Be Aware of History

Introduction

My basic belief is that you can scratch an analyst and a historian will bleed. The good professors and scientists at Caltech tell me that our memories are a critical decision-making part of our brain. Thus each of us are to some extent historians. On this weekend before the historic Brexit referendum I thought it would be useful to selectively search history for clues as to future wise investment moves.

Lowest Interest Rates in 5000 Years

In Mesopotamia about the first recorded interest rate was 20%. That was the same rate charged in Babylon in 1772 BC as well in Italian cities about 1150 AD. The highest recorded rate was in 539 BC of 40+% at the time of King Cyrus taking Babylon. What may have been a spur to colonization of the US, English interest rates were 9.92% in the 1700s. To show the volatility in the US, our rates were about 1.85% during WWII. By the 1980s rates rose to 15.84% compared to the 0.25-.50% the Fed is using currently. The sources for this and other similar data are the Bank of England, Global Financial Data and a book by Homer and Sylla entitled “A History of Interest Rates.” Dick Sylla an NYU professor for many years has been the chair of the Museum of American Finance whose board I served on. The purpose of showing the historic swings in rates is to alert investors that a future surge in rates may not peak in the mid single digit range.

One of the very best chart readers I know suggested to me that the continuously offered 30 year US Treasury Bond has possibly reached a thirty-five year peak in a move that began in 1981. I am conscious that Treasury officials, the SEC, and various hedge fund operators are concerned about the illiquidity in portions of the Treasury market. This may well be the reason that the Treasury is not materially expanding the duration of the US Government Debt structure. As investor for clients and my family in equity funds I find that any potential disruption in the most senior market can be unnerving. The modern theory of equity investing is based on the floor created by the risk free interest rate on US Treasuries. Perhaps it could be suggesting that we should be looking for a sub-basement below the floor!

Historic Perspective on Brexit

I do not know which way the vote will go, but the way I look at the polls as of now the “leaves” appear to be winning. Regardless on the outcome unless there is at a least ten point spread, it is my belief there will be other elections in the UK and Europe both for leaving and joining. From a historic point of view one can see that Common Market is just another attempt at European unity which goes back to the time of Julius Caesar. All of these have failed in the end for two intertwined reasons, (1) lack of confidence in the leadership particularly and (2) the provision of defense of the life of the homeland. During the Spanish Civil War there was great fear of the “fifth column” of enemies in civilian clothes creating great damage. Today throughout the world this fear is again present in the inability to properly screen immigrants or perhaps their children.

In the developed world these fears (along with concerns about the future economic outlook) are leading to a decline in the rate of marriage as well as fertility. Demographic trends take a long time to develop and change slowly. In time these trends play a political role and the referendum and the coming US elections could be influenced beyond the political leadership’s expectations.

Risk Management

On a recent trip to Europe one of my good analytical friends who is now a US citizen but was born elsewhere was anxious to return to the US, a land of risk-takers. By implication he was decrying that most of the Europeans that he was talking with were not attuned to taking risks. I believe that the US has benefited from the fact that many of our ancestors had to take big risks to get here. But we are not as much gamblers as other people are. What we risk is our hard labor against long-term goals.

One liberal arts university whose board I sat on recognized the need to offer business related courses to keep its attendance up to the level that they could afford the professors and staff. The would-be business professors came to the board and were outlining what they wanted to teach. In one case they wished to teach risk avoidance. I demurred. To me they should teach risk assumption and therefore risk management. Our whole private and public equity culture is based on wisely seeking risk assumption at the right price and conditions. To an important degree this drive is missing in many countries, but not others -  particularly in Asia.

Getting Bullish

The essence of risk management is to take on risk when others shed it as much as possible or are reluctant to commit to a future. While both Brexit and the high quality bond market may prove to be hurdles, they are not absolute impregnable walls. When too many are in their foxholes or trenches, this could be the time to advance. Clearly if bad things happen there could be cheaper entry points if one is not too petrified to move. Thus, I would urge long-term oriented investors to begin or increase their equity investing. If they are having trouble finding the appropriate funds to use, I will be glad to help for awhile.

Question of the week: Will the outcome of Brexit change your equity allocation by more than 20%? 

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Copyright © 2008 - 2016

A. Michael Lipper, C.F.A.,
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Opportunities Gained Through Losses for Some

Highlights
I.            The Best 401(k) and New Opportunities 
II.          Seth Klarman’s Warning and Permanent Losses  
III.       ISEEE White Paper on Emerging Companies

Introduction

This last week a number of things have occurred that will intrude on my work in the next several weeks.

Regular readers of these posts have learned that there are two related themes to my investment thinking. I am very wary of a future peak leading to a major stock price decline and I am impressed with the value of time horizon portfolios.  

One rarely appreciates the advantages or disadvantages that accrue to individuals based on the time they enter their first professional jobs. I began my first professional investment job in 1960 as a junior analyst/trainee. I was part of the second wave of young people to enter the business in a long time. Some others entered Wall Street about 1955. Each of the phalanxes moved up the ladders very quickly to replace the managers that were scarred by the tales of the Great Depression. Many of these managers (and more importantly, their clients) were extremely afraid that the post-World War II boom was about to end and therefore were reluctant to buy stocks in the early 1960s. Their clients found them to be wrong by 1968 if not earlier, and allowed us relatively unseasoned analysts and portfolio managers an opportunity to make important investment decisions. Out of these experiences I became conscious that the larger losses suffered because of the collapse of stock prices in the 1929-1932 market were not the dollar losses sustained. A much larger loss that many investors and their heirs suffered was caused by former investors or their friends and relatives neglecting to reinvest into the stock market. They lost huge opportunities to make a great deal of money.

Ever since that recognition I have been focused on not making that mistake for myself and clients. This is exactly why I believe in creating investment portfolios structured to meet needs for different times. I have little confidence in my and most others ability to make correct risk on/risk off decisions.

The #1 401(k)  - Our client 

For many Americans a large part of retirement savings is in their 401(k) salary savings plans sponsored by their employers. From my point of view as a manager and consultant to a number of these plans they should be invested for the long-term, utilizing my time horizon approach.

Each year BrightScope creates a list of the best 401(k) plans. This year they named the Second Career Savings Plan of the National Football League (and the NFL Players Association) as the number one in the country. Numerous factors were considered including total fees charged. Because of participant choice they did not measure aggregate performance. I can clearly state that investment performance was good as does the plan sponsor. This has been satisfying to all who have been involved.  I wish them well in the future. After twenty years of working with the plan,  I have elected to pursue other opportunities utilizing our expertise and efforts. They should do well due to the generous employer contribution and the structure and administration of the plan.

Seth Klarman’s warnings and permanent losses

Seth Klarman is a well known hedge fund manager that is used by some of the non-profits whose investment committees I sit. He has sent back cash to investors (rather than investing it), so his latest letter as published by John Mauldin is not a complete surprise. Let me summarize his points as follows:

• Most investors are downplaying risk and this never turns out well.

• Maybe not today or tomorrow, but someday a collapse may occur.

• The pain of investment loss is considerably more unpleasant than the pleasure from any gain.

• Correlations will be extremely high.

• Investors in bear markets are always tested and retested.

Analytically, I agree with Mr. Klarman’s cautions, but I do want to put them into perspective. For those accounts that have long-term needs beyond ten years, I would be reluctant to place less than 50% of the value of the portfolio in risk-assuming investments. I do recognize that in periodic down markets the major stock market indices can decline 50%. The decline from the peak in 2007 to the bottom in 2009 was 57%, with many good managers losing more. The recovery since the bottom has more than made up from the loss and then some additional gains, often more than 50%, above the former peak.

What to do?

Along with most professional investors, I do not posses the market timing skills of Mr. Klarman and a handful of others. Nevertheless, I am conscious of his warnings. Thus, recently I cut back on two of the largest and quite profitable stocks in my private financial services fund. Also I am reducing some of the positions in Small Cap funds in our managed fund account portfolios after they have performed very well and have no or little cash reserves. These moves will not be sufficient if I am totally surprised when the next major decline happens. I am, perhaps foolishly, expecting a more speculative rise before the peak is reached. There are two clear parameters to my thinking. The first is to get prepared for a decline and the second is not to get too long-term bearish as to flee from taking risks for long-term gains opportunities.

ISEEE white paper and emerging companies

There is a very healthy tendency of people in the global financial community to meet and discuss, often heatedly, their views as to the investment future. I belong to a couple of these and learn to appreciate from other professionals’ experiences. One of the groups I recently joined is the International Stock Exchange Executives Emeriti (ISEEE). This is a group of present and former senior stock exchange officials from around the world that meet periodically. Evidently my term of office as the Chair of one of the advisory committees to the board of the New York Stock Exchange qualifies me for membership. For a number of years the group has been concerned about the general inability of emerging companies to get adequate financing in most of the world’s markets. 

Next month at the ISEEE conference at the Museum of American Finance^* in New York (one of their conferences around the world) the topic will again be discussed. I have been asked to prepare a brief white paper on my concerns for losses while investing in emerging companies. There is no doubt that there will be some outstanding successes where capital will be multiplied numerous times. On the other hand, it is almost axiomatic that there will be loses sustained by inexperienced investors.

I don’t know that large losses can be prevented, but there are two concepts I am going to try and develop. The first is that various restrictions  caused by the regulators and case law should be modified to present more information about future plans and greater discussions as to the specific market opportunities and threats the company is likely to be exposed. The UK polices are more helpful than those in the US. A second proposal that also surfaced (to the best of my knowledge in some UK reports) is that each emerging company offering needs to require at least one or more institutional investors, with perhaps a required carve out of 10% of the offering. I have some other ideas that I might include.

I find it a bit ironic that for this conference I will be sitting in the old banking halls at 48 Wall Street, the former home of the Bank of New York, my first professional job after leaving the US Marine Corps.

I solicit the readers of this post to share their thoughts as to how we can protect investors from losses but still encourage them to be lifelong investors.

^* I am a trustee of the Museum of American Finance

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Copyright © 2008 - 2014

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

 

Unpopular, Unconventional, Painful and Disruptive

Unpopular, Unconventional, Painful and Disruptive is not the name of the new hot law firm. The title is a summation of some of my "out of the box" thinking flying home from a too-brief visit to an offsite board meeting of the California Institute of Technology and a visit to PIMCO, the world's largest bond manager.

"The New Normal"

One of the reasons bond managers think in terms of secular trends is that at times they invest, rather than trade, bonds with long maturities. While those who buy stocks should be thinking in terms of long to infinite time periods, many of them focus on much shorter periods; e.g., quarters, twelve months, five or ten years - certainly not thirty years. That is why understanding bond managers is important to equity investors.

In meetings held by senior PIMCO investment people with a group of Caltech trustees, PIMCO focused on an expected period of prolonged very low interest rates. They also shared their opinion that the various stimulus moves by leading central banks and governments will not lead to effective de-leveraging. I got the distinct impression that these moves would prolong the valley of low employment and a decline in the developed world's standard of living, while many of the emerging countries enjoy rising standards of living. A further examination for the sluggish response to the various government actions reveals that in the US, 71% of GDP comes from consumer spending with 47% of that total spent on services and only 24% on goods. As services are time perishable, the old pump-priming techniques of the 1930s don't work as well.

Re-thinking

If the present generalized approach is only going to prolong the problems, why not stop banging our heads against the stone wall and let the natural correction forces operate? In other words, let rapid de-leveraging happen through a normal bankruptcy cycle. During bankruptcies, various contracts can be abrogated. I would carry the process further by removing various constraints and restrictions in government policies that are no longer valid. What should come out of a bankruptcy is a new beginning with an enthusiastic attitude. Unfortunately, only 42% of the American public believes that hard work leads to success as indicated in a recent Wall Street Journal article. This attitude must change.

 

The whole idea of re-thinking past dictates of government is accelerating. I recently attended a conference organized by the Museum of American Finance at the New York Stock Exchange. The focus of the conference was how to restore individual investors' confidence in the equity market. For some time I have maintained that the regulatory pressure to lower transaction costs is a significant contributor to the problem. When commissions and spreads were large, retail salespeople sold stocks and provided other investment services to the public. As their remuneration rapidly diminished, salespeople gravitated to higher commission products such as hedge funds and structured securities. The chair of the NYSE recognized that the switch from quoting prices in fractions to decimals, including sub-pennies, has reduced the attractiveness of selling stocks as a business. I find it interesting that there are news accounts that the SEC is considering a test of a return to the use of fractions. If the SEC can see itself reversing some of its past policies, there may be hope that other government bodies can re-examine their past actions to become more pro growth.

One of the most rigid congregations in the world is the scientific community. Scientists regularly make pronouncements of various laws and theories. This weekend my wife Ruth and I listened to leaders that supervised the work at JPL (Jet Propulsion Laboratory, an affiliate of Caltech) of the Mars landing of  "Curiosity." Each manager described some of the various scientific beliefs and budget constraints to carry out the mission. This remarkable success is viewed around the world not just as a success of Caltech/JPL or of the US, but of mankind as part of its conquest of knowledge beyond our earth. I hope this achievement and the continuing reports back from Curiosity will lead to a greater understanding of what we are capable of doing with our collected talents. We can achieve growth by re-thinking our various constraints.

Investment implications

The markets ahead can be painful either on a prolonged basis with current government policies or more painful but of shorter duration if we allow normal "animal instincts" to operate. In terms of investment policies, in most cases I would not want to own government bonds. I believe the risk premium will rise and stocks will do better than bonds in general. In terms of stock selections, I favor disruptive companies that can take advantage of significant structural changes in our various market places.

What disruptive securities do you own?

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Financial Illiteracy: Too Many Are Not Ready For Retirement

This week my thoughts have turned to retirement for others, including my children and grandchildren as well as many others that I know. The concept of a voluntary cessation of producing an economic income and relaxing comfortably at leisure is shaping up to be one of the great myths. They simply won’t have the money to be only mild spenders and not earners at hard work. If we think the current debt structures and deficits are troublesome, we only need to look at the future. Unless we dramatically change the savings, investing, and living practices, the size of the population that will need help to retire with any sort of comfort will be huge. In my view the only long-term answer to the crushing problem is practical education. Of the three parts to the solution: saving, investing and life style, my only expertise is in investing. Nevertheless, I recognize the other learned skills of budgeting (controlled spending) and leading a healthy life are equally important.

Investment is an art that begins with reading

While almost all could benefit from reading Wealth of Nations by Adam Smith, Securities Analysis by Benjamin Graham and David Dodd or even to a much smaller degree my book MoneyWise, these are not what I am talking about. The kind of reading that I am alluding to is reading the situations around the world by observing every single day. Particularly now in these stressed times we watch conspicuous consumption with some awe. We do not pay enough attention to those who are not currently spending because they can’t and those who choose to spend less. Both groups are important to observe. Those with little resources and living moment to moment didn’t follow (or found it too difficult to follow) their few successful classmates, teammates, fellow workers, neighbors, etc. There are always some that took advantage of the opportunities to move up and out. Luck was not the source of their ascendency, but rather they recognized opportunity and the willingness to do the difficult. The second group of curtailed spenders may well be future-oriented as distinct from living moment to moment. The second group has internalized the fact that limiting current spending is transferring resources (no matter how small) to a future period. This transfer can earn additional awards through investing. Other places to read the economy are the gas stations (gas prices and level of maintenance and repair work), supermarkets (changing prices, excess inventories, the shifting to store brands from nationally advertised brands, quality of produce, etc), and shopping malls with high turnover stores (promotional and everyday prices, inventory of your size, stock liquidations, imports vs. locally produced merchandise).

There are too many financial illiterates

At the last board meeting for the Museum of American Finance where I sit as a Trustee, there was mention of a study by Annamaria Lusardi (George Washington School of Business) and Olivia S. Mitchell (Wharton School, University of Pennsylvania) entitled “Financial Literacy and Retirement Planning in the United States.” In a survey of 1200 responding Americans, the study asked three very simple questions; (1) understanding that interest rates can add to the value of savings, (2) understanding that inflation can reduce spending power in the future, and (3) whether some form of diversification lowers the risk of loss. Only 35% of the respondents got all three answers correct. What is even more discouraging is when the respondents were divided between those that are planning for retirement and those who were not, 47% of the planners got all three correct and the non-planners 23.9% got all three correct.

Salary savings plans: 401(k), 457, 403b come to the rescue

These savings plans increasingly require all the new, and in many cases present, employees to participate in defined contribution plans which are replacing defined benefit plans where and when possible. These plans are usually funded by employer and employee contributions. These contributions are invested at the discretion of the employee into various options including default options if they fail to make a choice. Open end mutual funds are the single most popular choice for managing this money according to the funds' trade association, the Investment Company Institute (ICI). Last week I contributed a brief column to Reuters on how I select the various options to be offered within a plan. In addition to the nine alternatives, I suggested that a managed account offered through the 401(k) could adjust the investments to changing market conditions and outlooks.

There are two dangers lurking in these plans

Both of the dangers lurking in these plans stem from some of the participants (beneficiaries) of the plan and an occasional sponsor of the plan not grasping that these are fiduciary accounts whose sole purpose is to build retirement capital. Another survey by Transamerica Center for Retirement Studies found that 63% of those who had participated in a 401(k) plan drew cash out when they became unemployed, and 34% of the underemployed did as well. Not only is there a tax penalty for a premature withdrawal, they are in effect robbing their own retirement money and/or benefits that could go to their family or heirs. I suspect that many who withdrew would have been part of the 65% who did not correctly answer the three basic questions in the other survey. Also they did not read (or see) the poor and struggling retirees around them. In the long run they and the rest of society who will give them some support will have suffered from their financial illiteracy and their inability to observe others around them. The contribution to our future deficits will be caused by this failure to educate our people.

The second risk, which is much smaller, but still a risk in some relatively small plans of privately held employers, is an attempt to replicate the senior executive's personal investment account. Even in the smallest of plans with just one owner and one employee, the sponsor has a fiduciary responsibility to the sole non-owner employee that the money is being invested in a prudent fashion. Also the executive who presumably has a significant personal account would be better off investing in potential capital gain earners in their personal account where, under current US tax regulations, they will pay fewer taxes when they liquidate.

What has me worried is when I see sector-oriented indexed exchange traded funds (ETFs) in retirement plans. These are narrowly focused portfolios designed to replicate a fixed list of stocks in one sector or industry. My concern is that these are good trading vehicles particularly when combined with short sales of some stocks within the industry. But the flows in and out of these ETFs are much more volatile than the underlying stocks. According to the ICI, the gross redemptions for all sector/industry funds through August, 2012 was $146 billion and the total assets in these funds was $246 billion. To be fair, the gross redemptions were somewhat offset by some inflows. Nevertheless, the gross redemption total indicates to me the speculation that is going on within these kinds of vehicles. This is just one of the types of investments that may be wonderfully appropriate in a personal account, but should not be found in a fiduciary account for all employees in a plan. Luckily, instances of these hyper-aggressive strategies in retirement plans are rare.

Opportunities

I speak with bias, in that I manage a small, private financial services fund that has positions in a number of investment management stocks. Despite the problem with financial literacy, I believe that defined contribution plans will continue to grow at rates faster than employment and the economy in general. Investment management company stocks should benefit from this perceived trend.

Are you reviewing your retirement planning?

My next blog will come from London.

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