3 Potential Risks - Weekly Blog # 495

Introduction

Contrarians are useful even when they prove to be wrong. In forming an investment committee for a non-profit institution of professional investors, I felt it was incumbent on me to somewhat balance the committee, largely populated by generic optimistic money managers with at least one contrarian that was well skilled in finding good shorts. While it would have been inappropriate for this institution to sell short betting on falling prices, the answering of some bearish views were useful in appropriately constructing our long portfolio which did well. We were better prepared to be long-term investors on the long side for reviewing and appreciating contrarian views.

Current Thinking Process

Stock markets around the world are rising well ahead of current sales and earnings, even adjusted for modest growth projections. The buyers are enjoying what could be called a “melt up.” Economic sentiments are moving higher.

While I do not know how long these trends will last - be it a day or multiple years - I believe it is critical to consider the potential risks that are currently apparent to this long investor and manager.

First Risk: Simplistic Decisions

On October 26th The Wall Street Journal published a multi-page critique entitled “Morningstar Mirage” which purported to show that the firm’s various ratings were not helpful in making decisions as to what mutual funds to buy. The article decried the marketing power of Morningstar’s ratings, not recognizing that at least since the 1930s funds that performed well attracted the most sales if they were known. In the same light there was no real discussion of the questionable mathematical processes used to reach its conclusions.

The biggest risk to investors is not the Morningstar Mirage. The biggest risk is that the financial community believes that investors want simple answers to complex questions. Sales people who can get very limited time with both their prospects and their accounts are trained to use the KISS principle, (Keep It Simple Stupid)” in their communications. It has never been clear to me whether the communicator or the investor was stupid.

Often people spend more time at a sporting event or preparing a special meal then they do making investing decisions which can have significant impact on their lives and those of the beneficiaries. At the game each play, each course or each critical ingredient is thought about deeply. As the readers may be aware I learned the basis of securities analysis at the racetracks, spending hours on each race. I am told that one of the most successful racehorse owners in the last 30 years in the UK spends a great deal of time on the races and the breeding of her horses. We should do no less than Her Majesty.

When Hylton Phillips-Page, my VP of Fund Selection and I analyze a mutual fund we spend a long time getting to understand how the fund, its managers, and supporting organizations impact the past results. A much more difficult task is guessing how we think the past will not be simply extrapolated into the indefinite futures. The term futures is a recognition that there will be interruptions of past trends as conditions change.

The risk of simplistic decisions is much broader than choosing mutual funds.  Not only investment decisions, but all types of other decisions, including political, career, and other personal decisions are put at risk when given only cursory attention. The past is useful as to what happened and more importantly what didn’t.  Most studies of human decision-making involve a number of biological organs. The brain and our senses are very complex and they interact differently when conditions change, and they are always changing.

Second Risk: Credit Withdrawals

In each of the general write-ups of major stock market reversals almost all the attention is devoted to stock prices. In truth almost every major stock market decline was slightly preceded by the withdrawal of credit support. Since we are not out of October, we should first start with October 28, 1929, the biggest single day drop in the Dow Jones Industrial Average up to that point. On that day, the index dropped 12%. Most recounts do not include the fact that the market had been dropping since August and a good bit of the buying was done with borrowed money called margin. The borrowed money came from the major banks who issued it to the brokers, who in turn offered it to their clients on the basis of their portfolios. The banks used call loans to the brokers using their clients’ collateral. As the market declined in the late summer and early fall of 1929, the value of the collateral fell, reducing the safety for the banks that were starting to call their loans. The brokers called their margin accounts to put up more collateral which most didn’t (or were not able to) and were rapidly sold out of their holdings. This is an example of a non-price sensitive insistent seller.

A similar thing happened in 1987 where in one day, October 19, 1987, the DJIA fell 22.6%. European stocks were down about 10%. Portfolio insurance used futures to hedge long institutional positions. Many of the futures contracts were margined against the long positions owned by financial institutions. In Chicago there was no requirement to be able to short on a price uptick as there was in New York. When New York opened there was a wall of sell orders.

A somewhat similar occurrence happened with the collapse of Lehman Brothers when the “repo market” to finance its fixed income inventory was closed to Lehman due to a different set of rules and expectations in London.

Trying to avoid a future similar event, the Dodd Frank Act focused on what banks and others owned, not the risk in their loans. I suspect that most of the inventory owned by the Authorized Participants, (the market-makers for Exchange Traded Funds and similar products) are highly margined. At some point the providers of these loans may get nervous as to their collateral cushion and may want instant repayment which could create a problem.

There may be similar potential problems in both the US Treasury and Foreign Exchange markets where high leverage is available.

Third Risk : Career Risk

If investors are guilty of simplistic investment decisions, professionals live in fear of being fired either by clients or employers, This is a particular risk if someone needs to publicly report performance or work for publicly traded companies. Thus, despite reasonable long-term results, near-term absolute and even more importantly - relative results - drive terminations. This is normally a mistake on the part of the terminator for two reasons. First, most of the time there is a partial or complete recovery. Second, and much more dangerous to the investor is the choice of the replacement, often a manager that has good long-term results which are appropriate for a decline, but poor results in expansions.

Bottom Line

Risk is always with us and it is the highest when least expected. Drive on two-way streets, they are safer.

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How to Survive Banner Headlines

Introduction

Investors and the public in general tend to believe in big headlines and invest in the direction of the headlines. Often this is a mistake. On the front page of The Wall Street Journal last week there was a five column banner headline trumpeting “Broad Gains Power Historic Rally.” A sub headline stated that for the first time since 1993 that six closely watched indexes rose in the first half of the year. (The indexes were two from Dow Jones - DJIA and Commodities; two from MSCI - World Stocks and Emerging Markets Stocks;  as well as indexes for Gold and Bonds.)

The financially sound investor would quickly point out that the flow into tradable elements was caused by people getting out of cash money. Institutions and individuals were recognizing that excessive borrowing to meet or prolong deficits and the central banks manipulating interest rates has caused a twenty year recognition that in today’s world cash is trash.

Those of us who have any knowledge of how people (particularly investors and voters) react will recognize that when there is a large imbalance of opinion that the majority will win for a relatively short while to be followed by major disappointments. Such may well be the case this time.

How do I know? Years ago I learned from a very sound investor who happened to be one of my accounting professors that I should read financial statements from the back forward. I should spend as much time reading the footnotes and auditor’s certificate as I would in reading the CEO’s comments even though the CEO’s comments were designed to be more easily understood. I suggest that all who wish to be informed and to have the ability to change one’s views to read the small articles at the end of the pages in most newspapers. If you do you might come up with what I am seeing.

Bits of information important to me

1.      In the last week the average interest rate paid on bank deposit accounts (MMDA) went from 0.37% to 0.43%. In most weeks there is no change or only minor moves of .01%. This 16% move could be for some technical reason or could be that banks, mostly retail banks, are starting to make loans and need more deposits.

2.      The five month increase in CCC (low credit quality) loans is up 17.2%.  At the same time there was a decrease in high quality loans being sold.

3.      Moody’s ^* is concerned that the combination of below trend profit growth and above trend borrowing will lead to an increase in defaults.

4.      Two very respected investors from quite different vantage points, Stephen Roach and Wilbur Ross, are worried about too much easy money. Steve is one of the leading experts on investing in China and Wilbur Ross has had a very successful career investing in distressed securities both in the US and elsewhere.

5.      Bank for International Settlements (BIS) which is the international bank that provides credit to banks globally is warning about “euphoric markets.”

Applying concerns to portfolios

As a professional investment advisor I need to be concerned each day as to how the accounts that I am responsible for are positioned. In almost all cases these accounts must be in the market to meet their long-term needs. Today, with interest rates in the range of perceived long-term inflation, (if not lower, as shown by the WSJ banner headline), the bulk of the accounts are balanced accounts with a preponderance in equities.

Regular readers of these posts have learned that I am worried about a major, once in a generation, drop in equity prices. Up to now I have been focusing on stock prices to generate sell signals. Increasingly I believe I should focus much more attention on fixed-income markets. The triggers to the last major declines were caused by the failure of Lehman Brothers ability to finance itself and the widespread fears of residential mortgage defaults. These were fixed-income problems that severely impacted stock prices.

I want to learn from other investors and investment managers. This is why I prefer in most instances to invest through funds managed by bright people. This week someone sent to me a copy of Schroders^* latest investment letter. In the letter Schroders divides its outlook for the future of its accounts into scenarios. The most probable is an extrapolation of present trends. However, the letter mentions seven other scenarios which could be important. I have listed them in order of their probability according to Schroders:

• Capacity Limits
• G7 boom
• China Hard Landing (Steve Roach believes the increasing codependence on China could hurt the US if we don’t come to a better relationship.)
• Secular Stagnation
• Eurozone Deflation
• Trade War
• Russian Rumble

^*Owned by me personally and/or by the private financial services fund I manage

While each of these could be the problem that sets off the market decline, to me the key is the proportion that Schroders gives to the most probable outcome, the essential “muddle through” scenario which is at 65%.

Why I am limiting equity exposure

Coincidentally because of my concerns after five good market years and below average economic years, I think it would be wise to limit equity exposure in a conservative balanced account to 65%. While I expect we could have one more major, almost skyrocket selected stock price move, I would be moving lower in terms of equities, if I could find some reasonably safe fixed-income alternatives producing above inflation rates of return.

The equity exposure mentioned is for those accounts that will have funding responsibilities in the next five years. Longer-term accounts could selectively be higher, except I am beginning to worry about long-term endowment type accounts. In the past I felt that this account should be invested all in equities as the best way to get the benefits of disruptive technology and favorable demographics. I am beginning to worry that pricing competition could be too fierce. 

In terms of demographics, I believe that the US will accept more legal and if not illegal immigration. My concern is as to the quality of our young labor force today. I find it disturbing that in the US Army’s reported view, only 29% of the population could be accepted. (I don’t know what the experience is for the US Marines, but we only wanted “the few”). Without the right people our long-term returns will not match our needs.

Please share with me your views.   

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Be Vigilant when Relying on Patterns

Introduction

In last week’s post I discussed that many investors are only interested in outcomes and not the causes of the outcomes. These investors search for repeated results and expect the same patterns to be continued into the future. For the last two weeks I have been drawing lessons from California Chrome’s losing the Belmont Stakes, and stated that it was a bad bet. Those who wagered on that result were betting that the colt’s past pattern would continue in this most difficult race for three year olds.

Those who follow history of sports, politics (Eric Cantor), theater, and human emotions all have experienced disappointment when the winning streak is not continued. The reason I said that the bet on California Chrome was a bad bet was that the betting odds were odds on, putting up more ($5) to win less ($4). This assumed a much higher degree of certainty than warranted on a young, head strong colt in the spring of the year.

Keynes lost several fortunes following patterns

In the June edition of the Financial Advisor Magazine there is a good article on John Maynard Keynes and his investment experience. There is no question that this Cambridge University don was exceedingly bright and had all kinds of ambitions. As an economist he was also a researcher and looked for patterns in commodities and currencies as well as US and UK common stocks. Each failed to produce a winning result every year and also led to large, (but less than market) losses in 1931. He did beat the UK market in 12 out of 18 years, which is exactly the ratio one would normally expect from a very good professional investor. The sad part of this experience in terms of the rest of the world is that various governments took his economic theories to be unassailable laws. If people only would have used the concept of applying a winning percentage to absolute belief in his economic laws, the world would have been a better place. Instead we had a Republican President of the United States intoning “We are all Keynesian Now.” This was almost exactly at the very moment of history when the US allowed its budget to get out of hand and began peace time deficits that continue to this day, which has led to a relative decline in the US standard of living.

Favorable patterns that may not hold up.

All humans look for patterns in everything they do. Even well-trained analysts look for what they hope for is certainty in patterns. Being a contrarian by nature I look for a reversal of trends, but currently markets are accepting the following patterns:

1.  On a year to date performance basis the Dow Jones Industrial Average is up +2.2% and its Utility average is up + 15.5%. This suggests that focusing on sectors is more important than the level of markets.

2.  Many portfolios are centered on various market capitalization levels which S&P provides. However the best performing S&P level is its 500 Index up +6.2%, and its worst is its Small Cap Index +2.1%. This suggests that market caps are relatively insignificant. We will see if this is true in the next major moves, particularly on the down side.

3.  Low perceived quality as measured by those stocks listed on the American Stock Exchange gained + 16.3% compared with those of the New York Stock Exchange + 5.5%. In 2014 (and for the last several years) higher quality, particularly of balance sheets has hurt relative performance. I doubt this trend will continue in an economic downturn. (Keep an eye on the default rate in high yield bonds.)

4.  Enthusiasm for various political leaders’ statements as to the future of their economies going through restructuring has driven their markets to possibly unsustainable comparisons. The Indian Sensex index is up +18.6% and the Japan’s Nikkei is down -3.5%.

5.  David Herro in his search for economic trends noted that the old indicator, an increase in lipstick sales, is being replaced by an increase in nail polish as an indicator.

6.  The trouble with following patterns slavishly is there is no room for a “black swan” occurrence.

Pattern Analysis can be useful

In a recent report Standard & Poor’s compared the performance of Large-Cap mutual funds to their respective S&P Benchmarks, showing in each of the last six years that the majority of funds beat the indices. The range of beats goes from 81% in 2011 to 51% in 2009. I found this data set interesting in that it shows actively managed funds can perform as well as the benchmarks. More significant to me is the extremes of performance. The low number occurred in a sharply rising market and the high number in a market that was declining in many sectors. My explanation for this result is that the indexes do not hold cash reserves where mutual funds do. Coming off a bottom, “cash is trash” and hurts performance, whereas in a falling market cash acts as a cushion. As I believe that this pattern will continue in our managed accounts, I have been cutting back on our use of index funds as a preparatory move for a future decline. (The impact of this move is to slightly raise our overall expense ratio.)

Moody’s^*  believes “Exceptionally thin spreads typically credit cycle slumps.” As the yield spread is historically small between low credit instruments and high quality ones, I believe that this is a pattern worth noting. This is particularly true as we are seeing a concerted push on the part of both mutual fund houses and brokers to invest in unconstrained fixed- income funds. Even various government agencies are concerned and have discussed an idea of trying to put some redemption constraints on bond funds, which I do not believe will happen politically. Further to the discussion is a comment by a former Federal Reserve Governor in referring to bond fund redemptions as “liquid claims on illiquid assets.”

^*Owned by me personally and/or by the private financial services fund I manage

Perhaps, my searching for the top of the stock market that precedes a major decline is misplaced, possibly the top will be caused by a malfunctioning fixed-income market. After all, the last major decline was caused by Lehman’s inability to fund itself in the short-term market. 

What patterns do you use?  

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Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2014

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