Time Horizon Decisions Require Different Skills

Introduction

The essential question facing investors this Monday morning is whether this just a rally in a trading/bear market or possibly the beginnings of a new bull market.  Only time will tell, but having the right skill sets and time frame focus will improve your odds. This is similar to the race track when a knowledge of various jockeys' preferred race tactics, the training and pedigree of the horse, the conditions of the race and those of the competitors’ may improve, but do not guaranty the gambler’s chance of success.

The Conditions of Today’s Race

We have had six years of generally rising US stock markets followed by six weeks of falling prices through mid February and four weeks of rising prices. Different patterns are affecting different major markets. Europeans seem to translate the latest multiple moves by the ECB as a reaction to a fear of a business slowdown. China is being pumped up by various governmental moves. Many emerging markets have suffered by negative currency comparisons and a sharp drop off of their exports to China and a cut back in the funding of various projects by the Chinese. Japan’s negative interest rate policy has hurt the value of the yen, but has not released constrained consumer and corporate spending. Clearly the almost 50% recovery in the posted price for crude oil is being treated as a symbol of recovering global demand in contrast to some beliefs that we are heading into a recession, forgetting that there is only a tangential connection between economic cycles and market cycles.

Misreading the Evidence

Many investors and traders are being pitched so-called value stocks. Others are being reassured that disruptive corporate and consumer spending will only be felt in a limited number of industrial sectors. Finally others are relying on flows into Exchange Traded Funds (ETFs) representing long-term bullish investment demand.  All three of these beliefs should be challenged and some or all will be found to be wanting.

Value is not a Trap, but some Value Stocks are a Trap

True value is defined when a knowledgeable unconstrained buyer meets a knowledgeable troubled seller and can agree on terms and price. One should be wary of pitches by a sales force that is part of an investment banking chain that focuses on book value or tangible book value.  I have been a buyer, a seller, and an adviser to buyers and sellers of transactions that produced values to all or almost all involved. In my blog discussion of Warren Buffett’s annual letter I agreed with him in terms of the validity of book value as a measure of investment value.

As someone who is long financial services securities both personally and in my private financial services fund, I do not start my investment process with the financial data. I start with an understanding of the relationships with clients, employees, regulators, and media. I attempt to calculate the cost and the time involved to reproduce the target under investigation. I then look at what would be a reasonable estimate of the costs involved of exiting various elements of real estate and other leases. Severance costs need to be determined as well as crystallizing all of the expected contingent liabilities. A good example of this I heard about recently is a financial operator taking over an upscale supermarket chain and before the deal even closed, selling a meaningful number of stores in a geographical region to a national company who was not really into the same local markets. This buyer was valuing the locations, management and shoppers and not the financials of the stores, assuming that the purchase of these supermarkets would be close to the dollar for dollar shown on its internal statements.

When I sold my data-based operations, I was transferring respected customer relationships with numerous major financial institutions. My people, most of whom had worked for our clients, were a particularly prized asset in my opinion. At the time we were able to expense practically all of our software development thus these assets were not represented on our balance sheet in a transfer of operating assets. I bought a number of modest US and non-US acquisitions, in each case acquiring management was the real goal. I couldn’t have hired them without buying their operations. While the investing public, be they institutions or individuals, may buy on book value-related trades, the professionals don’t.

Most Opportunities are “Disruptable”

A major investment banking organization recently published a well written thirty page report entitled “The Age of Disruption” which did a good job of describing the ongoing process of many companies and sectors that have been or are being disrupted. What caught my eye was that the report listed five sectors that have been the least disrupted with the presumption that they will continue to be protected from disruption. Two of those sectors were business services and real estate. I believe well within a generation if not well before that many of these sectors’ ways of doing business will be distorted if not totally eliminated. One of the major concerns for the taxing authorities in New York State and to a lesser degree in New Jersey and Illinois is that many organizations within the financial trading communities are reporting record revenues with decreasing profit margins. The number of employees is dropping due to technological replacement and greater concentration. I suspect that these trends are happening throughout the business service sector.

In terms of Real Estate the banks and others in the mortgage business have drastically reduced their head count through better controls and technology. Good creative real estate people who can quickly deliver transactions and provide other services should be in high demand well into the future. However, those that troll for listings can be easily replaced through technology. There will be increasing pressure on all costs involved with real estate including title insurance and closing costs. 

Surge in ETF Flows

I believe individuals and the media misinterpret the flows into and out of ETFs and also mutual funds. Most of the volume is essentially a beta play for or against an index. It is my belief that the bulk of the flow comes from traders; e.g., hedge funds and other fast market participants. Occasionally one sees brokerage firms and registered investment advisors committing discretionary or near discretionary money into ETFs. In almost all cases these transactions are part of complex trades (often carry trades) with the use of ETFs on the short side vs. individual securities on the long side. We see very few ETF holdings that are meant to be a permanent holding. Thus their flow data is for trading consumption not investment attributes.

Most mutual fund redemptions are, in effect, completions of self-administered investment programs to meet life’s needs. What gets reported is the net flows out of funds and into ETFs which are not related. As already indicated the ETF flows are principally from the trading community. The net redemptions of mutual funds (until last two weeks) is essentially a function that intermediaries have suitability and churning constraints with mutual funds they don’t have with ETFs. There are numerous undisclosed ways that the investment firms are better off dealing with ETFs than mutual funds. I hope to find out more in a panel that I will chair at the International Stock Exchange Executives Emeriti summit conference in April.

Investment Timespans and Skills

As the regular readers of these blog posts may recall, I have suggested that investments should be allocated to different time horizons by using the matrix of the Timespan L Portfolios^® to cover various time horizons between the immediate cash needs all the way out beyond our current lifetimes.

In building these custom portfolios there are different investment skills required to buy, hold, and sell securities. A good buyer is a prudent believer, often of changing conditions both within a particular security and its market environment. A good holder is someone who diligently follows trends and is quick to determine whether any variation is acceptable under the conditions. A good seller is essentially a skeptic that views the present and the future looking for any sign of contrary elements which should alert a sale process.

Applying Investment Skills to Timespans

1.  The first task is to identify whether the security, mutual fund, or investment manager is already on board or just one under consideration. (If you already own it you may have to do something, if you don’t you have the luxury of not doing anything.) In the case of the short-term operational portfolio one is very concerned as to whether on a total return basis the principal will be substantially intact during the short-term duration of this portfolio. Liquidity becomes very important in this analysis. One probably should not add to this portfolio unless it makes this portfolio more liquid and stable.

2.  In terms of the replenishment portfolio which is designed to provide capital to the exhausted operational portfolio, this portfolio has a limited duration in the four to seven year range and presumes at least one if not more down years. The critical skill for this portfolio is the diligent holder who is very alert to any variation to the outlook for any part of this portfolio. An appropriate risk balance is necessary to insure that the replenishment portfolio can and does perform its job well.

3.  The third portfolio type is the endowment which has a timespan from the end of the second portfolio to the end of the power base of those who are in command at the time and would be often in the ten to fifteen year range. All three of the investment skills  (buy, hold and sell) should work on the third portfolio.

4.  For  the fourth portfolio both the buyer and seller skill sets are important. One wants only those investments in this portfolio that look in the long-run to perform materially better than the market and when they don’t they should be replaced.

How Do I Come Out?

Recognizing that t the only thing I can promise my accounts is that I will be wrong time from to time and hopefully that I will correct quickly enough so that the client is not fundamentally hurt. With that as a caveat:

•For my conservative clients, I would be reducing risk in the operational portfolio as markets became more enthusiastic.

•For the replenishment portfolio, I would use periodic dips to raise  my market risk exposure a little bit.

•The Endowment portfolio should not be particularly market trend oriented, but should focus its attention on viable quality leaders.

•The Legacy portfolio should look for the survivability of disruptive companies.

Question of the Week: How are you addressing the market as a temporary rally, the beginning of a market upsurge, or a distraction?

Please let me know

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Markets Misread the Medicine

Introduction

Perhaps because of my cold I am more conscious than at other times to medicine. With all the wonders of modern science there is no sure fire way to cure the common cold, yet the market for cold remedies is very large and present in every country. We all want to get better quickly and will try any so-called remedies.

Wrong medicine sends markets higher

This week we have seen several examples of governments and/or their central banks prescribing the wrong medicine to the welcoming stock markets. The sugar pills that are being rammed down our throats are various forms of Quantitative Easing.

Perhaps exporting our problems helps

The US used to be accused of exporting our home grown inflation. At other times we were criticized for our declared strong but actual weak dollar policy. But now we are exporting a bigger fallacy. The recently retired chair of the Federal Reserve Board and mentor to the current chair in his continued advocacy of Quantitative Easing (QE) has quipped that in practice it worked, but in theory it shouldn’t. Further, he said “We were never concerned about [inflation]. Inflation was never a risk and inflation is not a risk now.” This is from a man that did not see the many precursors that multiplied and helped created the housing bubble.

The evidence of the lowering of underwriting mortgage standards was reported on within the Fed’s own documents. The comment about no inflation now is particularly inappropriate when using core inflation, the Fed’s preferred measure, which over the last twelve months has risen to 1.8%.  These mental lapses are acceptable for a busy ex-Princeton professor who was not challenged in the commercial world. His real crime against the US economy and now his followers in the central canks of the world is the belief that QE worked. There appears to be a loose correlation that the first dose of QE was stimulating. Those of us who follow the performance of securities prices have learned that correlation does not equal causation. The proof is that in this market additional doses have had increasingly less impact.

Japan’s experience revealing

Our Japanese friends have relatively quickly observed their own evidence when much stronger QE medicine was applied to their economy: it has led to them falling back into recession. On the weight of the evidence I believe we can conclude that QE is a poor if not bad medicine for economies, but not stock markets who need to believe. Thus this week’s Euro propaganda by the ECB buying bonds as they launch their latest QE attempt was good for their local stock markets, but is in and of itself unlikely to materially help the various economies.

The "Third Arrow" could really help

After fiscal and monetary changes in Japan, the “third arrow” was a deep and sustained reform movement which included removing many government imposed controls, including immigration.

Perhaps if the third arrow is successful, both the US and Europe could follow Japan’s lead. In the US, federal tax regulations are spread over approximately 79,000 pages. Renewed faith in the marketplace to provide much of the regulation with appropriate oversight would energize each economy. All one needs to do is to array the starting date of various industries along with the anticipated level of regulation to see where economic productivity is likely to occur.

What won’t help

Reliance on old economic theory and practice is not the answer to today’s problems. I won’t go on paraphrasing  Mark Anthony about coming to bury Keynesian thoughts. I am concerned more about an eighteenth century ghost of mercantilism. Today, as in the past, governments are trying to aid their exporters to earn increased amounts of currency.  The European governments of past eras were attempting the same maneuver by lowering the value of their own currency versus their competitors. This created an era of competitive devaluations. 

Both our Japanese and European friends are trying to accomplish the same thing today. This will set off a race to the bottom and deprive their homelands of more expensive imports. In terms of quality of life, cheaper goods often means items of less value to the user. To defend themselves, much of the wealthy classes are now exchanging their own currency for foreign luxury goods as a way to protect their own real wealth. Some of the preferred goods are securities. The $1 trillion dollar Japanese Government Pension Plan has doubled its commitments to both domestic and international stocks, each to 25% of their total responsibility. This surge is helping the Japanese market and I suspect is playing a role in the US as well.

What may be the root cause of the problems?

The as usual intriguing John Authers in the Financial Times has produced an article that may explain the unanimity of central bank thinking. In the article under the column head of “The Long View,” he has a title of  “Why we need to break the white male grip on the markets.” In the article he focuses on group thinking. The bottom line in the article is homogeneity makes a group overconfident. 

Most central bankers are learned economists. Most economists spend most of their time on macro-economic studies, in other words top/down. Coming from a securities analyst and race track handicapper my instinct is for micro- economics and focus on details that make something standout. I also learned at the track and in the marketplace to challenge the consensus thinking which is right some of the time, but wrong at other times. When right things go as planned, no problem; but when wrong they can be disruptive. Central bankers like most boards of directors and investment committees are made up of polite people that may occasionally question but rarely challenge the perceived truth. To have all the major central banks going the same way is an example of extreme consensus thinking which could well be risky.

Are good stock markets worrisome?

One of my individual high net worth clients reminds me that while he is delighted with the performance of his account, the pain of loss would be twice as large as the pleasure of his gains. He has his pleasure/pain calculus right even though over time a continuously invested stock portfolio has absorbed major market calamities with an average annual gain going back to 1871 of 6.8%. Nevertheless, if the medicine that we are swallowing is giving us sugar highs we need to be wary. The Lipper Balanced (Mutual) Fund Index is slightly elevated at 7.47% for the year-to-date. The index is benefiting from its ownership of large cap core equities that as a stand alone is up 11.42% in 2014. Neither of these numbers is of the nose bleed size, but after a remarkably strong 2013, we need to watch closely.

There are two indicators that we are watching. The first is the ratio of the purchase of call options as compared with the number of put options owned. This ratio is historically low and on this measure the market is not looking frothy. However, Friday’s stock price movements are a flashing cautionary signal. On the New York Stock Exchange 219 stocks hit new highs and only 15 hit new lows. This may show that the large amounts of institutional cash reserves are being committed. The reason for this belief is that on the NASDAQ there were only134 new highs, but 48 new lows. Often the NASDAQ is a more speculative market.

The patient is recovering

As my cold is leaving my body this evening I regain some perspective having recovered from the medicine I took. The issues in counseling my nervous client are the time horizons of his concerns. Clearly the US market could fall at any time in view of its long recovery. While the recovery has been long, it is not particularly robust. On a historical basis, we could see a possible 25% fall which could be recovered in perhaps five or so years. We are prepared for that potential. However, there is a bigger risk and it is on the upside. 

We may be in a period that many investors seeing the current gains and the popular belief in QE and other government remedies quickly re-enter the market and not in the large markets for companies like Berkshire Hathaway^*, IBM, Procter & Gamble as recommended by Goldman Sachs^*, but in much more speculative NASDAQ stocks and call options. This kind of surge could produce parabolic price patterns as we head to some predictions in the years ahead of 3000 on the S&P 500, but perhaps much sooner than expected. This kind of enthusiasm could set up my feared spike which could lead to a generational decline on the order of 50% like we saw in 2008. Normally the next big drop would be further in the future, but we can not count on it.

^*Owned by me personally and/or by the financial services fund I manage.

The key for my client mentioned above is what level and duration is his discomfort. He could experience pain as those around him in the short run make a pile of money before they lose most or all of it. My task is to be conscious of his pleasure/pain calculus as well as his longer-term performance.

Question of the Week: Where are you on your Pain/Pleasure investor calculus?

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Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2014

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

Politics Follows The Market, Not the Other Way Around

This weekend my wife and I drove down to Mount Vernon, the ancestral home of George Washington. For many years Ruth has been a member of “The Life Guard Society.” This is a fund and friend-raising group to support the preservation and enhancement of our first president’s estate and image.  The name Life Guard comes from the group of 150 officers that successfully protected General Washington against personal violence. In other words they were the forerunners of today’s US Secret Service White House force. The purpose of the meeting was to celebrate the acquisition of Washington’s personal copy of a book called the Acts of Congress. This book contains the Constitution, the Bill of Rights and legislation that was passed in the first year of his Presidency. What makes this particular copy extremely illuminating is that it also contains the President’s own notes and concerns. A glance at his brief comments shows he was concerned about presidential powers. His concern was to understand the separate powers of the President, Congress, and the Supreme Court. (He was the only President to appoint all nine of the Justices.) 

After the celebratory dinner there was discussion as to the importance of the written record of both the Declaration of Independence and the Constitution. Thomas Jefferson, one of the principal authors told Washington that there was nothing new in these documents as they expressed ideas that came from the Bible, ancient Greeks, and various philosophers. Once again this view gives me an opportunity to disagree with the third US President. What was new was not the words or thoughts, but that a diverse group of politicians and a few statesmen could and did agree with these principles and literally pledged their lives and assets in support of them.

The enacted political decisions of these 18^th  Century men became possible only when they believed that there was support for these ideas and ideals on the part of the people. This is a clear example that politicians and many governments will only move when they deem to have some, if not total support. The old line is that the job of a politician is to find a parade and get in front of it.

What does this history mean for investors in 2012?

I have previously written about being in despair at various learned investment committee meetings with the consensus wanting to hold off making fundamental investment decisions until various elections throughout the world are in the record books. I humbly suggest that is a prescription for not only being late, but also wrong as to the long-term impacts of purely political moves.

Investors need to wake up and look as to what is happening in the real economy and market prices. For example, the US stock market large cap leaders are up mid to high teens on a year-to-date percentage basis. These returns are in many cases twice the too high actuarial rates for many pension plans. If these long-term plans were properly equity oriented and if they went to cash today, which they won’t, they would have met their obligations for two years. Probably much more significantly, this summer’s equity rally reduces the odds in some minds of a fear of a major market decline.

Another sign of the markets moving ahead of the politicians in response to the manipulation by the US Federal Reserve and the ECB, is the significant sale of US dollars not only to buy stocks, but gold and the euro. The latter is a bit breathtaking. Following the very bad practice of US bailouts and corruption of the bankruptcy acts as a vote buying exercise, the ECB will supply enough capital through the purchase of bank bonds to be prepared to restore the major banks’ capital requirements after a soon to be appointed European banking authority eventually forces a substantial write-off of the debts incurred on the periphery.

What is missing in almost all countries that are running deficits is that the politicians provide goods and services because the people won’t. Individuals do not recognize the responsibility for their own deficits. These deficits are not the mismatch of their expenditures versus their incomes. The deficits are much deeper as in healthy lifestyles, competitive useful knowledge, work ethics, and accumulating retirement income for themselves. I am told by those on the left that I am asking too much. I suggest that once again we can learn something from the ancient Greeks. Look at the last Olympics, people all over the world cheered the success of champions and other participants in many competitions even if they had little real understanding of the sport.  Further, in our society someone becomes something of a celebratory for completing a piece of art, musical composition or a book despite what some might say is the poor quality of the work. It is the completion of a recognizable task that is celebrated. What we should celebrate and therefore encourage is striving. When more Americans and Europeans show signs of striving we will begin in a meaningful way to dismantle the deficit producing engines.

How do we develop portfolio decisions?

The first thing to do is to look around you. "The trucks are rolling" was the message I got driving back from Washington on a Sunday. There were many trucks on the Turnpike. Many of them were from logistics companies that have become a critical part of “just in time delivery.”

At last night’s dinner someone in the steamship business noted that business was increasing. A mixed view is the continuing office building and luxury apartment construction one sees driving through Washington. At a recent investment meeting someone noted that people were coming up and offering twice the price for a condo than the owner had paid.

One of the negatives expressed about equities recently is that American businesses are running at very high operating margins in part due to a significant increase in productivity of a smaller labor force. For many companies, global sales growth has been disappointing. If I believe my eyes and what I see out of the logistics sectors of our economy, we are in the early stage of a re-equipment surge. At some point, even to get out today’s volume of goods and services, we will need to replace worn out machines and perhaps people.

One interesting question is how unproductive the heady amount of global Internet and media spending on entertainment is, compared to what has been lackluster spending on the part of business? While I do own a few shares of Apple from a historic accident, I do not consider myself a qualified analyst on the stock. I do not own shares in Microsoft directly, but a number of funds owned by my clients and I hold shares in both Microsoft and Apple. With that as a background, I wonder at what point are we going to see Microsoft’s business clients start to show some of the enthusiasm that has posted orders for Apple's iPhone 5? If that were to happen, the world will become more serious about working on its problems rather than its entertainment.

In the meantime selling US dollars is probably wise.

What do you think? 

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