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.

 _______________________

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 - 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.

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

 

A Stock Market Peak Is Coming, What Should an Investor Do?

Introduction

While a somewhat premature warning of an on-coming market peak may be upon us, we need to think about the implications for our various portfolios.  I believe a sound investment advisor attempts with difficulty to anticipate major problems rather than being forced to react.

Growing evidence

Though no two market peaks are identical, many of them have similar characteristics. Expectations become elevated beyond normal valuations and knowledgeable bright people get sucked in with the belief that they can exit the burning movie theater before the mob behind them. With the benefit of their history (particularly of financial matters) and a cooler disposition, we Americans have a hard time believing our British cousins would get caught up into theses speculative surges. However, Sir Isaac Newton, Sir Winston Churchill and the famed British economist John Maynard Keynes all suffered major financial losses from the collapse of markets. Today the current versions of these “worthies,” many in the investment management business, are imploring us to get fully invested in equities. This is despite the combination of lackluster corporate sales growth and peak profit margins and the increasing prospect of higher taxes on the so-called wealthy.

In this last week both the Dow Jones Industrial Average and the Standard & Poor’s 500 reached new high points. We have come a long way from the bottom reached in March of 2009. Many of the pundits are looking for materially higher prices often with a “2 Handle” or 20,000 or 2,000 points respectively for the popular averages.

What are the signs of a peak?

Margin debt is at an all time high. With trading volume low, there is a presumption that those who are borrowing against their securities are institutions or sophisticated investors who are acting like hedge funds or other aggressive investors. While there is no public disclosure as to which security owned or to be purchased is the beneficiary of the borrowing of margin, I suspect that a good bit of it is to support being long or short Exchange Traded Funds (ETFs) or similar vehicles. In addition there is some borrowing to support “carry trades” where one borrows money cheaply and buys higher yielding securities.

What set my particular concerns off is when a retired CFO and CEO mentioned to me he was arbitraging interest rates by using low cost margin money. He probably does not need to do this, but it appears to be a sophisticated trade for a retiree to do. Some of the carry trade is in buying high yielding stocks and bonds globally. My concern is from a recent headline describing the frenzy as a “dash for trash.” More such evidence is needed before one can definitively call a top or peak.

If there is a peak, what should an investor do?

Before one initially invests in stocks, one should understand that 25% declines from peaks happen regularly, perhaps three times in every ten years. Once a generation, the drop has been 50%. After such a calamity, if companies don’t go bankrupt, their stock prices recover. I will share an extreme example of this. As a junior analyst I was doing work on the Radio Corporation of America (RCA). There was something of a celebration during the 1960s when the stock finally surmounted its 1928-29 high. In the 1920s RCA enjoyed the enthusiasm that the “Dot Coms” had in 1997-2000 era.  While this fact is of interest it should not be a mantra for investing. A better strategy has to do with time horizons.

Time horizon investing

Most institutions and individuals have multiple purposes for the proceeds from their account, but they think in terms of a single portfolio. I have been urging them to break up their investment portfolio into time horizons or Time Frame Portfolios. This principle works for wealthy investors as well as sophisticated institutional investors.

The first slice is the amount of money needed to meet current or near current obligations. Ideally the size of this portfolio will cover up to two years worth of expenses. Highly liquid, high quality, near cash investments should make up this portfolio. When the first slice is exhausted through payouts, it needs to be reconstituted out of the second Time Frame Portfolio which should be made up of intermediate high quality bonds and good stocks.

One way to look at these time horizon slices is the first is for the treasurer or controller.  The second slice should have an expected duration similar to the current CEOs career or the principal wage earner’s life. The third slice should have long-term duration similar to the way Warren Buffett buys operating companies and most of his selected major stock positions which he often says is “forever.”

Application of time horizons to peaks

Fears of peaks should eliminate securities with meaningful downsides from the first portfolio. Some small amount could be tolerated in the second portfolio. Not only could the third portfolio tolerate a declining price investment, it could look for an opportunity to add more.

Harvest time celebrations

This is the time of year in many cultures in the Northern Hemispheres we gather to celebrate the accumulated harvest. In the US we celebrate this coming week as Thanksgiving. My family and I have a lot to be thankful for our blessings. What I am particularly thankful is for an ability to convert some of our problems into opportunities for others as well as ourselves.

Please write and let me know about your:  Peaks/tops, time-horizon investing, and thankful opportunities this year.

_______________________

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