Paranoid? Compartmentalize.

Introduction

If you don’t know how to get some place, it is useful to know where you are. To be a successful investor over time, it is wise to guess whether you are early or late and which cycle are you playing.

Various commentators have described the current market in terms of “risk on.” The preponderance of those who are active participants are accepting more market risk as indicated through their buy orders.  There is substantial data to broadly support this view. While the popular stock market indices have been rising on relatively light reported volume, elements of both the bond markets and the commodity markets are showing significant strength. Non-energy related commodity prices are now showing mid single digit gains on a year to date basis which is also being translated into gains for many emerging market stocks. Commodities and emerging market stocks are normally viewed as more risky than general stock markets.

If one believes that in today’s environment institutional traders of all sorts see investing in high quality bonds in some form of a “carry trade” is another way to play a “risk on” game. In the past week an usually large amount of money has been invested through mutual funds and more significantly ETFs in high grade fixed income pools. This was not the case in high yield, lower quality securities as can be seen in the changes in their weekly yields. According to Barron’s, an index of high quality bond yields dropped to 3.42% from 3.58% the week before as distinct from intermediate quality bond yields slightly rising to 5.12% from 5.10%. The magazine believes the ratio between the best bond yields and the intermediate bonds is a good predictor of future stock market progress. This week the ratio was 66.8 vs. 70.2 last week and 75 a year before. Most of the time this confidence index moves less than one percentage point per week. A move of 3.4 is a dramatic indication of surging demand pushing high quality yields lower. A symptom of taking on more risk for investors is that Ireland can sell a century bond that follows a similar Mexican 100 year bond.

Clearly we have entered a “risk on” stage. The critical question for both the participants and those on the sidelines but with cash to spend is, “Does this move make me early or late?”  I am aware that my old friend Ralph Acampora, who worked with me on the board of the New York Society of Security Analysts, and who is the father of modern market analysis, has told clients that the correction phase is over. He believes that we have started a new market cycle. Thus he is in the camp of analysts who believe the current move is early in the cycle. He may be right as he has a good batting average on market calls.

One of my concerns is that many companies have become much more efficient in their human capital deployment. They have hired slowly and have used both technology and their external supply chains to keep their active employment costs low, particularly now in the face of rising healthcare costs. This works well in a flat to rising economy. This does not work well even in a modestly declining economy. 

I study the financial services business more intently than other businesses. One of the reasons many of these stocks did poorly in the first six weeks of 2016 was when revenues fell a little they did not have enough people to lay off to keep operating income flat. In one case the quarterly revenues of an important component of a financial services firm fell 3% and operating income fell 21%. In another case revenues fell one tenth of one percent and operating margins fell one percentage point. My concern is if we go into a stagnation phase, many managements will need to make draconian moves to generate cash to meet domestic debt service requirements. The current “risk on” attitude is not reflected in the stock prices of some managements that are unprepared for stagnation.

What to Do?

I rely on my approach of timespan diversification as captured in the Timespan L Portfolios^®. The biggest risk of not producing sufficient funding for current spending is in the shortest term Operational Portfolio. In this case if we see a quick reversal to a “risk off” attitude there can be a significant loss in prices before the next up cycle. Thus, as I have written previously, the operator of a short-term portfolio (and that includes many managers who can not tolerate under-performance for a single or even two years) should set up scaled orders to reduce the risk of disappointment on the way up.

Currently I do not see a significant risk in the longer term portfolios in the Timespan suite, now. The key word in the last sentence is “now.” At the moment most of the “risk on” players are confining their trades to the high quality portions of the market. Based on over fifty years of experience following the various markets I am on the alert for a switch in momentum from high quality to low quality in stocks, bonds, and commodities. Experience shows at sometime, (usually after a significant price rise) high quality issues disappoint and momentum shifts to lower quality. At that point some will remind us that over many long periods, low quality securities have better long-term performance than high quality. Not that they are superior vehicles, but that their entry points are significantly lower than when most investors invest in high quality paper.

The Key to Long-Term Investment Success

The critical key to long-term investment success is not primarily in security selection. The key is how to manage the investor. My approach is to break down or sub-divide  problems into bite size pieces. In effect what I am suggesting is to use compartmentalization to control the natural paranoia facing declining markets. Under this approach instead of using an overall asset allocation schedule, I let the assignment of funding needs dictate individual timespan portfolio compositions, accepting that most of the time the longer maturity portfolios will be consigned to “risk on” structures.

There may be help coming along the way. A recent paper produced by post doctoral students at Caltech and the University of Melbourne is studying contagion or the tendency of people to stampede into making hasty and often unhappy decisions. What they found was people are more likely to become victims of contagion if they have recently (directly or perhaps indirectly) experienced similar contagions in the past.

We should equip people with enough historical knowledge to know that those who participate in a stampede are likely to be trampled and investors improve their odds of survival with a more patient attitude on picking when to dismount the tiger that they are riding.

Question of the week: Where are we? 

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A. Michael Lipper, C.F.A.,
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Special Bulletin

Before we posted our normal Sunday thoughts below, we received an email from London stating that Ralph Acampora is now looking for a 23% correction. To me this is an important message.

Ralph Acampora is in my opinion and others, the Dean of Technical Analysts. He has taught courses all over the world on the use of charts and other quantitative data to predict price movements of stocks and markets. He has help found market analysts groups in many places and helped to develop their own qualifying exams.

Ralph has been a bull on the US market since 2009 and this is the first that I have heard of his turning bearish. Not only is he a friend but I deeply respect his talents. Nevertheless, I need to put his warning into perspective. My study of market history has me prepared for a 25% decline from peak levels three times in any ten year period. Once a generation a 50% drop is normal. Our performance and those of others have produced in 2012 and for the first seven months of 2013 way above “normal” returns. Thus, some give back was likely before this. However, in the context of a long-term investor who invests conservatively without leverage, a decline of 23% is painful, but tolerable.

Asian markets

On this weekend of indecision in Washington and other capital cities, Bloomberg Television reports on Sunday evening that the Asian markets do not appear to be negatively reacting in terms of currencies or stock prices. 

The next ten days could prove the old Chinese curse “May you live in interesting times.”

And now back to the statistical Ranch of my normal post……

Wrong messages from fund flows

All too often various published and internal pundits quote the size and direction of mutual fund net fund flow data as having some predictive power of future market directions. If they only took more time and analysis they might get some more useful insights. Both my former firm, Lipper Inc., and the Investment Company Institute (ICI) as well as some others regularly report on actual or estimated fund flows. While we get monthly data as an associate member of the ICI, much of the trade association's public release is also printed in Barron's magazine.

The analysis is time-period dependent

After the sluggishness of August one tends to forget the sharp recovery in July from June's disappointing results. In terms of mutual fund net flows, itself a mixed metaphor for investors’ drives, July saw a net positive flow of $19 billion over June's net redemption of $26 billion. Few if any pundits mentioned that the July gain in 2013 was less than the $28 billion in July of 2012. "Is the glass half full or half empty?" The answer depends on your bias. Yes, there was a swing of $45 billion from net redemptions to net sales, but the July 2013 net sales were behind $19 vs. $28 billion a year earlier. I suggest that looking at the next level down as to flows into various investment objectives shows a considerably more speculative attitude on the part of fund investors. For the most part speculators are much more short-term oriented than long-term investors.

Leading investment objective net flows

Comparing June 2013 to July 2013 and focusing on the $45 billion swing to net sales from net redemptions, the following investment objective activity caught my eye:

• The largest contributor was the retirement favorite of Growth & Income: $12 B.  
• The next biggest swing was the insistent search for yield, Strategic Income:  $11B. 
• Next was the retail favorite, Growth funds: $11B.
• Seeking price protection were Short-term Corporate Bond funds:  $8B.
• Finally, Aggressive Growth funds: $6B.

These groups represent the entire swing; while there were other contributors to net sales they were offset by a number of investment objectives which were increasingly in net redemptions. The key message that I get looking at these and other fund statistics is that the fund business is serving investors with very different needs and proclivities. The aggregate numbers are like population numbers, but not particularly helpful in setting sales strategies.


Channels show the business side of the story

I am starting with the proposition that in general, funds are sold not bought, which means there are forces beyond an investor’s desires that lead to a purchase of a fund or other investments. Today there are multiple ways to reach all investors who have the combination of needs and money. There is considerable overlap within these channels of distribution with individual investors being welcomed into formerly exclusively institutional products and services as well as the other way around. Many manufacturers and distributors of fund products are active in most channels. Nevertheless, the ICI, the trade association for the fund business attempts on the basis of surveys to allocate fund sales to a number of specific channels. In terms of the swing into net sales from a year ago one can look at the change in the levels of sales by channels.

• The biggest change in the month of July was in the institutional channel with net sales up $43B.
• Followed non-proprietary sales forces: $14B.  
• Direct Marketed funds: $10B.
• Proprietary Bank funds: $3B.

What these numbers suggest is that just as there are multiple of investment objectives attracting money, there are  a number of different ways money can flow into funds.

What does this mean to me as an investor?

As an example, to a car buyer the aggregate production and sales numbers for the automobile industry are of small importance. As a customer, you  are interested in the production schedule of the vehicle you want and within your range of comfort, also what are the locations that you can buy and service the car. However as an analyst, fund sales data can be very useful. Most investment management organizations manage funds alongside other accounts. These other accounts do not regularly publish performance or portfolio information. Thus, through intelligent analytical work on funds, one can see more of the institutional mind sets.

What do I see?

On this first day of September I see a strong desire for the world to become clearer both economically and politically. However, many investors no longer have the choice of sitting on the sidelines. They are in effect making the "risk on" bet by rearranging their fixed-income into both shorter-term maturities and employing money in more risky fashion. On the equity side while the bulk of money is invested in Growth plus Growth & Income oriented funds, they are increasingly adding to Aggressive Growth and less diversified Sector funds. There is a great deal of talk of trying to find European investments near their bottoms and some willingness to take a very long view on selected emerging and frontier markets. These various strategies may work out well, but they are not generating a lot of comfort. One caution is that I would separate the data on Exchange Traded Funds (ETFs) from that of the traditional mutual funds, which for the most part are being used by investors as a place for their money in terms of years. (The more the better.) In the last week, five out of the six securities that produced the most volume on the New York Stock Exchange were ETFs. I believe that most transactions in ETFs are for short-term purposes. Investors are using them to quickly modify their base long-term portfolios. It is these long-term portfolios that we manage for institutions and individuals.

Getting perspective

Future posts will reach you from London and Budapest. There are many investors there that have a lot they can teach me. Not only do they see things from a different prospective, but also they use securities differently because of their tax and other regulations. Hopefully I will return wiser.

How do you use mutual fund and ETF data?

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Did you miss Mike Lipper’s Blog last week?  Click here to read.

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 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.