What does 2015 say about ’16?

Introduction

Does what happened in the markets in 2015 set a trend for 2016? In prior posts I have discussed trends and the general comfort in trend following as well as the advantages in terms of bigger profits or smaller losses while picking up early divergences from a trend. On the last weekend of the year it is difficult to separate the evidence between nothing new and as ordered in “Alice in the Looking Glass,” the lobsters continue their dance. Or can we identify future turning points? Let’s look at the current situation for clues.

Continue the Dance

What will continue in 2016? We will enter the eighth year of the second period of the key US decision maker being a woman. My concern is not that these were both women, but that critical decisions were made by people unelected and/or unconfirmed by the US Senate.  The first was the second Mrs. Woodrow Wilson and now Valerie Jarrett. In the first case, some of our British friends suggest the decisions made through the Woodrow Wilson White House set in motion both the lengthening of WWI and the critical impetus to WWII. Some may be seeing a similar pattern being caused by the current occupant’s last year in office.

The Federal Reserve is one of the worst forecasters in the US. No recession is in its forecasts at least until 2019. Moody’s won't go that far, it believes that the “wide high yield spread doesn’t mean a recession is nigh.” Further, “jobless rate and yield curve have yet to predict” a recession. Stephen Roach’s latest piece in Project Syndicate suggests the reason for this is “the Fed, like other major central banks, has now become a creature of the financial markets rather than a steward of the real economy.”

Wall Street focused pundits are at best predicting a flat to middle single digit gain for stock prices. Numerous pension plans and granting foundations are using portfolio gain rates between 5% and 8% in their planning for the next year. This relative caution could be the cause of business capital expenditures to decline a bit, but at the same time consumer expectations are higher than current readings. As of the last weekend of the year, the Dow Jones Industrial Average without benefit of dividends is down -1.5% and the S&P500 +0.1%. That is not the full story, the Dow Jones Transportation Index is down -16.6% and the NASDAQ 100 is up +9.1%. This dichotomy explains the results of most equity mutual funds with those focusing on growth particularly in global health/biotech providers showing average gains of +9.45%, which is the single best performing investment objective tracked by my old firm Lipper Inc, now a ThomsonReuters company. Whereas portfolios largely focused on manufacturing and transportation showed losses, they were not alone, a value focused portfolio produced flat to slight declines. Many hedge funds both equity and debt-oriented also showed negative results.

Using the handicapping tools I learned at the race track trying to find suitable bets on imperfect horses, I tend to pay less attention to annual moves of 10% positive or negative. Big gains and losses of significance come in packages with at least 20% moves, even if they are a bit abnormal in coming. Thus in my portfolio selection efforts for 2016 for investing in the year as well making choices for Timespan Portfolios with 15+years duration, I am noting but not dwelling on 2015 results.

Negative Inputs

1. Electronic trading, including high frequency trading (HFT) is dominating the trading in US treasuries and now investment grade bonds to such an extent that the short side in US Treasuries is now viewed as a crowded trade. (Crowded trades are ones when the bulk of one side of the market is dominated often by fast traders; e.g., Hedge Funds and Proprietary Trading desks. The risk involved is that these players may follow momentum at any price, thus creating extreme market movements unrelated to price and value.)

2. Globally the US dollar has become too attractive vs. other currencies. Thus, at the end of 2012 the Canadian dollar was trading at parity with the US dollar and now the Loonie, the Canadian dollar is worth about $0.72 cents.

Compared to most other countries the apparent political risks to capital in the US is less. Almost all markets reverse and some will find eventual bargains in other currencies selling some of their US dollars to buy attractive goods and services as well as securities. On a long-term basis I am looking to add to my Canadian holdings of management company stocks. On a very long-term basis I find the Australian superannuation (pension) business attractive and I am hoping to find some euro denominated attractive investments.

3. Moody’s regularly publishes the market interest rates being charged on operating leases. These are very sensitive to credit ratings of the issuer. What caught my eye is that the interest rate range for those in the investment quality group from the highest to the lowest is 2.05%. On the other hand the interest spread between the highest quality “junk” and the most risky credit available in the market was 5.41% with CAA credits having to pay 10.07% which is higher than the average High Yield bond.

One of my concerns about our manipulated low interest rates is that far too many loans are priced to cover the cost of capital and operating expenses and too little for the cost of credit. My worry, despite the Fed’s lack of immediate worry about a recession, is that the size of the credit losses will be larger than historically expected. In the case of the US as distinct from China, the growth of other financial lending (shadow banking) has grown to about 33% of total loans compared with about 4% in China. Therefore the US banks won’t bear all of the costs of distressed credits.

Positive Inputs

1. The lack of any well known pundit screaming about a major upside

move is probably the single most bullish indicator. One should always remember as in golf the purpose of the market is to create humility,

thus the chance to be embarrassed the most is missing the upside.

Various sentiment polls of global portfolio managers are also expecting limited gains in 2016. If they are wrong they will have to play catch-up ball and not only commit reserves quickly but switch out of some under-performing holdings.

2. Retail fund investors both in the US and Europe have been adding to their fixed income fund investments. The combination of rising interest rates and increased credit concerns suggests to me that flows out of bond funds will eventually find a home in equity funds.

3. We like to be ahead of the market and thus now are looking at 2017, the first year of the new US Administration. History shows the first year of a new Administration of either party is often the worst of the four years. Whoever is sitting in the Presidential chair  would be wise to bring on a recession as quickly as possible so it could be blamed on the former occupant. Also with four years to work with, the new President should be able to get the economy expanding and be seen to be creating jobs.

4. I am finding lots of companies in the financial arena that I would like to permanently own at current prices. Combining this with the knowledge that there is a large quantity of talent that is ready to move for the right opportunity suggests to me that there are lots of profitable opportunities ahead.

Bottom Line

Because I have a contrarian streak, I expect a different sort of year in 2016 and if I am wrong, I won’t be hurt much.

Question of the Week: What do you expect in 2016?

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Another Victim of FICC Groups

• Where the Past Problems Generated Profits and Troubles
  
• Seven Immutable Laws of Investing
  
• The Currency Game
  
• The Interactions of Man and God
  
• Paper Money, Deficits and Hyperinflation
  
• We Are All Players-The Best Defense is a Good Offense

Where the Past Problems Generated Profits and Troubles

In an earlier era there was, in theory, a sharp distinction between brokers who were meant to act as un-conflicted agents and investment bankers and other dealers who were viewed as principals using their capital to enrich themselves. This theoretical distinction disappeared years ago, and its disappearance was reinforced by the combining of commercial banking activities with those of underwriting and market making. Out of this stew came the last financial crisis, through the sale and securitization of mortgages and similar debt instruments. The groups within the large financial conglomerates are labeled “FICC,” which stands for fixed income, currencies and commodities. Past blog posts have mentioned the growing attraction of the commodities segment to “investors” (really speculators) and the firms that service them. My concern with this blog are the $4 trillion dollar a day currency markets.

Seven Immutable Laws of Investing

This weekend I read an excellent piece by James Montier of GMO which many of us knew as Grantham, Mayo, Van Otterloo & Co. The seven laws are the following:

1. Always insist on a margin of safety
   
2. This time is never different
   
3. Be patient and wait for the fat pitch
   
4. Be contrarian
   
5. Risk is a permanent loss of capital, never a number
   
6. Be leery of leverage
   
7. Never invest in something you don’t understand

While we all should obey these seven laws all the time, for many of us this could lead to very little investing on our part. However, I urge all to apply these rules to their thinking when addressing the investment in currencies as an asset class.

Currencies can be traded by themselves in original form or through derivatives. This week, Barron’s published two articles that focused on currencies. The first piece focused on the growth of the market, some of the reasons for the growth and the use of ETFs to play the game. (An interesting point was made that it was better to short a currency ETF than to buy a bear-focused currency fund.) What the article did not stress was how much of the FX trade was leveraged by the use of various forms of derivatives or “margin” purchases. The second article was an interview with Ray Dalio of Bridgewater Associates, which has $90 billion under management. This interview focused on the difference between large deficit producing countries/currencies and those that have small deficits. Dalio favors the latter. I would suggest that unless you are in the FX markets everyday because you are hedging a stream of operating transactions, that currencies as a separate asset class fails the Seven Immutable Laws of Investing. Future exchange rates are not guaranteed or even have the same sense of reliability as do the maturity value of high quality bonds. Money has been traded around the world since the beginning of recorded time as noted in the Bible. Therefore, this time is not different.

One rarely sees a “fat pitch” (a perfect, or “too good to be true” pitch) that is advertised; note the FX dealer ads on the financial networks or popular press articles. The reason I mentioned shorting an ETF that is long a currency, is that is a contrarian move. From my own viewpoint, the short interest on the ETFs that hold Canadian and Australian dollars suggest that these may not be contrarian enough to be safe. Many of the academically trained participants in the market will look at the past movement of a currency and calculate the standard deviation around a 36 month trend line, and label this volatility as risk. Whereas risk is the permanent loss of capital, occurring when a government dramatically changes what its currency is tied to.

The second derivative of risk is not just the loss of capital, but the loss of the productive use of the capital. The problem with leverage, either through direct borrowing or through the use of derivatives, is that there is always a payment date that can be extremely inconvenient. Unless one clearly understands the real political pressures on the various central banks and how they in-turn apply pressure to their principal dealers, I would suggest that there is a lack of understanding that makes currency trading problematic.

The Interactions of Man and God

There are two old sayings that are worth remembering: “Man plans and God laughs” and “Man proposes and God disposes.” As long term investors, we try to think about the future, matching future streams of income with spending needs. In the past, many employers and their employees felt secure in terms of retirement on the basis of an average compound earnings rate on their capital of 8% or higher, with an inflation rate of 2%. That is not the world we live in today nor for the last several years. Not only were the forecasts very wrong, most investors did not have strategic reserves that could be applied to adjust the returns to meet some or most of their spending needs. The problem with reserves are that they don’t earn much money; effectively zero today, adjusting for published inflation. Even if we were smart enough to build strategic reserves, the removal of this capital from the higher earnings pools will reduce the overall return on the entire capital base and therefore a cut in spending plans will be required. That is an extremely difficult message for us to get accepted by various investment committees and wealthy families.

Paper Money, Deficits and Hyperinflation

One of the attractions of using currencies as an asset class is to escape too much reliance on any one currency, read US dollars. As most currencies today are not convertible into hard assets by their individual owners, the name of the game is to gravitate to those other paper currencies that have substantial excess earnings power that the issuing government is not spending. The current trends are not favorable either for the US or the UK, and many feel most of Europe, beyond Germany and Switzerland, is beyond hope. The US deficit is approaching the tipping point of 20% of federal government spending. Beyond 20% there is a very strong historic trend to go into hyperinflation, which will make most fixed income investments unsalable. (Thus, one can see why the FICC groups are building up their sales forces in the commodities and currency arenas.) If there is some chance of hyperinflation, one can see the investing public as reluctant to commit to what is probably a fairly priced, large capital equity market.

We Are All Players- The Best Defense is a Good Offense

In this blog, my intention is to cast doubt on adding to one’s present investments, suggesting the need for strategic reserves and altered planned spending. I further recognize that the earnings on today's strategic reserves don’t help the unavoidable spending needs. In response to these dilemmas, my training from the US Marine Corps makes me search for a good offense as a best defense. While I have some ideas to be shared at a later date with my clients first, I am not comfortable that these are the best or perhaps not even good moves on the offense.

I appeal to this blog community to suggest currently good long-term investments or sound strategic reserve elements that can be used for a narrow base of clients or shared with this entire blog community.

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