This is my 400th
weekly published blog post. Many thanks to my readers in the US and around the
world, in particular to those who have commented or written to me over the
years.
Amidst the global
market uncertainty last week, my blog post “Probable Causes of
Underperformance” was named one of the five Most Read Fund Manager Comments in
London’s Citywire Global. Click here to read.
Introduction
Thus far 2016 looks and feels different
than 2015. Our last two posts which were well received in the global investment
community highlighted some of the changes. My friend, the Wall Street
Journal’s Jason Zweig and Caltech have been researching how our brains are
wired to handle the processing of information that ultimately gets translated
into fear and greed. Both the financial journalist and the university acknowledge
that people have difficulty dealing with uncertainty. This is particularly true
when different elements trigger both the fear and opportunity tracks. We may be
at such a junction now.
Misreading the Visible
Some of the items that are being misread
are as follows:
1. Size
of government debt which does not include quasi-debt; e.g., actual and implied
credit in mortgage markets, social security types of retirement plans and critical-to-national-interest large commercial activities, (in China they are known as State Owned Enterprises
SOEs).
2. Fund
flows out of US and Japan, out of domestic stocks and corporate bonds and loans
as well as Exchange Traded Funds (ETF).
3. Declining
Returns on Invested Capital (ROIC) of money center banks and major brokerage
firms.
Investment Implications
1. Aggregate
government debt will rise as governments attempt to solve societal problems
directly rather than through personal and corporate channels which will mean
that governments will be sponsors of inflation to make fixed repayments easier.
2. Foreign investors have been correct about the
direction of their flows into and out of Japan. This is the first time in 25
years when they have been wrong when they produced net outflows and the Japanese market rose in double digits. I
suspect the foreigners were expecting greater declines in the value of the yen.
In the second half of 2015 foreign investment in US stocks and corporate bonds
declined. Also the US mutual fund investor was a net redeemer of domestic
portfolio funds while buying foreign portfolio funds. The net redemptions of
Fixed Income funds raises the question, “have
bonds lost their place as a balancing instrument in mixed asset portfolios?”
3. In
many ways the biggest implication of 2015 and early 2016 activities of large
money center banks and investment banks is the withdrawal of capital and people
from the marketplace. In a world where there is probably 100,000 tradable
securities, Merrill Lynch claims to follow only 3500 companies. We are already
seeing a talent shift out of the large leaders to smaller financial groups
including Registered Investment Advisors (RIAs). To the extent that the retail
public is buying ETFs, I suspect that the economics work better for a former
broker or bank advisor to use ETFs as an RIA. The market seems to recognize the
problems that these large organizations are in. Goldman Sachs* is
selling at $164 per share which is very close to its tangible book value of
$162. Thus the market is paying nothing for the firm’s talent and position in
clients’ minds. Morgan Stanley* is selling below tangible book. If
these two firms are accurately priced then I have to wonder whether the general
stock market is worth owning. If the "house" is not going to be
adding to its long-term value, is it reasonable to assume that the bulk of investors
will and if they don't, how much longer can the game go on?
*Held either personally or in the private
financial services fund I manage
What are they Missing?
The desire for hard data is what drives
both quantitative and fundamentally-oriented investors and limits them to the known in building their
algorithms or rules. A cookbook solution is usually created to publicize an
investment method. There are two problems with this approach. The first is that
I am told that the great chefs don't exactly follow a cookbook recipe as they
always modify and improve what they do. The second is in the real world uncertainties
are often present and could be large.
When I was a securities analyst studying new
potential investments, I made a list of the things I wanted to know about an
investment. Quickly the list reached on the order of 100 items. After diligent
work I could get up to perhaps 50-60% of the items covered before the fear of a
price moving away from the most desirous entry price occurred. Thus I had to
make a decision and accept a large amount of uncertainty or go find another
opportunity. Based on the luck of time
and investing in America, I had a favorable secular trend working for me so a
good number of my recommendations performed well. Thus to this day I am willing
to accept a level of uncertainty that would not be acceptable to “quants” and
other rule book investors.
One of the major fallacies that many
investors accept is that they only deal with what they think they know without
regard for what they don't know; or in a Mark Twain world, what they know is
wrong. Over the last year Money Market funds serving both individuals and
institutions gained $16 Billion, the most of any asset class which demonstrates
that their shareholders could not find suitable investments. Further, even with
significant mutual fund outflows, the vast majority of fund holders continue to hold their assets in
funds. To me the big uncertainty is what is on the mind of the fund
holders. Why are they not being swept up in the excitement of the market place?
I would suggest that there are two reasons for their current attitude. The
first is a belief that for the foreseeable future funds in general are meeting
their longer term needs. The second is the future is not clear enough to them
to make changes.
Another
long-term trend to consider is that selling mutual funds today is far less
profitable than other products like IPOs, hedge funds, private equity funds and
securities. ETFs can be much more profitable when they are leveraged and
frequently traded.
There is lot written about ETFs, but very
little about the source of their volume on the market. What looks like general
acceptance of the investment value of a particular ETF may be just the
opposite. The only ones who can transact with the ETF sponsor is one or more
Authorized Participants (APs). These are
market making dealers on the floor of the exchange. Many of their customers are
hedge funds or other trading entities who have shorted the ETF as part of a
hedged trade in which they are long. Thus they are betting that the value of
the ETF will decline more than what they are long.
Bottom Line
With many stocks down over 5% and in some
cases more then 10%, we could be half way to a bear market. I believe the real
risk for long-term investors is not being in a position to participate in the
next major upswing, whenever it appears.
____________
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Copyright © 2008 - 2016
A.
Michael Lipper, CFA,
All Rights Reserved.
Contact author for limited redistribution permission.
All Rights Reserved.
Contact author for limited redistribution permission.
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