that massive infrastructure spending programs will be announced. If these get funded, it will likely mean more bond underwriting at the federal, municipal, and commercial levels. Other increased expenditures that will generate buying is likely to be on defense, education, and health.

Conclusion

There are substantial opportunities for the financial services organizations to make or lose money, but most of the gains will be earned by groups that have talent in excess of their financial resources. Successful investing in this arena will be based on business type analysis not solely on financial statement ratios.

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Copyright © 2008 - 2016

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

Was the first week of October the Bull Market?

 Introduction

When everything was falling in price in August, I suggested that one should start to place orders to buy some of the "falling knives" which had the biggest declines, around -20%. These items included commodities and commodity related investments as well as TIPS. My view was that off a bottom there is often roughly a ten percent "relief rally" and this was the easiest money to earn in a new bull market.

In the period from October 1 - 8 , 2015, the following six out of 96 equity oriented mutual fund classifications' investment objectives produced double digit returns:

Natural Resource funds	+ 14.34%
Precious Metals funds	+  13.58
Global Natural Resources funds	+  13.32
Equity Leverage funds	+  12.04
Energy MLP funds	+  11.18
Basic Materials funds	+  10.76

As we know the price of crude oil rose 9% during the week, but there was more to these gains than the oil price pop. While there was undoubtedly a rush to cover various short positions, there were some participants that were sensing the potential for future inflation. More will be needed for the investors in these funds to break even for the year. Even after the double digit gains for the week, five out of the six groups shown above were still down double digits. (Equity Leverage funds were down -9.72% for the year to date.)

Smaller gains were made in the week by 93 out of 96 investment objectives tracked by my old firm now part of ThomsonReuters. Only few of these were able to show gains for the year. These tended to be large growth funds often with meaningful positions in the much politically derided Health/Biotech group. At least Moody's is concerned that we have not seen the bottom of oil prices, they have lowered the credit ratings on five US regional banks which have substantial energy loans outstanding. Being a contrarian I would watch these for an entry point, as I am convinced that in time the underlying collateral will be good on balance.

Even though we are not traders (as we invest for lengthy periods) we need to be aware of others in the marketplace. The risk for the trader is that the double digit that some funds enjoyed fulfilled "the easy 10%" pop expected after the sharpness of the summer declines. Now the trading question becomes whether the August lows will need to be tested in order to put in the low for the year, if we are going to have a meaningful recovery before the US presidential election year.

We Don't Care

As long-term investors we are not very excited by this year's performance unless it has significance in terms of the implications of meeting our clients’ longer term payments needs of their distant beneficiaries. Why am I so relaxed at the moment? First, I believe last week's move was in recognition of some changing attitudes beyond the "oil patch." As is often is the case, I look to the fixed income world for guidance. Domestically, taxable bond fund classifications showed gains, albeit small. These for the most part were funds that trafficked in lower credit rated paper. For people to bid these up they could not be very concerned about a meaningful recession. The other message that I perceived was that the poorly performing TIPS funds gained while other US Government Bond funds showed minor losses.

Foreign Signals

Emerging Market Bond funds, in local currencies, produced the best returns among fixed income types by a wide margin last week, +4.44%; in contrast with Emerging Markets Debt hard currency issues +1.84%. Bond funds which invested in more developed countries gained +1.3%.  My interpretation of these results is, at least for the week, that market participants were suggesting the meteoritic rise in the dollar was at least peaking.

Volatility

The investing public that is glued to the media is fearful of triple digit price changes in the Dow Jones Industrial Average. Using the somewhat less volatile S&P 500 since 1928 according to Factset/StockCharts, the days with a 1% (Up or Down) occurs every four or five days. As a matter of fact I set my computer alerts to only inform me when prices move at least 2% and don't consider action below 3-5%. The New York  Federal Reserve Bank is somewhat addressing these concerns in the corporate bond market that has had bank trading capital reduced by 75%. They maintain that there is ample liquidity to absorb sudden shifts in prices. (Interestingly enough, they did not address what in theory is the deepest fixed income market in the world, the market for US Treasuries. Because of rapid global trading of these instruments through computer interfaces by non-bank dealers and investors, I am worried. During hectic periods of unwinding "carry trades" when treasuries are collateral for borrowings in more exotic paper, I am concerned by the chance for some indigestion.) 

Question of the Week: How are you addressing this market, did this week mean anything?

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Copyright © 2008 - 2015

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