Is There Enough Left on the Upside?

Introduction

One of the many necessary elements for a peak to occur is the belief that the current market rise will continue. This belief is nurtured by cheerleaders and there were two highly respected ones sharing their views with us this week. The first was in Mark Hulbert’s column, where Sam Eisenstadt, the former statistical genius of Value Line stated that he believes in the next six months the stock market will rise 8% as the leadership will shift to higher quality companies rather than the lower ones which have been the leaders. 

The second was an observation from U.S. Global Investors’ Investor Alert which quoted a study by BCA Research which examined the 30 years since 1870 when the market was up 25% or more. They found that in 23 years following the big gain that the market had an average gain of 12%. A number of Wall Street types are now hoping to split the difference and are looking for a 10% gain.

Is 8, 10, or 12% good enough?

On the one hand (as the economist would say) these gains are 2-4x the recovery high on the US Treasury 10 year note at just over the 3% yield achieved this Friday. On the other hand someone trained on using the odds of meaningful success would start to get cautious. Just five years ago the percentage decline in the market offered a potential recovery to the prior peak of 2-3x what is now being offered. This is not counting on going on to new highs. The question now is, are we about to enter Sir Isaac Newton’s “greater fool theory” trap? Remember he participated early in the run up of the infamous South Sea Bubble. He got out early, but got sucked back in when his friends were making more money faster than he did. When the bubble did break he lost all of his gains and more. What we have learned from the recent studies at Caltech is that some people don’t retreat when they sense danger, but stay involved believing that their sense of timing will take them out of danger. As I mentioned in prior posts, I learned about this as a junior analyst and it was called the greater fool theory. To believe that future big gains are possible after large gains are achieved does not show the level of caution that many successful long-term investors use.

I used to question why we researched bonds when I was studying Security Analysis at Columbia with Professor David Dodd.  The name of the class was the same as the title of the book that he co-wrote with Ben Graham. What became clear to them and reinforced in the recent mortgage market collapse beginning in 2005 and culminating in 2008, that at times the fixed-income markets are much more sensitive to credit conditions and therefore the eventual health of the economy than my fellow stock jockeys.

As mentioned above on Friday the ten year US Treasury bond’s yield rose to a psychologically important 3% from a low of 1.63%. This in turn caused bond prices to decline in absolute terms. I look at historic 10-year yields the following way:

• I view the normal yield for the ten year to be about 4%. 
• During abnormal times rates would be in the 6-8% range, which should meet the relatively few defined benefit pension funds' actuarial requirements.
• Under economically stressed periods one could see yields in the 9-12% range if not higher. 

The higher current yields would occur when there is greater demand for capital than what is immediately available, usually with both the private and public sectors needing money to meet their immediate and longer-term needs. We are currently far from these conditions now, but sound equity investors should be alert to credit conditions as both the private and public sectors are short of capital for long-term productive investments.

Is there too much asset allocation?

For far too long investment pundits and those who direct the construction of long-term portfolios have found comfort in diversification into many different asset classes; e.g., domestic stocks, international stocks, emerging market stocks and bonds and now stocks from frontier countries as well as similar fixed-income asset classes going from the most to the least secure. To these lists add private equity, commodities of different types, real estate, timber, and elements from the art worlds plus intellectual property. While not a separate asset class, hedge funds owning one or multiples of these classes are included in the array for diversified investing. Many of these types of investments have badly trailed the simple stock market and some for 2013 are likely to show negative results, such as commodities and volatility measures. I would suggest there are three lessons one should consider before deploying asset allocation.

The first is that in declining markets and particularly sharply declining markets, correlations will increase. Wherever there are pools of liquidity they will be drawn down. Assets that can be sold quickly will be. Second, when there are choices to be made and particularly in the early phases of a rally, selectivity will be important. Along with the skills of the selector it is important to understand the relative sizes of compensation of the intermediaries. Isn’t it strange the highly compensated products and intermediaries get the first mover advantage? The third clue (the most difficult one for those of us who are trained in complexity) is to keep the strategy simple where most of the time is spent on selectivity.  In his weekend column in The Wall Street Journal, Brent Arends quoted a study by Andrew Smithers, a well-known and highly respected British investment thinker, who in a study for the investment committee of a college at Cambridge University recommended that it should have only two asset classes, stocks and cash. Stocks could range from 60% to 100% based on the level of the market, utilizing some long-term ratios. In today’s world this simple but effective approach is making a lot of sense, at least until reset approaches coming off the next major bottom.

What is increasingly missing from our command structure?

As a US Marine Corps officer, we never really retire, we just change uniforms. Over the weekend I enjoyed an interview with Camille Paglia  where she is quoted as saying. “The entire elite class, now in finance, in politics and so on, none of them have military service, hardly anyone. These people don’t think in military ways. The politicians lack practical skills of analysis and construction.” She finds “no models of manhood except on Sports Radio.” (My friends at the National Football League and the NFL Players’ Association will be glad to hear that they are her models of manhood.) However, they are not alone seeing the benefits of military thinking, conditioning, focus, and street smarts for returning service men and women. Prudential Insurance and JP Morgan Chase are among the leaders in seeking out these returning heroes and heroines with job opportunities. I am guessing some of these people will rise to the top of our leading organizations. On a global basis the benefits of a well-spent military life could, and I believe should, give the US an advantage in our international competition. This alone may be a reason to be long-term bullish on America.

What are your thoughts?

Drop me a line.

I hope all of the members of this community will have a Healthy , Happy, and Prosperous 2014.     

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Misunderstanding Mutual Funds, Spain and Goldman Sachs

As an analyst for more than fifty years, I have learned that I will never have enough information to be completely secure in my investment judgments. On average, I receive over one hundred business or investment related emails daily, and in addition, I read numerous trade and general circulation publications. I must admit one of these publications is the New York Times which every now and then gets something right, and almost always has impact on some investors.

The mutual fund myth

Many people, including some who would call themselves sophisticated, knowledgeable investors have an image that the bulk of mutual fund investors are naïve and will buy any fund that has good performance and then jump to the next fund that has better performance. In the Sunday Business section of the New York Times, a statistical table of the fifteen largest mutual funds is published. I find this data particularly instructive, compared to the often exaggerated image of mutual fund buyers as “Ma and Pa Kettle.” First, none of the fifteen largest funds has total expense ratios over 1%, thus a large number of investors own some of the least expensive funds. In the long run, the low expenses provide a performance advantage over the average fund. What is even more instructive is the fund management families that make up the roster of the fifteen largest. Seven are managed by the American Funds group that relies on salespersons to raise assets. The next largest group is the four Vanguard funds, followed by two from Dodge & Cox and one each from Franklin Resource and Fidelity. Six of the funds have no sales charges and two have share classes that have different sales charges. I believe that at least half of the combined assets of these funds are from institutional investors and probably over half represent retirement money. For the most part, the shareholders in these funds maintain their ownership for longer than average holding periods (even though a number of these large funds have not produced “top of the charts” performance for many years). Yet, they fill the needs of their holders. In many cases they have normal redemption rates, as voluntary or involuntary retirements and health issues require funding. New sales are now probably largely sourced from various retirement plans. For some time, more dollars have been leaving than arriving in these coffers. This imbalance may be about to change.

In February, my old firm, Lipper Inc., estimated that $1 billion came into Large-Capitalization Growth funds, and another $700 million came into Multi-Cap Growth funds. (Multi-Cap is a classification for a fund that has assets in different levels of market capitalization. Often Large-Cap is the largest commitment, but not the dominant market-cap.) During February the more speculative group of investors often including hedge funds, put $6.9 billion in Sector Exchange Traded Funds (ETFs) and $5.1 billion in World Equity ETFs. If these speculators prove to be correct, I expect it will ignite the interest in Large-Cap funds.

A survey of international asset managers compared expectations for the US market in January compared to their expectations in December. In January, 62 managers expected a rise versus 53 in December. Only nine were looking for a decline.

Disclosures: Both my private financial services fund and I personally own shares in most mutual fund management company stocks, including one mentioned above. We own a large number of these management company stocks within the US, Canada and the UK as a way to understand our primary investments for clients in their underlying funds. A number of the funds in the largest funds table are owned in our client accounts. I have been annually advising one of these funds as to the appropriateness of the advisory fees since the late 1970s. I believe my multiple involvements with mutual funds and their managers make me a more informed and better analyst. The prices of mutual fund management stocks are leveraged to the market’s expectation as to their growth in assets, which normally leads to increased profit margins.

Other tea leaves

JP Morgan Private Bank has noted that the US Consumer Spending is the largest source of consumer sales in the world by region. However, the US is behind both Europe and Asia in terms of the level of gross investment, and is the only major region that is a net importer. Brazil, Japan and other countries are fighting what they see as competitive devaluations through QE or other interest rate repressions. Until the fears of induced inflation increase and the exhaustion of the excess corporate capital hoard occurs, we are not likely to see meaningfully higher interest rates. As US taxpayers, we should hope that rates remain low for the next ten years as the US is facing the largest single refinancing need of any country or region.

Sam Eisenstadt, the long-time statistical genius behind Value Line is once again expressing a precise bullish view as to the market into August, where he believes the S&P 500 will reach 1520. Market Hulbert translates this in MarketWatch to a DJIA of 14360.

Spain, and its somewhat kissing cousin California, are in deeper trouble than they appear to be on the surface. Both have more complex conditions than are initially apparent. Officially, Spanish sovereign debt is listed as $732 billion and 68.5% of GDP. However, if you add in the bank and other guaranteed debt plus the regional government debt, the total indebtedness rises to $1.1 trillion or 103 % of GDP. What makes this difficult to swallow on the part of the task masters in Germany, is that it is too similar to Ireland, where the biggest part of its debt was the Irish government’s assuming the local banks' real estate debt. The Spanish banks' commercial real estate loans are larger than similarly combined loans in Germany and the UK. (Just as we went to Asia to get a better understanding of China earlier this year, we are trying to plan a visit to Spain to get a view on the ground.)

The connection with California (which has a long tradition of Spanish investment) is that as the EU was being formed, I was urged to invest in Spain as it was ironically touted as the “New California,” providing low cost labor for Europe’s manufacturing needs. Spain would be home for a real estate explosion as the Europeans from less favorable climates would want to vacation and retire there. For awhile it worked, until the production of debts rose faster than income, similar to, you guessed it, California. To bring the parallel up to date, in the annual period ending in February 2012, California tax revenue fell 22.5% due to sharp declines in retail sales as well as use taxes and personal income taxes. A sunny climate is not sufficient to produce prosperity.

Goldman Sachs

Last week was “The Week that Was” for the firm. Too much has been written about the reactions to a disgruntled employee. Much of this verbiage is in the so-called “popular press,” as distinct from the professional or trade press. I do not want to add to the collection other than to make two points. First, many amateurs do not understand the concept of agency where an agent is working exclusively at the time for a client. On the other hand, a principal is involved on the opposite side of the trade. A couple of generations ago there were separate brokers (agents) and dealers. Over time, driven by economics, these two functions were combined in the same firm. Most of the time people, (whether they recognize it or not) deal with Goldman as a dealer not as an agent. Clearly both some clients and a small number of employees of the firm do not appreciate the distinction. The popular press does not. The second point I feel compelled to disclose is that we are no longer clearing through an affiliate of the firm, as we did not provide sufficient revenue to them, but this has no effect as to our long-term holding of Goldman Sachs.

Investment conclusion

Read as many tea leaves as you can. Look for deeper implications from factoids because they are often visible before the full picture becomes clear. As many of these thoughts are not without controversy I would like to hear from you.

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