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. 

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Lifetime Investment Views

In last week's post I mentioned the views of Warren Buffett and Charlie Munger at the annual celebration of  Berkshire Hathaway in Omaha: that one should keep on learning over his/her lifetime,  I would suggest everyday. For me investing is an experienced derived art form, thus I believe that investing should be an everyday practice.  Every single day, whether one does or does not make a transaction and/or hold excess cash is an investment decision day. Everyday brings both new information and experiences of oneself or others that should be digested.

With these thoughts, I am trying to figure out what to say to my eldest grand daughter. She is graduating cum laude from William & Mary, the first chartered university in the US. She has had many investment-oriented advantages in her life including going to school outside of her home country and the fact that her father is the investment strategist for a growing asset allocation fund. Nevertheless I feel compelled to lay out some basic views that will help her to become a successful investor throughout her long and productive life.

To recognize that everyone is a gambler

The decision to get out of bed in the morning is based on a belief that the day will produce more good impacts than bad ones. While we have no enforceable guarantees, our experience is what has happened in the past. So we gamble that this is our fate for today. When we cross a street we gamble that everyone will follow both the laws of the land and physics, otherwise we are at risk of loss of life, injury, and property damage. There are many of examples of us taking gambles everyday. I believe that we cannot avoid gambling.

Every gambler believes that there is at least one more opportunity to win. Because we each take the gamble of getting out of bed and crossing the street, we are all optimistic. Some of us more than others. Chuck Jaffe had an interesting column focusing on the recent high of the Dow Jones Industrial Average. 

In the article he quoted an old friend and client of ours the late and sometimes great growth mutual fund manager, Bill Berger. Bill believed or at least said that in the 2040 period the famous benchmark could reach 116,200. The view was based on a mathematical rule that could produce two occurrences of a triple in thirty-two years. Few today would be that optimistic, but the rules of chance do not absolutely rule it out. It would help to start from a depressed level, which will happen sometime in the future. When that happens it would be wise to remember the words of Seth Klarman, a hedge fund manager with a brilliant long-term record. He has said, "Investing, when it looks the easiest, is at its hardest." The payoff from risk-adverse long-term orientation is just that - long-term measured over one or more cycles of looking stupid.

For my grand daughter and many endowments, they need to understand that they will live through many cycles of alternately looking brilliant and then appearing to be stupid. This could be labeled the curse of future orientation which pivots on the externally determined timing of events as well as a normal load of disappointments.

Hurdles

At any given time there will be problems that need to be understood and put into perspective. For example, let me deal with a couple that got my attention this week. 

Margin debt

According to the Wall Street Journal, the dollar level of margin debt is almost equal to its all time high hit in July, 2007, just before the market peaked out in the fall of '07. I noted the level but I am not unduly concerned because the size of the market has grown and some of the borrowing is for non-security investments not tied to stock market prices. Worth watching, but not worrying, yet.

High yield spreads - the canary in the mine?

John Lonski, chief economist of Moody's Capital Market Research is expressing concerns that the revenues of the companies that have issued high yield bonds is sub-par historically when the spread between the yields on these bonds compared to the yields on similar maturities of US Treasuries is historically small. The yield spread normally is a collective view as to the credit quality of the bonds. This dichotomy with concerns of low relative revenue growth could signify a potential problem. Smart stock investors have learned that the movement of bonds can foreshadow stock price moves. Again, in this case I have noted these elements, but I am not unduly concerned. The high yield bond fund of today is yield driven and not as sophisticated as those in the past. I will be concerned when the yields on US treasuries double from current levels.

For my grand daughter the lessons are first, there are always things intelligent people are worried about. Second, most worries need to be put into historical perspective. Third, be most worried when too many people have no worries. Fourth, like the great investors at Berkshire Hathaway^*, as well as good managers like Seth Klamer, use worrying times as buying opportunities and do not be afraid of looking stupid.

^*A position in our fund and personal holdings

Please share with me what investment thoughts are you suggesting to your young investors for the long-term.

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Did you miss Mike Lipper’s Blog last week?  Click here to read.

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 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission