Watch Energy and Guns on the Trip to the Peak

Introduction

Unlike drones and more like electrocardiogram plots, investments rarely go in straight lines but undulate; frequently reversing directions which is normal.  As has been stated in my past posts, I believe that our current journey will take us to peak equity prices. Unlike Irving Fisher’s comment in 1929, I do not believe that when we reach the peak in the future that we will achieve a permanent price plateau. After the peak, there will be a measurable decline whose fall will in part be a function as to how extended the rise is above a reasonable value base. Beyond the decline we will also have future rises to other peaks.

This seesaw pattern is why I am a firm believer in subdividing one’s portfolio into time horizon and perhaps other components to protect the ability to accomplish the majority of one’s investment goals.

Signposts

No two market cycles behave exactly alike. Nevertheless, there are a number of indicators that I watch and compare with previous cycles. One of the best contrarian indicators is bond prices. A decline in bond prices is caused by the current owners not wanting to own their existing merchandise and/or refusing to buy newly offered bonds. This will lead to the need for higher yields both for the existing and new offerings. The year 2013 was the first in many that prices of bonds and the performance of bond mutual funds declined, which in turn led to bond fund redemptions. When stock prices drop some of their owners may flee the fall and buy into bonds and bond mutual funds. This is not happening now.

A second important indicator is commodity prices. At any given moment the quantity of a commodity in the hands of buyers and sellers available for immediate shipment including movements from or to warehouses fluctuates. New production from newly planted crops, new mines, and new refinery and smelting capacities will not be available immediately. Rarely will new supply come to market at prices lower than current prices. Thus, falling commodity prices are both a sign of reduced demand and expectations. These lowered expectations, along with regulatory changes, are the reasons why major Wall Street brokerage firms are exiting the commodity brokerage and dealing businesses. (This reduction in commodity capacity at some point will lead to shortages and strong commodity prices but not now.)

A third current indicator and a very volatile one is the level of stock trading. The folk law of “The Street” is that as the first trading week predicts January activity which in turn is a good, but not perfect guide for the year. The thinking behind these views used to be based on when Wall Street bonuses were paid out, but in a more modern era of a shrinking financial community, the new flows are expected to come from defined benefit and defined contribution retirement funds which would have just received their cash contributions. For whatever reason, including weather or market volume, this last week was lackluster and most prices moved very little. Some of this sleepy behavior could be attributed to a strong December and a way-above-expectations 2013. On a purely technical basis the ratio of shares sold short to the average trading volume theoretically generates the number of trading days that would be needed for the shorts to purchase enough stock to cancel out their short position. With the NASDAQ market producing much better returns than the other organized markets, some shorting, hedging, or tax management activities were done in December. This year the short ratio of the number of trading days needed to cover declined approximately 21% from the prior month to 3.79 days. This has the potential impact of fewer shares being needed to cover and therefore less demand.

Sages

One of the many blessings I have is that I know a number of very thoughtful and accomplished people. Some of them share their views in writing with others. Two in particular have said or written pieces of particular interest at this time. Jason Zweig in The Wall Street Journal (subscription may be required) suggested that we were not in a bubble. He described a bubble as similar to the South Sea Bubble of 1720 based on the presumed ability to become the principal trading partner between Europe and the New World. This is the bubble that sucked in, as prior posts have mentioned, Sir Isaac Newton. In the bubble some investors temporarily made ten times their initial purchase in the unlikely event that they got in early and sold at the top quickly.  I agree that I do not see a bubble on today’s scene, but this does not reduce the risk of an eventual meaningful decline.

The second sage that I (and a lot of others) pay attention to is Byron Wien. Each year for many years he comes up with a list of ten possible surprises. While these are clearly not meant to be viewed as predictions, he believes that his surprises have better than a 50% chance of occurring while other people would not give them more than a 33% chance. A good example is his prediction that the price of West Texas Intermediate crude would exceed $110 a barrel. He is correct that others would find this to be a surprise. A recent panel of investment “experts” were almost unanimous with predictions of $80-90. All of these people are more expert than I on the price of oil and energy in general. However, in the search to find sources of capital to invest it has occurred to me that large portions of capital invested in energy are good sources for re-circulating capital.

The energy trap

As global GDP grows there is little question that the use of energy will grow with (it if not ahead), as people become greater users of energy as they get wealthier. Therefore I do not doubt the long-term demand side of the equation. What I am doing is to raise the question of excess supply and flat to falling prices. There is no question as to the increase in US production benefiting from horizontal drilling for oil and gas. Hardly a day goes by that the US or other countries’ claims of large reservoirs of gas are being published. The costs to develop all of this production are very large. For political reasons almost every government is adding to the operating costs structure. One of the better global investment managers that I know is a great believer in the capital cycle which in its essence is that building too much capacity too quickly will lead to lower prices. I raise this concern as a potential problem for those with large energy holdings on a longer-term basis.

In my model if you have at least three time horizon components to your portfolio, I would:

1. Utilize rising prices this year to reduce some of my equity commitment for your shortest-term portfolio.
2. For the intermediate portfolio I would recognize the cyclical nature of the market and be upgrading the quality of my holdings in both the stock and bond elements. You will suffer less when the decline hits.
3. For the truly long-term portion I would keep focused on likely future markets when you intend to convert your securities holdings to spending requirements.

Guns can shoot down asset allocation.

The past year has been difficult for many who practice the art of asset allocation. For those who use domestic and international equities and debt, plus commodities, real estate, venture capital and private equity there were too many negative or single digit returns, particularly if these investments were housed in a hedge fund or a fund of hedge funds. Smart asset allocation works well if a patient investor will allow the various cycles to work out to the advantage of a long-term relationship. However, I fear the normal cycles will be interrupted.

President Ronald Reagan noted that every war that the US got into happened when others presumed the US was weak and lacked political will. The black flags flying over Ramadi and Fallujah, two cities in Iraq that US Marines and others fought hard for and managed well for the inhabitants is the latest instance of weak US reaction to a significant threat to the World. Syria and Libya are other elements of concern. As an accidental offset, Iran may become somewhat less of a problem as it may fear that it is being surrounded by battle-trained Sunni warriors. Russia, China, and a good bit of Europe and Africa may become unstable due to these conflicts and our collective lack of response.

Perhaps, some additional reserves are warranted in our investment portfolios. What do you think? 

_____________________     

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A. Michael Lipper, C.F.A.,
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Introspection Can Improve Your Investing

Introduction

The holiday season and the turn of the calendar year can create an opportunity for introspection as to how you invest. While one should be just as introspective about wins, it is too difficult for most to separate brilliance and a bull market. Hopefully on the downside it is a bit easier to identify systemic elements that led to losses. To see what impulses are really working, we must shed the standard alibis – “someone lied,” an external negatively interpreted event surprised us, or the weather plus Christmas or Easter came early. While each of these excuses may have happened, your own particular losses are what you were thinking about before, during and after the market prayed upon our conscience.

The following items are what I have developed for review of my investments. I offer these points as a guide as to what one can produce through introspection.

Timing

First it is helpful to admit that very rarely can we buy at the bottom or sell at the top. For the long-term investor to be within 15% of the extreme prices would be remarkable and to accomplish both feats is just about impossible. My timing decisions for the most part are driven by internal and external needs. The internal needs are functions of incoming or outgoing cash flow requirements, a change in the portfolio structure caused by the desirability of exiting some investment and/or inflexible allocation strictures. The external forces have to do with prices or price-related ratios (price to intrinsic absolute value, price to book value, earnings or dividend yield). The external numbers can be viewed on an absolute or relative basis. A sound investment advisor can help with these decisions. In the absence of an advisor, investors are able to conduct the work themselves, accepting that one can be somewhat inefficient and can dollar cost average his or her overtime.

The result of any averaging approach is not to get the single best price. The average price is very likely to be below the best price achieved over the period. The benefit of this unaided strategy is that one has broken the paralysis of analysis. The disadvantage may be for the intervening broker (if you are not using funds), who prefers one large order rather than a series of smaller orders.

The value of the last conversation

In both the military and in various theatrical shows the last conversation usually places everything into perspective and then there can be an immediate action to solve the issue at hand. The last action may well be, but not necessarily, the most current information on a moving target. Like with all elements of information the last one needs to be evaluated in terms of quality of information: (how much is factual rather than opinion?), accuracy (do the “facts” tie in with previous information?), and motivation of the source (what does the provider in the long run expect in return?). In a world bound by concerns of inside trading and full disclosure regulations, the game has become more difficult but more rewarding. The SEC has accepted the “Mosaic Theory” approach to building investment conclusions, which is actually a defense against accusations of using insider information. This is a very tricky area. 

Many years ago I was managing money for a foundation that had a large block of the late founders’ stock in a large, listed deteriorating retail company with some representation from the company on the foundation’s board but not its investment committee. I was urging an immediate plan to move out of the stock as quickly as possible based on the fact I could not find any leading analyst following the company. The foundation’s external lawyers said that a sale would violate the insider selling rules as the foundation knew that the current management was incompetent. The founder’s company soon thereafter went bankrupt and a significant amount of scholarship money was lost. Bottom line: some additional insight is good, but too much is dangerous.

Looking too hard for negative indicators

Over time I have found it difficult to find individuals that have a spotless record of correct decisions. The best are right 2/3rds of the time and perhaps in a very rare instance ¾ of the time. On the other hand there are other people that have a superior history of being wrong. In the current environment certain political leaders and central bankers have been great negative indicators. One of the reasons I am increasingly cautious is the growing enthusiasm for the immediate future. A good example of this is a columnist for a major NY newspaper over the weekend discussed a bullish view of the future which is okay and could be correct. However, he said he could not find anyone that was extremely cautious to somewhat negative. He didn’t look very hard as we have seen significant sales of public stock by well-known investors and an increasing number of Small Cap mutual funds closing to new money additions. Thus, I am confirmed in my cautious attitude, but I must be on guard to the fact that every now and then a negative indicator could be correct.

How smart am I?

My brother tells me that our grandfather warned us that the person on the other side of the trade was likely to be at least as smart as we were and could possibly have better information than we did. This warning predated the SEC, but is as valid today as in the last century. The only way I can deal with this reasoned fear is recognizing that the buyer and seller may well have different time frames that they are being measured. Most of the time the seller has an immediate need for cash and the buyer is looking for a longer-term reward.

Too much attention to today

We can describe yesterday’s price with extreme accuracy to many digits beyond the decimal point. We have the headlines and perhaps more importantly, the buried smaller news articles for today. Almost all of the various pundits will focus on the current. As a long-term investor for my clients and my family, I should be more concerned about future valuations based on future conditions. Clearly, I can not view the future with any degree of precision, but in some ways these outlooks are of much greater value in building and sustaining wealth than the current obsession with precision and today’s market “news.”

When I visit good managers, it is difficult but rewarding to discuss how they see the future.

Too low a discount of expected future returns

In a period of manipulated interest rates there is a tendency to use current rates to discount future cash flows. As the current rates do not take into consideration the business and human risks present today and likely to be in the future, many investors, corporate executives, and investment committees are in my opinion over-valuing future flows of cash. Alternatively, I would suggest that a discounted rate should be the higher of a sound pension fund’s actuarial assumption or the yield on High Yield (junk) bonds to cover the risks and uncertainties. I am having difficulties finding suitable long-term investments meeting these criteria.

What introspections have you done or are likely to do in the future? Please let me know.

_____________________     

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Copyright © 2008 - 2014

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

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.     

_______________________

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Thinking About Selling

Introduction

For the last several posts I have been dwelling on the coming peak in stock markets. I have not been predicting that the current record levels are the peaks before major declines; however I am suggesting that many of the characteristics of a classic top are showing up.

The difference between smart and loud people

We are experiencing the beginning of an enthusiasm epidemic. The clamor of some media pundits echoing comments by economists and a few real market movers is almost becoming deafening. (I wonder whether there are any quiet bulls!) When I parse what they are actually saying I discover that they are looking for another year of rising stock prices and they are willing to see declining bond prices. This was reinforced to me this morning, when leaving our local gym I ran into the director of research of one of the smart new research firms. He said he felt that there was another good year ahead before the size of the government sector’s debt including the central banks would create instability.  This is the equivalent of believing that he can safely dismount from the tiger of “the greater fool theory” that I have written about previously. I earnestly hope he can.

In our continuing discussions with portfolio managers of successful small market capitalization mutual funds, I find they are not waiting to begin their exiting strategies. Quite a number have taken the steps of restricting the amount of money coming into their portfolios by closing their funds and their separately managed accounts to new money. One fund has already started a program of reducing the size of its commitments to some winning positions. Another technique being followed by some is not to fully invest the latest surge of new money that has entered their shop. Their cash build-up already approximates 60% of their maximum cash positions.

What to Do?

In terms of stock positions, one should start to think about net selling slowly. I stress net selling. At all times I would urge investors to follow my late friend, Sir John Templeton’s advice to always seek out better bargains. While a switch may improve the long-term results of one’s equities, it does not reduce the overall market risk of the stock portfolio. What I am suggesting is to begin to plan to reduce the overall commitment to equities. (For me this is a nerve-racking move as I have been long stocks for the last 40 years.)

The One-year Timeframe Portfolio

As regular readers of my posts, you are aware of my concept of dividing one’s portfolio into separate time horizon-oriented sub portfolios, or “Timeframe Portfolios.” At the minimum one should have at least three sub portfolios with time horizons of one year, five years, and ten or more years. My immediate focus is on the one year which is both for the net cash generation to meet current needs and the result most amateurs focus on in their discussions in mixed investment committee meetings with non-professional investors. For this section of the portfolio a selling program is needed to meet cash and competitive needs. The object of the exercise, while enjoying the probable rising market prices, is to raise sufficient cash to meet funding requirements. My suggestions are first to decide how much cash is required at the end of the year and then plan to sell an amount each month or quarter.

The next approach is to set price levels for each position that is a reasonable one year goal. Whenever the price is reached, sell the position and include the proceeds in the required cash raised for the month or quarter. Finally, there will be events, some positive and some negative that will cause the stock price to gyrate. Either way it would be a good time to exit the one year position.

The Five-year Timeframe Portfolio

The middle sub portfolio or the five year portfolio has a different set of issues and therefore suggestions. What is absolutely clear to me is that sometime over the five years stock prices will take a nasty hit, most likely in the 25% range, but possibly as much as 50% before returning to an upward path. The critical question facing this portfolio is, “Who will see the results?” If the only reviewer of this portfolio is its owner, then a sound growth-oriented portfolio would make the most sense as stock markets tend to rise three out of four years. However, if the portfolio is likely to be reviewed by a critic, a significantly different strategy might be best. To be over-simplistic, owners want upsides, critics want to avoid declines. 

Most of the time the discipline of a value-oriented portfolio has had less chance of declines. The overall characteristic of a value portfolio is that the stocks are selling significantly below their perceived intrinsic value. (Not so far below that only a small minority of investors would perceive the same value. These portfolios are often labeled “deep value” and better left in the hands of keen professionals.) Most often to keep value stocks from declining at the same rate as more aggressive growth-oriented stocks, the value stocks pay a dividend and may have a practice of buying back their shares from their shareholders. The dividend yield on these stocks should attract some additional buyers if the stocks go down in price and their yields rise. Currently the ten worst performing stocks in the Dow Jones Industrial Average (DJIA), often known as the “Dogs of the Dow,” have dividend yields of between 3% and 5%. Many so-called value stocks have similar or somewhat smaller yields. And this is what makes them more vulnerable today. 

For months the general stock market has been discounting the beginning of the Federal Reserve’s tapering and bond yields have been rising.  Over long periods of time when bond yields go up, stock yields go up and stock prices weaken. When this happens the partial safety net from dividends become less strong for value stocks. In addition, many value stocks are from companies that require significant capacity expansions to produce the same or higher dividends in a period of rising costs. I am increasingly concerned about some of these in the energy business. Quite contrary to past beliefs there is a multiple year threat of over production of oil which will lead to lower prices. Nice for us as consumers, but it is not a favorable outlook for maintaining or growing dividends. Thus, my recommendation for value-focused portfolios is to reanalyze the intrinsic value calculations as well as the value of future dividends as a price support for the stock.

Bond prices are declining

Contrary to much of market history, we have until very recently enjoyed having bond and stock prices rising at the same time. In the past their price movements have been inverse to each other.  As mentioned the markets have already sensed the slow pullback of the manipulations by central banks to keep interest rates artificially low. In addition, while it is clear some of the most damaged European economies have stopped shrinking and may be rising a small bit, the rating agencies are slightly lowering a number of the sovereign bond ratings. They are showing appropriate concerns as to the willingness of political leaders to continue the various austerity policies that helped to give confidence to the funders of the turnarounds. Removing this discipline runs the risk of a 1937-38 Roosevelt Recession which may well have been a contributor to setting up WWII. With the high-quality bond markets showing signs of nervousness, the yield spread for high yield, if you will junk bonds, will widen.  If this were to happen it will make the current wall of refinancing more expensive, perhaps prohibitively. Without support from the fixed-income world many of the expected merger and acquisition deals are going to be delayed which could hurt the value stocks.

When one hears of transactions, one should make the judgment whether the buyer or seller is smarter. I am very selectively and for specific purposes slowly beginning to sell a little bit.

Please let me know what you are doing.   

_______________________

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