Are We in a “Flat Earth” Phase?

Introduction

For most of human history there was the belief that we lived on a single plane of essentially a flat earth. This concept gave order to our belief as to our place in the world, and in our minds reduced the uncertainty gap. Only in the last seven hundred or so years did we appreciate that we live in a somewhat circular earth planet. Soon after Columbus’s voyages we came to recognize how we really live in a context of a spinning globe.

In a much less cosmic sense, stock market chart readers have recognized that there are periods, some of them quite long, when prices appear to be within a range bound with repeated highs at roughly the same level and similarly with recurrent lows around the same price levels. Some of these periods can last for years. It was a period of 16 years from the first time the Dow Jones Industrial Average (DJIA) first reached 1000 and finally decisively breaking out on the upside.  Depending on what measure you want to use, for example the NASDAQ or the Japanese markets, we are still well within these bounded ranges. Normally range bound markets, particularly those with narrow price ranges, last for a number of months not decades. We appear to be in a relatively narrow range bound market with the DJIA laboring between 16700 and 16000. (Some would use a narrower range.) There are two important findings after the market either breaks out or breaks down decisively. The first, the amount of time and the aggregate swings from the high point and the low point is, in theory, added or subtracted to the high point or low point when there is a break-out or breakdown. The second is whether on balance the smart money is accumulating assets from the less intelligent sellers or the smart ones are distributing their assets to the somewhat unsuspecting investing crowd.

A reader asked.....

One of our intense readers who is somewhat short-term focused has asked me if is there a way to successfully predict if we are likely to experience an upside breakout or a downside breakdown. As my crystal bowl is quite cloudy, I am focusing on two aspects that lead to range bound markets. The first, is there a change in the population of buyers and sellers facing each other in changing market structures? The second question is whether those with smarts and capital are changing their investment policies. It is this particular question that the remainder of this post is focused.

Is it smart to be reducing equity exposure?

The answer, or at least a guide, may have been foretold last night. At the New Jersey Performing Arts Center^* there was a showing of the movie classic “Wizard of Oz” with its soundtrack music played beautifully by the New Jersey Symphony Orchestra^**.  For those who are unfamiliar with the film it turns on the ability of an unseen voice to successfully control a community of happy people. The key to the dreams of the four supplicants seeking special transformative favors was the unplanned revelation that the disemboweled voice was an old man behind a curtain that very well played the role of the announcer that foretold what was going to happen. What occurred to me listening to this magnificent music and watching the film is in today’s financial world the role of the wizard (or in reality, the announcer) is played by the central banks and various media gurus. It is these spokespeople that give investors the courage to invest in an uncertain world.

^*I am the chair of the Investment committee for New Jersey Performing Arts Center (NJPAC). 

^**My wife, Ruth, is the co-chair of the New Jersey Symphony Orchestra (NJSO).

The question as to whether smart investors are changing their investment policies has a lot to do with the announcers that are speaking, particularly after the curtain has been removed and these experts prove to be humans and not all knowing and powerful wizards. To some degree the power of these announcers is based on the flat earth thesis that provided comfort for centuries. This comfort was based on the belief that the leading religious and technological leaders of the day were all knowing. It wasn’t that the few thinkers that did not buy into the flat earth syndrome were essentially smarter than the established thought leaders, but they started to ask questions that could not be comfortably answered by the established leaders.

Bringing the questions up to date and focusing them on the investment world can be broken down into three sub questions as follows:

1.      Are we so smart or just arrogant as to believe that we can perfectly understand how the economy and financial markets work and can be controlled?

2.      If the supposed leaders are so smart why are their decisions “data dependent?”

3.      Why are the so-called experts' forecasts so wrong, particularly in the long-term?

The constant revisions to the various time-series and the inability to correctly capture relevant information about the “informal” sectors of the economy, suggests that data dependent policies have to be wrong often. (In the computer world there is a germane term: “GIGO” garbage in creates garbage out.)

There are two other somewhat related and troubling concerns about how the governments and their hand-maiden central banks are attempting to manage the round earth’s finances. The first is the use of experimental low interest rates to stimulate the economy. There are at least two long-term problems with this approach. The first is that it makes a mockery of long-term savings, particularly in fixed-income instruments for retirees. Not only are they getting low returns on their hard earned money, but they are planned victims of induced inflation to counteract the experimental low interest rates. (I will leave for others to determine whether their healthcare expenses and quality of the services to be provided will be a sufficient offset to their decline in spending power. As a member of the Atlantic Health System’s financial oversight committee and chair of its investment committee, I have my doubts.)

The second negative to structural low interest rates is that it exacerbates a sound economic recovery. One of the reasons for the various financial and economic crises that have occurred is that for the time and price structure we had excess capacity. The benefit of economic declines is that the excess capacity is withdrawn from the market as supply overwhelms demand. While painful to the workers who have to find new jobs, the removal of these excesses is similar to the way nature handles over-population. The problem with low interest rates is that it removes pricing discipline in making sound investment decisions. Often new capacity is brought on stream by marginal producers whose supply can not be profitably absorbed.

One of the reasons given for the low rates and some of the bailouts is that various markets seized up. While that was true for a moment and perhaps that would have been extended for sometime, but if new markets were not created at reasonable prices, the investments that were shut out of transactions would have proved to be not adequately priced.

The second tool that is being used increasingly by central banks is to spur on their exports to encourage lowering the value of their currency. As most of the central banks are reading from the same outmoded text books, many are in effect entering a global currency war which in the end will worsen their problems and not productively expand their markets.

If you are considering changing investment policies, what to do?

I agree with Liz Ann Sonders and her associates at Charles Schwab that it is folly to try to time the market. This is particularly true if you share their view of a haltingly rising market. However, in my roles with various investment committees I am very conscious as to the time horizons of many members of these committees. This is exactly why I came up with the Time Span Portfolios concept. (We can discuss this approach privately to fit various investment needs.)

The place that may need the most attention is the second or Replenishment Portfolio. The purpose of this portfolio is to replenish the Disbursed Operating Needs Portfolio. The time span for the typical Replenishment Portfolio is probably five years. Over this period two events are likely to happen. The first is that there is likely to be a stock market price decline. The depth of the decline is likely to be driven by the speculative force that creates the price peak. The second event is that one or more members of the investment decision making group will be new to the committee and could be a replacement.

To change even only one member of the committee is often a cause for a change in attitude. Of the groups that I presently know, the Replenishment Portfolio is a type of Balanced fund with at least equity and fixed-income funds in the portfolios. I have been managing most of these portfolios up to the turn of the year with the highest equity commitment that was tolerable. Since the beginning of the year through today we have been redeeming some equity funds to bring the equity commitment to the midpoint in their target range. I suspect that as the market moves higher we will lower the equity proportion to the region of the lowest permitted.

Some changes may be warranted for the third portfolio which I have named the Legacy Portfolio (as distinct to the truly long-term Endowment Portfolio) which can tolerate market volatility but doesn’t like it. I do not want to reduce equities to side step a future decline that will happen. I do want to provide some comfort during a period of turmoil. The way I recommend that one should be in both the stock and bond sides upgrades the portfolio holdings. While some speculative positions will do better on the upside they will fare much worse when the eventual declines occur. Part of the reason for going high quality is that planned long-term expenditures, surprise needs or opportunities occur and the Legacy Portfolio may wish to accommodate these opportunities.

Please share with me your thoughts about changing any of your investment policies.  

____________________

Copyright © 2008 - 2014

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

Fund Choices: Questions are Better than Rules

Introduction

This post is being composed during the long weekend of deliberation on spending and taxes in the US. These endless, and in many ways pointless discussions and the resulting actions taken, will have some short-term impacts and will set up further imponderables for the future. All of this is of interest, but our clients pay us to provide long-term solutions to their needs. Thus, I need to focus on finding good investment choices of funds and separate account managers.

Citywire Global, an informative website and magazine for international fund selectors, asked its audience, “What are the rules you use in your selection process?” This approach is similar to those used by consultants and "gate-keepers" in the US. This “rules based approach” also works well in many manufacturing activities. Rules provide particular comfort to large organizations and those who like being within a crowd.

Wise investment decisions are an art form

While there is a great deal of math within investments, I believe that making wise investment decisions is an art form. I have held this view for many years after my failure to find absolute investment rules. This belief was reinforced this weekend when my wife Ruth and I attended the wonderful Aspen Music Festival. We heard Mahler's 4th Symphony and will hear his 5th on Sunday. This year is the 100th anniversary of Gustav Mahler's death. His track record includes ten symphonies, which many believe was essentially one continuous probing of the meaning of life and death. Many orchestras around the world, including the Sydney Symphony, the Berlin Philharmonic, the London Symphony Orchestra as well as the New Jersey Symphony and the New York Philharmonic noted the anniversary of his death by playing his music this year.

I believe the collective experience of these concerts has a direct bearing on the reliance of the past performance of great investment managers. For instance:

• Many, if not most of the anniversary concerts played particular interpretations of Mahler’s music. Many investment strategies have the same notes from a previous genius (EPS & other facts), but will get different results.
  
  
• Concert performance differences can be caused by the size of the orchestra. The results of a fund or portfolio is shaped by the size of the universe of available investments.
  
  
• Affecting the overall music are the individual talents within the orchestra. The varying abilities of supporting securities analysts similarly contribute to invesment returns.
  
  
• The availability of good soloists is critical to a performance. External research/intelligence sources are essential to successful investing.
  
  
• The acoustics within the hall affect every performance. Location-dependent results, e.g., different currencies, market caps, the use of external brokerage, etc., greatly affect investment results.
  
  
• The talent and personality of the conductor is constantly on view. The investment manager brings his/her own attitudes to help shape a portfolio.

After 100 years, experts still have different interpretations from the same inputs.

Critical elements missing

Critics and others in the media focus on the total results without adjusting or commenting on critical elements. For example, for many years the late and great Sir John Templeton was celebrated for his fund's great performance in the early 1960s. Few noted that most of the superior performance was due to large investments in Japan, not repeated in the rest of his long and distinguished investment career. Other high-profile fund leaders were celebrated, with little or no comment about the portions of their portfolios that seriously underperformed. A number of the portfolio managers (PMs) named, by others, as the “Manager of the Year” (or Decade), had the humbling situation of producing poor results right after being overwhelmed by receiving media accolades.

What are some of the questions for today?

The first series of questions for past good performers revolves around the changing structures of trading. With the locations of trading fragmented and no real central marketplace recording prices and total volumes, how do PMs know what is happening beneath the surface of the reported prices? Further, how have the practices of quantitative trading (algorithms), changed their ability to accomplish large trades in a turbulent market?

One of the things that happens to successful managers is that materially-increased cash flow moves into their funds, some from short-term investors. How are they dealing with this flow? Often as investment organizations grow, leading PMs are required to manage an increasing number of accounts. Further, they become responsible for more people and functions as they add executive responsibilities. How are these changes impacting the time available for investment decisions? Is the amount of money and available choices within their target asset classes changing substantially, and how will that impact their efforts? Has the nature and strength of the competition changed? Will this impact their organization?

An interesting question that came up at dinner Saturday night with a very well known and respected PM who has been “retired” for more than five years, is how much of his extraordinary results originated from working with selective industrialist clients on their private investments in non-public companies? The greater understanding of the economics and the personalities involved aided the PM in his selection of public companies. There are a number of other examples of these special insights. What happens to the performance of the PMs when they are no longer having these conversations?

We have come to expect something different every time we hear a great symphony play a popular piece of classical music, just as we now expect a somewhat different result from a great portfolio manager in an ever changing marketplace. Our analytical strength is in the questions we ask, not finding good past records.


____________________________________________

Add to the Dialogue:

I invite you to be part of this Blog community by commenting on my blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog .

To subscribe to this Blog, or to refer a colleague or family member, use the email box or RSS feed sign-up on the left side of www.MikeLipper.Blogspot.com

In the Hedge Fund Shadows

One of the ways that I try to give back to a society that has been very good to me and to my family is to volunteer at six non-profits. Often I sit on or chair investment and/or finance committees. In a few of these cases the committees have chosen to use hedge funds and separate accounts as well as mutual funds for their investing. During periods of volatility, often on the down side, there is considerable anxiety until the comprehensive monthly performance report is published.* There is fear that the results will be so poor that the committee will be criticized for not being on top of the portfolio deterioration that might have commanded some selling action. Most of the time one or more of the hedge funds is the last to disclose its performance, which holds up the report.

Back of the envelope

Trained as an analyst, I am often in the uncomfortable situation of not having complete and accurate inputs. What I attempt to do is to produce an educated guess as to the missing numbers. One approach, which goes back to being a scout or perhaps learned in physics or math class, was to measure shadows. In the classic experiment, if one could measure the size of a shadow and how far it was from the source of light, one could triangulate and determine the size of the object that was throwing the shadow. I use the same approach to guess the likely performance of a hedge fund.

This is not a commercial

My old firm, now known as Lipper, Inc, publishes daily, weekly and monthly performance records of almost all mutual funds in the world. While I have no financial relationship with the company, I am a user of its data for my commercial and volunteer investment advisory work. As a carry-over from when I was running the firm, it produces many investment objective indices of typically the 30 largest individual funds in each group. Since my sale of the operating assets of the firm to Reuters (now Thomson Reuters), there have been waves of “retail-ization” of hedge funds. To counteract some real and potentially large losses of mutual fund sales, various firms have produced funds that somewhat copy the techniques of hedge funds. At the moment, with new investment objectives tracking these funds, we must use their performance averages as substitutes for indices that do not exist. (For the purists in the community I would be happy to discuss the advantages of indices over averages).

What do the averages portray?

First there are four such new investment objectives that are titled: Absolute Return funds, Dedicated Short funds, Equity Leverage funds, and Equity Market Neutral funds. Second, in most cases, these are equity funds, and often their “shorting” is by selling short ETFs (Exchange Traded Funds). Third, their average expense ratios are between 1.52% and 1.73% before any performance fees, if earned. Fourth, they are somewhat constrained in their use of leverage by the Investment Company Act of 1940, as amended from time to time. This potential difference with the more unconstrained private hedge funds is one of the reasons that I use the mutual fund results only as an early indicator of what some hedge funds might produce. A tighter fit is possible by picking out specific mutual funds as a somewhat peer comparison with specific hedge funds.

The results

The average returns for the first 5 months of 2011 were:

• Absolute Return mutual funds: gained +1.20%
  
• Dedicated Short funds: lost -9.79%
  
• Equity Leveraged funds: gained +6.51%, (the best of the four new objectives)
  
• Equity Market Neutral funds: gained +1.02%
  

To put these results in perspective:

• S&P500 Index funds: gained +5.00%
  
• Multi-Cap Growth funds: gained +6.02%
  
• Multi-Cap Value funds: gained +5.78%
  
• Multi-Cap Core funds: gained +5.54%
  
• Large-Cap funds, on average, produced returns in the +4.6 to +4.75 range
  

Working conclusions

When the hedge fund numbers come out they are likely to be behind the publicly available mutual fund results. However, I expect there will be some spectacularly good results. The winners will possess great selectivity skills and may have used the greater flexibility that hedge funds have to their distinct advantage. I believe that performance numbers do not provide the answers to selecting investments for the future. Performance numbers should promote questions not answers. For example, if a portfolio has significant investments in financial services stocks, one should take into consideration that the average Financial Services (domestic) fund was down -2.74% year-to-date. Around the world banks and non-life insurance companies have been the worst investment group thus far in 2011. Part of the problem for these institutions is that for regulatory capital requirements they are being forced to own too much of their own government paper in addition to holding prior bad loans to other governments. At the moment the investing public, outside of speculating on a few IPOs, is not actively participating in the market place. [Disclosure item: I manage a private financial services fund that is only appropriate for long-term oriented accredited investors who believe in looking for depressed securities.]

*My good friend Larry Goldman, the CEO of the NJ Center for the Performing Arts (NJPAC), was kind enough compliment me and the members of the Investment Committee in pointing out that the Chronicle of Philanthropy ranked the estimated yearly return of 19.6% for the NJPAC’s endowment as #11 of the 72 endowments with similar fiscal year periods.

Correction to last week’s blog

One of the best members of this blog community quite correctly noted that I slipped the decimal to the right when I indicated that a doubling in 100 years was the equivalent of a 0.1% gain per year. Actually on a simple divisor basis it is 1% p.a., and a compound basis 0.70%. We have corrected the original blog on its website, www.MikeLipper.Blogspot.com .

____________________________________________

Add to the Dialogue:

I invite you to be part of this Blog community by commenting on my blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog .

To subscribe to this Blog, or to refer a colleague or family member, use the email box or RSS feed sign-up on the left side of www.MikeLipper.Blogspot.com

The Crowd Roared and Investors Cringed: Be Careful of Crowded Trades

Saturday night, my wife Ruth and I heard Mahler's Symphony No. 3, with the marvelous Jacques Lacombe conducting the New Jersey Symphony Orchestra in its concluding classical concert for the season. (Ruth is an indefatigable Co-chair of the NJSO.) When the last note was sounded, the nearly sold out audience at the New Jersey Performing Arts Center (NJPAC) exploded in a loud and enthusiastic roar of approval. (I am very pleased to see full houses at the NJPAC, where I am a trustee and chair an investment committee with very impressive co-members.) Though the Mahler symphony was composed over 100 years ago, being amidst Saturday night’s large and vocal crowd reminded me that one of the most valuable skills of some of the best investment managers that I have known and studied over the last half century, is to avoid crowds, especially early crowds.

Bond buyers and inflation

Last week bond buyers purchased between $40 to 50 billion dollars of securities, depending on which sources one used. Most of these issues were of high perceived quality and therefore relatively low yields. The yields were below many actuarial assumptions for pension plans, were below endowment fund expectations, and certainly did little to resurrect the retirement capital accounts of investors. Why the rush? The answer may well be that there is too much un-invested money sitting around earning next to nothing. The pressure to “do something” at times becomes unbearable. In the week, we saw the issuers take full advantage of the crowd; including Google raising $3 billion in addition to over $30 billion in cash on its balance sheets. Perhaps the buyers will be rewarded with interest rates dropping further (if that is possible) and therefore pushing bond prices up.

The two largest middle class populations outside of the US are in India and China. Both countries are experiencing reported and less-reported inflation at an accelerating rate. These populations are relatively unschooled in high finance, but are living through an inflationary experience and are acting smartly. Both are buying gold in all forms. In the first quarter of 2011, the purchase of gold by the Chinese was $40 billion, or about the same amount as its weekly bond buying surge. Often ordinary people are more correct than well-schooled experts, and therefore I am expecting an increase in the rate of inflation.

Gold buying is not the only defense against inflation. On Friday I attended the annual Investors’ Day for the Sequoia Fund, a mutual fund that has been held for many years by some of our investment advisory accounts. In discussing inflation, the president of the fund stated that ownership of well-managed corporations that have protected pricing power is an effective inflation-defensive strategy. I tend to agree.

Lack of Historic Perspective by Equity IPO Buyers

LinkedIn recorded a doubling of value on its first day of trading, a modern record. The key facts are: The company had no earnings, and at the initial prices it was selling at eleven times sales. By the end of the first day therefore, it was selling at more than twenty-two times sales. Assuming that full taxes are paid and that the after-tax operating margin is 50%, the potential price/earnings ratio would be a minimum of forty-four times earnings, if there were any earnings. When I was learning security analysis at a trust bank, there was a rule that senior investment management would not accept a terminal P/E valuation in excess of 25x. Further, there are very few companies that have a history of growing operating earnings with low double digit growth rates over a decade. A rare, exceptional company might be able to grow operating earnings in the mid to high teen range over a ten year period. I am not conscious of a company growing operating earnings 20%+ over ten years on a fully taxed basis. History would suggest that the first day closing price for LinkedIn was a function of undisciplined price behavior or aggressive shorting pushing up demand.

Lesson of The Week

Stand up and cheer great performances, but stay away from participating in crowded trades. This principle is applicable to bonds, stocks, or for that matter, anything that trades. Some of the biggest gains in the hedge fund that I manage have come from buying stock after an IPO price ran up, and subsequently collapsed well below the initial price. I doubt that I will buy into LinkedIn soon, (the stock, as distinct from the service). My early training at the bank requires publicly traded securities to have earnings.

Sharing Disciplines
What are the personal disciplines that have kept you out of investment trouble? Please share these disciplines with me via email; letting me know your choice whether to share them with the Blog community or for my use only.


____________________________________________

Add to the Dialogue:

I invite you to be part of this Blog community by commenting on my blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog .

To subscribe to this Blog, or to refer a colleague or family member, use the email box or RSS feed sign-up on the left side of www.MikeLipper.Blogspot.com