Are We Complacent or Petrified?

Introduction

On my recent one day visit to San Francisco when I spent 12 hours on planes for a two hour meeting, I chatted briefly with what seemed to be an intelligent stewardess. She wanted to know whether any of the papers I was discarding would make her rich if she read them. I suggested that she should enter the pilots’ cabin and learn to become a flight captain. She demurred as her friends who were pilots were mostly bored when flying these airliners. (Of course, boredom can turn to panic when something goes wrong.) Her comment echoed in me when I read that Dave Tepper, the New Jersey-based, very successful hedge fund manager was quoted as saying the market had an air of complacency. Examining my own and others' current thinking, I believe our low level of activity could be that we have become petrified.

Why are we petrified?

Sir Isaac Newton introduced the concept that God was the watchmaker in the sky that kept all the physical forces in balance so it would appear that many countervailing forces were in balance. During this period of extremely low stock market volume we instinctively should be taking advantage of apparently reasonably priced securities. Except that our somewhat undefined fears or constraints are playing off against one another, so we are doing nothing.

What is the import of these messages for bonds?

Both German and more remarkably French 10 Year bonds are yielding below similar US Treasury bonds. The lower yields are caused by investors pushing prices up and therefore yields down as German and French bonds appear safer than those of the US.  At the same time the spreads on the five year TIPS have widened which is somewhat counterintuitive. If the dollar appreciates due to higher rates, in theory, both inflation and recession risks should decline according to Moody’s^*. The desired loosening of underwriting standards for mortgages as dictated by the government brings fears that we are once again starting another residential housing bubble.

In terms of stocks: more confusion

One way to look at the stock market is to use a military approach. The large caps or if you will, the generals, are leading the grinding march upwards while the smaller caps are in retreat. In April, of the 10 S&P 500 stock sectors earning estimate revisions, telecom (+15.8%) was the only double digit gainer and discretionary (-10.2%) and financials (-11.0%) were the double digit losers. Five sectors were up and five were down which showed that within a relatively flat market there was a lot of selectivity. This selectivity was even more pronounced when one looks at movement within market capitalizations. In terms of price movements by sectors, eight of the large caps were up; led by energy (+5.11%) and utilities (+4.2%). In contrast for the S&P Small Cap 600, eight of the sectors declined, however the same two were the leading sectors but with much smaller gains of +1.84% and +1.08% respectively.

Thus hiding out in large caps has worked as it has in the past in a nervous, late stage bull market.

Better valuation methods

I am pleased that S&P is providing both reported estimated earnings price ratio and their estimate of changes in operating earnings. First, I have never been comfortable with the academically derived CAPE (Cyclically Adjusted Price to Earnings ratio) approach to valuation; i.e., accepting reported earnings as a basis for valuation. (Having run a company albeit a small private firm I am very conscious of the difference between operating earnings that one can spend and financial statements' bottom lines.) Second, the current market only looks reasonably cheap if one buys into the forward estimates. For example, the P/E for the S&P500 using 2013 earnings was 17.74x and 26.01x for the S&P600 (small cap) both declined using what looks to me a very generous estimate for 2014 price/earnings ratios of 15.1x and 17.99x respectively. The reason for my skepticism is based on S&P’s estimated gains in operating earnings, +17.51% for the 500 and +44.56% for the 600. In the latter case this is almost 3 times the operating estimate gain for 2013 of +15.96%.

The problem with too generous estimates

To my mind the overly generous estimate of operating earnings gains for small caps in 2014 is to some extent petrifying me in my investment management responsibilities. As regular readers of these posts know, I believe in utilizing time spans to segment portfolios. The longest time span is for a family fortune or an endowment for future users of an institution. Recognizing that a portion of the future belongs to those that successfully disrupt the markets of today, most often this kind of guts or perhaps desperation is found in smaller companies. Thus, smaller companies, particularly those found in small funds are a regular diet for most of our accounts. While I am looking for quintuples or “ten baggers” in this kind of merchandise, I can materially cut our returns by paying too high an initial price. Perhaps the very recent 10% correction in NASDAQ prices helps a little but not enough. I need a substantial discount in many of these biotech and new technology stocks which to use Warren Buffett’s term are beyond my circle of competence and thus I use appropriate mutual funds and related vehicles.

Count our blessings

The fashion of the times is moving away from the old numerical fads such as Modern Portfolio Theory (MPT) which was modern in the world of physics over one hundred years ago, had nothing to do with the construction of winning portfolios, and was a very much an unproven theory. During this current particular phase in the stock market as correlations within and among stock groups breakdown, we will need a new set of blankets to cover the different speeds the various proverbial horses are running. I would suggest two general approaches; the first has to do with operating results and second the nature of the ownership of the shares.

Correction: Last week I inadvertently gave a Caltech Degree to Charlie Munger which was not the case. He did get an education on meteorology from Caltech which probably helped him to become a very successful lawyer and investor as well as a partner in Berkshire Hathaway’s^* operating and investment success.

^*Owned personally and/or by my private financial services fund

Question: What are you looking at to characterize this market?

____________________________

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Copyright © 2008 - 2014

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

Three Warnings

1.)Bank Services Clients Should Be Wary
2.)Expected Interest Rate Increases in Second Half
3.)Short-Term Indicators Casting Shadows on Five-Year Investors

Introduction

The job of a good securities analyst is to analyze and predict, not to extrapolate current trends. There is considerable career risk to those analysts and even greater career risk to the portfolio managers who buy into these predictions. The difficult issue is attempting to spot the peak in sufficient time to position the portfolio to avoid meaningful capital losses. Unless the decline comes after a long flat period, rather than a sharp peak, the career risk in repositioning is being premature. Unfortunately, in the eyes of too many clients, to be premature is to be wrong. The purpose of my three warnings is to identify three of the items I am watching to reduce being classified as being too premature.

Bank services clients should be wary

One of the reasons I focus my private fund on investing in financial services securities is that I believe that financial services are key to the growth of the global economy. Sometimes this sector will lead and at other times it will lag the general market, but not much progress in either direction is likely without some significant movements within the financial services sector.

One of the analytical requirements in looking at a company or sector is to understand the benefits and problems of the providers of critical services to the prime groups. Going back many years this was driven home to me as an analyst who had the responsibility to follow the “white goods” (refrigerators, washers, dryers and dishwashers) as well as the “brown goods” (radio and television). The most successful seller of white goods, at that time, was Sears Roebuck and another large department store group was the leader, with a much smaller share of market selling brown goods. One of the reasons Sears was so successful in what many outsiders considered a commodity type product was how it managed its supply chain. Sears insisted on quality and eventually price leadership.

In order to achieve these goals it in effect became a partner with its critical suppliers. In a number of cases Sears took a meaningful minority interest in the supplier’s stock. By doing so, it could help its supplier earn a respectable (but not extraordinary) return on investment at the same time producing for Sears and some others very high quality products. The original relationship was one of a handshake and I believe the first contract on paper came twenty or more years later. On the other hand, in selling brown goods other large retailing chains always insisted that they get the lowest price for the merchandise that they were going to sell. One hundred years later Sears is still selling white goods and it is difficult to buy television sets in most department stores.

As mentioned in last week’s post major banks, particularly large trust banks evolved into paper and data mills providing investment and administrative services along with their deposit and loan activities. For many clients a bank’s product quality and service is as important, if not more, than to the family buying critically important white goods. Last week I pointed out that banks in general have regulatory requirements that very much restrict their ability to make the kinds of returns that they used to. This week we are greeted with the news item that Bank of New York^*, parent of Bank of New York/Mellon is contemplating selling its corporate trustee business to UFJ Mitsubishi. This follows by a few weeks JP Morgan^* selling its pension fund record keeping business to Great-West Life^*. Further, this week is the announcement that Barclays is going to lay off 7000 employees from the investment banking and related services activities. To the extent that this last move has to do with earnings from what the industry has dubbed “FICC” (Fixed Income Currencies and Commodities) this is going beyond reacting to reducing payroll, it has to do with escaping the capital requirements that most trust banks and other large banks are becoming burdened.

Why should I care as a customer of these banks? As operating profit margins are beginning to slip, there is a great drive to replace humans with machine driven functions. Computers are wonderful, but they lack a service capability to handle difficult or unusual needs of clients who are used to high touch relationships and have paid for it in the past by getting lower than street level interest rates on their balances. This is not a short-term problem which will go away when the economy is growing faster. There are two critical trends that will affect the banks:

At some point to reduce their labor cost including health costs, banks like many other US businesses will seek to employ workers less than 30 hours week, which is not likely to increase the quality of services provided. There is a second trend of some significance to those institutions that provide post-retirement services, which can be  profitable clients for many banking institutions. The trend is that the proportion of the population that will be retiring each year will grow much more slowly than the work force as noted by Goldman Sachs^*.

One possible clue to the investment world’s view on the future for the trust banks is that they are selling in the marketplace at lower price/earnings ratio valuations than the more cyclical brokerage and asset management stocks.

Expected interest rate increases in second half. 

Moody’s ^* believes that by the end of the third quarter of this year that the consensus is that the 10 Year US Treasury will be yielding 3.06% compared with the current approximate level of 2.61%. I suspect that this increase will not be led by the Federal Reserve, but by both internal and external pressures. Most observers do not believe this expectation is already taken into consideration for the equity market. Moody’s joins others that believe that the current yield spread between treasuries and high yield is too narrow with inappropriate concern for expected increase in defaults.

Equity investors need to pay attention to the bond market for clues to future stock price levels.

Short-term indicators shadows on five year investors

I am trying to navigate between two forces that I have been reporting on in these recent posts. The first is my belief that long-term investors should sub-divide their portfolios on the basis of the time-spans that each segment needs to deliver adequate total reinvested returns. The second of the four time-spans contemplated is the current operational portfolio which in many cases addresses obligations over the next five years. This portfolio is designed to replenish the first portfolio after it has paid out all of its capital to meet current needs, hopefully for at least two years.

The second force that I am dealing with is my earnest belief that sometime over the next five years we will suffer a meaningful decline in stock and many bond prices. (While I have mentioned my concerns in prior posts, I would be happy to discuss my thinking privately with subscribers.)

As I have mentioned in the introduction, I am very concerned about urging premature actions that can cause career risk. Therefore, I scan both the long-term factors as well as the short-term factors to get ready to get into position to protect the five year-oriented account.

In looking at the short-term indicators, Steve Shelton of Cornerstone Global calls to my attention that option traders have opened a large number of call options on the VIX compared with put options. This group of traders is betting on a major increase in volatility, which has been at a remarkably low level in an aging bull market. Perhaps related to this view is the fact that as of April 30^th, shares sold short on the NASDAQ Capital Market meaningfully expanded to 4.66 days of normal trading, as compared to just 3.31 days two weeks before, an increase of 41%. This is a measure of the number of days with normal volume required to buy back enough shares to close the short position.

These are among the indicators that I pay attention to in looking to avoid being too premature. Are there others I should follow? Please let me know.

^* Indirectly or directly I have investments in these securities.

_______________________

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Copyright © 2008 - 2014

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

Pretend & Extend vs. Prediction - Other Lessons from Berkshire-Hathaway

Introduction

A surviving investor is always learning beyond what is the obvious from platform presentations as well as gaining additional insights from past experiences. These are my inputs to today's post as I return from the annual investor conference for Berkshire Hathaway.

Clashes of past with different futures

As almost all the investing world knows there is a five hour question and answer session at the annual Berkshire Hathaway meeting which this year probably had an additional 10,000 attendees participating, including many well known value focused investors. If one was paying attention one could hear the clash of the quantitative/accounting approach written about by Warren Buffett's patron saint Ben Graham and a more real world focus on the nature of businesses and focus on people as advocated by Charlie Munger, a proud graduate of Caltech. The clash can be summed up in prior bank mortgage policies of "Pretend & Extend" vs. prediction of meaningful change.

The investment quants believe the future is captured by extended past published earnings reports projected into the future based on today's prices. The genius of the Berkshire Hathaway approach, particularly to acquisitions, is to focus on likely significant future changes. At this year's meeting there was focus on its two regulated activities, the railroad and the utility group. Part of the attraction of these two large and growing investments is that they are major cash users rather than cash generators. 

What Buffett and Munger, the 83 and 90 year young leaders are betting on is that the concerns about climate change will not dampen the world's thirst for liquid energy. The evolutions in the production of oil and natural gas have led to dramatic changes in quantity and processes. The railroad now has nine long tanker trains that can deliver petroleum twice as fast as the pipeline and it has ordered 5,000 new tanker cars and are looking at the possibility of using liquid natural gas to fuel its locomotives.

On the utility side this week Berkshire Hathaway purchased oil transmission pipelines in Alberta, Canada. In addition, it has recently purchased a chemical process that would speed the transmission rate within pipelines. The company is hedging its bets by being one of the largest tax benefitted suppliers of solar and wind power.

Clearly, the favorite mathematical measure that the quants use (extrapolation to determine future valuations) is likely to significantly understate the future value of these operations and for Berkshire Hathaway. In this particular case the predictive method is much more growth oriented than the mathematical models. It is this very specific focus on growth which is the key to likely future general stock market performance.

"Just not yet”

One of the leading theorists that study the market is Jeremy Grantham, who has a generally good but spotty record as a portfolio manager. Grantham believes that the current bull market will have to rise to an S&P 500 level of 2250 from the current level of approximately 1880. Jeremy believes this will happen within the current presidential cycle. He is generally viewed in the investment community as a bear. I find it a bit ironic that while possibly correct at a future peak, his timing may be too long-term.

Regular readers of these posts know that I am obsessed with spotting the next major peak and for our managed accounts, largely avoiding a substantial decline. My studies of past peaks have uncovered many similarities with the current structure of the bond and stock markets except the final parabolic advance. I believe we may be near the launching point of the final spike. We need wide scale public participation to get breakthrough acceleration. 

Typically before a major peak there is a period of almost exhausting enthusiasm which translates into parabolic price rises. Whether a potential 19% rise from the current level qualifies as a parabolic rise is questionable after 30%+ gains in 2013 and more than a double in the five year recovery. However if we look at the potential rate of ascent, a net 1% per day over a trading month might just qualify for the kind of blow-off that characterizes many peaks. If we don't get such a move, I would agree with Jeremy for now, with his belief that we are not yet at peak. However the increase of volume being generated by the more publicly oriented discount brokerage firms that we own in our financial services private fund is something to watch as an enthusiasm indicator.

Further declines in the quality of bank services

All sectors don't peak at the same time. The weekend in Omaha perhaps should be called the “Reunion of Value Investors.” Many of the well known value focused investors were there.  We met with and examined portfolios that like Berkshire and me have substantial positions in financial securities. In most cases (except me) they are in bank shares. We also see this high commitment to banks in the portfolios of many international stock portfolios, particularly if the portfolio managers were trained in Europe.

My concern is that on a longer term basis many banks increasingly rely on administrative services and investing for others as a source of earnings power. In a somewhat misguided rule change, regulators have reduced the potential for capturing yield spreads and at the same time required more isolated capital. Thus, the historic ways banks have to make money have been materially curtailed. As a natural outcome of these pressures on bank profitability, banks have been cutting their personnel rosters, particular trust banks that have less highly profitable loan opportunities.

Until I started to refocus on secondary sources of bank earnings power, I forgot one of my reactions as a young bank trainee at a trust bank. One of my tasks was to remove checks and letters from envelopes addressed to an insurance company's drop box. It was at that time that I recognized that among other things banks were giant paper processors. They remain paper/data mills as they process clearing and settlements, making transactions in securities, currencies, and structured loans. Years ago the banks had armies of clerks and support people to carry out these activities efficiently and safely. In the intervening years much, but not all of the work was automated. However, I fear that because of the combination of the elimination of some competition as well as the probable narrowing of the profitability of foreign exchange and structured loans utilizing LIBOR and related indices, some major banks have been forced to cut administrative and investment staffs. While some of these people may have been excess, I am predicting future bank services clients will be disappointed and their reliance on past experience will be similar to an analyst using extrapolation as a principal decision tool. We predict there is a good chance that the quality of bank services is likely to decline.  Don’t say that you weren't warned.

Questions of the week:

What predictions are you making that are contra to extrapolation?

Have you noticed a decline in the quality service you have been receiving from banks?

Please privately share your thoughts with me.

_____________________     

Did you miss Mike Lipper’s Blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2014

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