The Most Dangerous Part of the Portfolio - Weekly Blog # 581

Mike Lipper’s Monday Morning Musings

The Most Dangerous Part of the Portfolio

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

Our portfolios are invested with our emotions, perhaps unconsciously. While we don’t label each investment, we probably assign each to a capital appreciation or capital preservation label. We are willing to take a relatively large risk of temporary or even permanent loss of capital for expected larger returns with our capital appreciation assets. Much less risk is assigned to our capital preservation assets and we don’t expect to take significant risks with those. (Future blogs will discuss the thinking behind this allocation.)

My concern is that some investors, lured by perceived history, are potentially taking unexpectedly larger risks with their capital preservation assets. If there were some material losses with any of these assets it might shake us up emotionally and cause us to question our whole investment philosophy and portfolio. With this shock to our investment system, it could cause us to retreat from investing at exactly the wrong time and cause us to fail to generate long-term capital growth for the entire investment portfolio. The rest of this blog is devoted to specific risks related to our capital preservation assets.

What We Don’t Know
If we are to be honest we could right volumes examining what we don’t know. For the sake of brevity I will highlight just three topics of what we don’t know:

• The timing and extent of the next major market decline?
• Where today’s fragmented data leads?
• When will interest rate risks be materially higher and under what conditions?

The reasons these are questions is that I don’t know the answers. The reason that they are important to identify are because they are critical to the prudent use of high-quality bonds and bond funds as capital preservation assets. In looking at these assets it is important to recognize some of the essential differences between debt and equity, which impacts how we use capital preservation assets. Major bond considerations are as follows:

• Bonds and credits have fixed maturities, with some variability due to call features.
• Some fixed income instruments fit specific needs and might be held to maturity.
• Bonds are primarily traded between dealers acting as both principals and agents, without a consolidated tape.
• There are some differences in both law and regulation between stocks and bonds.
• Governments, through both their treasury and central bank intermediaries, use bonds to transmit messages to the economy.

Investment decisions are based on both experience and current thinking. In reaching any decision, investors would be wise to listen to the words of the late, great, and former client Sir John Templeton and recently quoted Howard Marx, another former client. They said the four most dangerous words ever spoken are “this time it’s different”. Or, is this the wrong standard of probability? (Lessons can be learned from the racetrack too.)

What Does the Current Data Show?
The answer is mixed and one can choose to emphasize almost any piece of data for either the bullish or bearish side, as follows:

1. The year to date share volume on the New York Stock Exchange is down 39%. (Investors not exercised)
2. Three major stock indices have eclipsed their 65-day moving average.
3. The ETF weekly performance winners are sector bets.
4. 47 of the 72 prices of stocks, ETF, commodities and currencies are generally rising.
5. Deposit interest rates jumped this week to 0.75% from 0.72% for MMDA.
6. The Barron’s bond confidence indicator is only a little less favorable to the highest quality.
7. The total returns on the average High Yield bond fund has rotated around those of General US Treasury funds. (No convincing pattern year-to-date, but behind for five years)

Where’s the Risk?
The risk is in the belief of some bond holders who hold low risk securities on the assumption they won’t go down materially in price. What could go wrong? Bonds, most of the time, move in tandem with general interest rate moves. (Current interest rates are historically low and many think they will go even lower still. However, current rates are insufficient to cover a possible partial or complete default at a time when there is increasing need to roll over maturing debt. At the same time rates are below the needs of retirement accounts, which are facing greater demands from retirees living longer.)

In the UK, bond fund holders have suffered from the collapse of net asset values caused by a well-known “bond king”. In the US, in every decade we have had at least one formerly very successful leading bond manager fall materially. The repeated pattern is that the manager discovers a group of bonds or credits that are under appreciated in the market before they rise. The manager’s success brings in more money for him/her to manage at the very same time that the cheap bonds are bid up by other managers and competitors who were not previously aware of these “bargains”. In time the formerly “cheap” merchandise becomes “expensive”, often at roughly the same time there are problems with the issuer of the bonds. What was expected to be credit quality gains become credit quality losses, with some of the bonds suffering from the withdrawal of buyers. The pattern has been repeated since the age of Shakespeare’s “The Merchant of Venice”, as well as in numerous other markets. Thus, I have high confidence that it will happen again at a time and place to be determined. Part of today’s problem is that there are very few bond analysts and portfolio managers who were operating more than 35 years ago when the bond bull market began.

Two Worries
The first is that for the relatively small number bond holders, directly or through investment vehicles like mutual funds, they will withdraw from investing at the very point when there are more than the normal number of bargains available.

Markets around the world are synchronized across asset classes with a reasonably fixed level of liquidity and move to where they can get the highest risk assumed rate of return. Thus, it is possible that a large problem in one asset class in will drain other markets, at least temporarily.

I have done my fiduciary duty by warning you, but I hope I am wrong, although the odds will be on my side eventually.

Question of the Week:
What would you do if one or more of the bonds you hold drops 10% in a day?
   

      
Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/06/on-right-learning-from-left-weekly-blog.html

https://mikelipper.blogspot.com/2019/06/confidence-deteriorating-normally.html

https://mikelipper.blogspot.com/2019/05/memory-traps-judgement-weekly-blog-578.html



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Should Reputations Have a Sell Date? - Weekly Blog # 562

Mike Lipper’s Monday Morning Musings

Should Reputations Have a Sell Date?

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

                                                               

Remember, the way we make judgements is by comparing the new with our memories. Most of what we remember are the results and perhaps the broader conditions of the event. Thus, we remember that Peter Lynch, John Neff, and Sir John Templeton were great equity mutual fund managers. In the US this Sunday evening, many Americans and others around the world will watch the Super Bowl, which is the game in which we crown the best US football team for the year. For more than a few years my wife Ruth and I attended these games as part of our responsibility as investment adviser to the defined contribution plan of the National Football League and the NFL Players Association. Because the teams, players, and owners were all our indirect clients, we had to appear neutral. That is why when asked who we were cheering for, my answer was for the black and white team, the game officials. All I wanted was for them to be correct with their calls. Thus, I saw the game differently than a very large majority of the fans. My memory is of the close calls and the correct decisions, where the play needed to be looked at from a number of different angles. (One can easily see that I often view things differently than most.)

The reason to bring up the LIII Super Bowl this early Sunday morning is not to predict the results, but to use it as a guide in the selection of investment managers and mutual funds. Come what may, one of the key people or perhaps the most important player in today’s game is Tom Brady, the 41-year-old quarterback for the Patriots. I believe his first Super Bowl was in 2002. He has been playing this game longer than the majority of portfolio managers. Most winning managers keep on doing the same things that generated their winning season. What makes Tom Brady different is that he modified his game as he aged, as rules changed, and as competitors played differently. In other words, conditions change.

Recently, I was examining a very nicely performing portfolio of equity managers. The bulk of the long-term performance of this portfolio came from a subset of four quite different managers. In some ways this recognition introduced a new future risk element to the portfolio. All these positions had for a long time, not as long as Tom Brady’s, generated an above average record and their share of the overall portfolio has risen since the decision to add them to the portfolio. Clearly, these decisions had worked. But would they be as productive in the future as they were in the past? One of the lessons from working within the NFL environment was the recognition that on any given game day almost any team could beat another, as a result of conditions changing. This is the same lesson I learned in handicapping my bets at the New York racetracks. While it was comforting to bet on the horse that had the best record, it didn’t always produce a winning ticket. Thus, I became less reliant on winning streaks. For me to be comfortable betting on a good record, I had to believe that current conditions were very similar to those that produced past victories.

All too often in selecting managers or funds, almost all the attention is paid to a particular portfolio and its allocation, specific positions, and the portfolio manager. As someone that invests in publicly traded investment management stocks, I am conscious of the benefits and pressures that management organizations place on the manager and therefore the portfolio itself. The owners of the management company can earn money, not only from the investment performance of portfolios, but also from the sales and redemptions of all their vehicles. One of the symptoms of a prior good performer reducing its chances for future performance success is a significant increase of flows into the fund. Although this is generally recognized, all too often the concern is not extended to the management company itself. Political changes evolve along with the flows of money, impacting talent allocation. One of the parallels with Tom Brady and his Patriots team today, is that he is the only current player that was also on his first Super Bowl team. This means that the skills of his receivers and defense are different. This also happens more subtly within management organizations through aging, personnel turnover, and technology. Most importantly, the competition changes.

What lessons are learned from these concerns in the selection of good professional investors and mutual funds?

1. There is no certainty, successful investing is a series of art forms.
2. Many non-statistical factors should be considered that are perhaps more important than the current excessive focus on fees and investment performance rankings. 
3. What time period is to be used for measuring future success?
4. What is an acceptable comfort level for a permanent capital loss and the resulting sting of self or external criticism?

Where Are We Today?

1. We have enjoyed a wonderful month, the January Effect has worked so far, with an up first day, first week, and first month. Whether that will deliver an up year is yet to be determined. 
2. The gains achieved in January recovered a good portion of the losses sustained in the fourth quarter. 
3. What are the chances that we have a repeat of 2018, where a strong January was followed by a problematic February and a volatile year?
4. We will soon have completed a thirty-five-year bull market in bonds, where are the successful bond bear market managers? 
5. There has been an increase in the number of investment management company mergers and acquisitions. The sellers have a less optimistic view of the future than do the buyers. Talented people throughout the asset management industry need to be reassured that these changes will not affect them negatively, whether their companies are directly involved or not. Most importantly, these changes need to benefit investors for the industry to progress.

         

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/01/excessive-security-risks-weekly-blog-561.html

https://mikelipper.blogspot.com/2019/01/completion-analysis-fuller-picture.html

https://mikelipper.blogspot.com/2019/01/twtw-recognizing-capitulationrisk.html



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The Most Important Trade: Switching - Weekly Blog # 494

Introduction

Almost all investment advice is framed primarily as buy recommendations and to a lesser extent sell recommendations. For the sake of brevity and complexity these recommendations are at best incomplete and in many cases misleading. Even when we start with cash and expect our estates to be settled in cash, we are dealing with at least with a two-step process.

Cash

Nothing can be simpler than cash or it may seem so on the surface, but it is actually a series of decisions that can be a major influence on the ultimate performance of any other investment. The single most important characteristic of cash is that it has the burden of opportunity cost. The decisions to accept or reject the opportunity to make or lose nominal amounts of money is borne by one’s cash pile. In an inflationary environment any uninvested cash will see its purchasing power decline. If the central bank’s desire for 2% inflation is achieved on average for ten years, most of the current purchasing power of cash is wiped out. While there is a low probability that our custodians will disappear with our money, a few have done so in the past, thus there is risk entrusting our cash pile to any single custodian (and some may say in any one currency or location).

Asset Allocation Switches

Most asset allocation, after costs of the transaction including taxes, produces dollars that are moved from one asset to another. Even a move into or out of cash could be viewed as a time or possibly price allocation when one side is immediately executed and the other side is delayed until perceived conditions change. The opportunity cost of the delay should be assessed. Perhaps a long-term reasonable approach to this assessment is a figure between the inflation rate and a generalized accrual pension target of seven to eight percent. Bear in mind that the current fifty two week gain for the average general equity fund is 20% which is highly unlikely to continue. However, it does show that the size of opportunity cost is variable as well as cyclical.

Motivated Switches

Most switches are motivated by either a strong desire to buy or sell an investment and almost all the emotional attention is spent on that motivation. I want to own “X” or I must get out of “Y.” Far less attention is spent on the other side of the transaction, the funding vehicle or the receiver of the proceeds. When one thinks of the longer term impact of the transaction there is some chance that the less-desired part of the equation will be more important than the initiating desire. Remember any decision could be wrong both in terms order of magnitude and direction of any swap. This is not a clarion call to be passive and let market, economic, and political events dictate results. Just consider both sides of any transaction in making one’s decisions. One approach is a quote from my old data and consulting client Sir John Templeton when he said his transactions were motivated by choosing “better bargains.” This suggests a reasoned analysis of both what one owns and what one may want to own.

Portfolio Driven Switches

In truth most individuals and some institutions actually own a collection of investments that were chosen only for the attractions of the individual investments. One of the reasons that I use mutual funds for clients is that they get judged on how well the entire fund performs not any individual investments. The long-term compensation of the portfolio management team and the owners of the management company is based on how well they perform compared to their peers.

For the managers of portfolios, the weighted mix of investments is critical to the ultimate results. Today I see too many portfolios of institutions and individuals owning some or all of the ten most popular stocks. Unfortunately while they own the names of currently winning stocks, they own less of these names than they occupy in the popular market indices. Thus when the indices rise they are underweighted in the winners and so lose out to the market, which can be costly in terms of marketing to outer-directed investors. They get some relative benefit when the market goes down, but probably lose absolutely.

I am attracted to portfolios that pay attention to their total opportunity and risks. Many of these use cash or equivalents to partially de-risk portfolios. At times it may be difficult to assign all of the cash to de-risking as many funds that have an easily stampeded audience carry redemption reserves. (Unfortunately in rising markets reserves of all types hurt near-term performance.)

Another important factor to me is how much investment sensitivity to long-term currency risks is in my clients’ base currency (which is currently in US dollars). As there is practically no US investment that is not directly or indirectly at risk or benefit from the movement of the US dollar, this is an important consideration for me and my clients. There are numerous ways to address this opportunity and risk. One can own foreign currencies, own foreign securities that are primarily owned by local investors and multinationals that are themselves operating globally and measuring currency and other risks. The funds to avoid are those that are not paying attention to both the risks and opportunities.

Are We Approaching a Tipping Point?

Almost all professional investors and many sophisticated individual investors are thinking or obsessing about the next major decline that could begin in a day, by year-end, after the 2018 Congressional elections or the 2020 Presidential election. I will let others focus on the timing of a major decline. I have suggested that unless we see a great deal more enthusiasm for equities, the next decline looks to be in the “normal” variety of around 25%. A review of fund history and those of many individuals, shows there are very few investors that can sidestep a normal decline and recommit at lower prices and deliver an investment performance better than the majority that held through the round trip.

However, with this week’s focus on the 22.6% decline on October 19th 1987, it reminds me that thirty years has passed and beyond the normal decline there is a once in a generation (which is normally about twenty five years) a 50% market decline. Some may feel the 2007-2009 decline represents the needed 50% decline. Perhaps they are right, but I see enough similarities in both declines to put me on my watch.

My Watchlist

1.  Both declines started with fixed income markets weakening due to excess speculation. I am wondering whether we are seeing that in both the US Treasury market and the number of new credit funds being established.

2.   The infamous South Sea Bubble was created by almost universal belief in the forthcoming riches from Latin America. Today the fast growing asset classes are Emerging Equity and Emerging Debt Funds. Bear in mind some concerns about the existing Chinese debt structure and probable expansion as it attempts to build its “One Belt One Road Initiative.”

3.   Not the cause, but a primary accelerator of the 1987 collapse was the regulatory mismatch between Chicago and New York stock futures markets. Is there a potentially similar accelerator in ETFs and ETNs?

4.   There are twenty mutual fund investment objectives tracking the diversified, general equity market. On a year-to-date basis, five are performing better than the S&P500 funds, but in the last four weeks eight are performing better, with three of the Small Cap investment objective joining the leaders. Until very recently, the NASDAQ composite has been out-performing the larger cap markets. One can’t help to question whether this is a late stage speculative surge.

Bottom Line

Think through your allocation switches as to what you are buying and selling and also pay attention to parallels with history.  

__________

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A. Michael Lipper, CFA

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Selling, Risk, and Liquidity

Introduction

“Drive for show, but putt for dough” is an old expression on how to win at golf. The vast majority of investment advice is about buying securities that are expected to go up in price. However, the terminal value of investing is the final conversion of paper wealth to spendable cash.

While investors in individual securities can benefit from my thoughts, my comments are directed at institutional and high net worth investors that have one or more portfolios of mutual funds. Those that own multiple portfolios of mutual funds should modify these comments due to the different expected timespans for each portfolio. (These can be discussed privately, if you would like.)

Drive for show

When a competitive golfer addresses his or her tee shot at a crowded first tee almost all the comments will be on the distance and direction of the first shot. However, the first shot is only positioning for the follow-on shots and in the end the key is how many shots it takes to complete the hole. Thus to some extent the first shot is like relative performance versus peers or benchmarks. If all you know is how good the drive off the first tee is, you really won’t know about the ultimate success of the player. Therefore, what the investor wants to capture is the cash conversion from the ultimate sale as one can not spend relative performance.

The more professional golf observer would pay attention to the form of the golfer, the particular club that was used, the amount of power the player used in hitting the ball, and the tactical position of where the first shot landed. If I knew these things I would be in a much better position to judge whether I wanted to bet on the success of the player rather than just remark that he/she hit a nice first shot. Applying this to the fund selection puzzle, I am much more interested in the process and procedures followed by the manager of a fund than their current relative performance.

Relative performance is a rearward looking device. We get paid to make future judgments and thus I am much more interested in the way  managers addresses their task, such as:

a)    What tools are likely going to be used?

b)   The time spent on studying the opportunities

c)    What comparisons with other opportunities in the present or past time periods?

d)   Compensation pressures, which might impact decisions?

e)    What does one know about the competitors that are playing in the game?

f)     And finally, what is the pattern of flows going into and out of the fund?

Since our major investments occur after several visits or points of contact, any changes in these processes or procedures need to be understood. We expect there to be changes as we live in a dynamically changing investment world. If there were no changes there is an increase of being blindsided.  Each of the items listed above can have an impact on future performance beyond general changes in the market. Our objective is to use process and procedure changes as early warning signals to begin to exit a meaningful position. To quote Sir John Templeton, “Progress requires change. Focus on where you want to go, instead of where you have been.”

Three reasons to sell

The first reason to sell is an actual or expected change in the nature of the account. This is particularly true if the account requires a higher than expected conversion to cash for operational spending needs.

The second reason to sell is actually to buy; the late Sir John said “the reason to sell is to buy a better bargain.” (We have had the honor and pleasure of supplying special data reports to him and also being called down to Nassau to consult with him and his colleagues.)

The third reason to sell is if some important deterioration in the process being used or fundamental change in the longer-term outlook for the investment occurs.

What to sell

Anytime one needs to add or subtract from a portfolio, the whole account should be reviewed. The change is an opportunity to partially redirect the course of the portfolio. Thus, the first pass should be to see whether the various components of the portfolio are properly balanced in today’s environment and future focus. This could be the ideal time to reduce a position that has gotten to be way out of balance. Depending on the nature of the account the natural barriers might be 10%, 20%, and 25% for an individual sector. In terms of a balanced account, the fixed income range should be between 25% and 60% with equities between 40% and 75% in most cases. If one is not hurried, changes should be averaged in or out over at least three time periods which can be days, weeks, months, or quarters.

The role of risk

If the account is all of the money of an institution or an individual without any expected new money coming into the account, a prudent investor needs to weigh the impact of a loss of capital on future spending needs. In the same light the investor needs to understand that the risk of not growing capital and therefore income can be a bigger risk than some downside diminution particularly after taxes and likely high inflation. While I am very conscious that various studies have shown that individuals feel a loss 2 ½ times more than a similar amount of gain, nevertheless for most tax-exempt institutional accounts whose demands go up on a countercyclical basis when economic times are poor, the risk to the organization of not growing the capital base is worse. A less than optimum capital base puts extreme pressure on earned income and fund raising in difficult times.

The role of liquidity

Another former client, Howard Marks, of Oaktree Capital Management wrote about liquidity in this week’s Barron’s. He said that liquidity is not important until it becomes vitally important. Further he characterizes liquidity as transient and paradoxical. Liquidity is the ability to get the last published price in a transaction, particularly when one is selling in troubled times. Normally mutual fund investors are not concerned about liquidity because when they place their redemption order they know it will be executed at the price (net asset value) calculated for the next close of the market. However, some fund investors may be surprised by the gap between one day’s price and the next one.

Some SEC commissioners and certain members of the US Congress are concerned about the potential evaporating liquidity in the bond market including US government issued debt. The professional investors (hedge funds) invested in various debt and equity Exchange Traded Funds (ETFs) could overwhelm the marketplace with a wall of redemptions, which will probably be met by the market makers immediately selling the heavily weighted securities in the ETFs which will put more price pressure on the final net asset value for the ETF and the companion mutual fund.

As a student of the market for over fifty years I would urge fund holders not to panic during troubled periods and add to the forced sales. Well designed investment portfolios of mutual funds should survive the decline and could be very well positioned for a subsequent rise.

Question of the week: For your accounts is there more risk on the upside of not generating enough future capital than on the downside of avoiding forced losses?  

__________    

Did you miss my blog last week?  Click here to read.

Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2015

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

Three Bad Bets: Recency, Overconfidence and Volatility

Introduction

One of the main differences between many brokers and a fiduciary investment manager is the focus on the time to reward. The broker gets rewarded for transactions. The ultimate rewards for the fiduciaries are the successful spending programs of the beneficiaries of their work. I am a professional member of the second tribe. Thus, I think about structure as well as selectivity as they evolve over time.

With the US and many other stock markets on balance going up more often than going down, one of my tasks is to avoid unforced declines. If the long-term secular pattern of rising stock market prices remains, my beneficiaries will receive payments for their reasonable spending plans. That is, if I as their discretionary manager avoid unforced mistakes. Three mistakes that I try to avoid are Recency, Overconfidence, and the misinterpretation of Volatility.

According to a study mentioned by Gene Epstein of Barron’s done by Professor Jeremy Siegel of Wharton and his former student at Wisdom Tree^*, in the last 144 years there has never been a 15 year period when an investor who invested in the popular indices of the US stock market lost money supporting the argument in favor of the positive secular trend. Almost all of the accounts that I am responsible for have a current belief that they will need to meet their payment obligations for 15 years or longer.

Recency

Like many of our readers of last week’s post I was surprised to find that recency is an acceptable word in our language. The word was listed in a long list of biases that have hurt investors over time. Almost all discussions about the outlook for the future of the stock market devote a lot of time to the very current situation. In theory, that is what is known. (Actually all we know is the outline of what happened not what made it happen; more on this later in the discussion on volatility.)

Very little time is devoted to the terminal prices of a considered investment.  What does the current price of say $10 per share tell us as to the odds that we will terminate our position at $5, $15, $ 50 or $100? Most brokers shy away from guessing future prices over an extended period of time, while investment managers need to ponder.

The question as to future valuations is exactly why I have developed the concept of the Timespan L Portfolios. I am aware that tomorrow the market could start to decline. Based on history beyond the Wharton study I am prepared for a periodic correction of at least 10% even though we have not had a five day consecutive period of decline since 2009 and no 10% decline since, I believe, 2011. I believe that it is reasonable to expect a 20% + decline at least once every 10 years and roughly a 50% drop once a generation.

In the Time Span Portfolios construct, the shortest duration portfolio to fund operational needs should have an excess over planned spending of 10-20%, depending on when the last decline occurred. Whenever the Operational Portfolio has completed its funding mission (which may be in two years), just as a good US Marine Corps general does after he commits his front line troops, he immediately reconstitutes a reserve element to replace the tired-out or expended troops. Thus, I have created the Replenishment Portfolio which will provide the next series of funding needs. Because the Replenishment Portfolio has a longer duration of possibly five years, it is reasonable that it may have to deal with a stock market decline of 50%.

Having the first two portfolios in place, the third or Endowment Portfolio would have a duration of 15 years or possibly a little more and should be able to tolerate an all equity-like risk. The general expectation for this portfolio should parallel the return on equity that the major market indices generate from their components.

Recognizing few if any of today’s leading stocks are likely to be the better performing stocks well into the next generation, a portion of the final or Legacy Portfolio should be crammed with potential disrupters of the present structure of our economy. Smart technology creators and probably more importantly, smart technology users, will be predominate in this all equity portfolio.

Each of the four Timespan Portfolios can be managed aggressively or conservatively as long as it stays focus on its designated timespan.

Overconfidence

Overconfidence is a risk that can grow exponentially the longer the period when doubt is appropriate. Or, as Berkshire-Hathaway^* CEO Warren Buffett said, until everyone else recognizes the nakedness of those skinny dipping or in the next parade of dignitaries when the king is marching naked.

My Grandfather who spent his working life running a successful carriage trade brokerage firm used to warn his grandchildren to stop being so certain. This was a difficult message for me and I believe the others to digest. After all, we had just learned a particular “fact” or relationship. Therefore, we were certain about something and our Grandfather just was not hip enough to get it. Only with age did I get to understand and appreciate his wisdom. When I see or hear the various media pundits or others selling their wares with 100% positive statements my risk avoidance mechanisms kick into my judgment apparatus.

Where are we today? Liz Ann Sonders of Charles Schwab^* quotes the late, great, an old friend and consulting and data client, Sir John Templeton saying that “bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” She thinks we are now in the third phase. Other sentiment indicators are in agreement with positive ratings of 50-70%. She is probably right, but my Grandfather’s caution comes to mind when I see the only Dow Jones stock price index that is up for this short year is the utility index. This is a continuation of the superior performance achieved in 2014. The only nagging problem is that utilities at least three times before enjoyed good performance on the basis of expanding price/earnings ratios which preceded a general market decline. I remember that from a portfolio construction standpoint utility stocks were generally used as bond substitutes.  Long-term treasuries were the best single large asset class in 2014 and so it is understandable about utilities performance. While I hope Liz Ann is correct, I am not retreating from my belief that if enthusiasm boils up we can see both a 20% gain and 20% loss from current levels based on past history.

^*Held by me personally or by the private finance services fund I manage

Volatility

Volatility, either as the price of the VIX or standard deviation, is not a measure of the potential loss of capital. They are useful descriptors of price movement. The fundamental problem is that they don’t explain price movements. In a prior post I warned about the tyranny of the single last trade of the year.  I find it somewhat ironic that traders from at least two major banks have had their bonus expectations cut by about 10% due to the market performance in the last two weeks of 2014. The reason this is ironic is that most traders believe they can make money out of volatile prices. That is if their bosses permit them to trade the market. A substantial portion of many trading desk’s profits do not come from executed trades but “marks to market” of the securities in their inventory. A number of financial institutions want to be early in their public reporting cycle; thus they are, in effect, restrained from trading at the end of the calendar year. Keen market observers noted that in the last half hour of the last day there was still some insistent sellers, probably for tax or statement purposes and little in the way of buyers, so in a 30 minute period market prices declined enough to make December a slightly losing month as compared to a probable winning month.

The reason for dwelling on the short-term price movement is that too many investors will interpret the fall in December and now the newly crowned peak of the market at the close of December 18^th  as having lasting meaning rather than understanding it as an imbalance of buyers and sellers in the last half hour

Question of the week:

Are we entering a new market phase?

__________    

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Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2015

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