Friday’s Market: An Investment Trap?

The Dow Jones Industrial Average rose 277 points on Friday, June 29, for a single day gain of 2.2%. The Standard & Poors 500 rose even more to 2.49%. Our own financial services private fund jumped 3.15% on a gross basis. That gain represented approximately three quarters of the estimated gain for June which in turn is about one-half of the six month’s gain. Clearly, I don’t want to give back Friday’s gains, but I am concerned that Friday’s market action could be setting a major trap for all of us.

A trap works if it looks to be relatively attractive compared to other actions. In this case there was the confluence of three incentives:  (1) favorable news as to the Euro crisis, (2) the Supreme Court ruling on Obamacare, and (3) the market mechanics. As we examine the three items, we need to recognize whether they are poison fruit.

The Euro trap

The agreement made early Friday morning to permit the central market to make funds directly available to the Spanish and possibly the Italian Banks requires the creation of a single banking supervisor for the 17 member countries that use the Euro. The supervisor is meant to be in place by the end of the calendar year and thought to be imbedded within the European Central Bank (ECB) with funding to start in 2013. If this were to happen on schedule, it might be considered the eighth Wonder of the World. First to get these particular seventeen countries to agree quickly will be very difficult. Already both Ireland and Greece are looking for similar bank support that does not raise the nominal debt of the country.  Until the money flows from the center to the banks, there is a good chance that depositors will shift their assets to stronger banks and/or currencies. These actions may cause substantial changes in market shares of specific banks. I wonder how the scheme to have a single bank supervisor is going to attract the other members of the European Community that do not use the Euro currency? In particular I question what would cause the UK to give up its banks’ sovereignty?  Without the UK, and the Scandinavian countries inside the tent, I do not see how the other banks will agree. One of the provisos that the German legislature required in their rapid agreement was a transaction tax. If this tax is put into place for all of Europe, Europeans will have ceded a good bit of the institutional market to the Americans and Asians, a very improbable event. Bottom line, I am not swallowing that the agreement on the Euro is really going to help any time soon.

The supreme trap

Along with practically everyone else I was surprised how the US Supreme Court ruled on the Affordable Care Act. Having read parts of the decision and much of the commentary produced by legal scholars and political pundits, my conclusion from a practical viewpoint is the decision just opened up many more questions than it attempted to answer. For approximately thirty years I have been inordinately concerned as to the rise of healthcare costs within the US. Initially my concern for the rising costs led me to complain to my firm’s trade association, the Securities Industry Association (SIA) as to the annual increase in health insurance premiums that the medium and small sized brokerage firms like my own were paying. In answer to my gripes, as is often the case, they invited the complainer to sit on the board of the captive insurance company. While on that board I did find some inefficiencies and failure to optimize the float for the benefit of the members. No matter what the other members of the board and I did we could not prevent annual premium increases of double digit percentages.

After that experience I felt that the hospitals were inefficient and therefore costing the patients and their insurance companies too much and once again the curse of being a complainer struck and I was invited on the investment committee of the local community-owned hospital. Once again costs continued to escalate. This in turn led to a series of mergers with other community-owned hospitals and now I find myself on the Financial Oversight Committee of a complex of three hospitals. Still the costs keep growing. Finally, my wife and I have informally become the healthcare reinsurer to cover expenses that are not picked up by others for a large and growing family.  Thus the rise in healthcare costs really does matter to me. The way I read the decision and the various expected “fixes,” follow-on legislation and regulation, all will add to our costs. Further, I see very little that will improve the quality of healthcare or increase the number of doctors and highly trained nurses and technicians. As you may suspect, I am gagging on the benefits of the Supreme Court delivered fruit.

Fruits of the marketplace

At the end of the trading day, the New York Stock Exchange produces a list of large trade imbalances that wish to have an execution at or near the close. On Friday there was a materially larger than normal list of stocks with an imbalance. I am guessing that the imbalance was many more shares were wanting to be purchased than sold. I am guessing that at least the final twenty point surge in the DJIA was caused by the desperate need for these trades to be executed. Based on my experience as a former member of the NYSE, I believe that some of these trades (as well as some of the above average volume) were initiated by market professionals to add to their first half published holdings, reduced cash positions, and covering exposed short positions. (In the weeks prior to the quarter-end the number of average volume trading days needed to cover shorts rose.) I view each of these trading factors as transitory and cannot be expected to play a similar role in the days and weeks ahead. 

Throw out the implications of June 29^th

As regular readers of this blog know, one of two of my most important learning institutions was learning to handicap (analyze) at the race track. One of the lessons in examining past performance was questioning which results were normal and therefore had a higher likelihood of repeating and which were abnormal. In terms of the latter, I learned to disregard atypical events as I had less confidence of a repetition. Using this hard earned logic I am suggesting to throw out the implications of last Friday. 

Having suggested ignoring Friday results, Sunday night and early Monday morning I will be looking at Bloomberg Television. The Sunday night focus will be on Asian markets. Europe is both an important source of trade and bank capital for the Asians. If their markets continue the New York rise, I could be wrong as to the significance of Friday. This trend could be reaffirmed by opening trades in the major stock markets in Europe.

If there are dramatic changes suggested by these trading sessions, I will send out a follow up bulletin. For those of you that depend upon social media, please let me know how I can reach you with a brief message.

As of the 28^th of June

The following thoughts stated briefly were going to be the basis of this week’s blog before the 29^th surge.

1.  Marathon Asset Management, a London based global asset manager, has a well-written monthly letter focused on the current battle between the optimists and the pessimists. As a long-term investor with a long portfolio, Marathon is clearly in the optimist category.  However the letter introduced the concept that  “a pessimist is an optimist with better information.”  The logic implies lots of reasons to be optimistic, but grants the pessimists the recognition that those good times are further ahead. I would suggest the recently announced trend of a slower rise in consumer spending than consumer income plays into the timing question. In the US, spending patterns may be suggesting that consumers are self-imposing their own austerity program which is bad for consumption, but good for savings long-term.  The result is better for the markets that long-term investors care about. The current downgrading of corporate sales and earnings guidance is reinforcing this trend.

2.  Moody’s* in its Weekly Market Outlook  produced an interesting analysis on the predictive power of the yield spreads between high yield bonds and equivalent maturity US Treasuries. Currently the spread is 100 basis points  higher than normal. This is a bit strange in view of the expected default rate which is below normal at about 3.5. The current spread suggests a default rate of 10%. This is an important bit of analysis for two reasons. First traditionally the bond market is ahead of the stock market at sensing economic and financial problems. Second, there can be another explanation along the lines of the old adage, “if the bridge won’t go up, lower the water.” Maybe the enlarged spread is indicating that in this interest-repressed world, treasury yields are not representative of the appropriate yield to give holders a real return after inflation. I am slightly more concerned about the second interpretation than the first.

* Moody’s common stock is owned in our private financial services fund.

For any of our blog readers who would like to discuss the two longer term items of my focus on the implications of June 29^th, please contact me.

For those in the US, I wish you a happy and healthy July 4^th Independence Day. To our other readers I will be checking your markets on the 4^th and hope that they are kind to all of us.

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. 

Lessons from Last Week: Look to Europe and Go EAST

To lose money realized or unrealized is painful. To lose without learning useful lessons is tragic. Frank Holmes of US Global Investors quotes Baron Rothschild, writing, “The time to buy is when there’s blood in the streets, even if the blood is your own.”

My analysis of what happened last week was not a reaction to the appropriate, if not overdue, Standard & Poor’s downgrading of some US Treasury debt. (The focus of the downgrade was the political unwillingness to stop the growth of the federal government’s deficit, not an inability to pay.) What caused the decline, in my view, was the increasing recognition of the seriousness of the European fiscal, political, and therefore economic problems, and how they may and probably will, impact credit conditions globally.

The fear transmission line

One of the louder voices of concern was Mohamed El-Erian, the co-chief investment officer of PIMCO, probably the largest professional bond manager in the world, who wrote, “Any further mis-steps from American and European policymakers risk converting raging crises within the global economy to a more devastating crisis of the global system. That is how fragile the situation is, and why the world risks not just a recession but -- even more worrisome -- a prolonged one.” His fears are being heard by the American people. In a recent Marist Poll, 68% believe that the worst of the country’s economic conditions are yet to come. What was surprising, 57% of the Democrats agreed. Another poll (Thomson Reuters/University of Michigan) measuring consumer sentiment, reported a sharp drop from the month before to a level that had not been seen since May of 1980 (no misprint). Jeremy Grantham stated in a recent interview that Americans respond to a market signal better than almost anyone.

The historical perspective

Governments of all types have believed that they can only maintain power if their people are well fed. The best example of this management technique was the ancient Romans. Rome's government had to produce “bread and circuses.” To support these basic needs, wars were initiated to bring back marketable tribute, including slaves of both sexes. When the wars became defensive in nature, the costs of these adventures, particularly the military costs of defending borders, grew to a point that the tax burden was crippling the economic growth, which subsequently weakened defense spending and promoted corruption. Substitute the welfare or “nanny state” for “bread and circuses,” with the size of the deficit absorbing all of the gross national product, and you have a good description of Mediterranean Europe, and a fear for the US and the UK.

The role of the banks

In most civilizations, the governments control the banks or the banks control the government. In modern society, banks extend credit often to governments directly or to government favored activities, e.g., mortgages, car loans, commercial loans to faltering employers, etc. In the cases of those countries with well-known problems, the banks are full of domestic loans as well as other allied sovereign debts. The US market reacted to fears that the French banks were following in almost lock-step fashion behind the Irish and Spanish banks, with the Italians not far behind. These concerns on the part of both US investors as well as those beyond, has propped up the prices of US Treasuries regardless of the downgrade, which was not a surprise to anyone who reads financial reports. In just the last week, investors put $50 billion into money market funds, reversing the $49 billion outflow the week before.

What are the lessons for me?

When I look across the Atlantic to Europe, I see an aging population of workers not being replaced by younger people who want to work. In addition, there is an incredibly weak military structure and a population that does not want to declare income to pay taxes. On the other hand, as the surviving economists who have escaped from Lord Keynes’ grip will point out, across the Pacific (with the exception of aging Japan), the populations are younger, eager to work, and possess a healthy combination of savings and higher quality consumption. To me, last week crystallized the need for our clients’ accounts to increase exposure to Asia. We already had significant exposure through exporters in Germany, Chile, Brazil, Mexico, Canada and a number of US companies in our funds’ portfolios. These investments are not riskless due to economic and political cycles, but the secular investment trend is up.

What did you learn last week?


____________________________________________

Add to the Dialogue:

I invite you to be part of this Blog community by commenting on my blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog .

To subscribe to this Blog, or to refer a colleague or family member, use the email box or RSS feed sign-up on the left side of www.MikeLipper.Blogspot.com