After Selling Short-Term, You Should Buy Long-Term

Two weeks ago I suggested that on a trading and cyclical basis one should sell on the Wednesday after the 2012 US election. My thinking was based on the premise that the election would not provide a meaningful answer to the economic future of the US or to the rest of the world. Since the election, on average six out of eight market sessions have recorded losses. This continues the trend for the last four weeks since the probabilities that the president would be elected rose, and the market average declined 5.66%.

What did the US election signify?

As this blog is increasingly being read by those who are not Americans, I should share with you my analysis of the election.  (Readers from over 40 countries have joined our blog community.)  In general, Americans have had a fear of government actions unless they are directly helped, and often vote by selecting the least objectionable candidate. This election was decided upon the basis of perceived personalities. There was no real focus on a perceived future. Despite the victor’s view, there was no policy mandate given, as only a little over half of the potential voters voted and the spread in the popular vote was less than 3%. However, there were at least two clear implications that will affect the next election cycle that began on November 7^th. The first is that the Chicago machine is well trained in urban get out the vote campaigns and produced a much better result than the Boston-oriented management consultants who thought they were dealing with a corporate turnaround. The significance of this disparity is that winning politics is not just policy, but performance. The second implication for the Republicans is that they need to select better candidates for the House and Senate. (Interesting enough, the Republicans were more successful in terms of races for governors, other state officers and state legislatures.)

Fiscal cliff or barrier mountains?

Those who want short and complete answers to complex problems speak in terms of a single fiscal cliff.  I see the challenge as a series of difficult to solve barriers to a free floating economy. The basic problem (which is not being discussed in the US and most other major countries) is that the governments are providing services to a population that is unwilling to commit to pay the bill. This is not a new phenomenon in the US. Alexander Hamilton, the first Secretary of the Treasury bemoaned this very same condition. In Hamilton’s 1795 report to the Congress, he described the public’s desire for services, and their unwillingness to pay for them through higher taxes. The answer was to borrow the shortfall. However, as much as he tried, at the time Congress was unwilling to establish a specific plan to extinguish the debt. Today we have the same problem. We are facing the threat of sequestration, which will automatically raise tax rates and cut both military and discretionary spending. In addition to sequestration there is the self-imposed debt limit, which will likely result in a credit rating drop. On Friday there was a happy talk session at the White House where the congressional leadership appeared in public to accept some broad but not defined principles of cooperation.  Believing that “God is in the details,” I have my doubts that we will see any meaningful solutions until we get a final House-Senate conference committee proposal. The earliest that I expect any sort of practical compromise will be in March and maybe not even then. The timing may be ironic, as in March the new leadership of China will be in command to somewhat more aggressively manage the world’s second largest economy.

Disclosure:  Not only did Hamilton and I graduate from the same college, he founded the bank where I gained my first fulltime employment on Wall Street.

As much as the politicians might want to be able to act in their own time, there may well be external pressures that will change the picture of cooperation substantially. The first pressure will be the probable need to restock the Cabinet with replacements that will have to go through what could be rough interrogations from the Senate minority party. The second force, dear readers are you, the investors. The bond market can no longer play its traditional role as bond vigilantes because of the manipulation of the credit markets by various governments. Replacing the bond market in its role as protector will be the stock market. If both individual and corporate leaders sell because they feel that their taxes will go up too much for them, there will be a negative “wealth effect.” If the general population feels that they will be poorer due to higher taxes, they may seriously restrict their spending. This could deepen the recession that the Congressional Budget Office (CBO) expects in the first half of 2013. International actions and other surprises could also change the arduous progress to various agreements. Moody’s is predicting that corporate default rates will rise from their abnormally low levels, moving back to their historically more normal ranges. Let us hope that a relatively minor increase in defaults won’t lead to a rise in unemployment, which could impact any congressional compromise.

Secular bulls:  your time is coming

As an optimist, (as is everyone who gets out of bed in the morning), I am concerned about the relative lack of other optimists; as a contrarian this absence makes me bullish. If one believes in secular trends as I do, you may see that we are setting up one of the great bull markets of our lifetimes, not in magnitude, but in length. PIMCO, the world’s largest bond manager believes that stocks will outperform bonds in the future, but the average rate of gain will be more like 5% than the historic 10%. While they may be correct in terms of the aggregate growth of operating earnings, I see a good chance that stock prices will be higher than earnings projections due to valuation adjustments. Beyond that, I believe that there are a number of opportunities to do materially better than the market. There are two very different examples as to how this can happen.

The global label

Even if the US solves its fiscal problem, the odds are that its standard of living will decline relative to other parts of the world. Work ethic, education and demographics trends are moving against the US. In recognition of this, I believe that US investors need to invest their equity in a portfolio that has at least 50% of its underlying earnings power from non-US sources. This can be accomplished by investing 60% of the equity portfolio in US multinational companies. These companies have at least 40% of their own earnings from overseas sources. They can accomplish this by having overseas production sites selling into local markets; e.g., Coca Cola, Colgate, etc., or by exports (net of imports) like Boeing and Deere or a hybrid like Apple,  whose annuity-like future I believe is in making and selling products in China. (Though I have used large company names, there are any number of mid-sized or smaller companies that would qualify particularly in terms of exports and royalties.)  The multinational portion of the equity portfolio would have foreign earnings of approximately 24% (60% x 40%  = 24%).  In addition to the 60% in US multinationals, an additional 21% of the equity portfolio should be invested in local companies overseas, particularly those that do not have much of their sales in the US.  Thus 60% + 21% = 81%, which will leave 19% for purely domestic investments. I have presumed that you or your adviser has the requisite knowledge not only to do the detailed analysis of foreign vs. US content, but to also pick winning stocks. If your level of comfort in these abilities is not high, then perhaps some or all of this strategy can be well executed through the use of mutual funds or similar vehicles.

Disruptive Opportunities

I search for companies that perceive opportunities differently than others. Everyone’s favorite example of this is Apple, but this was not a good example years ago when I got some shares. Allow me to use a very narrow example from my particular area of focus, the financial services industry. In a private fund that I manage for a few clients and my family, we own 22 financial services company stocks. Since I learned securities analysis initially under Professor David Dodd, of Graham and Dodd fame, I believe that any and all companies can be acquired. Currently the brokerage/investment banking business is having difficulties. In the last couple of weeks KBW (Keefe, Bruyette & Woods), a dominant financial services broker, is being acquired by a larger more diversified firm. This week ICAP, a UK interdealer firm has closed its New York floor operation and announced significantly down earnings. The general perception is that these businesses are having a rough time and could be terminally sick. This week there was the announced disruptive acquisition of Jefferies, a position in our portfolio, by Leucadia National. In the future, the combined company will be managed by the senior people from Jefferies and they will be able to use both Leucadia’s capital and net operating loss carry forward. What is significant to me about this deal is that as a result of this merger, the new company will be managed for the growth in its book value not its quarterly earnings. This approach is similar to two of our other holdings, Berkshire Hathaway and Alleghany Corp. Actually what has me excited is that I perceive this deal as creating the US equivalent of the very successful (for awhile), UK Merchant Banks. While the US rules are now different than the set of rules that operated in the UK, some of the activities could be similar. To the extent that all of the perceived advantages of this combination come to be, it will change the acquisition of turnarounds in terms of competition with private equity groups.

I am reasonably confident that these types of transformational deals will occur in many sectors of the economy and will create highly focused special opportunities.

It’s your turn

Now it’s your turn to share with me how you are structuring your portfolio.

___________________________________

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.

When it Comes to Taxes, We All Have Special Interests

A few days ago, I was asked my views on taxation fairness and was provided with two opposing views of tax policy for comment; one from a New York Times columnist and the other a Wall Street Journal opinion piece. My response follows.

The biggest unanswered question facing all nations with deficits is, “What are we paying for on an individual basis?” In the matter of tax policy each of us, in effect, forms a special interest group. Those of us living in suburbia are in favor of money to be spent on roads and possibly suburban transportation. Our urban friends would prefer that money be spent on mass transit in their cities. When we, our close family and friends are healthy, excessive spending on public health is overdone. However, when any of us are ill, we want the best healthcare available. Only those of us who fear future wars and terrorism are supporters of national defense spending etc., etc. Since we are not able to order our services à la carte, our next problem is how to pay for all the services that we want and pay for the sometimes wasteful spending for others that might have more votes than us. Governments pay for these services through taxes, fees, sale of assets, and borrowing. In the end, borrowing is self-defeating, but perhaps acceptable to many who do not have grandchildren.

One of the lessons from history is that the ability to levy taxes leads a society into certain actions. Think of taxes as the price we pay for services. If the price becomes too high, we will modify our behavior. If we tax income or capital at too high a rate, we will generate less income or capital. Since we have not successfully developed wide scale revenue-generating user fees, we will need to use taxes to pay for all those wanted and unwanted goods and services. Each of us has very good reasons to believe that someone else should pay our share of the expenses. As I believe that as a society we spend too much, I would favor various forms of consumption taxes with an appropriate carve-out for life sustaining items and the poor. Unfortunately the remaining purchases would probably be too small to be a good base for tax generation. There is another risk; that if legitimate user fees get to be too high, we will create a black or grey market with all its socially undesirable characteristics. There are other victims from an imposed tax on “luxury goods.” When we decided to tax large yachts, the yacht building business left the US for friendlier locations.

Because every inhabitant of this great country benefits from our collective government services, each person should pay something. Otherwise, we will continue the situation whereby people who do not pay taxes will want additional services to be paid by others. Thus, I am afraid we need a graduated tax rate approach. My own view is that income should be taxed and deployed capital should not until the capital is producing dividends. The more we adjust these principles to take into consideration legitimate needs of people, or the society as a whole, the more we will create special interest groups who not only want their needs taken care of, but who are willing to trade their votes to support other people’s needs on a reciprocal basis. (If you think sorting out US Federal taxes is difficult, attempt to do it for state and local taxes which have dramatic impact on the attractiveness of local communities. From our standpoint, there is one advantage at the state level: in most cases states are required to have balanced budgets. Thank you, Alexander Hamilton.)

We have often been told that the only certain things in life are death and taxes. Over time, we can learn to deal with those realities. However, there is a third constant in modern society which has caused more upset and bad decisions. The third item, perhaps the third rail, is tax changes, both in terms of rates and application. While I hope the debate between the Wall Street Journal and the New York Times is useful, I am concerned that it will lead to annual tax changes that will retard both social and economic progress.

Investing implications

As mentioned above, from a credit concern viewpoint, General Obligation bonds issued by highly-rated US states make more sense than US Treasury and Agency paper. However, because of the temptation on the part of the politicians (including those at the US Federal Reserve), one needs to be wary about inflation. Thus, in general I would restrict my fixed-income purchases to a portfolio of bonds with current maturities less than twelve years. For many of us who do not have sufficient experience in selecting and owning individual municipal bonds, or don’t have a highly competent advisor, one can use a package approach with (Open End) Mutual funds, Closed End funds (non-leveraged), and possibly Unit Investment Trusts (UITs). The keys in selecting these are restricting the choices to those that indicate that they are intermediate in maturity and have one of the lower current gross yields of the available products. As markets generally price risk into the yields offered, a lower yield may be less risky. The distinction between gross and net yield is the expense ratio on the fund. Other things being equal, a fund with a high total expense ratio (TER) will appear to have a lower yield than a fund with a lower TER.

For those who wish to add to their stock positions, and this may not be a bad time to do so, I would focus on investments in countries with relatively low deficits compared with their Gross Domestic Product (GDP). A number of these are found in Asia, particularly in southern Asia. Very recently, Indonesia has had its credit rating raised back to investment grade, many years after having suffered a downgrade. One must be cautious in using credit rating changes, as most often they are recognition of a change that has happened some time ago. In a forthcoming blog I will share my views as to these Asian opportunities.

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

Add to the Dialogue:

I invite you to be part of this Blog community by commenting on my Blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog.

To subscribe to this Blog, or to refer a colleague or family member, use the email box or RSS feed sign-up on the left side of MikeLipper'sBlog.Blogspot.com

Independence Day: A Chance to Re-think Our Portfolio Structure

• Independence
  
• Interdependence and Insights
  
• Items of Interest

In the United States we celebrate July 4th as Independence Day. Many countries celebrate a Nation Day, observing the date when they became independent from an occupying power. The US appears to be an exception. We celebrate the date we published our Declaration of Independence (actually agreed to on July the 2nd). Thus, we are celebrating a document of principles that we hoped would separate us from what was our Mother country. At the time in 1776, the wish would not have been considered a good bet. The British had the best army and navy in the world, and we had thirteen colonies of very different backgrounds and policies. In at least three states the delegations to the Continental Congress were split and many of our people remained loyal to the Crown, fearing the disruption that would be caused by this new form of government. They were right to be afraid. A number of those successful men who signed the Declaration, who survived capture, torture and death in battle, died bankrupt because of their loss of property during the war. They could not agree among themselves how to govern, even if their independence was won. After twelve long years of debate, a compromised Constitution was passed. Viewing this arduous procedure from today’s vantage point, one of the key political decisions was to create a currency union by assuming all of the outstanding debts of the individual states, and agreeing to make payments in the discredited national currency of the US dollar. I am particularly proud that the driving force behind this and the other financial matters of the new government went to the same college as I did. Alexander Hamilton attended what is today Columbia University. (I need to assure the young in my family that we were not classmates.)

The currency union rested on the ability of the federal government both to raise taxes (largely through tariffs), and to muster a standing army that was under the President’s command. The current problem with the fiscal conditions in Greece, Portugal, Spain, Ireland and Italy are subject to the weak currency union of the Euro. One of the lessons from the American Revolution is that while ideals can flow across borders well, commands do not. I am not suggesting that our various mother countries follow the American experience, but they should use it as a base for their thinking as moderated by local conditions. We also need to apply some introspection to our own activities and thinking, including our investment portfolios, which is the focus of this blog.

Interdependence and Insights

While some early Americans may have thought that they could be independent of the “Old World,” we now know that our very existence and markets are dependent on what is happening both in the Old World of Europe, but even more importantly, China and other countries that we label, somewhat incorrectly, as “emerging.” Perhaps it is my intellectual inheritance from Alexander Hamilton, but I view the world through the prisms of financial lenses. Hamilton, first as the Secretary of Treasury, was very concerned in paying off the war debt of both the country and the assumed debt of the states. He was aided by the development of an active bond market. Only after he left the government did he become involved with the stock market, in part by founding the Bank of New York. (BONY was my first employer after leaving active duty with the US Marine Corps.) Even today investors should first be conscious as to what is happening with the various fixed income (debt) markets. These markets are much more sensitive to changes within the economy than the longer-term focused stock market. Too many stock investors today are not paying attention to the signals from the bond market which can be highlighted as follows:

1. The interest rate spread between US Treasury securities and Treasury Inflation Protected Securities (TIPS) is widening to 2.7%, indicating that market participants over the next ten years expect inflation to be 2.7% or possibly higher.
   
   
2. A number of the bond dealing desks of banks are shedding both people and capital invested in making markets. This is causing some lack of liquidity with prices becoming more volatile with reduced volume. A similar pattern is expected on the stock side of these dealers. To some degree the use of Exchange Traded Funds (ETFs) is providing additional liquidity for the stock market, on both the long and short sides of trades. Lack of liquidity, at times can lead to sudden, large price movements.
   
   
3. High Current Yield bonds and their bond funds are marching to a different drummer/different direction. While we do not just yet have the final numbers for the second quarter fixed income performance, my friends at Lipper, Inc., to which I am no longer connected, estimate that High Current Yield funds will show the only declines in the fixed income averages. These small declines should have been expected. Again, as estimated, these funds had net redemptions of $1.3 billion for the second quarter. The enthusiasm for these “junk bonds” reached a peak in March, when close to $16 billion was purchased at the time of significant issuance by corporations taking advantage of low interest rates. By May the gross flows into this category of funds had dropped to $6.4 billion, which was lower than 14 out of the last 16 months. One of the reasons for the enthusiasm for these bond funds is that in May, Moody’s* estimated that no more than 2.7% of rated bonds defaulted, and they expect by year end this number could be lower than 2%. I have two reactions to the above elements. First, I view high current yield paper as essentially equity with interest payments due and are really a form of stock investing. When these become less popular, I am concerned that stock investing in time will become less popular (which we may be seeing now). Stock markets have difficulty sustaining a big rise without increased volume. My second reaction is that I believe most things follow a cycle pattern. While Moody’s may be correct that we will be in an era of low bond defaults, I have my long-term doubts and would expect as interest rates rise and there are more high-priced deal financings, that the level of defaults, will unfortunately also rise.
   

*Moody’s is a position in our private financial services fund.

Items of Interest

One of the benefits of serving on important tax exempt institutions’ boards of directors/trustees is sharing different points of view. Recently, one particular board was asked about the outlook of the various organizations represented. The concerns of the management were first, that during poor times the needs for its services will rise. Second, fund raising is more difficult when the economy, particularly the local economy, is not expanding. Third, could the endowment be expected to raise its contribution to the operating funds? Much of the answers could be expected if one read the local newspaper. However, there were two expressed views that were interesting. The first was from an accounting firm that was increasing its hiring at the entry level. (Considering the training cycle for the firm, this was a bet that business was expected to be expanding in 2012 and beyond.) The other view held by a number of financial types, excluding me, was a bit dour focusing on this country’s debt problems. One could say that the view from these elements of the financial community was already expressed above, in the drying up of liquidity and smaller staffs on trading desks.

Those who know me would not be at all surprised that I had a different point of view. I expected that the near-term would be a period of increased volatility filled with opportunities. Some companies will do unexpected things that they never considered doing in the past. I believe that there is more proven executive talent available now than at any other time. I saw sufficient long-term growth ahead to warrant investment of reserves above the level of contingencies. A few days after the above-mentioned board meeting, I read a survey conducted for Chase Bank (JP Morgan Chase) indicating that 72% of the companies polled expected higher revenues, 62% expected higher earnings, and 50% said they would be hiring. The difference between the Chase survey and my board’s comments was that Chase’s was a national survey and the board was New York centric. The Chase survey did show some elements of concern. First, with revenues expected to grow but less than earnings, raises questions as to a margin squeeze. Second, with revenues expanding, the expansion of employment is less robust.

Two inside baseball statistics hit me as perhaps significant regarding the changing structure of the fund marketplace. First the net sales, (sales vs. redemptions) in the institutional channel was, in aggregate, greater than the combined net sales in the first five months of the direct marketing, sales force, and variable annuity channels. Most of the money recorded in the institutional channel comes from the institutional shares used by salary savings plans, e.g., 401k, 457, 403b, etc. The second and somewhat related statistic was that US Diversified Equity mutual funds had net redemptions of an estimated $4.9 billion in the first half vs. net sales by similar ETFs of $7.8 billion. The impression I draw from these factors, mirrored by slow volume at retail brokerage firms, is that the investing public is disengaged from the stock market, and is only investing involuntarily through employers’ savings plans. While this is very understandable in view of investors’ experiences over the last ten years and what they read/hear from the media, in ten or more years from now they will look back regretfully at what they could have bought.

With the second half beginning Tuesday what are your views?
____________________________________________

Add to the Dialogue:

I invite you to be part of this Blog community by commenting on my blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog .

To subscribe to this Blog, or to refer a colleague or family member, use the email box or RSS feed sign-up on the left side of www.MikeLipper.Blogspot.com