What Have We Learned...if Anything?

Personal Perspective

I see the world somewhat differently than most. Perhaps I was always destined to be a securities analyst. Or learning basic analysis at the race track where betting on favorites for every race was a losing proposition. Or being trained the elements of leadership from the US Marine Corps. Regardless of the source of my learning, I tend to examine popular beliefs with a somewhat jaundiced eye. In reading my posts readers would be wise to remember how my thought process works. 

Introduction

Too much has been written about the causes of the late August declines in global stock and bond markets. The focus has been  almost exclusively on the various financial instruments and economic data. Almost nothing has been written or spoken about the key determinator of market prices. Did a significant number of people all of a sudden get a new insight as to how they should manage institutional or individual portfolios?  In general, the answer is ‘no’ and more importantly, they did not take away any lessons that they should use in terms of structuring their portfolios to be winners over time.

The Current Picture

Going from the most negative to the most positive, comments that I have seen are as follows:

1.      JPMorgan's leading mathematically driven analyst believes "half selling is done." Since much of the selling started with various derivatives it is worth noting that in August the CME reported a 60%+ increase in the volume of index trades. Further while the S&P500 market weighted index declined -6.03%, a version  whose components are equally weighted declined -5.39%. This suggests that large sales of market weighted ETFs (Exchange Traded Funds) contributed to the decline. (This in turn leads me to believe that the August market turmoil was a trading event rather than a fundamentally-driven move.) Put volume exceeded call volume which is also a bullish sign.

2.      A market analyst from Morgan Stanley has commented that the size of earnings estimate revisions have been declining for almost fifty years.

3.      At this time of year Byron Wien regularly reports in his series of exclusive lunch meetings for visitors to the Hamptons. His conclusion is that no one is expecting a recession. (Caution: one of his more perceptive guests commented that the consensus is usually wrong.) 

4.      It is worth noting that according to The Economist there are three local markets that have risen in US dollar terms more than ten percent this year: Hungary +18.8%, Denmark +14.7%, and Argentina +14.5%. I don't remember seeing any of these stocks in emerging market stock portfolios which shows that there are still opportunities for hard working analysts. 


Looking Forward

The second largest California State Pension Plan is electing to reduce its stock investments to 43% from 55%. It is somewhat following its larger neighbor which is pulling out of investing in hedge funds. I view both of these as good news. 

We all search for good indicators to follow. After many years of watching the record of the best positive indicators I have concluded that they are correct only 2/3rd of the time. The inverse of some negative indictors has a greater accuracy level. Thus I view the actions of the two California pension plans as positive.

A somewhat more positive view is expressed by actuaries which are recommending to their clients a 6.4% actuarial rate for pension plans. First, one needs to remember how conservative they are. Second the rate is for the entire pension plan. Assuming a "normal 60/40" split between stocks and bonds and a 4% total return on the bond portfolio would suggest an 8% return for the stock portfolio and a so called risk premium of 4%. The risk premium would drop if bonds were assumed to earn 5% and the actuarial rate remained constant.

One of the guests at Byron's lunches was a CEO of a tech company who addressed the concern that the tech world will run out of big new products or services within thirty years. With what he saw on the horizon if anything he thought technology would be accelerating its progress. 

Perhaps the most bullish and soundest piece of analysis was done by the good people at Charles Schwab. They looked at annual returns of the S&P500 from 1926 to last year to determine the performance extremes for one, five, ten, and twenty year periods.  

Time Period	Extreme High	Extreme Low
One year	+54 %	-43.3 %
Five years	+28.6 %	-12.5 %
Ten years	+20.1 %	- 1.4 %
Twenty years	+14.8 %	+ 3.1 %

These periods can be utilized in our Timespan L Portfolio^TM construct.

The longer the time period the smaller the extreme loss, with no loss for the twenty year period. These periods would be appropriate for operational, replenishment, endowment, legacy and custom portfolios. In custom making these portfolios one has at least five different attributes for his or her portfolios which include aggressive, conservative, middle of the road, rigid, and idiosyncratic. These attitudes can be exercised by the selection and combination of stocks, bonds, mutual funds, ETFs, and separate accounts.

What should have we learned?

There is a significant difference between our intellectual financial risk tolerance and our emotional risk tolerance. If we are using an operating portfolio and possibly a replenishment portfolio, we should have been reducing our risk in the first and starting to nibble at the second. As a practical matter (as one of our readers indicated) that procrastination was the mode of the day. This means that for most managers of their own or other people's wealth they have not thus far reached their emotional risk tolerance action point.

There is a good reason for this inaction. They do not believe all the focus on interest rate setting by the Fed and or the latest pronouncements of GDP. Without knowing it they may be practicing Goodhart's Law, introduced to me by David Kotok of Cumberland Advisors. The law states "When a measure becomes a target it ceases to be a good measure." In these two cases (over-utilizing GDP and interest rate data) the poor forecasting ability of the Federal Reserve Board and many of its banks makes one wonder why anyone thinks they could get monetary policy right. The calculation of GDP is not only suspect in China but also in the US as reported recently by John Mauldin. I suspect that many of us are giving additional credence to the fact that we are seeing more people being hired and more jobs that are going unfilled.

The current geopolitical picture is also an element of worry with a Chinese Naval fleet operating off shore in US waters near Alaska, the migration from the Mid-East, and the appeal to populism in many countries, including this week in the UK when the new Labor party leader is elected.

Bottom Line

For those who lack sufficient trading skills and are long-term oriented: stay the course.

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The Buyers’ Strike May Continue; Was Friday a Clue?

On Friday, June 4, the Dow Jones Industrial Average declined 323.31 points or 3.15%, with most of the damage occurring early in the day. The volume of reported transactions was only marginally above what is now passing for normal. In the past, major declines brought out “buy on the dips” volume, however not this time. Was this a sign that something fundamental was happening that had longer term implications? Let’s look at three news items that came out on Friday (or after the close on Thursday) and their possible implications.

A WAKE-UP CALL?

The new government of Hungary let it be known that the prior government’s statistics were so faulty that the country’s debt probably can not be supported without a devaluation of its currency, and therefore an induced inflation. The significance to investors in euros and US dollars was that this announcement might prompt us to raise a mirror to our own growth of government debt and a constrained economy. Hungary’s way out is its own currency. In effect Hungary, like Lehman and Bear Stearns, has access to capital markets. The countries collectively known as the “PIIGS” (Portugal, Italy, Ireland, Greece and Spain) do not have that option, at least for the moment they are trapped along with their richer neighbors in the single currency. The way out for the US (as the de facto world reserve currency) is induced inflation. Was this a wake-up call challenging those who feel that the problems in Greece, Portugal and Spain were being attended to, and the US would grow its way out of problems?

BANKS AND RETAIL BROKERS NOT LEADING THE MARKET

Also late on Thursday there were two unrelated news elements that brought additional concerns about the global financial community. The first was the rumor that Société Générale had suffered large derivative-related losses, which on Friday they denied. The key to the market was not that the French bank suffered trading losses, but rather that it and other banks could lose big. After the close in the US, it was announced that the president of Wilmington Trust unexpectedly announced his retirement. He is to be replaced as president by an internal candidate with corporate experience who has headed up Wilmington’s non-lending activities. Once again a bank is being led by a non-banker, similar to CEOs at JPMorgan Chase (a stockbroker), Bank of America (a lawyer) and Citigroup (a hedge fund manager). Tying these two elements together, are we projecting that banks will not make deposit gathering and lending their main source of future profits, but instead will rely on trading and other forms of investing to generate dividends for their various shareholders? Is this alternative being severely curtailed by the so-called reform measures in the conference committee of the US Congress which will put US financial institutions behind the less capitalized foreign universal banks? At this point in the cycle commercial banks and retail brokerage firms should be in a market leadership position and they are not today.

A PALPABLE LACK OF RETAIL CONFIDENCE

The third bit of bad news that hit on Friday was the extremely weak private sector jobs report. One could chalk the disappointment off to the “abysmal science” of the economists. Economists’ US estimates were way high and they were low in Canada, where job growth was twice what was expected and its unemployment rate dropped to 8.1%. There is a suspicion on my part that the economists and some analysts are not mall walkers, having under-estimated the Canadian market and over-estimated the US retail sector. The lack of confidence on the part of stores hiring retail sales people is palpable. There are still too many empty store fronts to support a growing economy. Part of the issue is that now with the bulk of the aggregate stimulus packages spent, our money supply is contracting. This is not a surprise to our government. Treasury Secretary Geithner has warned the other members of the G-20 that the “US can no longer absorb the world’s exports.”

ADDITIONAL INPUTS

How is all of this being translated into investment policies? There are additional inputs that might be useful in your own investment thinking,

The first is volatility. Notice that the press is full of stories about volatility primarily on down days. Few seem to worry about volatility on the upside. Part of this may be due to the harm that many financial academics have done to investing by equating volatility with risk. This is discussed more fully in my book Money Wise. The CBOE Volatility Index (VIX) is a popular measure of volatility (that few people really understand) which tracks the “bets” on the S&P500 contracts. When the number is high the “fear” indicator is high. The historic high on the index was approximately 80 and the low achieved a few months ago was about 15. On Friday the index rose 6.02 to 35.48, a one day gain of 20.43%. I believe that on May 6th the index was over 45. I would suggest in recognition of the fact that so many of the market participants are trading oriented that one needs to be prepared for volatility in today’s ranges. This translates that on most days we could see moves of 100-200 Dow Jones points. Expect this level of volatility as you manage your transactions.

As is often the case, the US bond market often is more sensitive to future trends than the stock market. Each week Barron’s publishes its confidence index which measures an index of high grade bonds divided by an index of intermediate grade bonds. A decline in the latter vs. the former generally points to higher stocks. In other words, as the yields on intermediate credit declines relative to high grade, their prices go up (which is often paralleled by more confidence in stocks). As an observer of this index for more than 40 years, I am used to seeing weekly moves of 1 point or less. For the week that just ended the reading was 79.0 up from the prior week reading of 75.2. A year ago the number was 68.7. While this indicator is far from infallible, it has produced winning judgments more often than not. I choose to be encouraged by this particular confidence indicator.

A LONGER TERM PERSPECTIVE

One has to have a strong contrarian point of view and a belief in institutional fallibility. The trend of leading pension plans to invest into commodities is growing. CALSTRS is joining CALPERS and the teacher plans in Texas and Illinois, as well BT from Britain and two Dutch pension plans in making specific allocations to commodities. I interpret these as long term bets on increased inflation caused by the deterioration of the value of money’s purchasing power. If these are more than a simple hedge, but a bet on institutionalized inflation, then one wonders whether long term bonds have any place in one’s investment portfolio. Stocks may not do well under these circumstances, but are clearly better than bonds. Many corporate pension plans are very much betting the other way, significantly switching equity money into corporate bonds. Both the government and corporate plans are reacting to their fears not to opportunities, which in the long run makes me bullish for our long horizon investment accounts.

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