Investment Traps: More Evidence

Introduction

Last week’s blog suggested that the surge of Friday, June 29^th could have been a trap for unwary investors. There were three different baits in the trap. They were the relief caused by the US Supreme Court’s decisions on Obamacare, the surprise and pleasure that the latest European summit led to some agreements on loans to troubled banks, and favorable market enthusiasm and market volume. Today we examine each to see whether they are baits or poisoned fruit.

The Supreme Court did not provide needed answers

This is a blog for investors that have substantial, for them, investment portfolios; not for lawyers nor politicians, even though they have been known to have large portfolios from their private sector investing. The implications going forward are that there will be a tax that some wish to call a penalty. (Aren’t all taxes penalties?) The Court’s focus should be interpreting the US Constitution and the conflicts between state and federal law, not to make overt economic judgments. Nevertheless, the decision that taxes or penalizes people for not buying medical insurance has large and unknown economic impacts.

More to the point, I have little confidence in the supposed results of Obamacare. The annual costs to society will be large and disruptive, creating uncertainty in the reactions of individuals, businesses and the medical world. Thus far I see nothing that will lower the society’s cost or more importantly, improve the quality and quantity of healthcare. From an investment viewpoint the Court’s decision leaves open the impact of its actions and thus makes it easy to continue the indecision on the part of employers to hire employees. Over time I suspect that it will lead to more work being put out to small contractors that have exclusions in the present regulations. Bottom line, I see no reason that the markets should rise on the basis of the decision. 

Summit agreement is illusory

By the end of the day Monday, we will learn from the meeting of finance ministers in Brussels how they are going to create a single European bank supervisor. This is not a trick question but a trick that Germany played on the supposed agreement to allow the European Central Bank fund to grant loans directly to banks. This single supervisor would supervise the safety and soundness of all banks in the seventeen countries that use the lamented Euro and by implication all banks in the other countries within the European Community, e.g., the UK. With both the Finnish and the Dutch governments looking for specific collateral and other terms, there does not appear to be much confidence in the existing financial statements of at least some banks. In voting their support for these loans, the German legislators insisted on one of their pet projects: a European (and from their viewpoint, global) transactions tax. London is having enough trouble holding on to its prominence as a financial center with the growing LIBOR scandal that would prevent it from buckling under any continental scheme in the foreseeable future.  The highly respected but controversial economist from Citigroup, Willem Buiter, is quoted as saying “the EU summit measures still fall far short of what is ultimately needed to ensure survival of the Euro area.”

Read with skepticism and believe it won’t happen

I wonder whether we will see the burial of the “Too Big to Fail” concept and recognize the inevitable; that while painful in the long run, it is cheaper and more efficient to let various banks go under. Their smaller replacements will be sounder. I am probably too premature, but the odds are improving every day that this historic approach is still the best one.  I recognize that letting banks fail could in turn lead to some governments defaulting, perhaps as in the past after extraordinary attempts to inflate their way out. After inflation eventually comes deflation; either quickly or agonizingly slowly as in Japan. The lesson from distressed investing is that the quicker the filing for bankruptcy, the smaller the losses sustained by the creditors.

Probably all or nearly all of the summit participants will fight against the fundamental recognition of the structural problem. Thus the ministers in Brussels may find a way to paper over these issues on Monday, but confidence is once again low. (Even if gold drops to a bottom of $1200 an ounce before a subsequent rise as some predict, the trading loss will probably be less than holding so called high-quality paper, the principal reserve element in lots of portfolios.) 

Market mechanisms no longer favorable

On the 29^th the reported volume on the New York Stock Exchange was 4.1 billion shares. This week the average daily volume was 2.7 billion shares, or a retrenchment of more than one-third. After Friday’s release of US jobs numbers, the lack of enthusiasm was palpable; pundits were stating that we have entered a stall speed. Experienced pilots and other flyers know that crash landings are probable in a stall unless there is rapid acceleration. 

We are seeing an increasing number of money market funds as well as hedge funds leaving the business. I am also seeing a small number of active equity funds being replaced by their shareholders or management companies with Index funds or ETFs.

To some degree all of this bearishness is a good sign. Bull markets begin when almost all are discouraged. Based on the past however, we need to see capitulation which we have not yet seen. We might if interest rates were higher.

Please share with me your views as to the opinions expressed.

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Friday’s Market: An Investment Trap?

The Dow Jones Industrial Average rose 277 points on Friday, June 29, for a single day gain of 2.2%. The Standard & Poors 500 rose even more to 2.49%. Our own financial services private fund jumped 3.15% on a gross basis. That gain represented approximately three quarters of the estimated gain for June which in turn is about one-half of the six month’s gain. Clearly, I don’t want to give back Friday’s gains, but I am concerned that Friday’s market action could be setting a major trap for all of us.

A trap works if it looks to be relatively attractive compared to other actions. In this case there was the confluence of three incentives:  (1) favorable news as to the Euro crisis, (2) the Supreme Court ruling on Obamacare, and (3) the market mechanics. As we examine the three items, we need to recognize whether they are poison fruit.

The Euro trap

The agreement made early Friday morning to permit the central market to make funds directly available to the Spanish and possibly the Italian Banks requires the creation of a single banking supervisor for the 17 member countries that use the Euro. The supervisor is meant to be in place by the end of the calendar year and thought to be imbedded within the European Central Bank (ECB) with funding to start in 2013. If this were to happen on schedule, it might be considered the eighth Wonder of the World. First to get these particular seventeen countries to agree quickly will be very difficult. Already both Ireland and Greece are looking for similar bank support that does not raise the nominal debt of the country.  Until the money flows from the center to the banks, there is a good chance that depositors will shift their assets to stronger banks and/or currencies. These actions may cause substantial changes in market shares of specific banks. I wonder how the scheme to have a single bank supervisor is going to attract the other members of the European Community that do not use the Euro currency? In particular I question what would cause the UK to give up its banks’ sovereignty?  Without the UK, and the Scandinavian countries inside the tent, I do not see how the other banks will agree. One of the provisos that the German legislature required in their rapid agreement was a transaction tax. If this tax is put into place for all of Europe, Europeans will have ceded a good bit of the institutional market to the Americans and Asians, a very improbable event. Bottom line, I am not swallowing that the agreement on the Euro is really going to help any time soon.

The supreme trap

Along with practically everyone else I was surprised how the US Supreme Court ruled on the Affordable Care Act. Having read parts of the decision and much of the commentary produced by legal scholars and political pundits, my conclusion from a practical viewpoint is the decision just opened up many more questions than it attempted to answer. For approximately thirty years I have been inordinately concerned as to the rise of healthcare costs within the US. Initially my concern for the rising costs led me to complain to my firm’s trade association, the Securities Industry Association (SIA) as to the annual increase in health insurance premiums that the medium and small sized brokerage firms like my own were paying. In answer to my gripes, as is often the case, they invited the complainer to sit on the board of the captive insurance company. While on that board I did find some inefficiencies and failure to optimize the float for the benefit of the members. No matter what the other members of the board and I did we could not prevent annual premium increases of double digit percentages.

After that experience I felt that the hospitals were inefficient and therefore costing the patients and their insurance companies too much and once again the curse of being a complainer struck and I was invited on the investment committee of the local community-owned hospital. Once again costs continued to escalate. This in turn led to a series of mergers with other community-owned hospitals and now I find myself on the Financial Oversight Committee of a complex of three hospitals. Still the costs keep growing. Finally, my wife and I have informally become the healthcare reinsurer to cover expenses that are not picked up by others for a large and growing family.  Thus the rise in healthcare costs really does matter to me. The way I read the decision and the various expected “fixes,” follow-on legislation and regulation, all will add to our costs. Further, I see very little that will improve the quality of healthcare or increase the number of doctors and highly trained nurses and technicians. As you may suspect, I am gagging on the benefits of the Supreme Court delivered fruit.

Fruits of the marketplace

At the end of the trading day, the New York Stock Exchange produces a list of large trade imbalances that wish to have an execution at or near the close. On Friday there was a materially larger than normal list of stocks with an imbalance. I am guessing that the imbalance was many more shares were wanting to be purchased than sold. I am guessing that at least the final twenty point surge in the DJIA was caused by the desperate need for these trades to be executed. Based on my experience as a former member of the NYSE, I believe that some of these trades (as well as some of the above average volume) were initiated by market professionals to add to their first half published holdings, reduced cash positions, and covering exposed short positions. (In the weeks prior to the quarter-end the number of average volume trading days needed to cover shorts rose.) I view each of these trading factors as transitory and cannot be expected to play a similar role in the days and weeks ahead. 

Throw out the implications of June 29^th

As regular readers of this blog know, one of two of my most important learning institutions was learning to handicap (analyze) at the race track. One of the lessons in examining past performance was questioning which results were normal and therefore had a higher likelihood of repeating and which were abnormal. In terms of the latter, I learned to disregard atypical events as I had less confidence of a repetition. Using this hard earned logic I am suggesting to throw out the implications of last Friday. 

Having suggested ignoring Friday results, Sunday night and early Monday morning I will be looking at Bloomberg Television. The Sunday night focus will be on Asian markets. Europe is both an important source of trade and bank capital for the Asians. If their markets continue the New York rise, I could be wrong as to the significance of Friday. This trend could be reaffirmed by opening trades in the major stock markets in Europe.

If there are dramatic changes suggested by these trading sessions, I will send out a follow up bulletin. For those of you that depend upon social media, please let me know how I can reach you with a brief message.

As of the 28^th of June

The following thoughts stated briefly were going to be the basis of this week’s blog before the 29^th surge.

1.  Marathon Asset Management, a London based global asset manager, has a well-written monthly letter focused on the current battle between the optimists and the pessimists. As a long-term investor with a long portfolio, Marathon is clearly in the optimist category.  However the letter introduced the concept that  “a pessimist is an optimist with better information.”  The logic implies lots of reasons to be optimistic, but grants the pessimists the recognition that those good times are further ahead. I would suggest the recently announced trend of a slower rise in consumer spending than consumer income plays into the timing question. In the US, spending patterns may be suggesting that consumers are self-imposing their own austerity program which is bad for consumption, but good for savings long-term.  The result is better for the markets that long-term investors care about. The current downgrading of corporate sales and earnings guidance is reinforcing this trend.

2.  Moody’s* in its Weekly Market Outlook  produced an interesting analysis on the predictive power of the yield spreads between high yield bonds and equivalent maturity US Treasuries. Currently the spread is 100 basis points  higher than normal. This is a bit strange in view of the expected default rate which is below normal at about 3.5. The current spread suggests a default rate of 10%. This is an important bit of analysis for two reasons. First traditionally the bond market is ahead of the stock market at sensing economic and financial problems. Second, there can be another explanation along the lines of the old adage, “if the bridge won’t go up, lower the water.” Maybe the enlarged spread is indicating that in this interest-repressed world, treasury yields are not representative of the appropriate yield to give holders a real return after inflation. I am slightly more concerned about the second interpretation than the first.

* Moody’s common stock is owned in our private financial services fund.

For any of our blog readers who would like to discuss the two longer term items of my focus on the implications of June 29^th, please contact me.

For those in the US, I wish you a happy and healthy July 4^th Independence Day. To our other readers I will be checking your markets on the 4^th and hope that they are kind to all of us.

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