Special Bulletin

Before we posted our normal Sunday thoughts below, we received an email from London stating that Ralph Acampora is now looking for a 23% correction. To me this is an important message.

Ralph Acampora is in my opinion and others, the Dean of Technical Analysts. He has taught courses all over the world on the use of charts and other quantitative data to predict price movements of stocks and markets. He has help found market analysts groups in many places and helped to develop their own qualifying exams.

Ralph has been a bull on the US market since 2009 and this is the first that I have heard of his turning bearish. Not only is he a friend but I deeply respect his talents. Nevertheless, I need to put his warning into perspective. My study of market history has me prepared for a 25% decline from peak levels three times in any ten year period. Once a generation a 50% drop is normal. Our performance and those of others have produced in 2012 and for the first seven months of 2013 way above “normal” returns. Thus, some give back was likely before this. However, in the context of a long-term investor who invests conservatively without leverage, a decline of 23% is painful, but tolerable.

Asian markets

On this weekend of indecision in Washington and other capital cities, Bloomberg Television reports on Sunday evening that the Asian markets do not appear to be negatively reacting in terms of currencies or stock prices. 

The next ten days could prove the old Chinese curse “May you live in interesting times.”

And now back to the statistical Ranch of my normal post……

Wrong messages from fund flows

All too often various published and internal pundits quote the size and direction of mutual fund net fund flow data as having some predictive power of future market directions. If they only took more time and analysis they might get some more useful insights. Both my former firm, Lipper Inc., and the Investment Company Institute (ICI) as well as some others regularly report on actual or estimated fund flows. While we get monthly data as an associate member of the ICI, much of the trade association's public release is also printed in Barron's magazine.

The analysis is time-period dependent

After the sluggishness of August one tends to forget the sharp recovery in July from June's disappointing results. In terms of mutual fund net flows, itself a mixed metaphor for investors’ drives, July saw a net positive flow of $19 billion over June's net redemption of $26 billion. Few if any pundits mentioned that the July gain in 2013 was less than the $28 billion in July of 2012. "Is the glass half full or half empty?" The answer depends on your bias. Yes, there was a swing of $45 billion from net redemptions to net sales, but the July 2013 net sales were behind $19 vs. $28 billion a year earlier. I suggest that looking at the next level down as to flows into various investment objectives shows a considerably more speculative attitude on the part of fund investors. For the most part speculators are much more short-term oriented than long-term investors.

Leading investment objective net flows

Comparing June 2013 to July 2013 and focusing on the $45 billion swing to net sales from net redemptions, the following investment objective activity caught my eye:

• The largest contributor was the retirement favorite of Growth & Income: $12 B.  
• The next biggest swing was the insistent search for yield, Strategic Income:  $11B. 
• Next was the retail favorite, Growth funds: $11B.
• Seeking price protection were Short-term Corporate Bond funds:  $8B.
• Finally, Aggressive Growth funds: $6B.

These groups represent the entire swing; while there were other contributors to net sales they were offset by a number of investment objectives which were increasingly in net redemptions. The key message that I get looking at these and other fund statistics is that the fund business is serving investors with very different needs and proclivities. The aggregate numbers are like population numbers, but not particularly helpful in setting sales strategies.


Channels show the business side of the story

I am starting with the proposition that in general, funds are sold not bought, which means there are forces beyond an investor’s desires that lead to a purchase of a fund or other investments. Today there are multiple ways to reach all investors who have the combination of needs and money. There is considerable overlap within these channels of distribution with individual investors being welcomed into formerly exclusively institutional products and services as well as the other way around. Many manufacturers and distributors of fund products are active in most channels. Nevertheless, the ICI, the trade association for the fund business attempts on the basis of surveys to allocate fund sales to a number of specific channels. In terms of the swing into net sales from a year ago one can look at the change in the levels of sales by channels.

• The biggest change in the month of July was in the institutional channel with net sales up $43B.
• Followed non-proprietary sales forces: $14B.  
• Direct Marketed funds: $10B.
• Proprietary Bank funds: $3B.

What these numbers suggest is that just as there are multiple of investment objectives attracting money, there are  a number of different ways money can flow into funds.

What does this mean to me as an investor?

As an example, to a car buyer the aggregate production and sales numbers for the automobile industry are of small importance. As a customer, you  are interested in the production schedule of the vehicle you want and within your range of comfort, also what are the locations that you can buy and service the car. However as an analyst, fund sales data can be very useful. Most investment management organizations manage funds alongside other accounts. These other accounts do not regularly publish performance or portfolio information. Thus, through intelligent analytical work on funds, one can see more of the institutional mind sets.

What do I see?

On this first day of September I see a strong desire for the world to become clearer both economically and politically. However, many investors no longer have the choice of sitting on the sidelines. They are in effect making the "risk on" bet by rearranging their fixed-income into both shorter-term maturities and employing money in more risky fashion. On the equity side while the bulk of money is invested in Growth plus Growth & Income oriented funds, they are increasingly adding to Aggressive Growth and less diversified Sector funds. There is a great deal of talk of trying to find European investments near their bottoms and some willingness to take a very long view on selected emerging and frontier markets. These various strategies may work out well, but they are not generating a lot of comfort. One caution is that I would separate the data on Exchange Traded Funds (ETFs) from that of the traditional mutual funds, which for the most part are being used by investors as a place for their money in terms of years. (The more the better.) In the last week, five out of the six securities that produced the most volume on the New York Stock Exchange were ETFs. I believe that most transactions in ETFs are for short-term purposes. Investors are using them to quickly modify their base long-term portfolios. It is these long-term portfolios that we manage for institutions and individuals.

Getting perspective

Future posts will reach you from London and Budapest. There are many investors there that have a lot they can teach me. Not only do they see things from a different prospective, but also they use securities differently because of their tax and other regulations. Hopefully I will return wiser.

How do you use mutual fund and ETF data?

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Lessons from 2011 for Earning in 2012

The year 2011 was not a good year for many stock markets, investors and advisors, (I count myself among them). However, there are useful lessons to be learned for 2012 and beyond. One rationalization is that we did not pay sufficient attention to “the Risk on/Risk off” dance. These rapid fire flip-flops were focused almost exclusively on macro factors. Macro factors included the overall levels of interest rates and currencies plus political changes. As these changes occurred or were rumored, the markets moved violently. The rapid fire changes were triggered by syllogisms. If you don’t remember your plane geometry, a syllogism is a form of reasoning with two propositions leading to a conclusion, e.g., “If factor ‘A’ is true and factor ‘B’ is true, there is only one possible conclusion.” A contemporary example might be that (a) the US is in a political deadlock, (b) a major credit rating agency lowers the US credit rating, therefore (c) the US dollar, Treasuries, and its stock market will decline. (Those of us trained as analysts of individual securities require a large number of factors to make a decision. We rarely feel absolute certainty about our conclusions, as all the facts never line up on one side.) The “Risk on/Risk off” switches created the volatility that so unnerved individual investors in 2011.

Incomplete/misleading headlines

If one totally believed the flash news, one could complete the syllogism and react quickly. Unfortunately, all too often the headlines do not include enough information to properly evaluate the news. The following are three examples of news articles premised with too-shallow thinking:

1. “A World with Too Much Debt,” * based on data from the Organization for Economic Co-operation and Development (OECD), examines unfunded liabilities and official government debt as a % of GDP. The US ranks sixth, with a figure of 620% (98% of official debt + 522% of unfunded liabilities). This is pretty scary when Spain, Italy, and Ireland have lower numbers, indicating that the US is in deep trouble, enough to hit the “Risk on” button. That is, unless you look at the details, as micro analysts do. First the unfunded liabilities are the difference between the projected cost of continuing current government programs and net expected tax revenues. Note that the figures do not take into consideration any dedicated assets to these programs. Second and much more importantly, is that liabilities are shown without any calculation as to a nation’s assets, even if it were just the government’s assets. One of the reasons for this mismatch is that the US government does not publish a balance sheet, even an unaudited one. (As regular readers of this blog have learned, I believe our credit rating should be lowered to the mid-investment grade level, not because we don’t have the assets/earnings power to pay off our debts. The downgrade is warranted due to the political unwillingness to materially reduce the US deficit production.) Bottom line, in my opinion: the US debt picture is unhealthy, but does not have to be fatal. Thus, I would delay hitting the “risk on” button.
   
   *This chart was brought to my attention by John Maudlin of Millennium Wave Advisors
   
   
2. “There is significant evidence that the economic growth in China is slowing.” The expressed fear is that to head off a slowdown in China, wages will rise. As we buy so much from China, we will be introducing additional inflation into the US that will hit the Wal-Mart shoppers hard. There are three reasons that this is interesting but not significant. First, a substantial portion of Wal-Mart sales are grocery items, of which very few are imported from China. Second, my guess is that the actual dollar value of imports is approximately matched by the combination of transportation costs, including fuel, and Wal-Mart operating costs. (This company along with a number of other US companies has been very good at finding ways to reduce costs while preserving quality.) Third, we have already seen some production has shifted out of China to lower cost sites, including back to the US, due to increased automation. An important part of the fear of a slowdown in China is that they will no longer buy US dollars and debt, and will begin to be sellers that will lower the world value of the dollar and drive US interest rates higher. One should remember that the largest single owner of US Treasury debt is the US government. In various trust funds, the US government holds about 40% of US debt. Also, the combination of Japan and the UK actually own more of the US debt than the Chinese. Perhaps most importantly, one needs to understand that the Chinese government is not trying to do us a favor by owning our debt, they are solving their own problem. Chinese producers sell their goods all over the world, often being paid in US dollars. To keep the local currency stable and reduce the impact of imported inflation, the Chinese government requires all those that internally hold dollars to turn them into the Chinese banking system in exchange for local currency. With the dollars so corralled, they buy US Government paper. As the trade surplus with the US grew over time, the Chinese became involuntary holders of our paper and very much interested in preserving its purchasing power.
   
   Like most investors and analysts I do not know what is likely to happen to the Chinese economy in the near or far term. I hope to learn more from a trip to Hong Kong, Singapore, and Shanghai beginning the last week of this new month. I would appreciate your suggestions as to investment people I should meet.
   
   
3. “The November decline of Exchange Traded Funds’ Net Issuance”
   Some market pundits have raised an alarm about the decline in the net issuance of Exchange Traded Funds (ETFs). In November, the net dollar issuance was only $5 billion, down from $20 billion in October and $99 billion year-to-date. For some, this was another reason to go for the “Risk on” button. Net issuance is the difference between purchases and redemptions. If one disaggregates the data, the biggest decline comes from a drop of $23 billion in issuance of index ETFs. I do not know with certainty the cause of this decline, however I suspect that various hedge funds and others have regular “short book” purchases, less index funds, to offset some of their short positions. My guess is that once we see the 2011 data from the Investment Company Institute, the December numbers will go back to their former trends.

The Trend is Your Friend, Go with the Flow, and 1987

In the ever-present attempt to simplify investment assertions, the two expressions “The Trend is Your Friend” and “Go with the Flow” get great market currency in a “Risk on/Risk off” market. There is a lot of evidence that these attitudes can work well for traders who can and do reverse their opinions rapidly during the trading day. Now that we know that the S&P500 for all of 2011 produced a zero return on a price basis, and the Dow Jones Industrial Average on the same basis gained about 5% , we can determine how many of these hyperactive traders actually added value to their accounts. In some respect the year 2011 is similar to the flat performance earned in 1987. Both were the third year of a US presidential cycle and both had significant foreign inputs, but with a difference. In 2011, fears of European problems held the US market in check but did not prevent many companies from producing solid earnings. In 1987, the US domestic economy had growing problems, but in this case was bailed out by its growing exports. While finishing flat, both years had sharp market breaks as well as recoveries. One can take the point of view that 1987 was the required preparatory period that would usher in the market boom of the 1990s. With the current market finishing over thirteen years of no forward movement in the averages, we are ready for a longer term explosive upside that we can explain at the current time.

My bottom line

While we need to examine macro factors closely, we also must keep focus on the micro factors and be in a position to benefit early from the next rise.

My best wishes

My wish to all the members of this blog community is that 2012 brings a happy, healthy, and prosperous year; and that we are able to increase the level of our personal and professional communications.
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Risk Reduction is Risky in the Long-Term

We can and should learn from every day of our lives. For those of us that are addicted to the securities markets, non-holiday weekdays are our primary classes. The markets of 2006 through 2010 were extremely difficult for all of the students and quite a number failed to finish. One might call these years a master class. However, very few of my fellow students could be awarded a Master’s Degree for the investment progress they achieved. The reason for the lack of success was not that the period did not offer ample opportunities to achieve some large gains as well as some startling losses, but it was difficult to link the periods where the net results were positive for those invested in equities.

Shorting successfully is difficult over time

The intellectual foundation of hedging initially is that carefully chosen securities will go down more than equally carefully selected securities would go up, so that the net result should be to preserve the larger gains of one’s purchases. The truth in the matter is that shorting is difficult to do well over long periods of time. An examination of various shorting approaches will identify the problems that might occur.

Sell the Frauds and the Fads

Until tried in a competent court of law, (and perhaps not even then) it is difficult to have absolute certainty from the outside that some action is clearly fraudulent. Even with the best forensic accounting practices applied to public financial statements, one can not be sure that there is a fraudulent intent. As we have seen in the Madoff and other cases, guessing when the various authorities will surface a complaint, let alone a conviction of fraud, is difficult. (Please do not confuse intellectual frauds when someone should know that what they are saying is wrong, with the intent to deceive through the use of fraudulent financial statements. Over time, intellectual frauds are dealt with in the market place and not a court of law.)

Throughout history there have been brief periods when a large portion of a population becomes enticed into certain actions, usually purchasing, some object or service of questionable utility. For the more senior members of this blog community a good example would be Hula Hoops. When rotated around one’s body, these plastic hoops were meant to aid in fat reduction and other health and psychic benefits. As only the young seemed to have hip movements that could keep the hoops from falling to the ground the fad died out quickly, but not before there were a few stocks that successfully touted these wonders. (From a potential short seller’s position, it is important to distinguish the difference between a relatively short period of a fad that has no lasting value from a fashion that may last for awhile. Both Nehru and Mao jackets did provide some continuing clothing benefits.) The most successful managers of short selling funds are expert at these two approaches. However, even with their clear insights they do not produce winning results every year.

Pairs

As an analyst, I used to recommend to some hedge funds that they invest in pairs of somewhat similar securities, with the strategy to purchase one and to sell the other short.

One example of this was to recommend for purchase an aerospace company who, in my opinion, was most likely to win a multi-billion dollar defense contract and to short the expected loser. The key to this strategy was not to stay too long, actually it worked best on the day of the announcement. By the time the earnings were expected to be generated by the winner, there was likely to be a recognition that the winner bid the contract at too low a price and would only become significantly profitable from change orders and possibly spare parts reorders. The loser was often free to position itself for the next exciting contract. A somewhat similar pair bet was available every autumn, focused on the Nielsen ratings for television programs. As NBC was buried within RCA, the choice was between CBS and ABC. There have been other event-oriented pair bets. More common is to focus on two large companies within an industry and buy the better-quality company and short the lower-quality company. The only problem with this strategy is that since the bottom of the stock market in March of 2009, often the lower quality stock did materially better than the high-quality competitor. (I am not hearing many pair recommendations either as stocks or as fund formats recently.)

Sector ETF bets

According to the Investment Company Institute (ICI), approximately 20% of the dollars in Exchange Traded Funds (ETF) are in sector or industry funds. Making judgments on sectors is very common today as described in the reports issued by mutual funds and other institutional funds. The funds that make sense to me are those that most of the time select individual stocks that do better than their sectors. Taking this approach further, one could suggest shorting the sector ETF. The problem with this approach is that often the ETF has more low quality names in the portfolio than the individual stock selected. As I have commented above, we have been in a period where the low quality stocks, with their bigger perceived potential, have performed better than the perceived higher quality stock chosen. I suspect that an uncomfortable portion of the transactions involved with ETFs are part of short trades or at least leverage transactions. If I am accurate, this may suggest that a new element of volatility has been introduced.

Market Timing/Macro Investing

The only thing more dangerous than guessing which way the market will go correctly one time is guessing correctly twice. By the time one does it three times in a row you convince yourself and others that you are expert. There are a very small number of professional money managers who do have a record of guessing the overall market trends effectively. Some of the best of these run Macro hedge funds which make big bets through derivatives and other forms of leverage on the sequential changes in direction of the major markets around the world. (I wonder if one made an equal size bet on every Macro fund that began each year and compared its average performance over the next ten year period to that of a collection of broad market indices (adjusted for country bets) which would win? This is not to deny that there will likely be a few spectacular winners, but many won’t finish and therefore for this exercise, they would be declared losers.) Those who are even less successful are called market timers. There is a long history, both at the individual and the institutional levels, as to the lack of success of market timing. Long-term faith in the belief that the trend is one’s friend does not have good results in the stock market, but could in the commodity markets.

Owning Winners

As strange as it seems, one of the best risk reduction approaches is to attempt to own only long-term winning stocks and to accept periodic volatility. (I must admit that it is with difficulty that I attempt to follow this precept.) The concept is one of muted optimism; that throughout our lives there will be an upward bias to stock prices. If one takes the absolute opposite point of view, one believes that long-term bouts of sitting with cash and very high-quality short-term instruments with occasional forays into the market is a correct strategy. Using the Dow Jones Industrial Average as an equity market indicator, in the past we have suffered flat periods of sixteen years and we are in an eleven year flat phase now. I believe that we will breakout on the upside eventually, at least in nominal dollars. And that is how I bet. Each year those that attend the annual meeting of the Board of Trustees at the California Institute of Technology (Caltech) participate in a contest to guess what the DJIA will be selling for at the next year’s meeting. I will almost always be betting for a significant advance because it will happen at some point.

The best way to avoid losing is to Win.
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