Nervous Investment Instincts and Cures

Introduction

One of the basics in US Marine Corps training is to develop survival instincts which should kick in during battlefield conditions. These are meant to save the lives of individual Marines, but more importantly for the other Marines he/she are responsible. As Ben Graham wrote in The Intelligent Investor, “We are in the battle for investment survival every day.” (Warren Buffett, wrote a subsequent Preface, and called the work  “By far the best book on investing ever written.” Jason Zweig added commentaries and additional documentation to the latest edition of this landmark title.)

An early warning

One of the frustrating emotions that comes from any long-term intensive study of stock markets around the world is that markets move differently than current economic trends and are not particularly good forecasters of economic movements. What appears to me a better forecasting device is extreme indications of sentiments. Remember that large drops in stock prices occur after large rises. Thus, an increasing level of enthusiasm may be interpreted as an early warning sign that some Marines would sense as a possible ambush.  

Bailouts not the answer

While I was preparing to give a US stock market view to a very experienced group of former stock exchange leaders, the Institute of Stock Exchange Executives Emeriti (ISEE), I was approached by a somewhat  sophisticated investor wanting reassurance that the market is safer now since the financial crisis. The mere question instinctively put me on my guard. (Perhaps I was reacting to my Grandfather's instinct. He had a high carriage trade NYSE brokerage firm that according to family folklore, got all of the his clients’ investment accounts out of the stock market before the 1929 crash.)

Since the 2007-09 "crash," various governments have been trying to build a defensive doctrine against "Too Big to Fail" bailouts. If anything these moves have increased the risk to long-term investors. The real purpose of the Too Big to Fail doctrine was to protect the politicians from their own folly. The public was incensed by the use of taxpayers' money to bail out commercial activities that created their own problems over many years if not decades. In the US the federal government bailed out Chrysler twice, one of the biggest commercial employers in the important electoral college state of Michigan and bailed out General Motors once. (DuPont bailed GM out of its over-leveraged position a long time ago.) In all cases a weaker company evolved while maintaining high relative prices for their merchandise. But the labor unions delivered the votes to elect Democratic presidents.

Mortgage underwriting debacle

When the financial community expanded the mortgage base as directed by Congress through the loosening of the underwriting standards of the federal mortgage companies, the somewhat expected financial crisis occurred. Instead of letting the private sector rescue the borrowers and some of the better servicers, the government elected to bail out the existing financial service companies. If they had not, following the tradition of financial bankruptcies, almost immediately new banks and mortgage companies would have been established taking over the loan books. They would have been populated by experienced middle managers from existing shops. Most of the equity owners would have lost almost all of their risk capital and some of the fixed income holders would have had meaningful haircuts. For the most part the depositors would have come out either whole or almost whole. Since this series of bailouts was directed to the hated Wall Street, the populists were particularly upset. They wanted to ensure that never again would there be a bailout of a large financial institution.

None of these bailouts added any value to existing or future stockholders. As a matter of fact because of their restrictions on some money making activities; (e.g., trading) and the requirement to have large amounts of underutilized capital, the big banks operating under the new rules became less attractive as investments. Large money center banks currently have lower price/earnings ratios than mid size or smaller banks.

As there are bound to be future crises, the existing big banks or insurance companies are likely to have sizeable excess capital available to buy a large worthwhile financial in trouble. Thus future prospects around the world are less safe for equity investors than prior to 2007.

Additional signals

Recently at an institutional investment committee meeting, the main point of discussion was a hedge fund that was making unexpected moves partly due to their success but beyond the expected portfolio discipline. Overwhelming the professional members of the Investment Committee,  the meeting was concentrating on the expected further capital appreciation. There was only one member who was concerned about the risk that was generated by exposures beyond the expected.

While in this particular instant we were talking about investing domestically in the US, the institutional community appears to be betting on foreign stock prices but not on foreign currencies. In the week that ended Wednesday, March 18, three times the number of net dollars were invested in non-domestic ETFs than domestic ($18.4 Billion vs. $5.4 Billion, according to my old firm, Lipper, Inc.).  Most of the money going into the international ETFs went into two country index funds with their currency hedged by WisdomTree^* and one other ETF invested into the MSCI un-hedged. These to me, are short-term trading type of judgments.

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

More conservative investors are also showing signs of becoming additionally comfortable with assuming risk. Domestic Health Care funds are up on a year to date basis +15.69 % and Global Health Care funds are up +13.0%, a continuation of last year's performance leadership that has benefited from spectacular M&A prices, though it raises some risk concerns.

Even in the high quality bond market we are seeing yields dropping much more than normal this week and for the latest 12 months. The lower yields translate to higher bond prices which is unsettling given the general view that eventually there will be a significant interest rate rise/bond price decline.

Cures

The best cures for nervous investors are:

1.  Understand the hyped enthusiasm

2.  Focus on the more important longer term, and

3.  Remember the implications from history.

One of our readers, Teddy Lamade, a fellow weekly blogger and an investment professional with Brown Advisory suggested reading Michael Mauboussin's More than you know: Finding Financial Wisdoms in Unconventional Places. The thoughtful book is a compilation of unconventional approaches to understanding problems from many walks of life-financial, sports, science, politics, and gambling. Below are thoughts from the first part of the book that I felt were particularly relevant to the nervous concerns expressed above:

You are better off focusing on decision-making than outcomes. (This applies to my concern about judgments of managers and therefore risks of repeated poor judgments as distinct from the potential of capital appreciation.)

Robert Rubin is quoted in a commencement address saying, “The only certainty is that there is no certainty...decisions are a matter of weighing probabilities...despite uncertainty we must act.”

In selecting investment managers it is important to understand both portfolio turnover and concentration. (The numbers themselves are the beginning of the discussion not the answer appearing on a screen.)

What is generally good for investors is not the same as what is good for the owners of the investment management businesses. Investors improve their odds by focusing on long-term horizons, (timespan portfolios should help), low fees and expenses, plus consideration of contrarian views as distinct popular choices.

Mr. Mauboussin also mentions one of my favorite investment anecdotes, that the year Babe Ruth set the home run record he also had a record number of strike outs. This highlights the concept that the frequency of correct decisions is less important than the magnitude of correctness. Warren Buffett and Charlie Munger have translated this into investment decision terms.
 

The probability of loss times the amount of possible loss vs. the probability of gain multiplied by the amount of possible gain is the way to make a judgment. (This is why in the long run Dedicated Short-biased portfolios underperform Long-only funds.)

Investors feel the impact of a loss 2½ times more than a similar gain. (Destruction of investment capital reduces the capital that can grow.)

One of the key differences between gambling and investing is that the more one wagers the greater the odds of losing; in investing the longer you invest the greater the odds that you will generate positive results. (Two reasons for this: first the more fees and expenses one pays, the smaller the capital in play. The second is that at least in the US equity market there is a long-term secular growth rate, which is why Mr. Buffett urges people not to bet against the US. However, he is increasingly willing to hedge that stake with international investing, a position we should all consider.

More insights

Another Michael, Michael Cembalest of J.P. Morgan Asset Management has written a very useful piece on his ten years of authoring market insights, three items of which are especially instructive.

1.  Mr. Cembalest expects a marked increase in the level of volatility. (We don't hear much about volatility during rising markets. The prevailing wish is that every price increase is fundamentally based and not a reaction to a trading imbalance.)

2.  Sentiment indicators are better forecasting devices than price/earnings ratios. He quotes five separate surveys each currently reporting at 90%+ of past records.   (As regular readers of these posts may remember, I am tracking the levels of market enthusiasm, which eventually builds to a peak prior to a major decline.)

3.  Central banks are determined to re-inflate their economies no matter what the long-term costs to their societies.

Question of the Week: what is your level of enthusiasm?

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Copyright © 2008 - 2015

A. Michael Lipper, C.F.A.,
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Are We in a “Flat Earth” Phase?

Introduction

For most of human history there was the belief that we lived on a single plane of essentially a flat earth. This concept gave order to our belief as to our place in the world, and in our minds reduced the uncertainty gap. Only in the last seven hundred or so years did we appreciate that we live in a somewhat circular earth planet. Soon after Columbus’s voyages we came to recognize how we really live in a context of a spinning globe.

In a much less cosmic sense, stock market chart readers have recognized that there are periods, some of them quite long, when prices appear to be within a range bound with repeated highs at roughly the same level and similarly with recurrent lows around the same price levels. Some of these periods can last for years. It was a period of 16 years from the first time the Dow Jones Industrial Average (DJIA) first reached 1000 and finally decisively breaking out on the upside.  Depending on what measure you want to use, for example the NASDAQ or the Japanese markets, we are still well within these bounded ranges. Normally range bound markets, particularly those with narrow price ranges, last for a number of months not decades. We appear to be in a relatively narrow range bound market with the DJIA laboring between 16700 and 16000. (Some would use a narrower range.) There are two important findings after the market either breaks out or breaks down decisively. The first, the amount of time and the aggregate swings from the high point and the low point is, in theory, added or subtracted to the high point or low point when there is a break-out or breakdown. The second is whether on balance the smart money is accumulating assets from the less intelligent sellers or the smart ones are distributing their assets to the somewhat unsuspecting investing crowd.

A reader asked.....

One of our intense readers who is somewhat short-term focused has asked me if is there a way to successfully predict if we are likely to experience an upside breakout or a downside breakdown. As my crystal bowl is quite cloudy, I am focusing on two aspects that lead to range bound markets. The first, is there a change in the population of buyers and sellers facing each other in changing market structures? The second question is whether those with smarts and capital are changing their investment policies. It is this particular question that the remainder of this post is focused.

Is it smart to be reducing equity exposure?

The answer, or at least a guide, may have been foretold last night. At the New Jersey Performing Arts Center^* there was a showing of the movie classic “Wizard of Oz” with its soundtrack music played beautifully by the New Jersey Symphony Orchestra^**.  For those who are unfamiliar with the film it turns on the ability of an unseen voice to successfully control a community of happy people. The key to the dreams of the four supplicants seeking special transformative favors was the unplanned revelation that the disemboweled voice was an old man behind a curtain that very well played the role of the announcer that foretold what was going to happen. What occurred to me listening to this magnificent music and watching the film is in today’s financial world the role of the wizard (or in reality, the announcer) is played by the central banks and various media gurus. It is these spokespeople that give investors the courage to invest in an uncertain world.

^*I am the chair of the Investment committee for New Jersey Performing Arts Center (NJPAC). 

^**My wife, Ruth, is the co-chair of the New Jersey Symphony Orchestra (NJSO).

The question as to whether smart investors are changing their investment policies has a lot to do with the announcers that are speaking, particularly after the curtain has been removed and these experts prove to be humans and not all knowing and powerful wizards. To some degree the power of these announcers is based on the flat earth thesis that provided comfort for centuries. This comfort was based on the belief that the leading religious and technological leaders of the day were all knowing. It wasn’t that the few thinkers that did not buy into the flat earth syndrome were essentially smarter than the established thought leaders, but they started to ask questions that could not be comfortably answered by the established leaders.

Bringing the questions up to date and focusing them on the investment world can be broken down into three sub questions as follows:

1.      Are we so smart or just arrogant as to believe that we can perfectly understand how the economy and financial markets work and can be controlled?

2.      If the supposed leaders are so smart why are their decisions “data dependent?”

3.      Why are the so-called experts' forecasts so wrong, particularly in the long-term?

The constant revisions to the various time-series and the inability to correctly capture relevant information about the “informal” sectors of the economy, suggests that data dependent policies have to be wrong often. (In the computer world there is a germane term: “GIGO” garbage in creates garbage out.)

There are two other somewhat related and troubling concerns about how the governments and their hand-maiden central banks are attempting to manage the round earth’s finances. The first is the use of experimental low interest rates to stimulate the economy. There are at least two long-term problems with this approach. The first is that it makes a mockery of long-term savings, particularly in fixed-income instruments for retirees. Not only are they getting low returns on their hard earned money, but they are planned victims of induced inflation to counteract the experimental low interest rates. (I will leave for others to determine whether their healthcare expenses and quality of the services to be provided will be a sufficient offset to their decline in spending power. As a member of the Atlantic Health System’s financial oversight committee and chair of its investment committee, I have my doubts.)

The second negative to structural low interest rates is that it exacerbates a sound economic recovery. One of the reasons for the various financial and economic crises that have occurred is that for the time and price structure we had excess capacity. The benefit of economic declines is that the excess capacity is withdrawn from the market as supply overwhelms demand. While painful to the workers who have to find new jobs, the removal of these excesses is similar to the way nature handles over-population. The problem with low interest rates is that it removes pricing discipline in making sound investment decisions. Often new capacity is brought on stream by marginal producers whose supply can not be profitably absorbed.

One of the reasons given for the low rates and some of the bailouts is that various markets seized up. While that was true for a moment and perhaps that would have been extended for sometime, but if new markets were not created at reasonable prices, the investments that were shut out of transactions would have proved to be not adequately priced.

The second tool that is being used increasingly by central banks is to spur on their exports to encourage lowering the value of their currency. As most of the central banks are reading from the same outmoded text books, many are in effect entering a global currency war which in the end will worsen their problems and not productively expand their markets.

If you are considering changing investment policies, what to do?

I agree with Liz Ann Sonders and her associates at Charles Schwab that it is folly to try to time the market. This is particularly true if you share their view of a haltingly rising market. However, in my roles with various investment committees I am very conscious as to the time horizons of many members of these committees. This is exactly why I came up with the Time Span Portfolios concept. (We can discuss this approach privately to fit various investment needs.)

The place that may need the most attention is the second or Replenishment Portfolio. The purpose of this portfolio is to replenish the Disbursed Operating Needs Portfolio. The time span for the typical Replenishment Portfolio is probably five years. Over this period two events are likely to happen. The first is that there is likely to be a stock market price decline. The depth of the decline is likely to be driven by the speculative force that creates the price peak. The second event is that one or more members of the investment decision making group will be new to the committee and could be a replacement.

To change even only one member of the committee is often a cause for a change in attitude. Of the groups that I presently know, the Replenishment Portfolio is a type of Balanced fund with at least equity and fixed-income funds in the portfolios. I have been managing most of these portfolios up to the turn of the year with the highest equity commitment that was tolerable. Since the beginning of the year through today we have been redeeming some equity funds to bring the equity commitment to the midpoint in their target range. I suspect that as the market moves higher we will lower the equity proportion to the region of the lowest permitted.

Some changes may be warranted for the third portfolio which I have named the Legacy Portfolio (as distinct to the truly long-term Endowment Portfolio) which can tolerate market volatility but doesn’t like it. I do not want to reduce equities to side step a future decline that will happen. I do want to provide some comfort during a period of turmoil. The way I recommend that one should be in both the stock and bond sides upgrades the portfolio holdings. While some speculative positions will do better on the upside they will fare much worse when the eventual declines occur. Part of the reason for going high quality is that planned long-term expenditures, surprise needs or opportunities occur and the Legacy Portfolio may wish to accommodate these opportunities.

Please share with me your thoughts about changing any of your investment policies.  

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Copyright © 2008 - 2014

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

Expect Unintended Consequences From This Weekend

I am writing this on the weekend that various members of the U.S. Congress and their staffs (working with, and/or against, members of the outgoing administration) prepare a bill that would mandate the use of taxpayer funds to rescue our economy, and to a large extent the global economy from various governments’ past mistakes. The noisy minority of the public is clamoring for the scalps of the perpetrators. While Congress, for the most part, gives lip service to the crowd around the guillotine, they don’t want the blame game to gain momentum.

The truth is one of the biggest contributors to our current market-clogging problem is the government. This guilt does not stem from government’s malevolence to those who are trying to earn capital. The mistake made by these good people is that they did not fully contemplate the laws of unintended consequences.

The difference is that the government has so much power, few can be heard questioning its wisdom. History has shown however, that leaving economic issues for the most part to the private sector, produces fewer mistakes. These mistakes are often then corrected through the brutal, competitive system.

“Good” efforts by government powers has often led to bad results for our society. Some examples are:

Support for first time home buyers
Result: Questionable qualifications for social purposes.

The repeal of two sections of the Glass-Steagall Act
Result: The recombination of two very different cultures, compensation approaches and regulatory setups for clients.

Trading in pennies
Result: Much less expensive for large traders to take advantage of retail customers who have left the daily market.


The practical destruction of the specialist system
Result: Specialists are needed to support two-way markets during periods of stress.

Fair Value Pricing
Result: Only individuals can now buy without an immediate write down in declining markets.

Restricting Short Sales
Result: A curtailment of early identification of trouble and future required buyers


Whatever comes out of this weekend’s negotiations, if anything, will create its own mischief. These new constraints on the market place functioning is a further devaluation of the old trading (tactile) manuals on how to survive and profit from other people’s transactions.

There are at least two, somewhat related events that encourage optimism. First is Warren Buffet’s purchases of stock in Goldman Sachs on very favorable terms not available to others. In addition, his lock, stock and barrel purchase of Chesapeake Energy at a very depressed price due to rumors as to its solvency, is positive. (Point of disclosure- our hedge fund and I, personally have been long time holders of Berkshire Hathaway stock.)

The second event of note is that the stock prices of Financials, beaten-down as a group during the turmoil in September, continue to trade above their July or earlier lows.

Long-term strategic buyers should use this period to slowly begin additional buy programs and to be prepared that the lack of historic trading practices may give the investor even more favorable prices, interspersed with extremely sharp price spikes as the natural sellers into a rally are reduced in number.

> Sunday Morning Post Script (1)
5:30 am – Reactions to the announcement of the Agreement in Principle on what the press insists on calling “The Bailout Plan”
1. Making a dangerous assumption that the announcement is accurate, my first reaction was the plan would be viewed as highly inflationary.
2. My second reaction is that no matter who heads the next administration and more importantly the make up of the U.S. Senate, we are looking at higher taxes at the Federal level and for many states as well.

>Sunday Morning Post Script (2):
10:30 am - My reactions after some sleep and a brief look at the “talking heads” on cable.
1. Until we see the actual details of the law and the regulations, we do not know the size of the problem; thus we are reacting to shadows without knowing how far the silhouette is from the candle.
2. The plan recognizes the major issue is not credit which is weak in many places, but liquidity which is almost non-existent. The “brilliance” of the plan is that it is creating a low quality Treasury window. For some, the mere existence of this window may mean that private liquidity will come back - knowing that if necessary the questionable assets can be sold to the Treasury.
3. Wall Street/Bank equity owners do not benefit from this liquidity plan directly, the main beneficiaries will be those seeking credit which are beyond the financial community.
4. Congress is lousy at communicating to the public and this increases the likelihood of a more powerful than usual “law of unintended consequences”.
5. In some ways because of point 4, we are lucky that the plan did not address Paulson’s pleas for a clearinghouse for derivatives, which is a larger problem.
6. I expect a significant relief rally for stock prices because the absence of new short sellers and the destruction of the NYSE specialist system.
7. New tactical trading plays will evolve quickly, while longer term strategies will evolve more slowly. The need for liquidity reserves will grow.