Melt Up-Expectation Risks

Introduction

All movements are either trends or turning points of different lengths and importance. Most people and most pundits are firm believers in riding whatever the current trend is. Politicians call it the “Big Mo” or momentum as they desperately try to find a parade to get in front of. I maintain the job of professional analysts of all types is to anticipate turning points. At least that is the self-imposed task that I assign myself as both an analyst and a fiduciary. However, I do not claim any special expertise at predicting the timing of critical tipping points as one reader was hoping.

The trend in stock prices is up

I have been concerned for some time that prices have been rising in general, despite my announced concerns about a potential major decline. The media celebrates round numbers called handles. Thus there is excitement when Berkshire Hathaway “A” shares went over $200,000 and Apple rose to $100 and then passed its own enthusiasm high point. The odds favor some time soon there will be a celebration of the Standard & Poor’s 500 going over its 2 handle (2000). According to my old firm, now known as Lipper Inc., so-called smart money or professional investors are riding the momentum with net flows into ETF equity funds, for the week totaling an estimated $8.5 billion, approximately six and half times more than the $1.3 billion going into equity mutual funds. Total assets in mutual funds (our normal playground) are many times larger than the size of the ETF arena. (Interesting to note that of the $1.3 billion going into equity funds that 76% went into emerging market funds as many of these were the distinct leaders in July. Perhaps the larger, slower group of investors is expressing some doubts as to the primary trend of US stock prices.)

Another category seeing significant inflows are the High Yield Bond funds, which an old observer called “stocks with coupons rather than assured payment bonds.” On both sides of the Atlantic money is flowing into Asset Allocation funds which are meant to participate to some degree in the rising enthusiasm for speculative bonds, loans as well as stocks. The Dow Jones Industrial Average and the S&P 500 have made many new highs this year and the NASDAQ is at a 14 year high.

Turning points

While there are frequent, small changes in direction of a trend, there are only a few that break the momentum of the trend and start a meaningful reversal beforehand, or if you prefer “a priori” These are difficult if not impossible to predict; e.g., the murder of the Archduke Franz Ferdinand.

However we can identify vulnerabilities or underlying deterioration. As of this writing, the following fears should be considered. 

1.   Some good market analysts are expecting the current bull market to conclude soon.

2.   Even this weekend there was another multi-billion dollar pharmaceutical acquisition. Both as an investor and as an entrepreneur I have participated in mergers and acquisitions. Any detailed study of past such activities indicates that the sellers are smarter than the buyers. The ones that have worked are when the buyer recognized not just a product line extension but a critical group of management professionals that can play an important role in the combined operation. The classic case is when the strong JP Morgan Chase acquired Bank One Corp. and Jamie Dimon soon thereafter became the leader of JP Morgan. The ones to watch out for are those where the acquirers believe they know how to manage better and can raise the acquirers’ profit margins. Warren Buffett is famous for buying good to great companies at a currently fair price. In today’s market an over priced or poorly thought-out acquisition has an impact on all other similarly viewed companies (which sends their prices higher).      

3.   In the last quarter stock prices have moved up more because of raised valuations than sales and earnings gains. We may be moving from a fairly priced region to a more fully priced one. Fully priced securities have difficulty absorbing negative news or even well constructed rumors.

4.   There is increasingly great reliance on government agencies to be able to prevent future market problems rather than being a major contributor; e.g., FNMA and Freddie Mac with housing and going off the gold standard with Richard Nixon in terms of inflation (“We are all Keynesian Now”). The past couple of US administrations have practiced bailouts to protect jobs that were in many ways capped and eventually lost. The SEC is attempting to finish the bailout process with new rules on redemptions on Institutional Prime Money Market funds. Already there are people within the Federal Reserve who question whether the new rules will actually accelerate “runs” on the fund in anticipation of gates to prevent withdrawals and/or penalty fees. The Commission believes that this won’t happen because the institutional shareholders will know more and can protect themselves. I don’t think that under current disclosure procedures this will work. I am pleased that some of the members of the New York Society of Securities Analysts, of which I am a long-time member and former President, are forming a committee to get more transparent information as to derivatives. Almost all high quality instruments in money market funds are to some degree buttressed by someone owning derivatives. If there is even a rumor as to problems in terms of significant issues, issuer, or dealer there will be a measurable impact on many fund money market instrument holdings.

5.   There is an even more serious potential problem caused by the SEC’s money market actions. By focusing only on the Institutional Prime Money Market funds, they are implying that all other money market funds are safe. Remember the movie “Jaws” when it was declared that it was safe to re-enter the water and then the sharks returned? As we use all sorts of funds, including money market funds, we attempt to understand how these funds invest. Some use a very restricted list of high quality brand names, others have seasoned staffs which look at their portfolios. The latter are preferable as long as they are fully staffed which was not true temporarily a number of years ago. Nevertheless, my attitude is that nothing is absolutely safe and that is why we attempt to intelligently diversify.

6.   While history can be instructive, it is very important to update the views of important leaders. In the Sunday newspaper there were two articles that caught my eye which illustrate this point. The first was an obituary on John Akers who was the sixth CEO of IBM. Though he was a trustee of Caltech, I didn’t know him. He led IBM from being primarily a manufacturer of computers, particularly large ones, into a focus on the development and sales of software and services. Without these changes IBM would have been part of the group of large computer producers. (Tracking this kind of major change in direction is not part of the selection process for ETFs, which is a disadvantage).

The second article which is entitled “Large Dams Just Aren’t Worth the Cost” is about a 180 degree turn by a emeritus anthropology professor at Caltech, Thayer Scudder. Until very recently he had been an impassioned advocate of building large dams in developing countries. He now believes that these multi-billion dollar projects don’t pay off as expected in a financial sense and more importantly do not bring to the displaced farmers better farming and living conditions. This change of mind by a single person, albeit a renowned expert could change the value of numerous bonds around the world as well as having important political implications.

7.   The apparent enthusiasm for index funds either in mutual fund form or ETF is shifting immediate interest into judging investments by price movement rather than by specific corporate developments. This in turn means that there will be fewer buyers interested when some good companies stumble, as almost all will at some point. The lack of these singular buyers of distressed prices suggests to me that when prices decline they will do it more quickly and deeper than past history suggests. This will produce two elements. The first is that many active and passive portfolios will have worse than normal performance. The second element will be a good price opportunity for those of us that have both cash and faith in particular companies.

Question of the week:

At some time a major decline will occur, how will you handle it?  Please share with me confidentially. 

__________    

Did you miss my blog last week?  Click here to read.

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

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 

Copyright © 2008 - 2014

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

More unconventional thoughts while waiting for the Metro

I am preparing this post on our drive back from a four-day birthday celebration in and around Washington, D.C. The location was picked first because it was convenient for four of the celebrants, and second that the Metro (DC's subway) made it easy for what could have been sixty people to meet for various activities. On Thursday, I was able to go from Pentagon City to the middle of the District for a business appointment in under 15 minutes. On Friday night the return trip took one hundred and five minutes. This “performance disparity" strikes at the efficiency of the government in Washington, albeit a local government responsible to the US Congress. In a related thought, I am fearful of what will be the middle-of-the-night debt ceiling compromise. I cannot predict the outcome, but what I can do is think about the inevitability of the conflict.

Unwritten elements in all constitutions

Whenever there is an unexpected crisis in a family, tribe or nation, a plaintive cry goes out to"do something." The leadership group fears that if they do not do something quickly, they will be replaced. One of the continual crises that governments attempt to address is the need for jobs. (Look to last week's blog addressing the need to focus on work, not jobs.)

The Bad Manual

Since the 1930s, almost all governments have been instructed in the writings of Lord John Maynard Keynes, a University of Cambridge scholar and British civil servant/speculator who advocated for governments to lower taxes and increase spending during poor economic times, and to raise taxes and cut spending in good times. Any realistic analysis will show that the first part has not worked most of the time. The second part (particularly reduced spending) has not been tried, thus rainy day surpluses have not been created in any sizable amounts. The theory is still widely taught and believed by economists. Economists like the theory because it places card-carrying economists in senior powerful government positions. The theory rests on the wisdom of the government elite to manipulate the economy for the benefit of the less fortunate who did not study under them in an ivy-covered hall. Early economists were professors of philosophy centered on ethics. Their thinking was based on the thought that rational humans would do the right thing if they were presented with all of the facts. The latter day economists and their political masters did not totally trust the populace to do the right thing and thus they manipulated the facts to force people to do what the politicians wanted.

Three clear examples of this current trend toward manipulation are first, the bailing out of those entities that were deemed too big to fail. Strangely, they did not realize that after every bankruptcy, the sun came up; new or different entities undertook many of the same functions at appropriate price/wage levels. The managements, equity holders and some debt holders became wiser as to the risks they were taking after experiencing their losses. The second current example is the Federal Reserve, buying treasuries to lower overall interest rates and thus stimulate lending. The result of quantitative easing was to make investment in emerging economies and commodities more attractive. Just as prior Fed manipulations created the dot-com and sub-prime bubbles, this time we may have created the biggest bubble yet in the form of significantly overpricing US Treasuries. The third manipulation was created by actions at both ends of Pennsylvania Avenue (the White House and the Halls of the Congress)for the last seventy years. The current impasse caused by the debt ceiling curiously comes as a surprise. The truth is that in deciding what is good not only for our own people, but many overseas, we have been bribing them with assets that that they couldn't afford.(Yet we treated these debts as good assets that would be repaid until periodic write-offs occurred.) We should have known that we had a government that we and the rest of the world could not afford.

What is going to happen now?

As I have already indicated, I do not know, but I fear that the result will not be well thought-out and efficient in terms of our resources, taxes and debt capacity. What should be happening is to examine the implications of an eventual default. First, at some point the risks overseas will appear to moderate, and the flight into the "safe currency" of the US dollar (and therefore our Treasuries) will become less intense and could reverse as higher and perhaps sounder interest rates will become very competitive to US paper. We should not blame only the scared foreigners for forcing up the price and lowering the yields on Treasuries. A good bit of the demand is generated by sophisticated US investors. These investors are looking for both the combination of higher return and escaping the presumed forthcoming wave of inflation. These smart guys/gals are buying commodities and other assets on margin. Guess what? They are supplying treasuries as the collateral for their leverage bets. A default could crunch the value of their collateral which supports leverage multiples of 50 times or more. If temporarily the value of the collateral should decline, unless they have other uncommitted assets, they will be forced to sell. I am hardly the only analyst to see this connection, thus any dramatic fall in the price of commodities may not be a function of inflation but a need to reduce leveraged positions. Less exposed, but tied to the US credit, are the assurances of various government agencies, e.g., FDIC,FHA, FNMA, SBA, etc. The prices of their paper also might react violently if the market really believes in a long lasting default.

Why is this happening now?

Around the world people are turning on their ruling political leaders because what they did in their attempt to do something is clearly not working. They are not producing new jobs. People want all of the benefits "promised," but they want someone else to pay for it. Their ability to achieve the retirement of their dreams is in tatters. For some time now I have questioned whether there are any truly popular governments, better than the other party or parties. However, all ruling political leaders are, or should, feel threatened.

This brings us to the current UK headlines on hacking. I am certainly not a defender of violating the privacy of individuals (including disclosures of the illness of a former Prime Ministers’ child). While there has been some apparent breeches of non-political leaders’ privacy, the strident calls for the hackers' heads is coming from the politicians and in some cases politically-oriented entertainers. If all of these people were as pure as the driven snow, they would have nothing to fear of the disclosures about their public positions or indiscreet activities. Clearly, they are human just like you and me. They must have some private feelings and doings which they would choose not to share. Apparently, that is not what the hackers in general are seeking. They want to catch the "Big Man or Big Woman" in a compromising situation which could cause the exposed person to lose face, if not power. If the people in power were secure in their popularity, probably no disclosure could unseat them. The focus on hacking in some respects is good for the powerful, in that it diverts immediate attention away from the continuing fiscal imbalances, the desires for current/enhanced services, and the unwillingness to pay for them.

What to Do?

Having the above thoughts, I am questioning the next steps in terms of our clients’ portfolios. Perhaps some of you in this blog community will share your thoughts. In the meantime, I will be patrolling the periphery of the markets to try and catch a fundamentally changing trend.

____________________________________________

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