The Bill Gross Effect and the Need for Other Negative Indicators

Introduction

The huge amount of press covering Bill Gross’s changes of investment house was a wonderful occasion of misdirection. The day of the announcement I reviewed the average performance of ninety-six fund investment objectives for the week. Of the long-term taxable fund investment objective categories, only two were positive. The two that had plus signs in front of their weekly performance were Dedicated Short Bias Funds and Alternative Managed Future Funds. I believe the unanimous performance declines in every single domestic and international equity and bond fund is symptomatic of deep fundamental concerns.

Lessons from NY tracks

One of the personal learning institutions that has impacted my investment analysis career was the New York based horse racing tracks. The percentage of winning favorites was typically about 33%. One should look at the dollar returns from winning favorites after expenses paid in taxes and fees to the track. The winnings would not cover the losses in other races, let alone cover the expenses of getting to and into the track and an occasional hot dog.  From the track math I learned that there is a tendency for those who make mistakes to continue to make mistakes. In other words they could be negative indicators. How could this be?

At that time the New York racing crowd was the savviest in the country, perhaps like those following stocks listed on the New York Stock Exchange. Clearly these bright people were being swayed into making uneconomic bets. They were following the results of past performance races. A horse that had recently won three or four races, regardless of conditions, was expected to repeat. The crowd could have included some member of the SEC staff who then required the phrase “past performance is no guaranty of future performance,” or similar language to be appended to all performance communications with the public. Unlike many politicians that worship at the foot of “Big Mo” or momentum, some regulators were appropriately concerned about momentum investing.

What are the historical odds of winning?

From my experience in looking at investing for more than fifty years, there are two matrixes that answer the question. The much more common one is to measure whether the price of the investment went up or down. For long-term investors, the odds are that 50% of the choices finish at higher prices. Why? The discouraged ones drop out of the class and, at least in the US, the long-term secular trend has been up. You have to live longer to win. Good managers probably win about 60% of the time. The truly great managers win over time probably about 66%. Just as the critical measure of a day at the track should be measured in terms of net dollars won after all expenses, so should performance results be assessed. Even better, if one was foolish enough to think going to the track as a business, one should look at the ratio of winnings to amounts wagered. On this basis I have seen people actually make money only being right some 40% of the time because they handled their money wisely and benefitted from the knowledge that winning positions grow in relative size compared to losing positions.

Lessons from Bill Gross’s departure

First, it is important to acknowledge that he had a very good long-term record that the institutional and individual communities translated into favorable momentum. Second, Bill was the pied piper for fixed-income investing which had some impact on equity investing. Third, none of our managed accounts owned funds that he managed and there was very little owned in some of the over $4 Billion in institutional portfolios of tax-exempt groups that have me on their investment committees.

What should have been included in the press coverage? First, in all likelihood we have seen the end of a thirty year bull market in bonds which began when the late and great Arnold Ganz told me that there was a generational need for bond managers; there were not enough to go around to all the openings he perceived would be coming. Considering that individual investors around the world were rushing into bond funds, the end of the bond bull market could be very destructive to the investment public and could cause interest rates to rise on government debt as there would be fewer buyers. By the way, many institutions with professionals on their investment committees own very little in the way of bonds.

Second, in later years Bill’s success was based in part on a very strong trading facility that he helped build. His great strength was in the timely use of derivatives. Banks are far and away the biggest dealers in derivatives, with PIMCO probably getting their first call and possible price concessions. Due to rapidly changing bank regulations, banks are cutting back on their inventories of derivatives. Thus, in his new home Bill may be offered less support than what he has been used to receiving.

Third, many news articles have been speculating on how much money will leave PIMCO. While this may be harmful to the fund management company’s bottom line, I suspect that it will be good for those investors that remain within a shrunken fund. There is no portfolio that I have observed that couldn’t be improved by judicious selling. A manager may love all of his/her holdings; however redemptions will force a ranking of those holdings that are least loved.

Fourth, Bill’s quick decision to join Janus, apparently his second choice, defies historical analysis. The board at Janus has a long history of making the wrong decisions in terms of senior executives. This could change.

The need for negative indicators

Since great managers in the long run are only right about 2/3 of the time, we would all like to improve our odds. From my experience those people who have been regularly wrong tend to persist in being wrong. My feeling is that these people are wrong about 75% of the time leaving them to be right 25% of the time. What we attempt to do is to take advantage of superior managers to enjoy them being right 2/3 of the time leaving 1/3 when they are wrong combined with the much smaller number of negative indicators that are only correct 1/4^th of the time. If we were absolutely successful we might potentially produce a 91% hit record. We don’t believe that we will achieve this result without your help identifying additional negative indicators.

Calling for negative indicators

I hesitantly nominate three groups to start your juices going as possible examples of negative indicators. The first is the current keepers of the Dow Jones Industrial Average (DJIA). In the last year according to Barron’s, they added three stocks. Two gained +5% and +1 % with the third declining -5%. They replaced three stocks that gained +47%, +8%, and +26%. These changes demonstrate their concerns for investors that are tied to the DJIA. Further, they have announced that in the future only those companies which are headquartered in the US would be eligible to be included into the World’s most famous stock indicator. They are following the action of the S&P 500 a few years ago. These choices will have an ironic impact. The next most popular index family, the Russell indices, are now owned by the London Stock Exchange, which might have its new owner’s proclivities in mind.

One might speculate that the keepers of the DJIA (which is now managed by a subsidiary largely owned by S&P which in turn is owned by McGraw Hill Financial^*) are defending themselves from a lawsuit by the Justice Department which it is alleged has to do with its downgrading of the credit rating of the US. Thus the announced DJIA move could be interpreted as an attempt to back the current Administration’s efforts to curtail tax inversions. Thus, we are seeing political capital topping investor capital. The history in the marketplace is that this is a short-term advantage and will actually just encourage more off-shore deals.

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

The second negative indicator nomination is for the California Public Employees' Retirement System (CALPERS). This judgment is based on CALPERS’s decision to redeem some $4 Billion invested in hedge funds because they were too complex and too costly. I wonder what they thought they were investing into in the first place. There is a chance that their timing is exquisite. After far too many years of declining interest rates and generally rising stock prices, we have currently seen the beginnings of rising rates and falling stock prices. As stated above, the only two fund investment objectives that were up this week were Dedicated Short Biased Funds and Alternative Managed Futures Funds. In addition, a closed-end diversified currency fund had a surge in trading volume.

Caveat emptor

My private financial services fund (which is structured as a hedge fund) has not had a short position in many years. In addition I personally own shares in a non-US manager of one of the largest futures funds in the world. Further some of the non-profit investment committees that I sit on have quite successfully used hedge funds in their portfolios. Thus, I believe that CALPERS is a good nominee as a negative indicator.

The third nomination is the previously mentioned Janus Capital Management whose board of directors has consistently chosen the wrong people and the wrong diversification moves at the wrong times.

I am looking into making a fourth nomination, of a  prominent talking head or columnist who is brilliant about extrapolating yesterday’s news.

Please send me privately your nominations of negative indicators. In the meantime, invest well for the long-term and trade well in the short-term.

__________

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

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Copyright © 2008 - 2014

A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Long-Term Investing is at a Crossroads

Introduction

There are three problems about thinking about the future. The first is not to believe the future as starting with what we see today. The second is “when does the future end?” Finally, “what unpredicted events will occur?”  Far too many investors ignore these questions. However, the best guess answers to these questions are the essence of long-term investing. We currently have the responsibility for investing for the indefinite future for institutional and family accounts and so must deal with these questions. Like all investment advisors, we need to do this well for us to be able to add new accounts.

As our present responsibilities to clients and beneficiaries require certain levels of current income, we managed balanced accounts on their behalf. Thus we need to pay some attention as to what is happening in the fixed- income markets, which leads to the first fork in the road. 

Fixed-income disruption

Usually the exploding bubble that brings down markets is caused by an imbalance of demand over supply. If the market can not supply sufficient merchandise the demanders will increase the prices that they are willing to pay. During the ramp up the owners of supply will become hoarders in the belief that prices will continue to rise; and so it will as sellers become scarce. The bubble pops when the hoarders become insistent sellers and the buyers retreat as their only interest was higher prices. 

In some respects the way fixed-income investors think about securities is the exact reverse as stock buyers. They translate their need for income into a yield calculation. Their literature is full of commentary about rising yields not falling prices which is the direct result of the fixed nature of fixed-income.

Any long-term history of bubbles will reveal that bubbles never really totally disappeared; the surviving “animal instincts” just shift their focus often with the help of governments. The speculative excesses from the “dot-com” arena morphed into the prime mortgage bubble. The way one can spot the next bubble is to look for large instances where there is excess demand over supply. In the fixed-income world that translates into higher prices for bonds and lower yields. We are currently within a huge increase in the demand for income to meet institutional and individual needs.

I have written in the past about the studies done at Caltech and other places as to how the mind accepts risk of sharp declines based on the belief that the mind will be able to execute a rapid withdrawal safely. Growing up in the investment business we used to call this “the greater fool theory” meaning one recognized that they were foolish buyers and owners of securities, but there would be always be a bigger fool who would buy the tarnished merchandise at a still higher price. Today, the nerves of the fool are quieted most of the time in the belief that the major central banks will continue to manipulate interest rates lower and in effect put a floor under these foolish bets.

The fears are not totally put to sleep as we saw this week when a single missed payment by a partially owned upstream affiliate of the largest Portuguese Bank (Banco Espirito Santo) triggered a broadly-based European stock market sell-off. This kind of market action reminds people of the unpredictability of events.

In the past, prior to government/central bank intervention, interest rates covered both the cost of money and a cushion for the cost of credit to make the loan eventually good.  The sharp drop has people concerned that what they thought was the proper attention had been paid to the question of credit repayment. Now they are wondering. This may well be the reason that in a US stock market which is hesitantly but gently rising, the stock price of its most powerful bank JP Morgan Chase^* is slightly down -4.6%.

One of the lessons that stock players over the years should have learned is that the fixed-income market is much more sensitive to short-term changes in the chances of getting repaid than the stock market. Thus for stock investors, the bond market plays the role of the warning canary in a deep mine. (This is not a totally new concern. In 2013, the Investment Company Institute reported that both Citi and State Street temporarily suspended redemptions of some of their Exchange Traded Funds.)

As all analysts are essentially historians, I am concerned about the excess of fixed-income demand over high quality supply. In addition, there are two newer concerns. The Federal Reserve has announced that after October they will no longer be regular buyers of US Treasuries and Mortgages, which may reduce the supporting buyers.

My second concern is that because of more restrictive regulations most major banks around the world are finding that they must reduce their expenses in order to get a reasonable return on their equity. This translates into laying people off. Some of these people are in supervisory and/or credit reviewing positions this could hurt all of the services that the banks provide to both institutions and individuals,

       

Melt up before melt down

As said by Monty Python's Flying Circus “Now for something completely different;” a quantity of  US stock investors is actually enjoying good returns.  I tend to look at stock returns in terms of multiples of pension fund and non profit institutions’ funding needs. If one assumes a 7% required rate of return (which is too high), then on a year-to-date basis the owners of Apple shares^* have earned more than double that rate, with an 18.8% gain. The same could be said for Merck with an increase of 16.8%. Even the bond substitute of Utilities is up 14%. (This relates to our fixed-income concerns.)

The truth about the stocks going up in price is that current prices are not drawing in sellers. As many have commented on the current bull market, it is the most unloved bull market in history. While the near-term outlook for revenue growth for most companies is modest and they already have record profit margins and are shrinking their capital base, one wonders what is driving some of these stocks higher.

I have a partial answer from my experience as a leader of a global analyst trip many years ago. I got a call late one night when we were in Australia from a brilliant international portfolio manager. He was asking how the trip was going. I started by reviewing for him our various visits. In his demanding way, he cut me off and asked whether my fellow analysts were believing or not. I asked him what his concern as to what we thought was. His reply was stocks went up on the basis of the weight of money behind each stock.

In a similar fashion I believe that the stocks that are going up are due to the weight of money. Some institutions and many individual investors are not fully committed to this stock market. (Fund net flows are larger for international funds than domestic oriented funds.) I suspect that if the S&P 500 on a price basis goes much higher than the current year-to-date gain of 6.4% (Vanguard’s 500 Index fund on a total return basis is up 7.6%), there will be a competitive rush to get fully invested. 

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

As readers know, I have been concerned about a major top in the stock market caused by stock price acceleration. Typically for a market to get into a bubble condition, the last phase is a parabolic rise where people start talking in terms of short-term doubles and more. It was just such a phenomenon that suckered in Sir Isaac Newton, who knew better, and much later, John Maynard Keynes into participating in the collapse of their bull markets.

I hope this doesn’t happen. But both from my study of history and my research lab at the New York race tracks I can not rule it out. I will be intently watching the action of the crowds, to see whether successful business people are giving up their well paid jobs to day trade from their home computers.

Muddle through

There is nothing axiomatic to the two extreme cases discussed above. The Wall Street Journal which started publishing on July 8^th, 125 years ago created what is known today as the Dow Jones Industrial Average. Over this period it has compounded at a little more than 7%. For those who want to catch the extremes, on the same day in the heart of the depression the index bottomed at 41, compared to today’s level of about 17,000. I must deny I had anything to do with the occurrences on July 8^th,  even though I was born years later on that date.

What to Do?

I don’t have the luxury of avoiding decisions to wait on clearing developments. I can neither wait until another major bottom appears nor can I be a seller at the top in a meaningful way. Thus, while I can adjust portfolios when warranted I must have a starting position everyday.

For long-term accounts that are looking well beyond ten years I express my faith in the power of well selected equities in well managed funds and would be committed to these holdings as long as I could meet funding needs through income supplemented by total return.

For accounts that for internal political requirements that can not see beyond five years I would reduce risk assets to no more than 66% and no less than 50%. For those unfortunate accounts that will be judged on the basis of annual returns, I would own no fixed-income with maturities beyond one year. I would accept that I might underperform a recovery in small cap and technology, including health care, by focusing on large caps, with adequate balance sheets that had a reasonable amount of secular growth in revenues and mutual funds that owned these kinds of securities.

My question of the Week

As these views are somewhat extreme what are your views? 

__________________

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All Rights Reserved.
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Strategic vs. Tactical: Follow the Lines and Spots

Tactical value investing...Was last week a tipping point?...Possible oncoming worries...Mutual funds holders: is your asset allocation correct?...Correction to last week’s post.

Introduction

Even to this day the academic world presents concepts on a black or white board or perhaps on a flat computer screen. Therefore in our minds’ eyes we tend to translate investment strategies in terms of continuous lines. We know that the objective is to end with more money than we started. Our experience quickly teaches us that there are many lines that can produce the desired result. In an oversimplification we contrast a perfect growth model that starts low and finishes at a peak. The line can be a perfect 45 degree slant or look like a hockey stick, flat to slightly down before an explosive burst that takes the line to its zenith. There are many variations of this plot, but we can label the group as growth oriented.

Tactical value investing

A second set of graphs are designed to produce the same result, but want to avoid the risks of falling off, at least temporarily, the growth curve. In this exercise there is a second discipline beyond finding securities that go up in price and that is the need to buy at a price spot that will rarely lead to a loss. This second approach achieves this goal by buying value at least in current terms and is called value investing. One might call it also tactical in the sense that timing is critical to successful entry points.

One of the advantages I have compared to most managers is that I can invest in what I think are currently the best Growth mutual funds and the best Value focused mutual funds. The key to this decision process for the client/investor is to get the appropriate time horizon correct in mixing the strategic Growth funds with the tactical Value funds. Read further and you will detect the questions that we deal with in attempting not only in getting our fund selection right, but also the right mix of Growth and Value. 

Was last week a possible tipping point?

Short-term performance is normally the equivalent of static on a poor radio device. However, every key turning point starts with a given day or week. Also individual funds can have a somewhat dramatically different short-term performance than their peers which would indicate that the outlier is doing something different. Thus, I am starting to question as to whether we have experienced a turning point. During the week, Value funds were off slightly less than 1%. Most Growth funds were down about 2.5% but Small Company Growth funds were down almost 4%. A couple of our very successful specific Growth fund holdings that were up 40-50% in 2013, declined in the range of 4-5% for the week. There could be individual corporate elements that caused these above-average declines or could it be for some reason certain investors were cashing in pieces of their Growth fund winnings, but leaving their Value focused holdings untouched?

Broadening the question to all equity funds, according to the Investment Company Institute (ICI) the net new cash inflow on a year-to-date basis through February was only $43 billion vs. $52 billion last year. Perhaps, more instructive is the weekly estimate from my old firm which estimates that the weekly net flow into equity mutual funds was $1.7 billion and the weekly outflow from Exchange Traded Fund (ETF) was $2.1 billion. In an oversimplification one might say the mutual fund buyers are long-term oriented riding up the curve of past incredibly good performance and the ETF sellers (often driven by brokers) were reacting to various news items. This dichotomy is also reflected in Friday’s flow of money into rising stock prices on the New York Stock Exchange (NYSE) of $2.2 billion compared to $0.9 billion in declining stock prices; whereas the more dealer oriented NASDAQ market was much more in balance with each side moving $1.3 billion.

If prices become negative this week we may have either seen a tipping point or we have just received some meaningless statistical static.

Oncoming worries

The job of a good analyst is to look beyond the headlines. The market will assess the current headlines, but analysts should look beyond. In brief, I am currently focused on three elements of the food picture. The first is that the preferred inflation statistic the government and the Fed look at strips the price of food and energy out of the consumer price indicator. While these can always be volatile, they usually stay within some bounds. Currently the price of food is skyrocketing, partly due to weather conditions, but I would suggest a continuing conversion of agricultural assets to other purposes. 

The rapidly increasing price of food is putting pressure on all families, but particularly on those with little or no income. Even with the big increase in the numbers of people utilizing food stamps, people are being squeezed. As bad as they are now, they could get worse. Most of us don’t realize where our food comes from and even if it comes from local sources, food prices move on global scales. 

One of the stories not being told about the situation in Ukraine is the plight of the farmers. Even before the hostilities many farmers there were heavily in debt to their suppliers of feed and other materials. Compounding the current problem is that under current conditions they have lost five different ports for their exports. Ukraine is one of the largest exporters of wheat and the odds are that they won’t be able to make deliveries to the normal customers. English translation: the price of wheat on our tables is likely to rise.

The third food related worry is predictions that there is a 50% chance of a series of repeated storms, some of these are known as “El Nino.” If these were to hit this would disrupt food production in India, China, and Latin America all of whom produce food for American and European tables.

Mutual fund holders: Is your asset allocation correct?

I have an allergic reaction to following the crowd. However, in general the way long-term mutual fund assets are allocated makes sense in terms of balancing growth opportunities and tactical value holdings. They have allocated approximately 69% of their long-term assets to equity funds and 27% of that total in consciously labeled Internationally oriented funds. The 69% is down from greater enthusiasm earlier and the international component is growing. I use the term ‘consciously labeled International’ as many so called domestic funds have up to 30% in non-US domiciled companies and some of the remainder are invested in multinational companies that through their foreign based operations and/or exports are serving non-American markets. I believe on a long-term basis this is wise as the relative future of our standard of living is likely to decline more due to greater education, work productivity, and savings than here. Our UK friends have recognized this for years and there are hardly any significant UK domiciled companies that are not globally focused. We are seeing the same characteristics in many European companies as well.

The 31% of mutual funds invested in fixed-income is a bit of a problem for me. There are two reasons to own fixed-income securities. The first is to generate necessary income that is not available from other investments. The second is as a strategic reserve if the equity portion falls dramatically. My problem is one of timing. At some point in the future the interest rate repression of the major global central banks will ease up and perhaps terminate. Interest rates will then rise to a level that recognizes both the deterioration of purchasing power of current money and appropriate payment from undertaking credit risk. At this point, if not before, bond prices will decline, damaging the strategic reserve value of fixed-income. Some fixed-income holders would be better off converting most if not all of their long-term fixed-income positions to well chosen dividend paying stocks and funds. If the current income is insufficient to meet current prudent expenditures, the law now recognizes that total return, including stock price appreciation is an appropriate source of income. Some bonds and other credit instruments that have equity-like characteristics, including risk of loss of capital, could be substituted for long-term high quality bonds as long as the investors recognize that the central banks have coerced them to take more risk.

Correction to last week’s post

There was an error in some editions of  last week’s post relating to my discussion of applying the “Rule of 72” to how long it would take to reduce by half (instead of all) the spending power of  principal amounts through the application of a 2% inflation rate. The correct answer is 36 years.  I thank the sharp reader in the UK who called this to my attention and I appreciate the notice of where I make a mistake of thought or proof-reading.  

Question of the Week: for you to ask yourself and perhaps share with me, so that we both can learn:

How are your assets allocated and where would you like them allocated at the end of the year and in five years?

____________________

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Copyright © 2008 - 2014

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