Signals or Static Perspective?

Introduction

I can’t avoid thinking like a US Marine this Sunday. We just received the notice of the memorial service for General Carl Mundy who was the 30^th Commandant of the USMC and my fellow classmate in Basic Officers Class. As Marines we learned to observe every detail about our surroundings and most particularly about our enemies. As in the battle for investment survival, which requires a degree of investment success, we also need to observe all elements that are visible and look for those that are beneath the surface. We know that each day or week could hold the clues to future actions. The difficulty that I face is separating meaningful signals from day-to-day statistical static. Carl did these well both in battles and in his post active duty service and I will try to emulate his skills.

First quarter 2014 mixed messages

Extrapolating the large gains achieved by equity funds, particularly the Small Capitalization funds with significant holdings first in technology and second in financial services, one would have been prepared for a continuation of these trends. On the surface there were very few surprises in the first quarter based on the financial headlines. Yet the natural order of performance was quite different. The leading performing large asset class was commodities, not across the board but a number of industrial and agricultural goods, in addition to gold and energy had positive results. Under normal circumstances this kind of price behavior would indicate inflation and significant shortages of supplies. But this was not the case as the central bankers were complaining about the lack of inflation to provide economic stimulus that the fiscal authorities were not.

Focusing on the next best asset class for some, which was taxable bonds, the best performing fund group was those funds that had mostly “A” rated corporate bonds in their portfolios with an average gain of +3.94%. They were followed by funds with somewhat lower credit rated bonds (BBB) which gained +3.32%. Somewhat surprising in a period of expansion, the third best bond category was the High Yield or junk bond funds up +2.75%. They normally lead in bullish times as in the last twelve months with gains of + 7.32%. What may be happening is that the wave of acquisitions that were being financed through high yield paper may have created supply bigger than demand. Further, those with a historical perspective may have felt that the yield spread versus the poor performing treasuries was too narrow. All of these results suggest to me that the fixed income and commodity investor was acting cautiously, but was questioning the value of the US government’s paper as well as the reality of inflation production.

The equity funds also sent out mixed and not very strong signals. Of the 31 equity investment objective classifications tracked by my old firm, now known as Lipper, Inc., four produced slightly negative results and five positive results. The losers were hurt by disenchantment with growth regardless of size (Small-Cap Growth -0.47%  and Large-Cap Growth -0.11%). The gainers were led by two traditional bets against the future lower value to the US dollar and/or increased inflation. The average Precious Metals fund was up +12.28% but still down -29.29% for the trailing twelve months. The second best was the Real Estate funds +8.13%. From a macro point of view the most surprising performance was from the average Utility funds +6.69%. This result was clearly better than any bond category. Often utilities are viewed as bond substitutes. The fourth best was Health/Biotech at 6.69%. The fifth best was the Mid-Cap Value funds up +3.14%. The other twenty two equity funds had gains below 3% or under the results for both bonds and commodities.

The ends of March

As indicated in last week’s post I detected a significant change in equity leadership. This change is better defined when one examines the month of March performance. The four worst performers were the Precious Metals funds -7.82% giving up some of their recovery, Health/Biotech funds -5.30%, Large Cap growth -3.22% (all of the growth fund categories declined in March). A good further explanation for their declines was the fall of -2.67%
in the Science & Technology classification.  Science and Technology has driven a good bit of the Growth funds' performance. Clearly the old war horses of the 2013 leadership in healthcare and technology were no longer producing bigger dreams for their owners. The new leaders seem to be very specific in terms of their own merits even though there appears to be greater attraction to value-oriented portfolios (see April observations below). British funds seem to be reading from the same playbook being used in the US.

If one is following the script of an aging bull market the switch to larger caps that have perceived value safety nets beneath them makes sense. However, if the next market collapse proves to be spectacular, we will need to have sudden, sharp, parabolic price explosion on the upside. That kind of performance is normally needed for a 50% decline. Without such a runup, the next decline is more likely to be in the neighborhood of  25% which is not enough to dislodge sound long-term investment portfolios.

Early April flows and ratings pluses

Being indebted to my old firm for flow data,  I can see some interesting cross trends if I parse the data carefully. The traditional equity mutual fund had net estimated inflows for the week ending on Wednesday of $2.2 billion; however $1.6 billion were non-domestic stock funds. This would indicate that only about $600 million was betting along with the Administration that good things are in the offering for the US economy. Some of the money leaving the US may be going to Europe on the basis that Moody’s is regularly raising western European credit ratings, that business is improving and the price/earnings discounts to comparable US stocks makes them attractive. I suspect a smaller piece is going out to buy Asian stocks that are recovering somewhat from their prior fall. In term of investment objectives, the traditional mutual funds buyer put the bulk of their net money in Large Cap core funds which category included index and closet index funds. Some of that money probably came from the $429 million net outflows from the Large Cap growth funds. These shifts were aligned with our prior observations.

What are most interesting are the flows into the ETFs. Their assets are considerably smaller than the traditional mutual funds, but they managed to put more money, $3.2 billion into their equity funds of which $2.5 billion were in non-domestic portfolios. The domestic fund investment benefited from a $941 million flow into a large S&P 500 index fund which appears to be a “parking lot” type of investment, rather than a long-term commitment.

Why focus on mutual funds?

First, mutual funds around the world, according to the Investment Company Institute (ICI) have $30 trillion dollars under management. In many markets they are the most transparent institutional investor. Often some of the 76,200 funds are managed in the same fashion as the other institutional accounts in their shops. Thus an analysis of what mutual funds are doing gives one useful intelligence as to what is happening in both the institutional mind set as well as the general investing public.

Second, I spend most of my working hours focused on the proper selection of funds for clients as well as our extensive charitable activities. Third we eat our own cooking, as we invest in these funds for my family along with a private fund that invests in mutual fund management company stocks and other financial services providers.

My question for the week is:

How prepared is your thinking for the next market decline? Please let me know, for General Mundy would expect me to look at any moving object that was somewhat visible.

___________________

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Strategic vs. Tactical: Follow the Lines and Spots

Tactical value investing...Was last week a tipping point?...Possible oncoming worries...Mutual funds holders: is your asset allocation correct?...Correction to last week’s post.

Introduction

Even to this day the academic world presents concepts on a black or white board or perhaps on a flat computer screen. Therefore in our minds’ eyes we tend to translate investment strategies in terms of continuous lines. We know that the objective is to end with more money than we started. Our experience quickly teaches us that there are many lines that can produce the desired result. In an oversimplification we contrast a perfect growth model that starts low and finishes at a peak. The line can be a perfect 45 degree slant or look like a hockey stick, flat to slightly down before an explosive burst that takes the line to its zenith. There are many variations of this plot, but we can label the group as growth oriented.

Tactical value investing

A second set of graphs are designed to produce the same result, but want to avoid the risks of falling off, at least temporarily, the growth curve. In this exercise there is a second discipline beyond finding securities that go up in price and that is the need to buy at a price spot that will rarely lead to a loss. This second approach achieves this goal by buying value at least in current terms and is called value investing. One might call it also tactical in the sense that timing is critical to successful entry points.

One of the advantages I have compared to most managers is that I can invest in what I think are currently the best Growth mutual funds and the best Value focused mutual funds. The key to this decision process for the client/investor is to get the appropriate time horizon correct in mixing the strategic Growth funds with the tactical Value funds. Read further and you will detect the questions that we deal with in attempting not only in getting our fund selection right, but also the right mix of Growth and Value. 

Was last week a possible tipping point?

Short-term performance is normally the equivalent of static on a poor radio device. However, every key turning point starts with a given day or week. Also individual funds can have a somewhat dramatically different short-term performance than their peers which would indicate that the outlier is doing something different. Thus, I am starting to question as to whether we have experienced a turning point. During the week, Value funds were off slightly less than 1%. Most Growth funds were down about 2.5% but Small Company Growth funds were down almost 4%. A couple of our very successful specific Growth fund holdings that were up 40-50% in 2013, declined in the range of 4-5% for the week. There could be individual corporate elements that caused these above-average declines or could it be for some reason certain investors were cashing in pieces of their Growth fund winnings, but leaving their Value focused holdings untouched?

Broadening the question to all equity funds, according to the Investment Company Institute (ICI) the net new cash inflow on a year-to-date basis through February was only $43 billion vs. $52 billion last year. Perhaps, more instructive is the weekly estimate from my old firm which estimates that the weekly net flow into equity mutual funds was $1.7 billion and the weekly outflow from Exchange Traded Fund (ETF) was $2.1 billion. In an oversimplification one might say the mutual fund buyers are long-term oriented riding up the curve of past incredibly good performance and the ETF sellers (often driven by brokers) were reacting to various news items. This dichotomy is also reflected in Friday’s flow of money into rising stock prices on the New York Stock Exchange (NYSE) of $2.2 billion compared to $0.9 billion in declining stock prices; whereas the more dealer oriented NASDAQ market was much more in balance with each side moving $1.3 billion.

If prices become negative this week we may have either seen a tipping point or we have just received some meaningless statistical static.

Oncoming worries

The job of a good analyst is to look beyond the headlines. The market will assess the current headlines, but analysts should look beyond. In brief, I am currently focused on three elements of the food picture. The first is that the preferred inflation statistic the government and the Fed look at strips the price of food and energy out of the consumer price indicator. While these can always be volatile, they usually stay within some bounds. Currently the price of food is skyrocketing, partly due to weather conditions, but I would suggest a continuing conversion of agricultural assets to other purposes. 

The rapidly increasing price of food is putting pressure on all families, but particularly on those with little or no income. Even with the big increase in the numbers of people utilizing food stamps, people are being squeezed. As bad as they are now, they could get worse. Most of us don’t realize where our food comes from and even if it comes from local sources, food prices move on global scales. 

One of the stories not being told about the situation in Ukraine is the plight of the farmers. Even before the hostilities many farmers there were heavily in debt to their suppliers of feed and other materials. Compounding the current problem is that under current conditions they have lost five different ports for their exports. Ukraine is one of the largest exporters of wheat and the odds are that they won’t be able to make deliveries to the normal customers. English translation: the price of wheat on our tables is likely to rise.

The third food related worry is predictions that there is a 50% chance of a series of repeated storms, some of these are known as “El Nino.” If these were to hit this would disrupt food production in India, China, and Latin America all of whom produce food for American and European tables.

Mutual fund holders: Is your asset allocation correct?

I have an allergic reaction to following the crowd. However, in general the way long-term mutual fund assets are allocated makes sense in terms of balancing growth opportunities and tactical value holdings. They have allocated approximately 69% of their long-term assets to equity funds and 27% of that total in consciously labeled Internationally oriented funds. The 69% is down from greater enthusiasm earlier and the international component is growing. I use the term ‘consciously labeled International’ as many so called domestic funds have up to 30% in non-US domiciled companies and some of the remainder are invested in multinational companies that through their foreign based operations and/or exports are serving non-American markets. I believe on a long-term basis this is wise as the relative future of our standard of living is likely to decline more due to greater education, work productivity, and savings than here. Our UK friends have recognized this for years and there are hardly any significant UK domiciled companies that are not globally focused. We are seeing the same characteristics in many European companies as well.

The 31% of mutual funds invested in fixed-income is a bit of a problem for me. There are two reasons to own fixed-income securities. The first is to generate necessary income that is not available from other investments. The second is as a strategic reserve if the equity portion falls dramatically. My problem is one of timing. At some point in the future the interest rate repression of the major global central banks will ease up and perhaps terminate. Interest rates will then rise to a level that recognizes both the deterioration of purchasing power of current money and appropriate payment from undertaking credit risk. At this point, if not before, bond prices will decline, damaging the strategic reserve value of fixed-income. Some fixed-income holders would be better off converting most if not all of their long-term fixed-income positions to well chosen dividend paying stocks and funds. If the current income is insufficient to meet current prudent expenditures, the law now recognizes that total return, including stock price appreciation is an appropriate source of income. Some bonds and other credit instruments that have equity-like characteristics, including risk of loss of capital, could be substituted for long-term high quality bonds as long as the investors recognize that the central banks have coerced them to take more risk.

Correction to last week’s post

There was an error in some editions of  last week’s post relating to my discussion of applying the “Rule of 72” to how long it would take to reduce by half (instead of all) the spending power of  principal amounts through the application of a 2% inflation rate. The correct answer is 36 years.  I thank the sharp reader in the UK who called this to my attention and I appreciate the notice of where I make a mistake of thought or proof-reading.  

Question of the Week: for you to ask yourself and perhaps share with me, so that we both can learn:

How are your assets allocated and where would you like them allocated at the end of the year and in five years?

____________________

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Copyright © 2008 - 2014

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

Inflation, the Biggest Sin Tax

Highlights: Sin Taxes, Lessons from the Cosmos, The Political Crutch,

The Enemy, How an Award Winning 401-K Invests During Inflation,

Other Currencies

Sin taxes

Governments have many problems but all have two in common. The first is that certain crimes appear to be endemic to their societies and don’t appear to be susceptible to inexpensive eradication. For example we know there are enormous social costs due to chronic losses from gambling, and there are others as well. Many governments take the attitude that they can not stamp out these sins; however they can hurt them by imposing taxes on them. There is a naïve belief that if they raise the cost to participate that eventually the public will not indulge. This brings us to the governments’ second need which is a source of growing tax revenue, not to pay for the social costs of the crime, but to meet general government expenditures. Just look at the incredibly sharp increase in taxes on cigarettes and alcohol in our lifetime. The victims of these sins are often labeled addicts. Strange, we do not label governments as addicts, though they are addicted to sin tax revenues. By the way I believe by far the largest sin tax in terms of impacts on our societies is inflation.

Lessons from the cosmos

We may believe that inflation is a relatively new phenomenon from the time of the birth of coins and currencies. Evidence just revealed this week proves that Albert Einstein^* was correct in suggesting that it was present in the original Big Bang Theory^* at the creation of our universe. This week according to James Bock, a Caltech^* physicist along with others using a telescope from the South Pole, found evidence of gravity (waves that Dr. Einstein, a century ago predicted would be found that were the direct result of the Big Bang that created our universe.) I will leave to others, more learned than me to explain the theory. For those of us that live in the world of numbers and taxes, the key to the discovery was the term used for the exponential growth of particles that became planets and other objects. That term was ‘inflation.’ Thus the term from the physical world describes a power that keeps growing.

^* When he came to the US Albert Einstein spent some time at the California Institute of Technology (Caltech). I have stayed in the room/suite that was prepared for him to stay in the faculty club on campus. Princeton lured him away to teach in New Jersey, where we now live. His Big Bang Theory is used as a title for a current television comedy about very bright scientists adjusting to functioning in the everyday world. I will admit my good wife is addicted to watching both the original and re-runs of these hilarious shows. Many believe that Caltech graduates are the models for these characters. There is much amusement about the success of the program at Caltech board meetings that I attend.

The political crutch

I have read a number of constitutions from around the world, and in none of them have I found that the sacred duty of the government is to create jobs for the governed. Yet any government that wants to stay in power, whether elected or not, is at risk when people are out of work and there is general lack of sufficient food. The leaders of the government, rather than to solely rely on the underlying economy to produce sufficient income and jobs, believe that they must do it. In general, governments have two sets of financial tools, fiscal and monetary policies. Fiscal policies are those that set the level of taxes raised from the population. As most people do not want to give up some of their hard earned money to the government, raising net effective tax rates is generally not favored.

The second set of policies is monetary policies. These deal with the levels of loans made by the financial community and in its essence the value of money. There is a long history of the latter. A monetarist would point out the Roman Empire, like all great empires, did not fall to the hordes of barbarians. Rome fell because for many years the government was literally shaving some of the metal from its coinage money. In effect it was devaluing. The public was not dumb and realized that the value of the money declined and so they raised the prices for their goods, services, and labor. Rome fell because it could no longer be protected by the best, most expensive, military in the world. In the Middle Ages shaving coins was punishable by death. A government which is not popular, and few are, can either publicly raise taxes or more quietly devalue which creates inflation. All too many of today’s leaders are unwilling to pay for current and future government services through tax revenues and so resort to forms of inflation that the public does not fully comprehend.

Central Banks which are titularly responsible for monetary matters and in theory independent of political forces are in fact beholden to them. Because the political leaders can not obtain sufficient taxes they have the central banks induce inflation into the economy that they hope will stimulate individual and corporate savers to spend and invest that will create new jobs and incidentally lower the value of their debt repayments.

The enemy

In a closed society that is not expanding, the need for increased spending and investment is high. By definition the people that have the necessary money are the savers. These people are those that are choosing not to spend in order to provide for the future spending needs of themselves, their families, and worthwhile charities. By lowering the value of their savings by inflation, central banks are in effect stealing from these savers. Thus, the savers become the target to generate the future growth. If they don’t readily provide the necessary funds they become the enemy. 

The current policies of many central banks including those in US, UK, Europe, and Japan is to raise inflation to 2% or more to drive their economies. The theft comes in by understanding the long-term effects of inflation. The collapse of the Weimar Republic in Germany brought Hitler into power when their money was practically worthless. Many would say that can’t happen here. If successive central banks meet their goals of 2% or more inflation in one or two generations the entire wealth of the savers can be wiped out. (The rule of 72 shows the number of years it takes to double your money by dividing the current or expected interest rate into 72. The same calculation can be used in reverse to see how long it would take to lose half. Two divided into 72 suggests 36 years. For those of us responsible for long-term investing for endowments or multiple generations of families, 36 years is a short term when century-100 year bonds are being eagerly sought.) 

How an award winning 401(k) invests during inflation

There is no complete answer to creating an investment portfolio that can meet the needs for reasonable returns that is aware of the risks of inflation. We have addressed these needs in a 401(k) that BrightScope labeled as the best in the country in terms of many attributes including low costs  As the participants can not withdraw their money from this plan for ten years, the ten year performance numbers are relevant as a guide for long-term oriented accounts. Below is the annualized performance for ten years through the end of February of the nine options offered to the participants and their rank within the nine alternatives:

Rank/Category=Total Reinvested Return

1.    Small-Cap Core=9.23%

2.    Small-Cap Value=8.23%

3.    Index fund=7.89%

4.    Growth=7.76%

5.    Value=7.07%

6.    Balanced=6.71%

7.    International=6.27%

8.    Bond=4.73%

9.    Stable Value=3.10%

Do not fixate on the actual numbers which were influenced by numerous special circumstances. During this last ten years I have been very concerned that after-inflation returns were going to be important for all of our accounts to meet their spending needs beyond the financial world. To me the best overall way to do this was to assume more volatility and liquidity concerns by investing in smaller companies. In any given ten year period the actual returns will almost certainly be different as will probably those ranked between 3^rd and 7^th. As the end of this period was February the ranking of International was hurt by currency movements.

Believing that the US will not adequately address its inflation issue, which should be zero based, I believe on a relative basis the long-term value of the dollar will decline upon the leaders. Thus, at this point in time for long-term accounts I would be increasing exposure overseas even with the economic and credit risks in China. The Bond return of 4.73% includes significant investments in TIPS to provide some real return benefits from owning bonds. Because I expect interest rates to rise the total reinvested return in bond funds in a cash flow account will enjoy higher rates that can offset some lower bond prices. Stable value returns over time should equate to the inflation rate.

Are there other long-term oriented 401(k)s with which we should be speaking?

Other currencies

The way we invest into non-US dollar currencies is through funds that have equity and debt positions in selected currencies. With the US dollar being the temporary safe currency it has appreciated against other currencies. This means that the other currencies have lost value relative to the greenback.  Liking to buy when things are down, I am attracted to investments in sound Canadian companies. The relatively newly appointed head of the Indian Reserve bank appears to me he could be making India’s securities more attractive by raising interest rates as some investors may want to diversify out of some of their direct holdings in China. Along the same line of thinking, the Taiwanese dollar could be of interest.

My question for all of us is: How are we going to hedge our inflation risk ahead of inflation manipulation replacing interest rate manipulation?

Please share your thoughts.  

___________________

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

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Copyright © 2008 - 2014

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