Are We Safer?

Introduction

Some people consider me an expert, thus I get lots of investment questions. Usually I can divide the questions and therefore the answers by identifying the depth of investment knowledge and experience of those asking the questions. I find it useful to divide those asking the questions into three broad groups with lots of sub-divisions.

The first group, are often the managers of the funds we choose to consider for investment.

The second group are people who devote little time and effort into financial and investment matters; e.g., the general public.

The third  group includes gatekeepers or members of investment committees mixed with pros and others.  In many ways this is the most difficult group; those who pose as members of the first group, but in their heart of hearts, they are much more like the public that watch general news or read mass publications.  Thus, when I get a question from this third group, looking for a simplistic answer, I don’t know where to start other than saying most specifically ‘No’ or in less than polite society ‘H… No!’ This is followed, if they are really interested, in a discussion of human nature and doses of history and why they are vital investment considerations.

Safe for whom?

Governments pass laws and regulations to promote their own safety and to prevent themselves from being turned out gently or violently by the abused public. If you examine almost all prudential regulations, they are designed to avoid criticism of the regulators. Little or no real efforts are made to help investors to either make good investments or to at least avoid bad exit investments. Bottom line: Gains and losses are the product of human behavior, driven by greed, fear and sloppiness with an accelerator of leverage thrown in to shorten the terminal period. This is the way it has always been and probably always will be.

A historical example

Jason Zweig who is a columnist at The Wall Street Journal, but in reality is a history scholar, mentions in his weekend piece that some 4000 years ago in Mesopotamia there were legal regulations as to future contracts on silver and barley. (I wished I had read them when I tried to take advantage of the apparent mismatch between London Silver and US Treasuries on light margin.) At one of the cradles of our culture, there was an attempt to keep the trading businesses thriving to prevent the losers from destroying the winners and the government. Thus a pattern was ignited that has been repeated by many societies all over the world to “keep the game going.”

A current and controversial example

When a large number of employees who normally vote with their powerful and high spending unions could have lost their high-paying jobs due to mistakes made by management, politicians and unions, it was decided to bailout GM and Chrysler rather than let them go through what private companies would do (an orderly bankruptcy). The US government loaned these and other companies taxpayer money through a pre-packaged bankruptcy that ignored the priorities in the Bankruptcy Act.

Because of this bailout attitude, the government followed a similar practice with the US banking system and at least one large insurance company. These bailouts ignored the history that after similar bankruptcies in the past, new organizations sprung up employing many of the former mid to low level employees at market rates. High priority lenders received reasonable payments, lower credit borrowers or vendors much less and for all practical purposes the equity owners were usually wiped out.

Quite properly voters were incensed by the spending of their money in a way not intended at the time when they voted for President and members of Congress. To prevent future criticism the two administrations and Congress felt they were trapped by “too big to fail” financial institutions. In practice, these politicians followed the old Pentagon approach of planning for the future by fighting the last war brilliantly.

Notice the current US Administration and its immediate predecessor were repeating the failed strategy of the Mesopotamian rulers of protecting the government from criticism, not preventing management and investor mistakes. Today all are free to produce below-market quality products at over-priced levels with inadequate research just as investors are free to hide from their long-term investment responsibilities until the next series of crises. Based on history they are almost guaranteed to occur.

Where are we?

As we entered this year I stated that the odds involved a 20% or greater movement of price. That is either a gain of 20% or a loss of 20% or possibly in an extremely volatile year, both. This is a year that superior tactical skills will be needed for the first two of our Timespan L Portfolios™  of operational needs and replenishment capital. These portfolios should have largely, if not exclusively, easily sold or redeemed securities (funds) because prices are likely to offer more than normal risks and opportunities.

Where am I looking?

I am first looking to sense the amount of investor enthusiasm that is present. There are always some isolated pockets of extreme enthusiasm and desperation. A great deal of enthusiasm will be needed to generate my 20% gains. (Also, this level is needed to create a top from which a major collapse can occur. ) An example of this is the recent price of Tesla which at one point was selling just shy of ½ the value of General Motors. Tesla produces about 90 cars a day. GM makes about 90 cars every five minutes. On a full accounting basis it appears that it will be some time before Tesla can report a regular profit. What is important is that some people are willing to project way beyond 2020 when Tesla is expected to break even and begin to show exponential growth. It has believers. (As they say at the track and in politics, I don’t have a horse in the race either as an owner of either Tesla or GM cars or shares.)  

By the way: Tesla's innovative manufacturing can be viewed in this clip. 

I am searching for a similar level of enthusiasm for other investments in the years ahead. Possibly I might get sucked into investments falling for the greater-fool-theory trap and hope that I will be able to execute a separation in time. Greater volatility is expected; e.g., on Tuesday the Dow Jones industrial Average moved 424 points.

Since for the first time in many years the market had five consecutive days of losses, I am looking for proverbial canaries in a mine that can signal potential elements of strain. One such item is a much larger than normal decline in the Barron’s Confidence Index of the yields of high grade bonds versus intermediate bonds. The index dropped almost 3 percentage points this week when normally it moves 1 percentage point or less. While it could be a warning because both yields declined (greater popularity), the best grade declined more, 22 vs. 12 basis points. Are the bond mavens becoming worried about intermediate quality paper? These are not the energy-related high yield plays.

As strange as it may seem to most readers, I wonder whether there is a message in the price of gold. If you accept gold as a quasi currency in 2014, it was the second strongest major currency. Even before the Swiss National Bank move, investors have been flowing into Treasuries and Gold. Will these fearful investors prove to be ahead of the crowd?

Question of the Week: What are the signals that you are currently using? Please share with me (not for publication or attribution).

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Copyright © 2008 - 2015

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

Enjoy Enthusiasm Now, but Not for Too Long

Introduction

All of us want the stock market to rise, particularly the ones that our clients and we own; that is unless we are net short or have a disproportionate portion in cash. While Mae West, the burlesque queen said too much of a good thing is wonderful, wiser advisers have suggested that people should be careful for what they wish. A number of commentators have said that the current rise in the stock market is the least loved bull market in memory. It is unquestionably lacking enthusiasm.

I agree that on the surface the general public is not enthusiastic about the stock market. Market peaks are characterized by great bouts of market enthusiasm. Previously, I commuted into Manhattan from the suburbs with an individual in a well paying position who one day announced that he quit his job and would be sitting at home and would be day trading one particular dot-com stock which he said would provide him a handsome wage. His financial fate and those of his kind are well known. Others have described similar historical periods as the madness of crowds. I suggest that most important peaks are so characterized.

Up, Up and Away

Regular readers of these posts are aware that while I believe that we are, for the moment, in a melt up, I am concerned that the next eventual decline could be severe if selected market prices rise in the short-term in a parabolic fashion (1>2>4>8>16). Managers of long-term funds producing rates of return 2-3 times the normal (ten year rates of return) will be fired in favor of mysterious managers producing gains, at least in the short term of 5-10 times normal rates. When these “hot hand” managers no longer deliver they and much that they invest in will plummet.

Breakthrough handles

 There is considerable enthusiasm today within the professional and pseudo professional communities as we have pierced various prior statistical barriers. In previous posts I discussed the term “handles” used by the news media to describe various breakthrough price levels expressed in round numbers. The three big handles recently touted and their handles were the S&P500 (2000), Berkshire Hathaway^* ($200,000 for the “A” shares), and Apple^* ($100 on the 7/1 split shares). A fourth one may well be looming in Alibaba ($100).

^*Shares owned by a managed private fund or owned personally

Masking

The proper job of a professional investment manager and analyst is to look underneath the enthusiasm. There are elements that need to be understood and may be of concern in each case mentioned below.

S&P 500

The recent rise may be a function of an extreme amount of money being invested by institutions into ETFs tracking the index. Popularly it is believed that hedge funds and other aggressive investors are the main drivers. In the last week investors only redeemed net $0.6 Billion in domestically focused mutual funds, in the same week ETFs had net equity sales of $6 Billion of which $5.7 Billion went into the largest, S&P 500 ETF.

Berkshire Hathaway - $200,000

Unlike last year it is likely that Berkshire’s published book value and unpublished intrinsic value will rise more than the S&P 500, as it is already doing. Most equity oriented institutions are underweighted in the stock and some feel that they must catch up.

Apple - $100

While the stock is reacting positively to the various new product and service announcements, I believe the gently rising stock price is in part due to a massive buy back program. Ruth and I visited The Mall at Short Hills twice over the weekend to check out the lines not only at a massive Apple Store but also smaller, but still busy Verizon and AT&T stores. What impressed me in all of these stores was very sound and pleasant crowd control. They know what they are doing.

All four of my older personal Apple units have now been upgraded to the new iOS8 software and we are seeing already important improvements. From my particular point of view Apple is not an equipment producer and seller, but a creator of annuities which can probably go on long after the neat new products are no longer annual events.

Alibaba - $100

The high NYSE price on its opening day was $99.70 which could well set up the Alibaba $100 handle. There is enough which is not fully fathomed about the company as well as China that a highly volatile future is likely.

Contrarian Corner: Hedge Funds

There was a negative column on hedge funds in Sunday’s New York Times indicating that a very large California state government pension plan intends to exit some $4 billion dollars they have invested in hedge funds. I suggest that this may well be a clarion call for those sophisticated institutions and some individuals that have not invested in hedge funds to begin their hedge fund research in earnest.

The keys to understanding a hedge fund

Probably there is more misleading information about hedge funds than any other financial community topic. While there are services that track those funds that are willing to be tracked, people do not understand that hedge funds are not an asset class that has well defined rules and regulations. The key documents in the relationship with a hedge fund are the various agreements with the investors which are not necessarily the same for all investors. Because of the perceived profitability to the managers of hedge funds, they have attracted some of the best portfolio managers, analysts, traders, and sales people from both mutual funds and broker/dealers. The attraction has been too great! Thus the ability to distinguish one fund from another has narrowed. We are seeing a number of hedge funds retiring from competition either because they were not successful enough or they made too much money so their principals could retire from client-facing work.

The market environment has not been favorable to many of the past ways some hedge funds have made money. A number of funds in the last couple of years have underperformed, particularly when compared with market indices that were inappropriate measures. Using an average performance measure often gives an inaccurate picture of skills. For example, I was recently made aware of the three year cumulative performance of funds investing in India. Goldman Sachs^* came out on top with a gain of +19.1% and worst was -8.4% by a fund managed by Jupiter^*, taking a mean of 5.4% tells us nothing about the two extremes and more importantly as to how either will act in the future.

We may well be on the cusp of a new period where the skills of hedge funds could produce good results. First instead of a low interest rate environment, Moody’s^* believes that we are coming to an end of the period of cheap credit.  Already one of the measures that I look at daily is the average interest rate paid by banks on deposits which has gone from 0.38% to 0.42%, which indicates that banks are making loans above the rate they can earn leaving their money with the Fed.  This changing environment will introduce opportunities for significant rewards and risks particularly in the intelligent use of leverage. Notice in the discussion above the underlying elements of the market could be significant opportunities through more volatile markets. A retired very successful short seller tells me that profitable short selling is something of a lost art. In the aftermath of greater enthusiasm which will drive prices too high, the art form may resurface.

My thoughts are biased because I serve on a number of investment committees that have used hedge funds successfully in the past. Further, my private fund could be considered a hedge fund, because we can sell short. We haven’t done so in many years as we thought there was, in general, more to gain on the upside than on the downside.

How to play in an enthusiastic arena

As most of you are aware we recommend the use of Time Span Portfolios (Operational, Replenishment, Endowment, and Legacy). The portfolios that have time horizons of five years or less need to be able to use the expected volatility to their advantage or at least to avoid major losses. The longer term portfolios should be conscious that from time to time there may well be attractive bargains available.     

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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.

The Need to BUY Now

Introduction

I have a belief that for the moment we are in a melt up phase which is short of the type of parabolic explosion that signifies a generational top. Further, I believe that in general we have moved from a fairly valued stock market and are on the way toward a fully valued market. Thus, I have been focusing on reducing the opportunities to take large risks of losing substantial capital. I have not, however, devoted as much space in these posts to all the different types of risks there are out there. The quotable Howard Marks of Oaktree Capital, a long-time user of our performance data, has produced another one of his great letters where he has enumerated 24 risks which show the breadth of ways to lose significant chunks of capital.

Nevertheless, a number of professional investment managers feel compelled to buy some positions now. Some may be sensing a “bandwagon” surge on the part of their clients to more fully participate in the melt up. Others have picked up my view to look for unconventional investments. Still others have devoted too much effort on avoiding losses over the years and now need some new winners. These feelings need to be corralled under a term similar to the one that earlier drove investors into the market which was TINA (“There Is No Alternative”) to assuming risk and enter the market. The new term suggested by Howard Marks is FOMO (“Fear of Missing Out”).

A buy a day

I believe that on any given day that there is a security someplace in this world that represents a real bargain. However, to paraphrase Jason Zweig’s excellent interview with Charlie Munger in this weekend’s The Wall Street Journal, one must recognize the extent of one’s circle of competence and not stray beyond it. Further, Mr. Munger has said that patience is needed. He has gone through a period of years without adding a new name to his roster of investments. Charlie’s innate wisdom may be greater than mine, but I am willing to suggest areas that professional investors should examine as long as they are within their own circle of competence.

Framework for seeking new names

My preferred search procedure rests on my introduced Lipper Time Span Portfolio concept. This concept rests on four independent portfolios which may contain funds or individual securities. The four time spans are the Operational Portfolio to provide the next two years of funding. The Replenishment Portfolio which is designed to renew the funding capability of the Operational Portfolio within five or so years. The Endowment Portfolio is to cover the currently identified longer-term needs of the major beneficiaries. The fourth and ultimate portfolio is the Legacy Portfolio which is to produce capital for spending beyond the grantor or initial investor. Typically the Endowment Portfolio is to cover a time span of more than ten years or beyond the competence of the existing investing decision makers; while the Legacy Portfolio, if desired and well managed could be, in effect, a perpetual portfolio.

With the time spans in mind, I find it useful to make some general predictions of the currently likely investment environments in each of the four time spans recognizing the old quote of “Humans Plan and God Laughs.”

At this point in time I believe that the Operational Portfolio will struggle with below historic interest rates which at very best may reach double current rates.

The Replenishment Portfolio should expect at least one major market melt down of at least of 25% and if the current melt up goes parabolic, 50% or possibly more.

Assuming that the market is in a form of recovery by the time the Replenishment Portfolio has done its job, the Endowment Portfolio should be moving up in a cyclical fashion over its life, averaging an inflation adjusted return on equity for stocks and a “real” rate of return similar to returns on capital employed by the general economy. The Legacy Portfolio will largely be driven by the disruptive forces unleashed by technological and sociological changes.

While I would prefer to focus on the longer-term portfolios, my investment management friends and I need to perform well with the first two portfolios or we won’t be given the opportunity to direct the two other portfolios.

Looking for short-term winners

If we were in “normal” times with interest rates tied to credit concerns and inflation, high quality short-term paper would be earning in the 4-5% range which could easily acquit the funding requirement. The so-called riskless investment in US Treasuries can’t do it. My suggestion is to research within your circle of competence the following unconventional thoughts:

1.     In August there were a number of currencies which gained 1% which could be of interest; Norwegian Krone +1.42%, Malaysian Ringget + 1.39%, South Korean Won +1.37%, Brazilian Real +1.24%, and Mexican Peso +1.01%.

2.     Very selected Commodities; Cotton +5.89%, Natural Gas +4.75%, and Aluminum +4.74%, all for the month of August. I would not recommend Livestock +11.45% gain year-to-date or shorting its corollary, Grains -11.28% year-to-date.

3.     Not immediately but in time, one should also select, high quality municipal bonds which are likely see their interest rates go up when newly issued. The banking authorities have ruled that these issues can no longer be counted as High Quality Liquid Assets (HQLA) for bank reserves' calculations. Combine this news and the fact that banks are being forced to cut back on their trading desk’s Muni positions. This means that there will be fewer buyers of this paper particularly at a time that the US needs to dramatically improve its physical and educational infrastructure. Demand for financing will force interest rates up.

4.     Bank loans recently shunned because of fears of a recession may well be priced attractively if we are entering a slow down, not a recession.

Searches for the Replenishment Portfolio

The next five years or so are likely to be difficult for portfolio managers. The melt up momentum will drive a lot of stock prices higher, but one needs to be careful with some biotech and new small companies being priced generously. Focusing on firms which are spending their excess funds wisely to build competitive advantages might be prudent.

Because we believe in the rising capabilities found in many emerging markets we have a number of investments in these kinds of funds for our Endowment and Legacy Portfolios, but I would not be adding them into the Replenishment Portfolio now as these stocks have led in seven of the last ten and half years.  Most of the flows into this sector come from institutionally-driven ETFs (Exchange Traded Funds) which added $3.5 billion in August compared to the much larger and more conservative mutual funds which added only $1.8 billion. Our financial services private fund is doing better recently by not being burdened by deposit-oriented banks.

Question of the week

Where are you finding stocks to buy for the short term (five years)?

__________

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.