Extreme Popularity Creates Risk - Weekly Blog # 541

Mike Lipper’s Monday Morning Musings

Extreme Popularity Creates Risk

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

Risk from Other Owners
Too many investors focus their analysis on the risks to the issuer of their securities, as well as external factors like the political economy. The big lesson learned from major price declines is that the single biggest risk comes from the other owners in the securities. When it comes time to sell in a period of high anxiety, the other owners become competitors until the exit is completed. That is the missing lesson from the series of articles on the price collapse in sub-prime mortgages, Long Term Capital Management, Lehman Brothers, and the Reserve Fund. In each case the specific liquidity problem of the issuers triggered a market liquidity crisis for other securities and markets.

The history of big crises is captured in those three letters =big. Due to the popularity of investing in a security or type of security which absorbs liquidity on the way up, there is often insufficient capital to provide liquidity on actual or rumored mass exits. In other words, at the point of contemplated or actual exiting, there are few to no buyers left.

Could we be approaching such a situation in the credit market? Will it stampede the corporate bond market and possibly the stock market? Will the stampede include some bank capital positions? Maybe.

When? Now or Soon?
Timing is the most difficult tool in the investing art form. As with our favorite portfolio strategy of sub dividing a portfolio into separate time spans, there are three different approaches depending on time spans. Randall Forsyth in Barron’s stated “Since 1950, September has been the worst month of the year for the Dow and the S&P 500”. That is the immediate worry period.

The great economist Hyman Minsky identified that periods of stability bread instability. This makes sense, as far too many investors take current conditions and extrapolate them into the indefinite future. That is a lazy way of thinking. Change occurs every day, most of it small, but the increments add up leading to an unrecognized reality, until there is a shock of some sort. Investment committees and wealth managers are particularly susceptible because they are planning finite periodic distributions.

The longer-term change is a slow recognition of a faulty set of assumptions. There is one visible today, utilizing mutual fund performance data from my old firm Lipper, Inc, presently a part of Thomson Reuters. For the last five years there have been two trends that  cannot continue forever and have been contrary to investors best interest. For the last five years through August 30th, the average US Domestic Long-Term Fixed Income Fund has grown at the rate of +2.55% per annum, in contrast to the average US Diversified Equity Fund which has grown +11.11%. During the same period there has been a net flow into bond funds and a net redemption in equity funds. The biggest net redeeming group has been Large-Cap Growth Funds, which gained +15.78%. Possibly, those that guide investors will wake up during the next decline and sell out of their fixed income funds, which presumably will go down less than the stock funds, and recommit their assets to stock funds. (Some may overcome the relative pleasure of losing less, but most won’t until much later.) Even in executing this maneuver, they will probably still be behind most stock fund investors who stayed through the period.

The Two Biggest Risks
The first is that we have moved from a pattern based on business cycles to one based on capital cycles. Almost all activities used in inflation defenses have become directly or indirectly leveraged by the use of borrowed money or float. The financial community, in order to supply the necessary funding to make the system work, has moved from sole reliance on stocks and bonds to rapidly expanding the use of credit instruments. Most brokerage firms and other investment organizations have entered the credit markets as packagers and sellers. The competition to become the dealer in the paper has become intense and has led to weaker covenant constraints in the underwritten bond market. Many of these instruments are traded in private markets, with little public price discovery. These are conditions that could well be a ticking time bomb under the whole financial market. There will be actual or rumored defaults on these instruments.

As with the current concern for contagion in Emerging Market bonds, stocks, and currencies, it may be time for similar fears in the credit markets. The contagion risk is not primarily in the instruments themselves, but in the capital structures of both the leveraged holders and the market makers. When a holder of damaged or defaulted paper recognizes the problem, its immediate need is to restore its capital cushion. Typically, the way they do this is by selling their most liquid holdings to raise as much cash as quickly as possible. A sudden and desperate need for capital in one market often flows into other markets. Thus, it is possible a credit market problem can cause disruption to the bond market, which in turn can affect the stock market. Remember, most of the time investors and traders value their holdings relative to other securities. If the other securities are weak it impacts the value of their securities.

The second big risk, and this is over considerable time, is the cost to the ultimate beneficiaries of our wealth, which in times of stress may withdraw from the combat of investing. Cash becomes too comfortable and low-price opportunities are missed, sacrificing future earnings growth. These losses are much larger than the temporary losses resulting from riding sound investments down before they revive.

FORWARNED IS FOREARMED
 
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A. Michael Lipper, CFA
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Are There Big Traps in the Credits and Foreign Exchange Markets?

Serving on numerous non-profit boards, investment and finance committees as well as being investment advisor to various wealthy investors and financial institutions provides me with the advantages of having a wide source of information, opinions and talents. By regulatory definition these clients qualify as “sophisticated investors.” As each investment pool is designed to meet the specific needs of an account, there is only a minor degree of overlap in investments. Thus when I hear from different groups the desire to add a specific type of investment product or strategy, these desires become an important trend to consider.

Recently this development occurred when members of diverse groups from both coasts wanted to add investments in credits to their portfolios. They were not focusing primarily on bonds, except those that were in distress. Instead, they were focusing on mortgages, asset-backed loans, bank loans and other credits perceived to be in trouble. My concern is that both the credit and FX markets have similar characteristics which have been troublesome in the past. These are:

• Over-the-Counter trading without central price reporting and settlement of trades


• Unfamiliarity to most institutional and individual investors


• The availability of high margin (up to 99% in some cases)


• A largely unregulated global market without fixed market hours


• Apparent hedging through complex derivatives


• Trading requires specific skills and broad networks


• Many, but not all, of the players are working for unfamiliar names

Note that often these credits are not in the form of securities and may not be under the aegis of the SEC. In most cases the search for such investments leads to managers who are not used for high quality investments and are often engaged with low fees. None of the managers have relevant track records, but all share the characteristics of wanting high fees and/or profit participation roles.

Certain aspects of this market may offer a prescription for high level, leveraged, and operationally intensive, price and fraud risks.

I have no doubt that there will be some money made in credits in the months and years ahead. (My definition of “money made” is the aggregate withdrawals that can be made after relevant taxes without invading inflation-adjusted principal.)

The search for credit opportunities is almost exclusively institutional in nature. The retail equivalent of this search is Foreign Exchange (FX). FX exists in the global 24-hour market whose heavy, cable-advertised drumbeats may mask some of its toxic nature. While there is a bit of institutional interest in trading FX directly, FX trading in size is usually conducted through bank channels. Many investors have learned to their dismay that price risk, with its relatively small movements, is not the only risk. In the credit and FX markets, counterparty risk should be examined; the other side may not be good for its trade. To many, the Lehman Brothers’ bankruptcy exposed the unfathomed depths of counterparty risk. The critical interrelationships of these markets are underscored by the name which many brokerage firms identify this combined market group: “FICC” standing for Fixed Income, Currency and Commodities. This group is traditionally a major user of its firms’ capital and a generator of profits, and more recently, large losses.

I am not advocating that one totally avoid investing in either credits and/or currencies. What I am suggesting is that instead of being a strategic reserve element to a portfolio, that these investments can prove to be high risk/high reward elements that should cause lowering the potential loss of permanent capital in other parts of the portfolio.