Almost Everyone Is Really Bullish

Introduction

After listening to amateur and professional investors for a lifetime, I have concluded that I should largely disregard what most people say and write. What matters is what they actually do. 

At the moment, market volumes are low, people are not selling their tangible investments (including their homes and the artwork in their homes or in secure free port locations) en masse.  We are not seeing smart, investor-focused companies liquidating. In other words “TINA” (There Is No Alternative) has been replaced by “FOMO” (Fear Of Missing Out). These are two arguments as to whether or not prices will be higher. There is some stroking of one’s intellectual chin as to when and how big a valley we must ride through to get our rewards.

Two Arguments

The favored ways of reaching these conclusions are (1) reliance on our faith that the cyclical secular bull market that has existed in the US and elsewhere for two generations will continue; or (2) like my fellow numbers oriented addicts, they can pour over the current and future dispatches from the global investment fronts. As is often the case, faith wins out in terms of our emotional and psychological stability. As a continuing student of history, particularly of unfulfilled predictions, I can not say this is a wrong approach. However, in this era of microsecond overload of so-called facts and figures, I can not escape my predilection for gathering and sorting almost every morsel in the hope of finding at least temporary clarity. The rest of this blog post is designed to help my fellow missionaries as they look deeply for investment truth or at least a higher level of certainty.

The US Stock Market

We have now gone through what seems like a lifetime of not achieving a new high. It has only been one year. I remind readers that it took the Dow Jones Industrial Average sixteen years from the first time it hit 1000 until it finally surpassed that number in a meaningful way. Market analysts characterize a long flat period as either one of accumulation or distribution. If there is a sustained price rise going through the old high it is labeled accumulation. Likewise if the range-bound price level is broken on the downside it is labeled as a distribution. 

In an oversimplification, market analysts attempt to characterize the flow of money from strong players to weaker ones. History suggests the weaker ones are largely driven by emotions (as the disappearing individual investors) and the strong players are felt to be the professionals.

The Financial Services Sector

As many know I follow financial services companies intently. Most publicly traded brokerage firms with large retail business are not reporting commission income gains. This is seconded by many mutual fund management companies whose individual equity businesses are not growing. Many institutional investors continue to experience positive net flows from contributions and other sources. However, this is not just a two-sided battle between long-term institutional investors and retail public investors. In addition there is the trading community including hedge funds. As they can be long and short, they tend to magnify the intra-day volatility because of their leverage through margin and the use of derivatives.

My View

As with most who are gathered under the FOMO banner I believe that we will see meaningful new highs. Notice I did not put a time tag on the prediction or indicate how low the market may go before reaching a new high.

Index Funds, Revisited

Some foolish investors believe the way to play this dichotomy is through Index funds. The reason that it is foolish is not that it won’t participate in the move. It is exactly that it will participate, but not optimally.

According to one public survey some 71% of retail Index fund investors believe they are taking less risk than in actively managed funds. They are confusing the somewhat muted daily volatility of a broad based index with a concentrated fund portfolio. I believe this advantage is lost, as over time market emphasis shifts and leadership changes. Further, Index funds do not carry cash and rely solely on “approved participants” to bring in or take out securities.  (In our managed mutual fund portfolios we use both passive Index or like Index funds as well as concentrated funds.)

The Real World

We normally think of snow in terms of the winter. Gamblers often refer to a stream of bad luck as snow.  After recovering late in the first quarter, the global economy hit snow in April. The first confirmation to me was a luxury company that announced April sales were 15% behind a year ago. When the wealthy cut back they are sensing something. Globally, almost every company that we follow experienced what I hope is only a hesitation. This is an April phenomenon as, according to ThomsonReuters, 73% of the 493 reporting companies in the S&P 500 beat earnings estimates. (Normally the beat ratio is 63%.) What is more worrisome to me is that only 52% beat the ratio in terms of revenue estimates, suggesting some financial engineering is at work.

Are Yields Heading Back Up?

The fixed income marketplace is broad and deep and it is a bit unfair to use only two yields to identify a trend that could be something of the canary in the mine as a warning to equity investors. According to Barron’s the average yield on a group of intermediate quality corporates last week rose to 4.93% from 4.58% the week before, but still a little lower than the 5.09% a year ago. Minor changes in yields for the highest quality corporates perhaps should calm us. Money Market Deposit Accounts also bounced up.  In this case from 0.22% to 0.25%. This may indicate some tightening of the available money for consumer lending.

Two Former Morgan Stanley Thinkers Worth Reading

1.  Byron Wien, now with Blackstone, for years was reporting on his conversations with an unnamed influence he dubbed the “Smartest Man in Europe.” Unfortunately, the investor, Edgar de Picciotto, Chairman of Union Bancaire Privée in Geneva, recently died.

Wien recounted Picciotto’s numerous investment successes and his philosophies. He clearly was early onto numerous investors that did very well. I believe he had very concentrated investments. He foresaw opportunities that were considerably less risky than they appeared to others who came in later. He used his mistakes to improve his thinking. Contact Byron for a copy of his latest blog.

2.  Steve Roach for Project Syndicate has once again highlighted the US dependence on China. (He headed Morgan Stanley’s Asian business after a career as its global economist.) His view is that the US is growing by absorbing savings from China. He is concerned that this source of support for the US will not continue. Roach believes that the US needs to be generating sufficient savings to invest in its own growth.

Other Asian Views

Matthews Asia, a Pacific oriented fund group is re-positioning one of its funds. The Asian Science & Technology Fund is broadening out to become the Asian Innovators Fund. Matthews Asia sees this new focus as a much bigger mandate, as not all innovation is produced by technology. Many commercial and financial activities are benefiting from non-tech innovation. (We have been shareholders of the prior fund.)

Much of the flows into and out of Exchange Traded Funds (ETFs) is caused by shorter term traders. For example in the first four months of 2015, $65.4 Billion went into Global/International funds. In the first four months of this year net redemptions were $5.9 Billion.  In only one of the four months was there was a net inflow of $4.2 Billion. Not surprising in the first two months of the year $10 Billion exited. This kind of volatility was magnified by the thinness of most overseas markets and particularly some of the Asian markets. Investors can use this to their advantage if they counter-time their moves to the regional headlines.

Patience will be required as both “TINA” and “FOMO” are functioning, but one needs to be prepared for temporary reverses.

Monday is a Memorial Day holiday in the US, where we recognize all those who have served their country in times of war and other troubles.

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Do Minor Price Changes Lead to Major Moves?

The Risk that Greece Will Not Leave the Euro

While much of the world worried about “Grexit” and its impact on the world’s economies and markets, much larger risks loom if the central banks continue to ignore the fundamentals, allowing governments in stress to thumb their noses at the laws of supply and demand and other realities faced by the rest of the world. My historical reaction is that if Greece remains in the Eurozone, it may mean the “Fall of France” eventually out of the Euro along with a couple of others that consistently run large deficits that threaten the value of the central currency. One could envision with France and possibly others out of the Euro, it will look like the old Hanseatic League. Led by German Baltic ports and allied with England, the Hanseatic League dominated free trade in northern Europe for the years between the late Middle Ages and the 1700’s.

Factors Behind Declining Interest Rates

Interest rates being quoted on US Money Market Deposit Accounts (MMDA) declined to a low of 0.31% and a weekend rate of 0.34% vs. 0.36% a week ago. Could this be that a number of banks don’t want to show “excess” deposits on June 30^th reports? Perhaps these rates are dropping  because some banks do not want to have too much in the way of excess deposits as they might be of interest to an unwanted acquirer. Or is there a recent drop-off in the demand for short-term loans, as the average short/intermediate US Government & Treasury mutual fund dropped ‑0.14% for the week when the average general domestic taxable fixed income fund was flat on the week? The only major fixed income fund category to gain was the High Yield funds +0.11%.

Equity Funds Show Divergent Trends

The only domestic funds that showed gains in the week ending June 25^th were Financial Services +0.09% and Health/Biotech +0.07% among the majors, plus Dedicated Short Bias funds +1.41% and Alternative Equity Market Neutral funds +0.14%. All the other domestic equity funds showed declines as somewhat predicted by the continued net redemptions of domestic equity funds. In contrast, every global and international fund posted gains for the week led by the average Indian fund rising in US dollar terms +2.36%.  In spite of the attention to the Greek stand off, international markets in local currency terms showed gains for the week of +3.9% for the Nikkei 225 and +3.36% for the Xetra DAX.  

While this was happening the internal Chinese market was crashing and had entered at least a correction (­­‑10%) or a bear market after a one year bull market gain in excess of +100%. Morgan Stanley is publicly telling its clients not to buy into this particular dip. Early Monday morning prices are down in Asia reacting perhaps to Greece. But more likely it is the need of the Chinese authorities to liberalize bank reserves and lower interest rates to stop the slide in their stock market. Some have even suggested restricting buying on margin. As a reaction to these moves on Sunday night in the US, the DJIA futures are being quoted off some 260 points.    

To some degree what didn’t happen was the most interesting occurrence of the week. Friday was the day when the annual reconstruction of the Russell indices took place with the DJIA going up marginally, the broader S&P 500 and the NASDAQ declining marginally.

Apparent Conservative Funds may be Risky

For the last seven weeks the oldest form of mutual fund,  the Balanced fund has seen net additions, with $1.6 Billion net coming in for the week alone. Is this just a sign of confusion as to direction or conservatism? Possibly the rise is due to 401k and similar defined contribution plans for employees being treated as mixed asset funds (bonds and stocks) which are somewhat more modern Balanced funds. If that is the case I hope that fiduciaries supervising these accounts have sufficient memory and education to recognize the risks of underperformance of mixed asset portfolios in sharply rising and falling markets. The Investment Company Institute, the fund business’s trade association, indicated that there were $741 Billion in retirement target date funds and another $400 Billion in somewhat similar “lifestyle” funds at the end of the first quarter. Under the correct personal conditions and understandings these vehicles might prove to be satisfactory; for others they may in the future prove to be problematic as these funds will own fixed income securities which may not perform well (as discussed below).

Fixed Income Risks

John Authers of the Financial Times had a very thought provoking column on Thursday exploring the “Bondification” movement to address the fundamental concerns that have led bond fund managements to under-perform. Most bond investors start with the assumption of a “risk free” interest rate based on local country Treasury yields. The problem is that with various bouts of qualitative easing as managed by many central banks, these interest rates have proven to be quite volatile. In my opinion, the restructuring of bond markets in a period of diminished capital on trading desks makes bonds anything but stable. The bond professionals have responded by developing a culture of unconstrained fixed income portfolios that allow managers ultimate flexibility in terms of maturity, credit quality and inclusions of derivatives and in some cases commodities. While this flexibility can, if well executed, produce good relative results, they bring into question how bonds should be used to provide some risk-dampening to a mixed asset portfolio. I hope the owners of target date funds and lifestyle funds understand these changes from past performance records.

Liquidity Concerns

Exchange Traded Funds (ETFs) have become an important institutional trading device; the US Securities & Exchange Commission (SEC) is showing concerns as to the use of derivatives both within ETFs and their marketing partners. For the most part institutions and individuals buy and sell ETFs through market makers called Authorized Participants (APs). When a buyer or seller of an ETF operates through the limited number of APs, they are utilizing the liquidity of the AP for each ETF. Some of this liquidity is in the form of derivatives. The SEC and other analysts would like to understand the size and nature of the liquidity that exists for specific ETFs. My particular concern is primarily based on sector and some single country vehicles. We will see whether the SEC will get the details on a timely basis and make them publicly available.

The use of public disclosure of how various funds manage their portfolios can add some reassurance. For example, the National Economic Research Association (NERA) has published a white paper examining if a fund broke any of the constraints being applied to Money Market funds. Among their findings was a theoretical conclusion that at worst there may be a temporary 1-3% break from the dollar NAV with most of that happening in the first two days followed by a recovery likely by the end of the first ten days. I hope that they are correct as I have regularly used Money Market funds to hold required firm capital.

Outliving Retirement Capital

Many people are  living longer. As a group, they have not changed their spending and savings habits. Also, governments have not fully recognized these implications. Both the workplace and retail distributors are behind in adjusting to this reality.

GDP for the first quarter in the US was revised to a decline of only ‑0.2% from ‑0.7% as originally reported. As previously pointed out in these posts the change was not a surprise. In this case the markets were a better forecaster than government agencies. The size of the adjustment is too large for those who steer our ship of state to put reliance on their own statistical collection approaches.

Question of the Week:  Based upon the week’s news, do you remain a Bull or a Bear?

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Copyright © 2008 - 2015

A. Michael Lipper, C.F.A.,
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I Suspect and I Accuse

Introduction

Today’s post is a double header with the first part focusing on thoughts as to the current markets and the second on longer-term issues that should be considered for investment policy considerations.

I suspect a “Melt-Up”

In last week’s post I discussed three possible directions for the current market, “melt-up, muddle along, and decline.” At this juncture, for at least awhile, the apparent path of least resistance is to go up in price.

Positives

There is a belief that surviving a problem that doesn’t kill you makes you stronger.  Most global stock markets did not fall on the two threats to geo-political peace last week; the downing of the Malaysian airliner over Eastern Ukraine and the beginnings of the Gaza strip ground attack. If the markets did not fall, then some believe the path of least resistance is for stock prices to rise. (Remember it took one month from the assassination of the Austrian Archduke and when World War I was declared on the European continent.)

Often when low to intermediate credits rise in price (decline in yields) relative to high quality paper, it is favorable to stock prices. Each week Barron’s publishes a confidence index based on this relationship. Normally it is quite stable. For the week that just ended the current reading was 69.9% vs. over 74% one year earlier. English translation is “risk-on.”

Because so many analysts and portfolio managers are relatively new to the business they tend to look at past history in terms of calendar movement of the Standard & Poor’s 500 index. They do not recognize that in an average year since 1980, according to JP Morgan Chase there is a 14.4% decline from peak to bottom. I am particularly sensitive to 1987 when for the year the S&P 500 index was up slightly but there was a  -34% peak to trough decline thru the year, and much worse in the average stock. In our analysis of mutual funds for our clients we pay particular attention to the declines of- 49% and -19% in 2008 and 2011 respectively. But who cares, the market always come back.

The consulting community and institutional “gate keepers” pay attention to ranked performance particularly of short periods. We have maintained for some time there is little in the way of persistency of good performance from quarter to quarter and even for one year and particularly for three years. S&P recently did a study of top first quarter performers for the first quarter of 2012. They compared these winners to the top 25% winners for the similar quarter two years later. They found that only 3.78% of the funds repeated in the top quartile. What were even worse were the large capitalization funds where only 1.9% repeated. Remember large cap stocks have more analysts following them than smaller companies. What this suggests is that the market may well be shifting to favor short-term momentum winners which would be leaders in a sharply rising market.

Ignoring what you don’t like

If you can ignore facts and views that are cautious, one can become more bullish quite quickly. Some of the subjects that investors seem to be ignoring are: 

1.      Private Equity Funds are selling their holdings at high valuations.

2.      Lust for yield is forcing investors into less conventional-higher risk paper.

3.      People seem to forget that most Merger & Acquisition deals work out poorly for continuing investors. That it took so long for Steve Forbes to find an acquirer for the majority of his company shows that the private equity buyers are more cautious now than the public investors.

4.      Interest rates are rising each week, for example: 15 and 30 year mortgage rates, new car loan rates and the banks’ cost of deposits (MMDA). At the same time numerous banks are reporting, as forecast, lower quarterly earnings and are looking to new markets to replace their crunched earnings power, e.g. PNC. This is occurring in a period when people are saving less and the spreads between high and low credit quality is narrowing.

5.      Many US investors are turning to Europe to find good investments. This surge in demand has led to a 102% increase in Western Europe High Yield issuance in the first half of the year. (Anytime there is an increase in low credit quality issuance I wonder when we will see a meaningful uptick in defaults.)

I Accuse

This is the famous title of an open letter to the President of France by Emile Zola about the “Dreyfus Affair” which eventually led to Captain Dreyfus being exonerated and a public recognition of societal biases in France. In a far less dramatic context I accuse my fellow members of the global financial community of complacency. While we all see any number of troubling events, most do not change or plan to change our investment positions. In effect many have elected to play “the greater fool theory” card in an undisciplined way.  A few of the things that should cause at least some of us to begin to shift away from risk of loss of capital are as follows in no particular order:

The sale of the Russell indexes to the London Stock Exchange opens more questions as to the future value of index production.

Internally both the US and Canadian central banks are looking for methods of improving their research in private recognition that they have not been very good.

We are seeing considerable “flight capital” movements. In the US the net sales of international funds is increasing as domestic oriented funds are in slow growth or net redemptions. In Europe we are seeing that the bulk of the long-term fund sales are not in funds from cross-border managers and are often going into investments outside of their domestic market.

Some very visible investors have made the following statements:

Carl Icahn:“This is the time to be cautious.”  

David Kotok: of the esteemed Cumberland Advisors indicates that tapering is now going to be tightening.

Kathleen Gaffney: Well-known bond fund manager now of Eaton Vance^* noted that traditional bonds have interest rate, credit and liquidity risks which is shoving us into unconventional paper.

*Stock owned by me personally and/or the private financial services fund I manage

An example of a real concern of mine is the discussions of an informal group of retirees, semi-retired and active portfolio managers, analysts both fundamental and technical, and an experienced institutional salesman. In periodic meetings, from my viewpoint, too much of this group’s discussion is on the issues of the day (often political) and not enough about individual securities and portfolios.

This group may well be a microcosm of the investment community trying to get the last high price for what they own while wringing their hands as to problems facing the investment world.  Within my own responsibilities I have only recently started to sell long held positions, but still are very much an investor in equity funds and some individual stocks, mostly in the global financial services arena.

What we should be doing if the melt up gathers momentum is to place sell orders at various different levels so that we maintain our survival capital for the next major bull market, which I expect beyond the next five years.

To my readers at Citywire Global

Thanks to my City, UK and European readers for once again making my blog one of your top choices.  Last week’s post was listed as Number One of the five most read stories on Citywire Global. I appreciate your readership.

Question of the Week: Do you have any specific plans to liquidate some of your “at risk” assets? 

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Did you miss my blog last week?  Click here to read.

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

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 

Copyright © 2008 - 2014

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