Note:
In
order to ease indexing, I have added the blog sequence number to my weekly posts.
Introduction
All
life is cyclical going from good periods to poorer periods. No one has
repeatedly been able to predict the tops and bottoms on a regular basis. Unlike
actuaries, those who learn the basis of analysis at the racetrack assume that
they will be wrong some of the time. There are two keys to investor survival,
the first is to be selective in which races to bet on. The second is to change
the levels of the bet based on both the intensity of the conviction and to a
lesser degree the need to preserve some wealth. At least this is how I look at
the markets and manage the money for which I am responsible.
Any
survey of known history identifies periods of rising and falling prices as
human emotions react to changes in perceived conditions. From a portfolio
management perspective, to me the odds favor a meaningful decline between now and
probably the time of the next US Presidential election. The decline will be
measured in terms of prices of securities and/or general economic data; e.g.,
Gross Domestic Product (GDP).
There have been times when individual markets or economies have fallen and
occasionally both at roughly the same time.
The problem
is that few investors have had a good record of timing these declines. My
life-long study of mutual fund performance suggests that winners in a
particular phase who raise a lot of cash on the downslope are not very
successful at recommitting the cash on the way up and often over long periods
of time underperform those that accept the pains of declines, but in general
remain largely fully invested in equities and especially in well managed equity
funds. This is less true in bonds and commodities.
To
attempt to answer the questions as to selectivity, weighting, timing, and
turnover, I have developed the concept of Timespan investing. Thus, today I
look at the future through the filters of at least four different Timespan Portfolios.
Short-Term
Operational Portfolios
At the
moment these are the most price sensitive portfolios because these have near-term
payment responsibilities. For some non-profit institutions and active families
the next several years can be particularly stressful. Not only that the odds
favor some price disruptions in most securities and commodities markets, but
there are the new imponderables of net federal and state tax payments. At the
very same time as we may be experiencing a cyclical decline, calling for more
contributions to those who are suffering, but a high likelihood that those of
wealth will be paying more taxes as forgone taxable deductions will have
greater impact than a decline in federal tax rates. In addition, in many states
and local communities taxes will go up to fill some of the smaller grants from
the federal government.
Often
these short-term portfolios are made up of income-producing securities. As
corporations see new opportunities to profitably invest in capital expenditures
(even as they may reduce buy-backs) the rate of dividend increases may slow.
Depending on the depth of the decline, markets may fear that there will be reductions
in some dividends.
To
balance the stock risks in these portfolios often a significant part of the
money is invested in a variety of credit instruments. Historically the prices
of these instruments did not move much. There is however a good chance that
some of these will become much more volatile. Over the last couple of years
many institutional investors with a primary background in stocks have offered
to their clients new Credit funds. (In some cases to improve their yields these
portfolios are leveraged with borrowed money.) One might be concerned with the
impacts of a rumor on the credit worthiness of any of these instruments
creating volatile prices which will surprise some holders.
To
those that are funding some non-profits and/or family spending, they may be
caught in a squeeze as inflation rises. I tend not to give too much credence to
government produced inflation figures. For those who have borrowed on the
doubling of LIBOR levels in the last year as it moves closer to the mythical 2%,
it could be driving costs up for some people. Interestingly there is a real
dichotomy on savings rates offered by institutions who are paying LIBOR or
higher rates, while the average money market deposit rate has dropped to 0.29%.
Limits
on Upside Removed
Now
that the price gaps have been filled in by the recent declines, the limitation
on further price appreciation has been probably eliminated. This elimination
does not guaranty gains, it is just more likely to occur than recently.
Bottom
line: shorter-term portfolios will require more than custodial attention.
Intermediate
or Replenishment Portfolios
These
are the portfolios that are meant to replenish the operating portfolio’s payments.
The duration of these portfolios should be tied to the internal policies of the
account. One guide may be the period that the chair of the company or
investment committee is likely to be in place. From a stock market vantage
point it would be wise to consider that the period should include an expected
market cycle.
As I
have worked with funds advising on incentive compensation, I have favored four
to seven years to set the target period of a portfolio manager’s performance
pay. I am particularly concerned about the use of three-year periods, because
they can be one directional and not show important elements of a full cycle.
Over the last fifty years in the US 37% of the time there has been a down
quarter which means 63% of the time the stock market has risen and therefore
there is no institution-wide experience
in down markets. This may be of real significance today as there has been only
15% of the quarters in decline since the first quarter of 2007. We could well
see a major rise in down quarters to bring the current 15% closer to the
historical rate of 63%.
Portfolios
often own both growth and cyclical stocks. Almost all companies are affected by
the cyclicality of the economy and various segments. If one could count on the
bouncing ball type of behavior of a cyclical market to come back to prior
levels, a buy and hold strategy would work fine. This is particularly true if
the dividend is maintained through the cycle. However, in some cases former
performance is not repeated. For example investments in telephone companies
largely dependent on physical long lines in the age of the internet are
unlikely to reach their old levels of profitability. For years there has been
the substitution of aluminum and plastics for steel in cars and trucks which
suggests that despite what happens on the tariff front it is unlikely that many
steel companies will return to their old levels of profitability and
employment.
Bond
Downgrades, Reality or Rumor
Without
signs of great enthusiasm for stocks, any cyclicality is likely to be limited
to a decline in the twenty percent range which is a difficult arena to
successfully raise cash and redeploy fast enough to beat many buy and hold
quality stocks. This is not true on the bond side as there has been too much
money coming into the bond markets at current prices and yields. At some point
rising interest rates will drive bond prices down. It is quite possible some of
those who purchased their positions with leverage will be forced to sell out into
an illiquid market. A credit rating drop from investment grade BAA down two
levels to B increases the expected default rates for maturities of five years
from 1.67% to 22.06%, In other words the rumor or the fact of downgrade could
raise the possibility of losing over one-fifth of the par value of the bond.
Long-Term
Aspects of the Endowment Portfolio
Our
Endowment portfolio is meant to fund the expected needs of those currently
alive and thus expected to live through numerous cycles. Quite properly long-term
investors should be concerned about a major market decline. In the past
approximately once a generation there have been a period, usually quite short,
of a 50% decline. All investors at all times should be on the lookout for the
bubbles that lead to theses declines. Bubbles are created by human nature when
greed relegates fear to a forgotten corner of the mind. Those of us who dwell
in the world of numbers will often be very premature, that is wrong, in
spotting bubbles through the use of market or economic statistics. The more
useful guide is to listen to the level of enthusiasm both the professionals and
the public express. Some of the attributes of past bubbles are as follows:
- A new discovery that is expected to bring wealth to many.
- Apparent liquid markets, often one-sided in reality.
- Easy and cheap credit.
At the
moment in terms of stocks I don’t yet see signs of a bubble which means that
long-term endowment accounts should stay reasonably well invested in stocks
now.
Legacy
Portfolio Items
Periodically
equity market prices are focused predominately on near term results which are
often troubled. At the very same time these enterprises are developing not just
the products and services that will be in great demand in the future, but more
importantly a cadre of managers that can bring a lot of the potential to
fruition. To an important degree it is like looking at young racehorses who are
expected not only to have winning records but to be successful breeders. Not
easy to find, but worthwhile. Currently perhaps the best returns in these
searches may be found in frontier and emerging market investing. All of these
opportunities will experience some turmoil during their development. One needs
very skilled analysts and portfolio managers to find these opportunities and
enough patience to hold them.
Questions:
What
are you going to do in the next decline?
Have
you been able to identify desirable Legacy investments?
__________
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A. Michael Lipper, CFA
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