Too Much Gloom and Too Many Opportunities

There are two relatively standard question clichés about travel experience, “Are we there yet?” And, “are we rearranging the deck chairs on the Titanic?” As this post is being composed on Sunday afternoon, the 30^th of December, we don’t know whether we are ‘there’ (a solution to the fiscal cliff) yet. We don’t know whether the political leaders in the US Senate can come to an agreement that the President and the majority of the members of both Houses of Congress can agree on prior to Tuesday. There is little reason not to be gloomy as to the result.  The gloom is not on the chances of an agreement, but rather on the probability that whatever agreement is made will not address the problem.

The problem is that the solution did not begin with the originator and popularizer of the term “fiscal cliff.” The Chairman of the Federal Reserve, a professor of economics from Princeton, was warning that monetary policy as controlled by him could not solve the shortage of domestic demand and that fiscal policies had to address the problem. His plea to the politicians was correct according to Stephen Roach’s latest letter, in the sense that experimental monetary policy has not worked in the US, Europe, or Japan. As I discussed in last week’s post, our economic problem is that we are suffering from a cyclical binge of too much debt combined with a multi-generational deficit.

The second question as to the rearrangement of the deck chairs on the Titanic actually may well be focused on a much bigger fundamental question. Often the deck chairs on the open decks of a cruise ship are assigned to various price classes for the voyage; the higher price tickets get the better seats, etc. In earlier days, epitomized by the Titanic, the crew and the management of the cruise line were more concerned about proper deck chair configurations than the absent life boat drills; actually there were too few life boats for the passengers and crew.

The current Presidents of the US and France want to redistribute the wealth among the passengers, akin to moving the chairs on the Titanic rather than paying attention to the life-saving needs for life boats and safety drills. Also like the Captain of the Titanic, the Presidents are not focusing on where they are going and having the best available communication equipment and personnel on board. History will determine whether the parallel is appropriate.

Staying with the ill-fated travel of the Titanic, one should point out that other ships made the crossing that night without running into an iceberg. Cruise ships have provided safe and pleasant travel to many thousands since then. The telling point is that with the correct management one can avoid some major, predictable crises. The key to that belief is the word predictable. One of my favorite Wall Street Journal columnists is Carl Bialik who writes interestingly and perceptively about statistics. In his latest column he writes about some of the pet peeves of professional statisticians. The first of Bialik's two pet peeves is that in too many cases, in the popular press and mindset, a single number is predicted without an accompanying statement as to the margin of error. The principal owner of the Titanic, his navigator, and single radio operator did not recognize a margin for error in their actions. Perhaps even more perceptively, Mr. Bialik mentions his second peeve, that the absence of evidence is not the same as the evidence of absence. (Those of us who live in New Jersey were victims of this misunderstanding when NJ Transit did not move its rolling stock to higher ground when the super-storm Sandy was approaching, for their preferred locations had never flooded. Because something hasn’t happened, doesn’t mean it can’t. The damage to the railcars will take hundreds of millions of dollars to repair and will interfere with commuter travel for many months.)

Many opportunities

I get out of bed in the morning, therefore I am an optimist. I believe that there are many opportunities offered to us every single day. Because of our own preoccupations, particularly about today’s problems, we don’t see the opportunities. In preparing for this blog, I saw information on three such opportunities.

Opportunity #1:  The growing middle class

The President of the US and his political cohorts are focusing on protecting middle class Americans from paying their share of the accumulated deficit. What he should be focused on is that there are already 500 million middle class Asians and it is expected by some to be over one billion middle class Asians in the foreseeable future, as mentioned by Kishore Mahbubani in the Financial Times. This is a  market that is currently crying out for the perceived quality of western brands. The US middle class can earn its way out of its share of the deep fiscal hole it is in by focusing on products/services marketed to this growing segment. Most of our investment portfolios recognize this opportunity by investing in multinationals and indigenous companies through selected mutual fund portfolios.

Opportunity # 2:  Net cash generation

Chip Dickson's daily letter from his firm Discern focused on US (registered) non-financial corporations that are in the longest period of sustained excess cash generation in history. I suspect that companies all over the world are awaiting similar investment opportunities. Most of the US corporate spare cash is being kept where it was earned, overseas. Often commentators blame the uncertainty of tax rates for the unwillingness to spend cash. This is not completely true. In the US, we have had changes in taxes about every two years. The retarding issue is that there is a lack of vibrant demand in the US. In the 19 quarters since the beginning of 2008, again quoting Stephen Roach, consumer spending adjusted for inflation, has been growing 0.7% per year, compared to a more normal 2-3% in the recent past, and over 4% in our halcyon days. Some of this decline is due to deleveraging by consumers, particularly in housing. These people are scared about their future and I suspect they sense the current anti-capital mood emanating from the Beltway. As shown by online buying, they want to spend wisely. The opportunity comes when they feel more confident and start spending. At that point, so will the corporations of the world.

Opportunity #3:  Technology helps

Exxon periodically produces an incisive look at the future for energy many years out. Not surprisingly, it sees growth in the demand for all elements of energy consumption and therefore production. Most of the growth relates back to the first opportunity listed (the growing middle class in Asia), but also in Latin America and Africa. What I found of interest is that this substantial growth will only be partially offset by an increase in energy efficiency. Exxon fully expects that improved technology will help produce, transmit and consume energy. This is another testimonial to the likelihood of growth in demand for technology. My guess is that in an aggregate sense, spending on technology will grow at close to double the rate of growth in the overall global economy. This growth rate is not fully discounted in many technology stock prices.

How are you going to handle the fiscal cliff, or more properly the fiscal slide or slope? Please share your thoughts.  

Clarification:

In last week’s post I compared the ratio of various nations’ debts to GDP.  Further in the paragraph, I referred to “Europe’s deficit as a unit.” I should have written “Europe’s debt as a unit.”

Ruth and I wish a happy, healthy and prosperous New Year to all members of this blog community.

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Copyright © 2008 - 2012   A. Michael Lipper, C.F.A.  All Rights Reserved.

 

The Shapes and Shadows of Things to Come

As I have stated numerous times in these posts, it is the job of a good analyst to explore impossible thoughts. Too much of the focus of the media and the politicians is on the immediate future. Good analysts, particularly those like me who try to divine future secular trends, need to look to the furthest time horizons that are visible and to understand what might be beyond the horizon. With these thoughts in mind, the following topics are presenting themselves for recognition, interpretation, and investment implications:

1.     The Bernanke-labeled “fiscal cliff” is an income statement problem not a balance sheet problem. We must all recognize that this is a multigenerational challenge.

2.     There is no consumer strike, just a lot of caution.

3.     Multinationals think globally as to where to store up cash and borrow money.

4.     Problem solving by attempts to change the laws and not behaviors is illogical.

5.     Two illuminating front page articles in the Sunday New York Times next to each other, “Clinton’s Countless Choices Hinge on One: 2016” and “Tax Arithmetic Shows Top Rate Is Just a Starter.”  

Fiscal Cliff:  Income statement vs. balance sheet

All of the current focus in Washington on the “fiscal cliff” is focused on changes to current tax rates vs. ten years of budgeted expenditures. This is governmental math. We have never seen a balance sheet for the federal government and for that matter most governments. The expenditure for payrolls is treated the same as for buildings and equipment that may have some value after the money is spent, as distinct from payroll spending. If the government was a business there would be charges to depreciation and amortization accounts. Further the government does not recognize future liabilities, particularly contingent liabilities; e.g., replacement of existing facilities, impacts of changing health expense inflation, technological obsolescence. To be fair we have not seen even a list, let alone a valuation of governmental buildings, lands, mineral rights, and what intrigues me the most, intellectual property. Because of these assets I am not now worried that the US government will be forced to default on any of its loans. Nevertheless, I believe that its practice of being a slow payer will continue and accelerate. Please bear in mind our possible forerunner in terms of debt repayments, Greece, is having difficulty in selling some of its assets, but at the right price the Greek government will trade. I believe that the US has better quality assets and could raise substantial capital through sale or lease programs. The rating agencies have threatened another round of credit rating chops if there is not a discernible political willingness to address the spread between US revenues and expenditures.  I am guessing that the global bond market has already discounted on the prospect of another rating cut.

Consumers vs. governments

As regular readers of these posts may remember, my good wife Ruth and I regularly walk and observe in the very glitzy Mall at Short Hills. Today it was raining and parking was directed by security people. By far the biggest line was for pictures to be taken with Santa. Some stores had reasonable crowds, including the Apple store. Others were quite empty. When a clerk at J. Crew was asked about some out of stock merchandise, he volunteered that we should try the website. Internet shopping is filling many FedEx, UPS, and US Postal trucks. These observations suggest to me that consumers are not on strike but are being cautious. Whether they are buying now because they feel that their after-tax income will shrink next year or that prices will rise because of some scarcities, including the need for price relief from higher taxes, I don’t know. We will be watching for trends in early 2013.

Global vs. national

During the week there was news about Emerson Electric borrowing in the US to pay dividends, possibly special dividends, while they had significant cash sitting overseas. The history of Emerson Electric is that it is a prudent Midwestern US company who has a major share of the world market for small motors which drive many machines and equipment. The media commented that this was a strange act to borrow when it had a pile of cash. I believe that the press reaction is also mirrored by this Administration, members of Congress, and the Fed. They all miss the point; that business, consumers, and increasingly investors live in a global world rather than a national location. While I am not privy to the thinking of Emerson Electric, it appears to be rational. The company made money overseas and probably sees opportunities to make more by investing outside of the US. Emerson’s own treasury may feel that the interest deduction is worth more in a high tax state like the US, particularly when they may feel that the Fed has guaranteed inflation so they can repay the debt with less valuable dollars. In setting our economic policies, the leaders of this country should be thinking globally, particularly recognizing the economic problems of other governments and peoples,

“Raise the bridge or lower the water” won’t always work

There is an old saying from Venice, Italy when it was one of the leading city-states of the world, and a leader in financial transactions, that when an overloaded barge could not fit under a bridge they could either raise the bridge or lower the water. Modern governments are attempting to change the rules of commerce to accomplish the same goals of forcing a solution to problems. Many times the solutions are short-term until they come up to a bridge that can not be raised or the water lowered. The only way to move the vessel, or if you will the government, is to off-load some of the burden. While that might help navigate a particular obstacle, it will have no lasting impact without a change in behavior. In order to lower the tonnage that the government is carrying, we must ask the government to carry less and shift some of the perceived necessary burden back on to the people. As with any meaningful behavior modification, it won’t be quick or easy, just look at the attempts to eradicate cigarette smoking; a difficult task, but not an impossible accomplishment to achieve.

Is the front page editor of the New York Times a political prophet?

As mentioned earlier, Sunday’s New York Times had two timely articles next to each other on the front page. The first and somewhat expected article due to the newspaper’s political orientation, explored the possibilities of what will occupy Hilary Clinton’s time  when she steps down from a somewhat impotent position as US Secretary of State. In her next phase she will be able to espouse policies that she has personally developed whatever they happen to be. Even those who have opposed her in the past are very conscious of her own political skills as well as those of her husband.

The Clintons are pragmatists and are good at making political judgments. Whether we will vote for Hillary or not, her attention (or lack of) to the fiscal problems in the run-up to the 2016 is something we should watch.

The second article, somewhat surprising in the New York Times,  deals with the need for substantially more revenue than would be generated by the President’s proposal to tax the wealthy. This is the beginning of an analysis of how difficult it will be to quickly and meaningfully reduce the size of the deficit. In my opinion, our deficit as well as those of many other countries began two or three generations ago. We collectively wanted more from the government than we were willing to pay for in taxes or user fees. My guess is that if it took two or three generations to build these deficits in relatively low interest rate environments, it will take at least as long to eradicate the deficits.

Implications

As investors are reading of these shapes and/or shadows, they should recognize that these conditions drive longer-term portfolio choices. At this point while pure US stocks, if there are any, may be cheaper than similar issues overseas, significant global holdings make sense. While European opportunities are enticing trades, selective Asian and Latin American companies are more appealing. Both Mexico and Canada could make sense for some portfolios. In all cases, unless you have specific expertise, I prefer to use funds or management company securities.

Please share your views.  

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For Political Types, Traders, and Investors

Recently, the US markets have been headline-driven, focusing only on the so-called fiscal cliff. This fixation is unfortunate, as there are many other (and in the end, more important) issues to focus on than the dances in Washington, D.C. Nevertheless, it is an important subject and I wish to share my ruminations with you.

For political types

The real and present danger is not going over the proverbial cliff.  My fear is “the sausage.” That is how the process of passing pieces of legislation has been described; stuffing together different points of view without any overall or in-depth understanding of what the new law actually dictates. When the current ruling party had control of the White House and effective control of the two houses of Congress, they gave us two classic examples of this phenomenon.  Both the Affordable Care Act (Obamacare) and the Dodd-Frank bill are structurally very important pieces of legislation that are so long, complex, and poorly drafted that to this day the American public does not understand how they work and what implications they have upon the rest of our lives. In the month before we in theory go over the fiscal cliff, and become a victim of the Budget Control Act or “sequester” of mandated overall tax and expenditure dictates, there does not appear to be the will or perhaps the ability to make major progress as to our habitual deficit production. Some believe that there will be a last minute compromise on enough items to get an agreement to “kick the can down the road,” delaying enactment of any meaningful reforms. Based on past legislative history, my deep concern is another omnibus “solution,” written largely by aides and lobbyists that few if any fully understand.  

The fundamental issues facing the dancers in Washington are very deep and are similar to those facing most nations with democratically elected governments. For a number of generations we have been spending too much of our personal money and permitting governments to spend too much of our money. With the example of Greece and possibly France before us, America now needs to begin a very long process of getting out of debt to one another. Without an immediate behavior modification we will bring the sword of Damocles down on our grandchildren. Our personal sufferings should be shared with our children so that their children can better control their lives with the resources required to build a sustainable future. The willingness of politicians to attempt to put their opposition, to use a wrestling term, on their hip in order to bring them down, is very understandable, however lamentable in the face of these multiple generation challenges.

One of the jobs of a good analyst, be it a securities analyst, a political analyst, or a budget analyst, is to think through the so called impossible thoughts. To some extent the fear of going over the fiscal cliff is media made with help from the lead currency manipulator at the Fed. Only very few have examined what would happen if we subject ourselves to “sequester.” Often one can get a different and at times better perspective in listening to those overseas. From its London base, Marathon Asset Management (an institutional manager with large US holdings and a prestigious book of US endowment clients) and Brendon Brown, an economist with Mitsubishi UFG International believe that if we went over the cliff it would lead within a year to an expanding US economy. Nassim Taleb, the author of the famous book “Black Swan,” has similar views. Interestingly enough, even the Congressional Budget Office (CBO) has stated that if we go over the cliff that unemployment would rise from the present 7.9% to an unhappy but not devastating 9.1%. (What the CBO does not say is how many of these newly unemployed would be ex-government workers.) But further along in the CBO’s analysis of the post-cliff period, it claimed “short-term pain would be followed by long-term gain.”  What the people in Washington are neglecting to ponder is the multiplier impact of returning to the private sector the capital that is being absorbed by the deficit-producing government.

Thus, I am more concerned about a poorly crafted set of compromises than a reallocation of the country’s resources. I am looking at this problem not only as an analyst, but also as a human, mindful of the pain any major adjustment will entail for many rather than a few.

For traders

There are many microscopes one can use in examining market actions. Because of my background as a global mutual fund analyst, I pay particular attention to the flows into and out of mutual funds and their kissing cousins, exchange traded funds (ETFs). To my way of thinking the latter are much more important now from a trading perspective and mutual funds remain very important to longer-term investing. Though there is some interest on the part of retail investors in ETFs, there is much more interest on the part of institutional investors. My usage of the term institutional investor includes the traditional definition but also hedge funds, commodity trading accounts and some retail relationships that are part of “wrap accounts” with either an internal manager of the brokerage house or an external one that is making the decisions. Performance measurement is important for all of these investors. I believe this is one of the reasons that we are seeing something of management fee war among the major providers of ETFs. I view ETF flows to be a pulse rate for the short-term focus of the enlarged institutional community. That is why I found the flows in October vs. September of interest. In October, net new issuance of ETFs was $ 1.9 billion compared to the month before when there was issuance of $ 37.7 billion or a drop of 95%. The sharp contraction of sales is understandable as the total net assets of equity related ETFs declined by $17.4 billion on a month-end base of $1.03 trillion. Most of this decline was in the domestic broadly based category ($18.6 billion and $5.4 billion in the sector/industry category). Global/international and fixed income assets rose. Perhaps more significant is the short position in various ETFs of the 13 largest short positions on stocks traded on the New York Stock Exchange (NYSE); 4 were ETFs and 2 were in the largest 7 names. A lot of the ETFs are narrowly focused and 6 of them have more shares sold short than the size of their capitalization. Clearly these are trading vehicles most of the time used as part of a complex strategy.

Harking back to my recent post on our annual walk through a glitzy shopping mall, I commented on the lack of shopping frenzy and lower price points on merchandise at Tiffany. One of the fears in making a specific investment in a stock like Tiffany is that to some degree it is at the mercy of the general economy. One way to protect against the general economy/general market would be to be to short a broadly based ETF index like the Vanguard 500. Unfortunately, Tiffany had other problems with rising silver prices and shrinking gross margins which were revealed this week. I suspect that while the theoretical hedger made some money on the short of the ETF, it was less than the loss for the week in Tiffany shares.  

For the long-term investor

As a member of three investment committees of various sized institutional endowments, I try to avoid following the news accounts of what endowments, particularly large ones, are doing with their investments. First, like the classic picture of a small investor, institutions often follow a herd instinct and could be accused of being wrong at turning points. To be fair, news articles about endowment flows tend to be quite dated and may not represent current prices and conditions. Second, to understand why an endowment makes major decisions it is important not only to know about its spending policies, but also about the overall organization’s financial conditions and future obligations. Third, almost all investment committees are made up of people who are primarily focused on giving the money away and another group who are focused on building the capital base for future and perhaps unspecified needs. Thus the actions of the committee will be a compromise. With these thoughts in mind, I would not be rushing into private equity, unless one thought there would be a sharp increase in smaller merger & acquisition activities and an increased appetite for initial public offerings (IPOs). I would also be careful about quantitatively driven funds primarily investing in the difference between the short-term performance differentials of published indexes.

What would I be looking for as equity investments? In the long run it is believed that there will be 2 billion more people on this earth in 35 years. In order to feed them we will need to produce 70% more food than we are doing now. I believe that this increased production will come from capital and technological resources and probably less from human labor. At some point in the far future more food from the sea and perhaps other planets will play a role.

Back on earth and much more immediate, I would be looking for disruptive companies that are changing the cost, supply and demand curves in our world. These may be tech start-ups or more likely companies that use technology in a different way to create dynamic change. An example of this is the impact of mobile phones in the deeply emerging markets that are radically changing cultures. Most of these investments won’t fit well in many indexes which could be an opportunity for the astute investor. No review of potential investments should exclude the impact of improving economic conditions in China. In my mind the way to participate in this phenomenon is very much open to discussion.  How would you now play the China card?

It is your turn to share your thoughts on the Fiscal Cliff, ETFs and short-term trading signals, Long-term investments and China.

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