Misinterpreted Signals – Weekly Blog # 511

Introduction

There should be much to learn from the last six weeks that could influence our investments going forward. Unfortunately, these inputs do not lead to a quick sound bite, which isn’t bad.  “Sell in May and Go Away” with a return in November, might help equity traders, but would be of little help for long-term investors who are tasked with paying a long stream of future bills. To aid our diverse audience I have divided my focus into three buckets; equity, debt, and inflation.

Equity Prices

Analysts tend to utilize tools which they are most familiar with. In my case, the main investment vehicle is mutual funds, particularly actively managed funds. Each week, my old firm publishes the average investment performance of 8,452 diversified mutual funds largely invested in the US (USDE). After fourteen straight months of gains I saw that the USDE had a gain of +4.37% for January. By the 15th of February the gain for the first six weeks of 2018 had shrunk to +1.53%.  Disregarding the effect of compounding, if that gain was to continue for calendar year 2018, it would be a gain of +13%. That is still too high relative to its past history of +8.41% for the past three years or +8.12% for the past ten years (through the end of January). These eight percent moves are within the long term range of 9% since 1926 for the S&P 500 Index, so are believable. Contrast that with the 12 months performance of the USDE to the end of January of +21.34% or twelve months through February 15th of +14.73%. Thus, there is room for those who expected a continuation of last year’s growth rate to be disappointed. Near term, some of my market analyst friends would only believe the February recovery if there is a meaningful test of the recent low points.

I have an additional concern that the majority of portfolio managers did not actually experience the 1987 decline and recovery and they won’t be attuned to additional insights from that experience. Almost all of the words written about 1987 are about the failure of so-called “portfolio insurance,” not only to protect institutional portfolios but more importantly the contribution to massive sales of equities and derivatives into a weak market. 

There are two other insights that have value today. The first, as pointed out to me by a client during the onslaught, was that while our domestic economy was shrinking due to the Volcker-administered high interest rates created to break the inflationary spiral, corporate earnings were growing smartly through a combination of exports and foreign subsidiary earnings. I suspect that these trends are even stronger today.

The second missed input was that one of the best and strongest specialists went to the wall (bankrupt) using his last equity and borrowing power to absorb some of the selling. Because of regulatory changes, there is even less capital positioned to absorb selling today. Also, little has been written about  the beginning prices of 1987 being similar to the year ending prices, the market was flat. Thus, the market system actually worked and provided the basis for a long bull market that extended many years.

Hopefully we can look for useful lessons from our immediate past that we can apply to our current and future investment policies.

Credit Concerns

These past few weeks we have seen some reversal of the more than a year long global rush into fixed income funds. Due to global central bank downward pressure on interest rates, investors have been in a scramble to find higher income yields without a great deal of concern for principal risk. It is not yet clear if the sizable redemptions in High Yield funds are a display of concern that the inevitable rise in interest rates will make the refinancing of high yield debt more difficult or the beginning of a concern that some of the debt won’t be paid off as scheduled. At the moment we are not seeing the institutional market reflecting the same reaction to bank loan/floating rate vehicles. However, a number of private equity managers have noted that they are seeing an increase in the use of leverage globally.

It is important to understand the impact of a defaulted loan or delayed interest payments on the financial system. Loans from various financial institutions are treated as earnings assets which produce income to pay bills. If these experience slow or no payments, the expected users will have to change, usually by restricting their ongoing payments. In addition, if the defaulted loan was an earning asset for a financial institution, its capital is involuntarily reduced. Perhaps, the most insidious element of defaults is that they cause rumors to fly within the global financial community and beyond. This causes the institution with the perceived bad loan to quickly restructure its loan and other portfolio elements, magnifying the impact of the rumored or real defaulted loan.  Loans can go into default for lots of reasons, mistakes in judgment as to the extent ion of credit to clients, bad product and pricing decisions, acts of nature, and loss of integrity anywhere along the payment line. Unfortunately, as interest rates rise the pace of activity accelerates, which can lead to an acceleration of the problems listed. More exposed fraud becomes visible as rates rise.

There is a strong connection between a threatened credit community and the equity market. Many equity based financial institutions are vulnerable, including money mangers, brokers, and liquidity providers such as market makers, authorized participants for ETF/ETNs, and credit extenders. Most often they function with borrowed money, usually in the form of call loans (which can be called at anytime without reason). The firm that went to the wall in 1987 and Lehman Brothers could have been saved if instant credit was available to them. I am not aware of such a need today, but the rumor or the reality of such a need can come very quickly anyplace in the world.  As we are so interconnected globally, it is conceivable that on any given morning we will be forced to react to such a happening.

Inflation

Hardly any investment meeting that I have attended in the last couple of months has not included a discussion on inflation. I believe that these discussions, along with the purported discussions at various central banks and by most pundits, have been focused on easy and incomplete data. The focus has been on prices, including reported wages. Not only does the data not deal with changes in quality, terms of trade, and non-reported wages, it also does not deal with the “informal economy.” 
 
I am becoming increasingly concerned that the strength of deflationary trends is not fully understood in assessing spending habits of consumers at all levels. One of the major deflationary trends is technology under Moore’s Law. Each year the power of our cell phones and other technology grows. This can be measured easily, but what can’t be is its value in terms of what we can now do that we couldn’t do last year in terms of commerce, enjoyment, and better health.

I suspect that one of the reasons for the declining number of auto deaths is due to the large number of computers in each new car. It has also led I believe, to less time in the repair shop. This is caused by two trends. The first is that the modern repair shop is equipped with its own computer set up to interrogate the car’s system. And second is a trend we see in all of our mechanical devices, of replacing rather than repairing. (How many young repair people do we know?) 

When economists look at wages, they look at it from the workers' take home pay level and exclude payments the employers are making to benefit the worker in terms of social security taxes, health insurance and retirement contributions, all of which have been growing faster than take home pay. I wonder whether the increase in quality of what we are wearing is included. We are no longer wearing cheap, poorly made imports. Walmart and other supply systems are selling much better quality, which is often delivered by Amazon. In the competitive era that we have been going through, the terms of trade are often more important than price e.g., delivery time and conditions, payment schedules, advertising support, etc.

For the above reasons I have little confidence in the value of the published inflation numbers and hope that the Fed and the other central banks will be slow in reacting to reported trends. The consumer and commercial worlds are much better at adjusting to change in conditions than people sitting in capital cities.

Conclusion

We are in a new era of more rapid changes. Dividing one’s portfolio by various timespans can minimize the risks to your total capital.

Question of the Week;

Have you materially changed your 2018 portfolio?      

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Unintended Consequences: Investors Again Lose to the Politicians

Two quotes came to mind last week, the first was by New York Judge Gideon Tucker (sometimes attributed to Mark Twain): "No man’s life, liberty or property are safe while the Legislature is in session. The second was Will Rogers', “This country has come to feel the same when Congress is in session as when the baby gets hold of a hammer.”

We are about to watch the ultimate sausage manufacture of legislation, which continues a long line of unintended painful consequences to American investors, and much more importantly, to our economy. Soon there will be a conference committee named to resolve differences between the US Senate’s “Restoring American Financial Stability Act” and the House’s “Wall Street Reform and Consumer Protection Act.” As the various lobbyists and their dependent members of Congress write the new legislation (in which almost anything can show up), there is one almost guaranteed certainty. The ultimate result will not provide either meaningful stability or reform. This is not to say that there won’t be change. There are likely to be many changes, some large, drafted in the desire to help us avoid future problems similar to what we have suffered from over the last several years. Almost in a Newtonian fashion, the problem is that any legislative action will produce an opposite reaction by those beyond the Washington Beltway. If history is any guide, the unintended consequences will produce additional serious dislocations and risks to the soundness of investors and their retirement capital.

FEAR AND GREED

The legislation is an outgrowth of the clamoring by many “to do something” about the losses of capital, income, and most importantly, jobs. Unfortunately, changes in the rules of the game (like moving the goal posts in football), probably do not significantly alter the actions, ambitions, and the talents of the players for the most part. Throughout history, from Biblical times to the volatile trading of May 6, investors’ “animal instincts” drive people in the market place whether it is in the stock markets or the job markets. In a gross oversimplification, these are often summed up as fear and greed. (For those interested in these drivers, you may wish to read my book, MONEY WISE.) No law or regulation can prevent someone from buying something they shouldn’t own because they either do not understand it or can’t afford it. When there is a rush to leave a sports arena it is difficult not to join the exit rush.

EXAMPLE: EXECUTIVE COMPENSATION

There are many trails of unintended negative consequences created by various actions of governments. I could not list all of these, but let me start with one example and trace out some of the implications. Perhaps as a way to control compensation for executives, the IRS limited the tax deductibility of compensation expenses over $1 million dollars, unless the compensation was tied to performance. Within a year after the passage of this diktat, companies found ways to measure performance. Often these were earnings and revenues among other statistical measures. (Note that there were no restrictions on how these success ratios were to be achieved.) In some cases, executives could be richly rewarded but the investors suffered as their stock prices declined. In partial answer to these complains, the movements of stock prices were included in the reward criteria. Most often there was a comparison against a general market index as well as a narrow and hopefully more relevant subset. As CEOs were now less likely to be founder/owners, they looked to their compensations as their payoffs for doing a commendable job. Thus these professional managers now had to worry about relative stock price movements.

LOSING FOCUS ON THE LONG TERM

This change in motivation set off three impulses. First, managers manage against the time period for their assessment, which in many cases led to more short term decisions. Often these short term decisions postponed longer term benefit to the shareholder. Second, my fellow analysts were quick to sense the change in management’s focus and they also became more short term oriented. Further they understood that relative performance ranking became increasingly important. In turn, this could lead to building mathematical models in order to predict stock prices in the short term. (Later on, these and other mathematical models have led to the development of algorithms which some traders now use exclusively.) The third impulse was to view defined benefit pension plans as profit centers to hopefully produce the equivalent of earnings. At all costs, significant pension losses were to be avoided. (Again the long term investment value could be sacrificed for the benefit of this year’s financial statement.)

PORTFOLIO INSURANCE

As the concern to protect the corpus of the pension fund progressed, many institutions were attracted to “portfolio insurance,” which was an approach that in part, used futures to hedge the market. When the market went down, futures were sold, or in effect, “puts” were put on. The more the market declined, the more “insurance” was placed. Thus in the aftermath of the 500 point drop in October 1987, when the market rallied sharply, the results for some funds were disastrous. To avoid a repeat of this type of automatic trading, once the market started to drop midday on May 6th 2010, many statistical traders cancelled their automatic buy programs. This purported action may well have led to the 997 point intraday loss. (Sometimes it takes awhile for unintended actions to explode.)

A YEAR IN ONE WEEK

Last week the news was full of European debt and related problems as well as some disappointing domestic economic news. Not only was the Senate passing a stability act but there was also legislation attacking the capital gains treatment for “carried interest.”

Perhaps investors showed their fear of the unintended consequences of the week that ended on Thursday, May 13th, when we saw a “normal” year’s net asset value moves in only five trading days. There were twelve fixed income funds up 5% or more for the week and eleven down 5% or more. We saw twenty equity funds up 25% or more and ten that were down a similar amount. What is important to note that is all but one of the equity funds that gained were those with a dedicated short bias. The next best performing group was funds that held general US Treasuries, which was up about 3%. To put this calendar week in perspective, one stock, T Rowe Price (NASDAQ: TROW), perhaps the highest quality publicly traded mutual fund management company (and a personal and fund holding) ended the week at $50.99 after hitting a low of $47.32 and a high of $54.01. Another indicator of the fear in the market place is the VIX which measures the fear level surrounding the S&P 500. VIX is now about 45 compared to close 15 a few months ago.

IMPLICATIONS FOR INVESTORS

What this means to investors is that we are likely to see more swinging markets for there will be fewer swingers on the dance floor, another unintended consequence of government intervention.

What do you think?
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