Peak Ahead, But Not Just Yet

Introduction

In a somewhat long, scary piece on the re-hypothecation of gold bars, John Hathaway of Tocqueville Asset Management intones “In the financial markets, a person that is one step ahead of the crowd is considered a genius, but two steps ahead, a crackpot.”

I do not claim to be a genius, I am just an investment manager who attempts to anticipate problems. There is a danger in this; my wife and driving companion urges me to forget my learning to drive in New York City. When the center traffic light on a broad Manhattan avenue is yellow, it is a command to speed-up. Ruth stresses the danger in this approach as other drivers perpendicular to my direction may anticipate the change in their light signal from red to green and jump out as my cautionary light is changing to red. The investment message is that we do not know for sure what will happen and thus we can not anticipate every turn of events. All that I can do is to fall back to my handicapping days at the local racetracks. I can assess the reasonable possibilities and probabilities versus the weight of money calculated odds derived from the parimutuel pools (less track and government takes). With these thoughts in mind I will list some of the positives and negatives looking forward for the next one to three years. (For those investors who properly view their investment horizons beyond five years these discussions are less germane.)

Positive outlooks

Annual Statistics - Jeff Tjornehoj from the Denver office of Lipper, Inc., now an affiliate of Thomson Reuters has studied the history of the Dow Jones Industrial Average (DJIA) since 1896. His analysis shows that the year following a 20% gain produces an average 8% gain. Only two down years after 20% gains happened in 18 years. Steve Leuthold’s group also noted that the DJIA in November reached an inflation-adjusted high which took 13 years and 11 months to accomplish. The S&P500 needs to reach an equivalent inflation-adjusted 2061, which is above the 2014 year-end estimate of ten leading market strategists according to Barron’s.

Valuations - We have been looking to add additional large cap growth funds to client portfolios. In three cases of good performing funds we have noticed that the current valuations based on their current measures have taken a significant gain in terms of price/earnings, price/book value and price/sales ratios. In terms of P/E comparing the three funds’ current vs. 2012 ratios: 35.22x vs. 29.46x, 30.52x vs.24.58x, and 33.52x vs27.36x. There is a logical explanation for this escalation. If we go back to the period of the former DJIA inflation-adjusted high some 14 years ago we had 8,823 individual stocks listed on the principal US stock exchanges. At the end of November 2013 there were 4,916 listed stocks. With interest rates manipulated below their inflation-adjusted credit risks, it is not surprising the money flowed into the equity market creating the TINA impact (There Is No Alternative). Most of the almost four thousand missing companies did not go out of business, they were acquired by larger companies or taken private. (See more about the next logical development of this trend in the lists of negatives.)  

Enthusiastic Managers - Saturday night Ruth and I went to a wonderful Pops Concert at the New Jersey Symphony Orchestra featuring John Pizzarelli as well as the Salvation Army Band. Ruth is the very active co-chair of the NJSO. Our guest for the evening works for one of the most successful hedge funds and he repeated his leader’s published bullishness about the outlook for more than the next year. I have read similar comments from three UK managers who are quoted as the “outlook for equities has never been better.” A US small cap manager has now a greater willingness to embrace risk. Part of this enthusiasm is based on the bear market induced concentration of correlation. They all went down. Statistical correlation is becoming less binding and this is the phase when security selection should pay off. In a recent survey, analysts with CFAs were given the choice of what would produce the biggest performance for their funds; 47% voted for security selection with only 26% for asset allocation and only 12% for macro bets. (This raises lots of questions as to the fad of running money through the use of Exchange Traded Funds (ETFs).

Negative outlooks:

Destruction of capital from too much money

As an electronics, broadcasting and aerospace analyst, and eventually a multi-product conglomerate analyst I was in a small department with an aluminum analyst. He was a profitable contrarian. The market got excited when the companies he followed brought more furnaces and mills on line. He recommended sales of these stocks and only recommended purchases when there was a pretty massive shutdown of facilities. He believed accurately that over time when too much capital was committed to a market it would lead to price wars. Price discipline was eventually restored when companies had to earn at least their cost of capital. A somewhat similar philosophy is espoused by a very successful London-based manager, Marathon Asset Management that applies to numerous sectors globally. In the positive section above I highlighted the substantial drop in the number of securities. As someone who has been both a buyer and a seller of companies as well as benefiting from acquisitions of stocks that clients and I have owned, I suggest that most acquisitions lower the buyers’ long-term margins and return on invested capital. This factor plus the need of various private-equity and venture capital funds to produce cash returns suggest to me that we will see at some point and perhaps soon an increase in the number of new issues. While at the moment many financial institutions and individual investors have excess cash, at some point the cash needed to take up these IPOs will come from sales of existing holdings. (This is a familiar pattern in a number of cash short non-US markets.) While the new shares may rise in price the shares sold will put pressure on the older position. 

Perhaps a clearer example of a market that is absorbing too much capital and with a limited number of experienced players is the hedge fund market. This will be the fifth year that the aggregate number of hedge funds has underperformed the stock market. While there has been a number of very successful hedge funds, many funds particularly some new entrants have not been able to generate sufficient performance to get properly funded so that they can attract necessary talent not only on the investment side, but also administrative, trading, compliance, investor relations and sales people. 

Less enthusiastic managers

According to the British newspaper, the Telegraph, BlackRock, the world’s largest investment manager predicts the US rally is near exhaustion. Further they are warning their clients to pull out of global markets at the first sign of trouble.  However, BlackRock does believe that there is a 25% chance of a “growth breakout.”

Other managers, particularly small cap managers have closed their funds to new money. Some of the more successful hedge funds are sending money back to their holders. (Understand the math, with less money and a proportionately greater percent owned by the managers there is an improved chance of earning various performance fees.) In theory all managers get paid on the total of the assets that they manage, doing anything that results in smaller inflows or a reduction in actual size of their funds is a near-term hit to their bottom line, but they may be preserving their good records.

Bond market worries

The first worry is that eventually we will see interest rates go up which will push already outstanding bond prices down. This could start soon. Lower bond prices will lead to negative returns for Bond funds which will accelerate the outflow from Bond funds. Switching Bond fund investors to Equity investors within the same investment complex may be difficult without figuring a way to compensate the distribution channel for the switch. The redemption proceeds can be new money for a different organization and its distributions channel.

The second worry focuses on the high yield part of the market. The current yield spread between the high yield and the high quality parts of the market is historically quite narrow. There are a couple of concerns going forward. First during the period of low interest rates and substantial flows into the high yield arena some issuers may have loosened their financial disciplines and there may be an increase in defaults. The second concern is that we are entering a period where there will be an increased need to issue new debt as a way to pay off maturing debt.

The importance of these concerns to the equity market is that directly or indirectly any of the Merger & Acquisition activities require the sale of high yield bonds to finance the equity deal.

“Brace for a 20% correction”

This week’s Barron’s has an interview with Ned Davis and two of his leading associates under the headline, “Brace for a 20% Correction.” Ned Davis is a very well known and respected source of technical analysis. At the moment they remain positive but they can foresee a 20% drop in the future.

 My investment take

Unfortunately too many so-called investors have short investment time horizons of a year or less. For these accounts I would begin to raise cash slowly, withdrawing a portion each month so that a 20-25% decline would not interfere with meeting short-tem funding requirements. For the investor that has at least a five year time horizon, moving slowly into high quality stocks, particularly well-priced value and high quality bonds makes sense. For my favorite investors who look to a ten year or longer time horizon, I would be shortening my fixed- income maturity so as to have additional cash to invest for high quality growth with an understandable future.

Please share your thoughts with me, I hope to learn from you.

_______________________

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Entering the Most Dangerous Market Phase: In Three Parts

Introduction

Many years ago I heard an unoriginal line in the elevator (lift for my British friends) coming down from the New York Stock Exchange Luncheon Club. “Do you know how to make a small fortune,”  the old floor broker asked then he quickly supplied the answer, “start with a large one.”

There are two important axioms about a major stock (and bond) market decline.

1.    Big losses are only possible after big gains. This is not quite as earth-shattering as Sir Isaac Newton’s discoveries. But the result to one’s portfolio is indeed grave.

2.    Historically by far the biggest loss suffered by investors is not the decline from the peak to the bottom. A much larger loss over time is sustained by the disheartened investors who feel foolish or embarrassed by the loss and withdraw from participating in future markets. One of the reasons that those of us who entered the US market in the mid to late 1950s did so well was that many of the more senior investors were concerned about another Roosevelt 1937-38 type collapse and so were sellers and not buyers.

Part 1: The Market Can Go Higher

My last several posts focused on some of the pre-conditions present in past peaks. I am not flashing red lights for investors to come to a stop of what they are doing. I am stressing that I perceive the need for additional caution. I fully recognize that the stock markets in many countries can get further extended by those who are focusing on the upside by touting the following points:

1.    In a chart supplied by Strategas Research Partners and T. Rowe Price^*, after 57 months of expansion of the last 13 Bull Markets, the average gain was 165% which compares with our present rise through mid November of 164%. Thus we are on track in terms of up phases. There were four Bull Markets which showed further up-side. In terms of greater S&P500 advances the 1990-2000, 1932-37, 1949-56 and the 1982-87 Bull Markets performed greater than we have achieved in this phase. The first two on the list had gains of about twice to three times what we have gained so far. So there is potential for more upside. Morgan Stanley^* is leading the cheering section with a published view that we will see 2014 on the S&P 500 in the year of same number.

2.    The financial conditions in Europe are not only not getting worse, but Moody’s* is selectively raising up various lowly-rated sovereign debt ratings. (In the end, if he could have held on, Jon Corzine would have made money on MF Global’s leveraged bet on the euro.)

3.    Surprising to some, the US domestic economy is showing a pickup in growth. One might wonder whether what we need are more bouts of government shutdowns to help productivity?

4.    There appears to be some chance that we won’t see another US government furlough program as some members of Congress are putting together a budget that takes us through next year’s elections.

Part 2: Deep Structural Problems Are Not Being Addressed

All is not well or improving in our world with some very serious structural problems not being part of current proposals.

1.    We live in a paradoxical world where there is substantial unemployment and under-employment at the very same time that businesses cannot find qualified applicants to fill job openings. The missing elements for the employers are not just a mismatch of training skills. In talking with employers what are missing are basic academic skills, work and discipline attributes as well as work-oriented integrity. Even with an expanding economy many may not find work. In effect we have structural unemployment.

2.    Around the world the size of individuals’ retirement capital is significantly insufficient. To the extent that this lack of retirement funding is going to be addressed by individuals, the only place that they can get the money is by spending less and saving more which will hurt our consumption models.

3.    As a nation there is every chance that, in aggregate, US health care costs will go up beyond various budget assumptions. The strong odds are that society will pay more with less-strong odds that the quality and efficacy of health will improve to the same degree as costs will rise.

Part 3: The Trap is Being Set

There is nothing that I have laid out in this post that is startling new. Most investors will focus on Part 1, the upside. With the rising momentum people will not be overly concerned about Part 2, the problems not being addressed. This behavior is similar to the aforementioned Sir Isaac Newton who bought and then sold out of the parabolic rise in the South Sea Bubble caper only to be sucked back into re-purchasing out of envy and then again lost all that he had committed in the subsequent collapse. He fulfilled the same role that my professor friends at Caltech have demonstrated in the study of the brain which focuses on past successes or pleasures. As a junior securities analysts we quickly learned of the power of the greater fool theory. For a long time fools have more buying power than prudent investors.

What to Do?

I have five suggestions:

1.    Be careful it is easy to get sucked in, many bright people will.

2.    Focus on investment with well-financed companies that have quality products and services that remain essential in the future. You probably will earn less, but probably will also lose less.

3.    Reduce the ratio of your net purchases to your net sells. While cash is the equivalent of trash today in these low interest rate markets, Warren Buffett has amply demonstrated his acumen at Berkshire Hathaway^*, emphasizing the value of cash during periods of stress and accepting under-performance until the rising cash pile can be used dynamically.

4.    Remember that future opportunities will occur and in the long run that will be good for you.

5.    Use the time horizon strategy I have previously suggested separating your intermediate time horizon investments from your longer-term investments. (Please contact me if you would like these posts emailed to you.) The intermediate investments should be current price-oriented. When the bidding for these good companies gets excessive on a historic basis, be a supplier (seller) into the market. Ride out your long time horizon investments and when they periodically decline due to short term factors buy more.

Do You Disagree? Please let me know I am always anxious to learn from wise people.

^*Stocks of the companies mentioned are either owned in my private fund or are in my personal portfolio or both.

 _______________________

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

More Cautionary Signals for Investors

Introduction

The mission of a good investment analyst is to think about the impossible thoughts or at least the ones that seem improbable to most. The job of a prudent portfolio manager is to anticipate problems in the face of increasing momentum.

In last week’s post I raised concerns about a forthcoming peak or top of the global stock markets. This week I see more signs beyond the increase in margin debt I highlighted last week. I doubt that I (or anyone for that matter) can call the top with any precision. Nevertheless, I am concerned that we are much closer to a peak than a five year-old bottom and increased caution is warranted.

My concerns are outlined below. I would be happy to discuss these items with members of this blog community.

Black Friday: Traditional research could be failing

Long-term readers of these posts are used to my shoe-leather research of going to the near-by “The Mall at Short Hills” on Black Friday. This year my wife Ruth, my niece Alisa and I went to the glitzy, largely high-end mall Friday afternoon. Parking was less difficult than on other Black Fridays. With exceptions, both the shoppers and the stores were tight with their money. Relatively few people were carrying four shopping bags at once. As a matter of fact, this year there were many mall “walkers” and some in lounge seats without any bags at all.

I only noticed one shop advertising for additional help. The only two stores that seemed to have any frenzy around them were the Apple and Verizon outlets, both sellers of Apple products. (One should be careful, even analysts and portfolio managers see what they want to see. I am a long-term owner of Apple^* stock and we buy these products through the Verizon store.) In past years these perambulations gave me a good clue as to how overall Christmas sales were going. I now question this approach as there is some chance that on an overall basis there will be more sales over the Internet than in the physical stores in 2013; if not now then surely next year. We should have an easier time finding a parking place next year.

Mutual fund signals

One should expect because of my history and portfolio that I would pay attention to what is happening in the mutual fund business. In October investors added a net $21 billion to Equity funds as compared with a net redemption of $16 billion in October of 2012. For the ten months the net flow was $134 billion compared to a net redemption of $99 billion in the same period last year. This money probably came from a $221 billion smaller net contribution into Taxable Bond funds and a net swing into redemption from net sales in Municipal Bond funds of $91 billion. What has me concerned is that the biggest increase both percentage-wise and dollar impact was the $115 billion increase in World Equity funds followed by $104 billion increase in total sales by the Capital Appreciation funds. Both of these groups typically assume that the fund owner will be able to redeem quickly from these more volatile type funds. Only $67 billion was added this year into the less volatile and more likely retirement money of Total Return funds. Adding to these concerns was that most fund channels showed increases in October over September, except the institutional channel and the proprietary bank channel. I am concerned that the lower sales in October in these two channels could have to do with the restructuring of the marketplace in anticipation of the so-called Volcker rule restricting proprietary activities of banks.

In addition, Variable Annuities are seeing net redemptions across the board except for the Hybrid and High-Yield investment objectives, which suggest that even in this supposedly long-term arena for retirement, investors are looking for performance in some risky places. (All of the numbers quoted are sourced from the Investment Company Institute.)

My concern about market restructuring can be gleaned from information re-published by John Mauldin on the number of pages of major financial laws. The list is arrayed chronologically and also inversely as to their lasting importance: Remember the more pages, the less effective the legislation becomes.

• Federal Reserve Act (1913) 31 pages
• Glass Steagall Act (1933) 37 pages
• Graham-Leach-Bliley Act (1999) 143 pages
• Dodd-Frank (2010) 2319 pages

All of these bills created hurdles in the end and at great expense defeated the fundamental purpose of each legislation, but made a lot of money for lawyers, including those who had service on Capitol Hill.

Portfolio managers cherish their investment records as well as having concerns for the long-term benefits to their shareholders. The obvious fear on their part after a number of years of good to great performance is concern about a less good if not an outright nasty future. In some cases of over 40% gains this year, certain Small Company funds are closing their doors to new money or new accounts. The latest one to announce this softly is T Rowe Price^* New Horizons fund who has executed this move a number of times in its long and distinguished history. Other Small Company funds have built up their cash holdings to over 40% and in one case, it is reported, to 65%. We are increasingly finding it difficult to find growth-oriented funds, particularly Small Company funds that meet my standards of research and prudence for our fiduciary accounts. As the market rises on more enthusiasm, it will be more difficult to pick long term winners.

Two-handed economists and portfolio managers needed

While a former US President once sought a one-handed economist, an economist that shows the proper degree of balance is actually more worthwhile. The control of the leading Central Banks of the world is now in the hands of those who believe that no mess is quite so bad that official intervention won’t make it worse, asserted the UK's Daily Telegraph. In this era of multiple quantitative easing (QE), some academically driven measures can work. Over the weekend Moody’s^* upgraded the Greek Government Bond rating from “C” to “Caa3” with a published view that after six years of the economy contracting that in 2014 there will be some growth and by 2015 the Greek economy will be rushing ahead at a 1% growth rate.

Two missing important caveats should be added. First there is no measure of the long-term impact of exporting brains and labor to be employed elsewhere with little probability that they will return. The second point:  to a market observer the Moody’s announcement is not a surprise as both the markets for Greek bonds and shares have been rising for some time.

The lead/lag effect between the markets and the economy needs some explanation to many who are not deeply involved with the market. I will share with you a synopsis of two conversations about this dichotomy I had in a 24 hour period. The first was with a confused cousin who is a graduate of a well-known university who also has a locally obtained master’s degree. She was confused as to how the US market (where she has some investments) could go up, and the economy be so bad that her sales of a professional product were not up to expectations. I asked her whether she had two left hands. She said she had a right and a left. I asked if there are there times each hand is doing something different. My comment was that the market and the economy were like her two hands each performing different tasks. This apparently made some sense to her. 

Saturday night at a reception for donors to the New Jersey Symphony Orchestra (an organization lucky enough to have my wife as its Co-Chairman), I was talking with a senior staff member who had a similar question. I suggested that we would not want our Concertmaster who is a world renowned violinist switching places with an equally professional timpanist for an important piece of music. He got it that in terms of harmony one needs both, but they play different roles. That seemed to satisfy him.

Buy, Sell or Hold 

Howard Marks, the CEO of Oaktree Capital, a very successful investment management firm, and a friend for 30-plus years believes that markets are forever cyclical and those who do not expect future cyclicality are at risk. At the moment, while cautious, he is not calling a top. I am also cautious, particularly because my private financial services fund last week had a gross year to date gain of 34% which is high for a quality-biased conservative portfolio.

Nevertheless for clients I am responsible for making decisions or at least suggestions. Thus, I have to make Buy, Sell, and Hold decisions. As mentioned in previous posts I array my decisions along the different time horizons. I am, for the most part, reserving my buying to stocks that appear to have substantially more long-term upside than shorter term downside.

My Selling is largely driven by cash funding needs, rebalancing within agreed-to guidelines and in anticipation of some current holdings enjoying upward momentum, but which have a history of significant drops when the markets turn nasty as they always do. For long-term oriented endowments and my own family I favor Holding, as I believe the underfunding of global retirement capital will lead long-term capital flows into the markets that will produce good results for long-term, prudent investors.

*Disclosure: Either owned personally or in my private financial services fund.

Please share your thoughts with me on these topics.

_______________________

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.