·
Debt, a four letter word
·
Killing off the Individual Equities Investor
·
Asset Allocation: Correlations?
·
Learn from today’s investors
Investment analysis is
like a narcotic or a very difficulty habit to kick. At the beginning of the week, I may not have
an idea about what I will post the following Sunday night. Though I am exposed to a myriad of
communications, in many ways the most valuable inputs are the conversations I
have with investors and investment professionals. This week I will focus on four suggestive
thoughts, or quandaries for 2013.
The
worst four letter word
Growing up I was told
that it wasn’t nice to use certain four letter words like F*@k or S*#t. What
my Mother never told me was the worst four letter word of all; a word that has
bedeviled mankind for centuries. That great economist William Shakespeare put
the following words into Polonius’s mouth, giving guidance to his son Laertes, “Neither
a borrower nor a lender be.” The four letter word is debt.
There are three
essential problems with debt. The first is that it must be paid back, often at
inconvenient times. The second is the additional payment of interest, which can
be either fixed at the time of the loan or flexible, but each is based on the
assumption that the rate is high enough to pay the lender to forgo spending and
has a sufficient risk premium that is an accurate gauge of the odds on getting
repaid in full and on time. The issue here is what appears to be the
appropriate lending rate at the beginning of the period may not be the right
rate at the end of the period when conditions have changed. The third problem
is collateral that in theory guarantees to the lender that he will get his
money back in full and on time. Securities can often provide the margin for a
loan. Of course, if the securities go down in price the value of the collateral
may become less than the size of the loan. Some upstanding people, companies,
and nations have been able to borrow based on their good names. J.P. Morgan is
reported to have said that he loaned money on the basis of a man’s character.
There is a problem with this as fittingly portrayed by Shakespeare again, in
“The Merchant of Venice,” in the legally sanctioned, but inhumane attempt to
collect on the collateral on a defaulted loan.
The main purpose of
debt is time-shifting. The borrowers want an asset that at present they cannot
pay for, and the lenders are willing to delay their own spending if they get
paid for this indulgence. Unfortunately what has become the custom is that new
debt is raised to pay off expiring debt. The question facing both the
borrowers and the lenders is what is the optimum level of debt that can be
added on top of a given level of assets? This is called debt capacity. It is
usually calculated on the basis of assets and/or income that are not encumbered
by other debt. What is usually done for nations is to compare their outstanding
debt, most often without concern for future debts, to the their Gross Domestic
Product or GDP. This number is the estimated annual generation of goods and
services within the country. (Two weeks ago, I blogged on the approach of
looking to a more complete analysis of both the assets and liabilities for the
US.)
Nevertheless I will stay with the convention of looking at a nation’s
debts as a ratio of its GDP. Europe’s deficit as a unit is now 131% of its GDP.
China has a 120% ratio, all of Asia excluding Japan is 104%. (Hong Kong 275%,
Singapore 137%, Malaysia 117%, Indonesia 33%) These reported ratios include
personal and corporate debt as well as sovereign debt. Thus globally there is
too much debt.
In the US, as is often
the case, the private segments of the economy are moving differently than the
government sector. The private sector is deleveraging its debt structure
whereas the federal government is adding to its debt by issuing bonds that are
largely being purchased by the Federal Reserve System to neutralize their impact
on the level of interest rates. The combination of the private sector
deleveraging and the Fed’s increased borrowings leaves the US debt level,
according to one source, at 62% of the GDP which is down slightly from prior
readings.
Translating the
economic figures into the bond market, the following three facts are of
interest:
1. Some
Investment Grade (corporate) debt is yielding less than some sovereign debt.
This would indicate that the market believes that corporates are safer than
some nations. One possible reason for this is that Europe, with 7% of the
global population, spends 50% of global
social spending.
2. The
yield on the S&P 500 is higher than an index of BAA bonds. Again, the
market is suggesting that lower investment grade credits are safer than
dividends on the S&P 500 stocks. At the same time this represents an
unusual opportunity to view large cap stocks as a more productive source of
current income than investment grade bonds.
3. We
may not be out of the sub-prime mortgage mess. The Federal Housing Administration
(FHA), is by far the largest guarantor of conventional mortgages. Not only does
it already in effect own a number of defaulted mortgages, but there is pressure
from Congress and the Administration for the FHA to loosen its underwriting
standards. Only a significant recovery in house price and possible individual
incomes will bail out the taxpayer liability.
“Who
killed Cock Robin”
The somewhat
shotgun wedding of the New York Stock Exchange and IntercontinentalExchange (ICE)
publicly demonstrates the fact that while derivative trading particularly not
based on stocks is very profitable for an exchange (and therefore
broker/dealers), trading in individual stocks is not. As an analyst and owner of
brokerage firm stocks, for some time I have taken the position that listed
equity agency business for brokerage firms is not profitable. Try to get a
brokerage account opened to buy 100 shares a quarter of General Motors. What
you will quickly find in a broker (if one will talk to you at all), he or she
will attempt to sell to you some complex structured product or a high fee fund
or possibly introduce you to using a margin account (interest bearing and
securities loan revenues). This reaction by the peddlers of our business has
been successful in discouraging individual investors from buying and holding
individual stocks. Thus, the title to this section, “Who killed Cock Robin” is
an English nursery rhyme, but the real killer of interest on the part of
individual stocks is the regulatory agencies, particularly the US Securities and
Exchange Commission (SEC). In 1968 the Commission forced the beginning of the
end of fixed-rate brokerage commissions, which were totally replaced in 1975.
Prior to those dates there was a vibrant and useful retail research and
individual sales business by brokerage firms. Institutions received tons of
reasonably high-quality research and other services from “Wall Street.” Continuing
this trend of not understanding the impacts of its actions, the SEC permitted
multiple locations where a trade could take place which denuded the central
marketplace’s liquidity. Carrying this approach further, the substitutions of
penny decimals for fractional prices made professional traders withdraw their
capital from the marketplace. The way all markets work is that there has to be
a perceived profit potential for the professional participants to play. Without
the professionals in the game the market will shrink in size and its use as an
important economic indicator will be vastly reduced.
I do not mean to
be negative on the announced deal, because the holders of my private financial
services fund and I benefited. Our holding in NASDAQ OMX rose 3% on the day of
the announcement. My guess, the thinking is that NASDAQ itself may be in a
merger situation or that the change in control of the NYSE means that it will
be a less fierce competitor for new listings and daily trading. While this may
benefit my fellow investors and me, it won’t do anything positive for the
individual investor and could hurt.
Is
asset allocation really about correlation?
At this time of
year, institutional investment committees have meetings to decide on the
appropriate mix of assets for their portfolio responsibilities. Historically
this was a decision made for them in that the initial funds in both the US and
UK were balanced funds with a reasonably fixed percentage in bonds and stocks.
Balanced Funds and their modernized versions are still an important part of the
mutual fund business. The whole excitement about asset allocation was generated
by a flawed study of corporate pension funds that showed that funds with a
higher percentage in equities did better. For the most part there were only two
asset class accounts, bonds and stocks. Later on other classes were added in
terms of venture capital, private equity, international securities,
commodities, gold, timber and various forms of real estate. Then 2008 came
along, with the exception of US Treasury Bonds all the other asset classes
declined and often in roughly the same percentage declines.
My approach to
this question is first to have an opinion as to how closely the correlations of
the asset classes will be over time. Using US mutual fund investment objective
averages over ten or more years, most fall within 100-200 basis points in terms
of annual returns which suggests to me that on a long term basis it is
difficult to pick winning asset classes.
Jason Zwieg’s latest piece in the Wall Street Journal on a young 107 year-young
investor and manager, Irving Kahn, takes a different point of view. At his age
he is invested approximately 50% in well-researched global small caps and the
rest in cash. I have worked with Irving for many years on analyst society
activities. He and his late wife Ruth were on an analyst trip with my wife Ruth
and me in Italy more than 25 years ago. They both set a blistering pace which
was a challenge for us younger types to keep up. Out of all of these
experiences, I have developed a real respect for his acumen; besides he is one
of the very few people alive that remembers my grandfather’s Wall Street firm.
If the committees have Irving’s research skills, I would approve of their
allocation if not some other forward looking approach was warranted. We should
be watching and listening.
Learn
from today’s investors
Most
individuals do not have CFA certificates or have logged more than 50 years as
an investor, but we can learn from what they are doing as shown in the
following examples:
1. As
already indicated, on a personal level they are paying off their debts. If one
disregards student loans, consumer debts are declining. Savings as calculated
by the government is rising a bit. Individuals are slowly, but I believe surely
are going through their own austerity program particularly in terms of being
more astute shoppers.
2. While
retirement flows are continuing to benefit from 401(k) and similar salary
savings plans, the purchase of mutual funds for individual retirement accounts
through directly marketed mutual funds is well off peak gross sales. This
may be in response to investors' own actual or feared employment picture. Possibly
they are using what would have gone into their IRAs to reduce their debts or to
improve their homes for a future sale.
3. The
most intriguing demographic trend of all is that there is a substantial
increase in the number of singles. In many cases these are, according to Gary
D. Halbert, white women who have made the decisions at least temporarily to
forgo Children and Marriage.
The young appear to be
worried about their future and they should be. Our debt burden and less than wise
investing will make their lives more difficult. However, after worrying in
American fashion, they will find innovative ways to improve their condition.
This is one of the major differences between Americans and Europeans.
You can’t agree with
everything I have said. Please discuss your
thoughts with me by reply email.
I hope on Tuesday you
can relax with family and friends, not worry about these quandaries and that
the rest of the week won’t be too eventful.
____________________________________
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