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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Lessons from Last Week: Look to Europe and Go EAST

To lose money realized or unrealized is painful. To lose without learning useful lessons is tragic. Frank Holmes of US Global Investors quotes Baron Rothschild, writing, “The time to buy is when there’s blood in the streets, even if the blood is your own.”

My analysis of what happened last week was not a reaction to the appropriate, if not overdue, Standard & Poor’s downgrading of some US Treasury debt. (The focus of the downgrade was the political unwillingness to stop the growth of the federal government’s deficit, not an inability to pay.) What caused the decline, in my view, was the increasing recognition of the seriousness of the European fiscal, political, and therefore economic problems, and how they may and probably will, impact credit conditions globally.

The fear transmission line

One of the louder voices of concern was Mohamed El-Erian, the co-chief investment officer of PIMCO, probably the largest professional bond manager in the world, who wrote, “Any further mis-steps from American and European policymakers risk converting raging crises within the global economy to a more devastating crisis of the global system. That is how fragile the situation is, and why the world risks not just a recession but -- even more worrisome -- a prolonged one.” His fears are being heard by the American people. In a recent Marist Poll, 68% believe that the worst of the country’s economic conditions are yet to come. What was surprising, 57% of the Democrats agreed. Another poll (Thomson Reuters/University of Michigan) measuring consumer sentiment, reported a sharp drop from the month before to a level that had not been seen since May of 1980 (no misprint). Jeremy Grantham stated in a recent interview that Americans respond to a market signal better than almost anyone.

The historical perspective

Governments of all types have believed that they can only maintain power if their people are well fed. The best example of this management technique was the ancient Romans. Rome's government had to produce “bread and circuses.” To support these basic needs, wars were initiated to bring back marketable tribute, including slaves of both sexes. When the wars became defensive in nature, the costs of these adventures, particularly the military costs of defending borders, grew to a point that the tax burden was crippling the economic growth, which subsequently weakened defense spending and promoted corruption. Substitute the welfare or “nanny state” for “bread and circuses,” with the size of the deficit absorbing all of the gross national product, and you have a good description of Mediterranean Europe, and a fear for the US and the UK.

The role of the banks

In most civilizations, the governments control the banks or the banks control the government. In modern society, banks extend credit often to governments directly or to government favored activities, e.g., mortgages, car loans, commercial loans to faltering employers, etc. In the cases of those countries with well-known problems, the banks are full of domestic loans as well as other allied sovereign debts. The US market reacted to fears that the French banks were following in almost lock-step fashion behind the Irish and Spanish banks, with the Italians not far behind. These concerns on the part of both US investors as well as those beyond, has propped up the prices of US Treasuries regardless of the downgrade, which was not a surprise to anyone who reads financial reports. In just the last week, investors put $50 billion into money market funds, reversing the $49 billion outflow the week before.

What are the lessons for me?

When I look across the Atlantic to Europe, I see an aging population of workers not being replaced by younger people who want to work. In addition, there is an incredibly weak military structure and a population that does not want to declare income to pay taxes. On the other hand, as the surviving economists who have escaped from Lord Keynes’ grip will point out, across the Pacific (with the exception of aging Japan), the populations are younger, eager to work, and possess a healthy combination of savings and higher quality consumption. To me, last week crystallized the need for our clients’ accounts to increase exposure to Asia. We already had significant exposure through exporters in Germany, Chile, Brazil, Mexico, Canada and a number of US companies in our funds’ portfolios. These investments are not riskless due to economic and political cycles, but the secular investment trend is up.

What did you learn last week?


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