What does 2015 say about ’16?

Introduction

Does what happened in the markets in 2015 set a trend for 2016? In prior posts I have discussed trends and the general comfort in trend following as well as the advantages in terms of bigger profits or smaller losses while picking up early divergences from a trend. On the last weekend of the year it is difficult to separate the evidence between nothing new and as ordered in “Alice in the Looking Glass,” the lobsters continue their dance. Or can we identify future turning points? Let’s look at the current situation for clues.

Continue the Dance

What will continue in 2016? We will enter the eighth year of the second period of the key US decision maker being a woman. My concern is not that these were both women, but that critical decisions were made by people unelected and/or unconfirmed by the US Senate.  The first was the second Mrs. Woodrow Wilson and now Valerie Jarrett. In the first case, some of our British friends suggest the decisions made through the Woodrow Wilson White House set in motion both the lengthening of WWI and the critical impetus to WWII. Some may be seeing a similar pattern being caused by the current occupant’s last year in office.

The Federal Reserve is one of the worst forecasters in the US. No recession is in its forecasts at least until 2019. Moody’s won't go that far, it believes that the “wide high yield spread doesn’t mean a recession is nigh.” Further, “jobless rate and yield curve have yet to predict” a recession. Stephen Roach’s latest piece in Project Syndicate suggests the reason for this is “the Fed, like other major central banks, has now become a creature of the financial markets rather than a steward of the real economy.”

Wall Street focused pundits are at best predicting a flat to middle single digit gain for stock prices. Numerous pension plans and granting foundations are using portfolio gain rates between 5% and 8% in their planning for the next year. This relative caution could be the cause of business capital expenditures to decline a bit, but at the same time consumer expectations are higher than current readings. As of the last weekend of the year, the Dow Jones Industrial Average without benefit of dividends is down -1.5% and the S&P500 +0.1%. That is not the full story, the Dow Jones Transportation Index is down -16.6% and the NASDAQ 100 is up +9.1%. This dichotomy explains the results of most equity mutual funds with those focusing on growth particularly in global health/biotech providers showing average gains of +9.45%, which is the single best performing investment objective tracked by my old firm Lipper Inc, now a ThomsonReuters company. Whereas portfolios largely focused on manufacturing and transportation showed losses, they were not alone, a value focused portfolio produced flat to slight declines. Many hedge funds both equity and debt-oriented also showed negative results.

Using the handicapping tools I learned at the race track trying to find suitable bets on imperfect horses, I tend to pay less attention to annual moves of 10% positive or negative. Big gains and losses of significance come in packages with at least 20% moves, even if they are a bit abnormal in coming. Thus in my portfolio selection efforts for 2016 for investing in the year as well making choices for Timespan Portfolios with 15+years duration, I am noting but not dwelling on 2015 results.

Negative Inputs

1. Electronic trading, including high frequency trading (HFT) is dominating the trading in US treasuries and now investment grade bonds to such an extent that the short side in US Treasuries is now viewed as a crowded trade. (Crowded trades are ones when the bulk of one side of the market is dominated often by fast traders; e.g., Hedge Funds and Proprietary Trading desks. The risk involved is that these players may follow momentum at any price, thus creating extreme market movements unrelated to price and value.)

2. Globally the US dollar has become too attractive vs. other currencies. Thus, at the end of 2012 the Canadian dollar was trading at parity with the US dollar and now the Loonie, the Canadian dollar is worth about $0.72 cents.

Compared to most other countries the apparent political risks to capital in the US is less. Almost all markets reverse and some will find eventual bargains in other currencies selling some of their US dollars to buy attractive goods and services as well as securities. On a long-term basis I am looking to add to my Canadian holdings of management company stocks. On a very long-term basis I find the Australian superannuation (pension) business attractive and I am hoping to find some euro denominated attractive investments.

3. Moody’s regularly publishes the market interest rates being charged on operating leases. These are very sensitive to credit ratings of the issuer. What caught my eye is that the interest rate range for those in the investment quality group from the highest to the lowest is 2.05%. On the other hand the interest spread between the highest quality “junk” and the most risky credit available in the market was 5.41% with CAA credits having to pay 10.07% which is higher than the average High Yield bond.

One of my concerns about our manipulated low interest rates is that far too many loans are priced to cover the cost of capital and operating expenses and too little for the cost of credit. My worry, despite the Fed’s lack of immediate worry about a recession, is that the size of the credit losses will be larger than historically expected. In the case of the US as distinct from China, the growth of other financial lending (shadow banking) has grown to about 33% of total loans compared with about 4% in China. Therefore the US banks won’t bear all of the costs of distressed credits.

Positive Inputs

1. The lack of any well known pundit screaming about a major upside

move is probably the single most bullish indicator. One should always remember as in golf the purpose of the market is to create humility,

thus the chance to be embarrassed the most is missing the upside.

Various sentiment polls of global portfolio managers are also expecting limited gains in 2016. If they are wrong they will have to play catch-up ball and not only commit reserves quickly but switch out of some under-performing holdings.

2. Retail fund investors both in the US and Europe have been adding to their fixed income fund investments. The combination of rising interest rates and increased credit concerns suggests to me that flows out of bond funds will eventually find a home in equity funds.

3. We like to be ahead of the market and thus now are looking at 2017, the first year of the new US Administration. History shows the first year of a new Administration of either party is often the worst of the four years. Whoever is sitting in the Presidential chair  would be wise to bring on a recession as quickly as possible so it could be blamed on the former occupant. Also with four years to work with, the new President should be able to get the economy expanding and be seen to be creating jobs.

4. I am finding lots of companies in the financial arena that I would like to permanently own at current prices. Combining this with the knowledge that there is a large quantity of talent that is ready to move for the right opportunity suggests to me that there are lots of profitable opportunities ahead.

Bottom Line

Because I have a contrarian streak, I expect a different sort of year in 2016 and if I am wrong, I won’t be hurt much.

Question of the Week: What do you expect in 2016?

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How to Survive Banner Headlines

Introduction

Investors and the public in general tend to believe in big headlines and invest in the direction of the headlines. Often this is a mistake. On the front page of The Wall Street Journal last week there was a five column banner headline trumpeting “Broad Gains Power Historic Rally.” A sub headline stated that for the first time since 1993 that six closely watched indexes rose in the first half of the year. (The indexes were two from Dow Jones - DJIA and Commodities; two from MSCI - World Stocks and Emerging Markets Stocks;  as well as indexes for Gold and Bonds.)

The financially sound investor would quickly point out that the flow into tradable elements was caused by people getting out of cash money. Institutions and individuals were recognizing that excessive borrowing to meet or prolong deficits and the central banks manipulating interest rates has caused a twenty year recognition that in today’s world cash is trash.

Those of us who have any knowledge of how people (particularly investors and voters) react will recognize that when there is a large imbalance of opinion that the majority will win for a relatively short while to be followed by major disappointments. Such may well be the case this time.

How do I know? Years ago I learned from a very sound investor who happened to be one of my accounting professors that I should read financial statements from the back forward. I should spend as much time reading the footnotes and auditor’s certificate as I would in reading the CEO’s comments even though the CEO’s comments were designed to be more easily understood. I suggest that all who wish to be informed and to have the ability to change one’s views to read the small articles at the end of the pages in most newspapers. If you do you might come up with what I am seeing.

Bits of information important to me

1.      In the last week the average interest rate paid on bank deposit accounts (MMDA) went from 0.37% to 0.43%. In most weeks there is no change or only minor moves of .01%. This 16% move could be for some technical reason or could be that banks, mostly retail banks, are starting to make loans and need more deposits.

2.      The five month increase in CCC (low credit quality) loans is up 17.2%.  At the same time there was a decrease in high quality loans being sold.

3.      Moody’s ^* is concerned that the combination of below trend profit growth and above trend borrowing will lead to an increase in defaults.

4.      Two very respected investors from quite different vantage points, Stephen Roach and Wilbur Ross, are worried about too much easy money. Steve is one of the leading experts on investing in China and Wilbur Ross has had a very successful career investing in distressed securities both in the US and elsewhere.

5.      Bank for International Settlements (BIS) which is the international bank that provides credit to banks globally is warning about “euphoric markets.”

Applying concerns to portfolios

As a professional investment advisor I need to be concerned each day as to how the accounts that I am responsible for are positioned. In almost all cases these accounts must be in the market to meet their long-term needs. Today, with interest rates in the range of perceived long-term inflation, (if not lower, as shown by the WSJ banner headline), the bulk of the accounts are balanced accounts with a preponderance in equities.

Regular readers of these posts have learned that I am worried about a major, once in a generation, drop in equity prices. Up to now I have been focusing on stock prices to generate sell signals. Increasingly I believe I should focus much more attention on fixed-income markets. The triggers to the last major declines were caused by the failure of Lehman Brothers ability to finance itself and the widespread fears of residential mortgage defaults. These were fixed-income problems that severely impacted stock prices.

I want to learn from other investors and investment managers. This is why I prefer in most instances to invest through funds managed by bright people. This week someone sent to me a copy of Schroders^* latest investment letter. In the letter Schroders divides its outlook for the future of its accounts into scenarios. The most probable is an extrapolation of present trends. However, the letter mentions seven other scenarios which could be important. I have listed them in order of their probability according to Schroders:

• Capacity Limits
• G7 boom
• China Hard Landing (Steve Roach believes the increasing codependence on China could hurt the US if we don’t come to a better relationship.)
• Secular Stagnation
• Eurozone Deflation
• Trade War
• Russian Rumble

^*Owned by me personally and/or by the private financial services fund I manage

While each of these could be the problem that sets off the market decline, to me the key is the proportion that Schroders gives to the most probable outcome, the essential “muddle through” scenario which is at 65%.

Why I am limiting equity exposure

Coincidentally because of my concerns after five good market years and below average economic years, I think it would be wise to limit equity exposure in a conservative balanced account to 65%. While I expect we could have one more major, almost skyrocket selected stock price move, I would be moving lower in terms of equities, if I could find some reasonably safe fixed-income alternatives producing above inflation rates of return.

The equity exposure mentioned is for those accounts that will have funding responsibilities in the next five years. Longer-term accounts could selectively be higher, except I am beginning to worry about long-term endowment type accounts. In the past I felt that this account should be invested all in equities as the best way to get the benefits of disruptive technology and favorable demographics. I am beginning to worry that pricing competition could be too fierce. 

In terms of demographics, I believe that the US will accept more legal and if not illegal immigration. My concern is as to the quality of our young labor force today. I find it disturbing that in the US Army’s reported view, only 29% of the population could be accepted. (I don’t know what the experience is for the US Marines, but we only wanted “the few”). Without the right people our long-term returns will not match our needs.

Please share with me your views.   

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All Rights Reserved.
Contact author for limited redistribution permission.

Too Much Gloom and Too Many Opportunities

There are two relatively standard question clichés about travel experience, “Are we there yet?” And, “are we rearranging the deck chairs on the Titanic?” As this post is being composed on Sunday afternoon, the 30^th of December, we don’t know whether we are ‘there’ (a solution to the fiscal cliff) yet. We don’t know whether the political leaders in the US Senate can come to an agreement that the President and the majority of the members of both Houses of Congress can agree on prior to Tuesday. There is little reason not to be gloomy as to the result.  The gloom is not on the chances of an agreement, but rather on the probability that whatever agreement is made will not address the problem.

The problem is that the solution did not begin with the originator and popularizer of the term “fiscal cliff.” The Chairman of the Federal Reserve, a professor of economics from Princeton, was warning that monetary policy as controlled by him could not solve the shortage of domestic demand and that fiscal policies had to address the problem. His plea to the politicians was correct according to Stephen Roach’s latest letter, in the sense that experimental monetary policy has not worked in the US, Europe, or Japan. As I discussed in last week’s post, our economic problem is that we are suffering from a cyclical binge of too much debt combined with a multi-generational deficit.

The second question as to the rearrangement of the deck chairs on the Titanic actually may well be focused on a much bigger fundamental question. Often the deck chairs on the open decks of a cruise ship are assigned to various price classes for the voyage; the higher price tickets get the better seats, etc. In earlier days, epitomized by the Titanic, the crew and the management of the cruise line were more concerned about proper deck chair configurations than the absent life boat drills; actually there were too few life boats for the passengers and crew.

The current Presidents of the US and France want to redistribute the wealth among the passengers, akin to moving the chairs on the Titanic rather than paying attention to the life-saving needs for life boats and safety drills. Also like the Captain of the Titanic, the Presidents are not focusing on where they are going and having the best available communication equipment and personnel on board. History will determine whether the parallel is appropriate.

Staying with the ill-fated travel of the Titanic, one should point out that other ships made the crossing that night without running into an iceberg. Cruise ships have provided safe and pleasant travel to many thousands since then. The telling point is that with the correct management one can avoid some major, predictable crises. The key to that belief is the word predictable. One of my favorite Wall Street Journal columnists is Carl Bialik who writes interestingly and perceptively about statistics. In his latest column he writes about some of the pet peeves of professional statisticians. The first of Bialik's two pet peeves is that in too many cases, in the popular press and mindset, a single number is predicted without an accompanying statement as to the margin of error. The principal owner of the Titanic, his navigator, and single radio operator did not recognize a margin for error in their actions. Perhaps even more perceptively, Mr. Bialik mentions his second peeve, that the absence of evidence is not the same as the evidence of absence. (Those of us who live in New Jersey were victims of this misunderstanding when NJ Transit did not move its rolling stock to higher ground when the super-storm Sandy was approaching, for their preferred locations had never flooded. Because something hasn’t happened, doesn’t mean it can’t. The damage to the railcars will take hundreds of millions of dollars to repair and will interfere with commuter travel for many months.)

Many opportunities

I get out of bed in the morning, therefore I am an optimist. I believe that there are many opportunities offered to us every single day. Because of our own preoccupations, particularly about today’s problems, we don’t see the opportunities. In preparing for this blog, I saw information on three such opportunities.

Opportunity #1:  The growing middle class

The President of the US and his political cohorts are focusing on protecting middle class Americans from paying their share of the accumulated deficit. What he should be focused on is that there are already 500 million middle class Asians and it is expected by some to be over one billion middle class Asians in the foreseeable future, as mentioned by Kishore Mahbubani in the Financial Times. This is a  market that is currently crying out for the perceived quality of western brands. The US middle class can earn its way out of its share of the deep fiscal hole it is in by focusing on products/services marketed to this growing segment. Most of our investment portfolios recognize this opportunity by investing in multinationals and indigenous companies through selected mutual fund portfolios.

Opportunity # 2:  Net cash generation

Chip Dickson's daily letter from his firm Discern focused on US (registered) non-financial corporations that are in the longest period of sustained excess cash generation in history. I suspect that companies all over the world are awaiting similar investment opportunities. Most of the US corporate spare cash is being kept where it was earned, overseas. Often commentators blame the uncertainty of tax rates for the unwillingness to spend cash. This is not completely true. In the US, we have had changes in taxes about every two years. The retarding issue is that there is a lack of vibrant demand in the US. In the 19 quarters since the beginning of 2008, again quoting Stephen Roach, consumer spending adjusted for inflation, has been growing 0.7% per year, compared to a more normal 2-3% in the recent past, and over 4% in our halcyon days. Some of this decline is due to deleveraging by consumers, particularly in housing. These people are scared about their future and I suspect they sense the current anti-capital mood emanating from the Beltway. As shown by online buying, they want to spend wisely. The opportunity comes when they feel more confident and start spending. At that point, so will the corporations of the world.

Opportunity #3:  Technology helps

Exxon periodically produces an incisive look at the future for energy many years out. Not surprisingly, it sees growth in the demand for all elements of energy consumption and therefore production. Most of the growth relates back to the first opportunity listed (the growing middle class in Asia), but also in Latin America and Africa. What I found of interest is that this substantial growth will only be partially offset by an increase in energy efficiency. Exxon fully expects that improved technology will help produce, transmit and consume energy. This is another testimonial to the likelihood of growth in demand for technology. My guess is that in an aggregate sense, spending on technology will grow at close to double the rate of growth in the overall global economy. This growth rate is not fully discounted in many technology stock prices.

How are you going to handle the fiscal cliff, or more properly the fiscal slide or slope? Please share your thoughts.  

Clarification:

In last week’s post I compared the ratio of various nations’ debts to GDP.  Further in the paragraph, I referred to “Europe’s deficit as a unit.” I should have written “Europe’s debt as a unit.”

Ruth and I wish a happy, healthy and prosperous New Year to all members of this blog community.

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Copyright © 2008 - 2012   A. Michael Lipper, C.F.A.  All Rights Reserved.