Your Investment Gifts May Contain Good and Bad Surprises

Introduction

At this season of both sacred holidays and financial year-ends, we receive wrapped packages. Often we can guess what is in the package by its shape and/or wrappings, others are a mystery. When we closely examine the financial packages, some have surprises within them that will affect our portfolios in 2012 and beyond.

Byron Wien, my good friend and former fellow board member of the New York Society of Security Analysts, is world famous for his list of the surprises he sees for the forthcoming year. Over time, he has an above-average record. Often when he is right in some unexpected event, the returns are high; when he is wrong, not much damage is caused because most investors did not have the same expectations. On the basis that imitation is the sincerest form of flattery, I have hereby prepared my list of investment surprises, published a week before Byron’s. My list is more of an evergreen list than his, and I do not expect to have his winning average. The main purpose of my list of surprises is not to demonstrate my predictive talents, but to develop a list of items that sound investors should periodically review with their portfolios and business plans in mind. Because of my responsibilities for fiduciary accounts, the list generated contains more possible negatives than positives. Further, in the current market environment, it is easier to think about what can go wrong than right; which is probably another indicator that we will see the commencement of a significant upward move of global equity prices.

Surprise: The big money bets can go wrong

The history of huge collapses of market bubbles is that over time the remaining intact assets gravitate to new/different asset classes, often seeming to be more secure. In order to constrain the air coming out of the “Dot Com” bubble, the Fed and other government and non-government leaders became advocates and enablers in throwing money into residential real estate. We all know the results of this over-bet. By the middle of the last decade there were all the classic signs of over-investment by governments, financial institutions, and individuals. Five years later we are still dealing with the buried and yet-to-be buried corpses of this over-investment in supposedly “safe” assets. Where did the money that survived the residential housing collapse go?

The flight to perceived “quality” and safety has led to a situation where the only commodity that is now up in price is the US dollar. This is after the one credit rating agency broke its strangle hold on the highest credit rating, AAA. The other credit raters have not yet followed. If one looks carefully at the US, we still have no substantial effort to materially reduce our deficit production policies. At best, there is an attempt to hold the deficits back, but eventual rises in interest rates and almost guaranteed new overseas military-like commitments suggest that the existing budget plans from both sides of the aisle are naïve. A realistic assessment of our willingness to pay down our debts in “real” terms is no better than mid-to-low investment grade, only scoring that high because of a lot of valuable assets that could be sold. Eventually some of the other major countries of the world will make progress at their own deficits and could become “safe haven” currencies to absorb those dollars that need to be diversified, thus resulting in the price of the dollar going down and dollar yields going up. My contrarian conviction in this possibility was recently strengthened when the CEO of an investment bank was quoted as saying that the US Treasuries are the safest investment in the world. Extreme positions seldom work out over time. A number of Asian countries are agreeing with China to settle trade accounts in yuan rather than dollars; five years from now this could be a significant amount. Currently the only too-strong currency is the Japanese yen. At some point, investors may feel the need to view these two Asian currencies as additional “safe havens.”

The analyst’s nightmare surprise: bad numbers

As an analyst I will never be totally satisfied with the amount of numbers that I have. Part of this skepticism is that we must remember no numbers exist in and of itself in nature. Numbers are an abstraction of someone’s perception of reality. More numbers give me different slices of reality, which may reinforce the initial set of numbers or qualify the applications that the numbers can be used. For some, published numbers by governments, corporations, trade associations and even the specialized press are everything. These are the only actors on the stage of security prices. From experience, however, some of us believe that while numbers are important, they are not all important. In the end, qualitative factors can trump numbers at key junctions in terms of profitable decisions. All of these thoughts are based on the general belief that the numbers are being produced honestly.

For those who want to look, any history of mankind has to reveal that intellectual, spiritual and monetary fraud is a common occurrence. Too many people ask me whether Madoff and perhaps MF Global are the last of the frauds. They want to be assured that all the bad actors have been exposed. This is silly. I am afraid that every single day someone someplace is doctoring results to give a good impression. Most of the time these perpetrators are caught, with relatively minimal damage to most people except the historians. The historians suffer because the fudged numbers are not often replaced with the correct numbers. Thus all too often, the so-called “lessons of history” are based on incomplete facts, with potential damage to all of those that extrapolate from the past. All of this is to alert investors that there will be frauds in the future. The painful ones happen when investors have all or most of their money bet on certain numbers by a trend or manager. The only way I know to defend against such risk of loss of capital is to diversify into different investment approaches that don’t intersect through the same general numbers.

The portfolio managers’ nightmare surprise: hedging creates risk

Many investors and their managers wish to avoid volatility, rather than take advantage of it, or perhaps even better, ignoring it. One of the more popular methods of hedging today is through the use of Exchange Traded Funds (ETFs). The more advanced of these strategies is to use sector ETFs to counter-balance either individual securities or portfolio sectors. That would work well if the sector ETF chosen did truly represent the sector. In Saturday’s Barron’s, there was an advertisement for the nine sector ETFs titled SPDRs (Standard & Poor’s Depository Receipts), often called “Spiders” and managed by State Street Global Advisors (SSgA). The ad showed the percent of each Spider invested in each of the ten largest holdings in the sector. ETFs are often compared with actively managed mutual funds. By policy, most mutual funds do not invest 5% or more in any one stock. Applying the same screen to these sectors, one gets very different impressions as to the diversification in the ETF. For example in the Technology Spider, 47.91% was invested in the first six positions. In the materials Spider, 45.71% was invested in the top 5 positions. In the consumer Spider, the top 5 accounted for 45.04%, and in the Energy Spider, the top 3 were 39.71 %. Any one of these concentrated leaders can have specific risks or positives occur that are not representative of its larger sector. Thus, a gap will open up between the base that the portfolio manager was trying to protect and the hedging vehicle. This becomes important when the manager believes that he/she has reduced the total risk of loss, when that might not be the case. All too often we have seen investors unhappily surprised by these so-called safer vehicles, when the results were not what were expected. In general, I prefer to do my attempts at hedging in separate vehicles where I can track and attempt to understand what each side is doing.

The entrepreneur’s bad dream

With regulators regulating through press releases, aided a news media always hungry for bad news, each business person is fearful of reputational risk. A hard-earned reputation that has taken years (and in some cases centuries) to create can be tarnished or destroyed in a matter of a few days or even hours. Can an investor get ahead of this potential train wreck? No, but one can reduce the potential loss. One clue, particularly in a portfolio of “great companies,” is to cover the name and then look where the price/earnings ratio should be, based on the record. Then compare your theoretical P/E with the actual one. The difference is largely the size of the value that the market places on the firm’s reputation. One way to lessen the risk of sudden reputational loss is to have some preset limit in the portfolio of “great (recognized) companies.”

Surprise: Now, some good news

As regular readers of this blog know, I regularly visit The Mall at Short Hills, with its collection of glitzy stores many of which are part of European brands. Ruth and I visited the Mall on “Black Friday,” and were unimpressed at the shopping volume, as we were able to park easily and saw relatively few shoppers, most with only one or two bags. Today, Monday, is a work day for me, writing this blog and preparing for meetings later in the week. In the course of the day, I drove by the mall and had difficulty getting on to the adjacent highway; there were three jammed lanes trying to get into the mall and past the police that were restricting traffic. The lines to enter the mall were at least two miles long. My guess is that the crowd was not primarily returning unwanted presents, but attempting to buy advertised and unadvertised bargains. This certainly proves that at least some Americans will buy when they perceive value. In an article entitled “U.S. Stores Hope ‘Mega Monday’ Led to Brisk Sales,” Reuters reports that December 26 is expected to be the third-busiest sales day of 2011, trailing Black Friday and Friday, December 23, according to ShopperTrak, which measures retail and mall foot traffic.

Technological breakthrough Surprises

As some of you might know, one of my early roles in the investment world was that of an electronics analyst. Building on that experience and my exposure as a Trustee of the California Institute of Technology (Caltech), I always expect some wonderful new products and services will be introduced to our commercial world. I do not believe 2012 and beyond will be an exception. At one end of the extreme, the truly exceptional items will come from small developers, increasingly located outside of the US. They are the equivalent of the garages that spawned Hewlett-Packard and Apple. At the other end of the spectrum, advancements will come from giant companies with established research and development groups and facilities. The surprise coming from these large groups will be products and services that they were not looking to produce. The potential of this accidental re-purposing can be very large and happen at any time.

The new high: certain, but when?

Despite various twists and turns, any study of history and particularly of human development, leads one to expect progress to benefit many. When will this be translated into tradable market prices? I don’t know. We have been told history does not repeat itself exactly, but it does rhyme. The last reference is to indicate that there will be some similarity of the past stanzas to the new ones. From my technical analysis days of reading price and volume charts, I believe that we are in a long trading market that will unexpectedly either have an explosive rally or a sharp collapse. (These moves are often presaged by false moves, sometimes in the wrong ultimate direction.) From the time the Dow Jones Industrial Average hit one thousand points until it finally surpassed it in a meaningful way, it took sixteen years including a nasty bear market with periods of high inflation and deteriorating economics. Currently we are in the thirteenth year of another long, arduous trading market of reduced volume. As I am breathing optimist, I believe that when we do breakout we could see a substantial upside. If we measure the movement from 1983 to the current high, one can make the case of a 13-14 times gain with rising volume. With my financial services individual securities fund and my portfolios of other funds, I certainly hope this is the case.

What are the surprises you expect, both on the up and down-sides?
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The Fork in the Road to your Investment Policies

The fork to the left is pinpointed by real world observations, the fork to the right deals with possible negatives.

As many of the members of this blog community know, one of my critical investment laboratories is Ruth’s and my walks through The Mall at Short Hills. For those of the community who are not familiar with our annual rite, the day and the weekend after Thanksgiving each year find us at this very upscale mall looking at the size and intensity of the crowd as well as the number of labeled shopping bags they are carrying. Another clue to the robustness of the Holiday sales is how far away we have to park compared to our normal spot.

POSITIVE SIGN: HIGH-END SHOPPING

We have just returned from a visit to the mall on a very pleasant sunny Sunday. We had to go to the less convenient level to find a parking place. There were more than the normal numbers of intense shoppers, not walkers. The Apple store (NASDAQ: AAPL) in particular looked busy and the Verizon store (NYSE: VZ) appeared to have a good crowd within. In the past I have commented on the depressing number of vacant store sites. Today there are fewer vacancies and there are a number of large stores advertising their future openings and upscale merchandise. Bottom line: people were buying, merchants were expanding, and mall operators were showing signs of success in filling their sites (perhaps at discounted leases).

RESIDENTIAL REAL ESTATE

In this part of the country, dinners and cocktail parties' participants spend some time on our “local sport.” To my grandson’s dismay, this is not soccer but residential real estate. Increasingly we are hearing about bids being hit or exceeded, but with contingencies for mortgages or prior sale of the buyers’ current homes. Months ago there were little or no such conversations.

INVESTMENT IMPLICATIONS

The investment implications of this left fork are that the economy is in a state of uneven recovery and some hope has returned. From a portfolio standpoint, investment in depressed consumer discretionary items as well as some ties to home improvements appears to make sense. These moves are based on the return some form of normality, even if it’s the “new normal” of lower returns.

SOBERING SIGNS FROM EUROPE

The right fork is more difficult to elucidate. Last week one of the questions that my blog dealt with was, "Why didn’t a number of investors jump in at what appeared to be bargain prices?" As mentioned, sharp market movements in retrospect often are found to be inflection points, marking changes of direction in investment thinking. The immediate concern in the first week of May was the clumsy way the European Community was dealing with the Greek problems. The bounce-back sustained in this past week focused on multi-tiered funding approaches by the EC and the IMF. There were some austerity measures announced for Greece, Portugal, Spain and Ireland. I suspect that these will not be sufficient in the long run. At this point a much bigger potential funding deficit in Italy is not being publicly addressed. A number of commentators have compared the deficit tracks of Greece and the US, which is sobering. What has one concerned is the pattern of governments to socialize, if not nationalize, what in the past has been private responsibilities. As families became clans, then tribes and morphed into nations, the primary need assigned to government was defense from without.

GOVERNMENT SERVICES OR PRIVATE JOBS?

To pay for services by government, taxes were introduced which led to government sponsored coinage and building roads. Over time, provisions for education and retirement became government obligation in some societies. In Europe and now in the US, the provision of health care is being socialized. What is not written in our, or other countries’ constitutions, is the creation and preservation of jobs.

Almost inevitably when a service that has been or could be provided by the private sector is turned over to the government, inefficiency and corruption occur at some levels. These are additional transfers from the private sector to the public sector, not dissimilar to declared taxes. There are differences caused by these inefficiencies and corruptions which build rigidities into the economic systems. Over time these elements act as an additional tax on the provision of these services to the community. Countries, states and cities with higher net effective tax will inevitably lose economic opportunities and therefore jobs to more efficient locations.

MANAGING EXPECTATIONS

Are the problems of just about every country which borders the Mediterranean akin to a flock of canaries in the mine? Did some investors perceive the problem without seeing any significant attempt to structurally reform our own economy? If that is their growing perception, they should start to discount more heavily what they expect to be normalized or peak recovery earnings. In other words, do stocks in the future, not have the same potential capital appreciation that they delivered to us in the past century? (Not counting the last ten years of little to no real growth.)

MY OUTLOOK

For those that are looking down the right fork, they should consider using significant recovery rallies, including new highs, as selling opportunities. As long term bonds are already unattractive in terms of income and inflation, they are unlikely to be a long term attractive alternative for equity money freed from the domestic market. What is worthwhile, starting today, is the search for governments that are being more responsible to their citizens and investors. Those that are doing so today are more likely to continue to do so rather than the countries that recover from too much government spending.

The choice of which fork is up to you and for awhile one could attempt to do both, but that will require an alert investment manager. Keep us informed.

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