The Most Dangerous Part of the Portfolio - Weekly Blog # 581

Mike Lipper’s Monday Morning Musings

The Most Dangerous Part of the Portfolio

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

Our portfolios are invested with our emotions, perhaps unconsciously. While we don’t label each investment, we probably assign each to a capital appreciation or capital preservation label. We are willing to take a relatively large risk of temporary or even permanent loss of capital for expected larger returns with our capital appreciation assets. Much less risk is assigned to our capital preservation assets and we don’t expect to take significant risks with those. (Future blogs will discuss the thinking behind this allocation.)

My concern is that some investors, lured by perceived history, are potentially taking unexpectedly larger risks with their capital preservation assets. If there were some material losses with any of these assets it might shake us up emotionally and cause us to question our whole investment philosophy and portfolio. With this shock to our investment system, it could cause us to retreat from investing at exactly the wrong time and cause us to fail to generate long-term capital growth for the entire investment portfolio. The rest of this blog is devoted to specific risks related to our capital preservation assets.

What We Don’t Know
If we are to be honest we could right volumes examining what we don’t know. For the sake of brevity I will highlight just three topics of what we don’t know:

• The timing and extent of the next major market decline?
• Where today’s fragmented data leads?
• When will interest rate risks be materially higher and under what conditions?

The reasons these are questions is that I don’t know the answers. The reason that they are important to identify are because they are critical to the prudent use of high-quality bonds and bond funds as capital preservation assets. In looking at these assets it is important to recognize some of the essential differences between debt and equity, which impacts how we use capital preservation assets. Major bond considerations are as follows:

• Bonds and credits have fixed maturities, with some variability due to call features.
• Some fixed income instruments fit specific needs and might be held to maturity.
• Bonds are primarily traded between dealers acting as both principals and agents, without a consolidated tape.
• There are some differences in both law and regulation between stocks and bonds.
• Governments, through both their treasury and central bank intermediaries, use bonds to transmit messages to the economy.

Investment decisions are based on both experience and current thinking. In reaching any decision, investors would be wise to listen to the words of the late, great, and former client Sir John Templeton and recently quoted Howard Marx, another former client. They said the four most dangerous words ever spoken are “this time it’s different”. Or, is this the wrong standard of probability? (Lessons can be learned from the racetrack too.)

What Does the Current Data Show?
The answer is mixed and one can choose to emphasize almost any piece of data for either the bullish or bearish side, as follows:

1. The year to date share volume on the New York Stock Exchange is down 39%. (Investors not exercised)
2. Three major stock indices have eclipsed their 65-day moving average.
3. The ETF weekly performance winners are sector bets.
4. 47 of the 72 prices of stocks, ETF, commodities and currencies are generally rising.
5. Deposit interest rates jumped this week to 0.75% from 0.72% for MMDA.
6. The Barron’s bond confidence indicator is only a little less favorable to the highest quality.
7. The total returns on the average High Yield bond fund has rotated around those of General US Treasury funds. (No convincing pattern year-to-date, but behind for five years)

Where’s the Risk?
The risk is in the belief of some bond holders who hold low risk securities on the assumption they won’t go down materially in price. What could go wrong? Bonds, most of the time, move in tandem with general interest rate moves. (Current interest rates are historically low and many think they will go even lower still. However, current rates are insufficient to cover a possible partial or complete default at a time when there is increasing need to roll over maturing debt. At the same time rates are below the needs of retirement accounts, which are facing greater demands from retirees living longer.)

In the UK, bond fund holders have suffered from the collapse of net asset values caused by a well-known “bond king”. In the US, in every decade we have had at least one formerly very successful leading bond manager fall materially. The repeated pattern is that the manager discovers a group of bonds or credits that are under appreciated in the market before they rise. The manager’s success brings in more money for him/her to manage at the very same time that the cheap bonds are bid up by other managers and competitors who were not previously aware of these “bargains”. In time the formerly “cheap” merchandise becomes “expensive”, often at roughly the same time there are problems with the issuer of the bonds. What was expected to be credit quality gains become credit quality losses, with some of the bonds suffering from the withdrawal of buyers. The pattern has been repeated since the age of Shakespeare’s “The Merchant of Venice”, as well as in numerous other markets. Thus, I have high confidence that it will happen again at a time and place to be determined. Part of today’s problem is that there are very few bond analysts and portfolio managers who were operating more than 35 years ago when the bond bull market began.

Two Worries
The first is that for the relatively small number bond holders, directly or through investment vehicles like mutual funds, they will withdraw from investing at the very point when there are more than the normal number of bargains available.

Markets around the world are synchronized across asset classes with a reasonably fixed level of liquidity and move to where they can get the highest risk assumed rate of return. Thus, it is possible that a large problem in one asset class in will drain other markets, at least temporarily.

I have done my fiduciary duty by warning you, but I hope I am wrong, although the odds will be on my side eventually.

Question of the Week:
What would you do if one or more of the bonds you hold drops 10% in a day?
   

      
Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/06/on-right-learning-from-left-weekly-blog.html

https://mikelipper.blogspot.com/2019/06/confidence-deteriorating-normally.html

https://mikelipper.blogspot.com/2019/05/memory-traps-judgement-weekly-blog-578.html



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Be Vigilant when Relying on Patterns

Introduction

In last week’s post I discussed that many investors are only interested in outcomes and not the causes of the outcomes. These investors search for repeated results and expect the same patterns to be continued into the future. For the last two weeks I have been drawing lessons from California Chrome’s losing the Belmont Stakes, and stated that it was a bad bet. Those who wagered on that result were betting that the colt’s past pattern would continue in this most difficult race for three year olds.

Those who follow history of sports, politics (Eric Cantor), theater, and human emotions all have experienced disappointment when the winning streak is not continued. The reason I said that the bet on California Chrome was a bad bet was that the betting odds were odds on, putting up more ($5) to win less ($4). This assumed a much higher degree of certainty than warranted on a young, head strong colt in the spring of the year.

Keynes lost several fortunes following patterns

In the June edition of the Financial Advisor Magazine there is a good article on John Maynard Keynes and his investment experience. There is no question that this Cambridge University don was exceedingly bright and had all kinds of ambitions. As an economist he was also a researcher and looked for patterns in commodities and currencies as well as US and UK common stocks. Each failed to produce a winning result every year and also led to large, (but less than market) losses in 1931. He did beat the UK market in 12 out of 18 years, which is exactly the ratio one would normally expect from a very good professional investor. The sad part of this experience in terms of the rest of the world is that various governments took his economic theories to be unassailable laws. If people only would have used the concept of applying a winning percentage to absolute belief in his economic laws, the world would have been a better place. Instead we had a Republican President of the United States intoning “We are all Keynesian Now.” This was almost exactly at the very moment of history when the US allowed its budget to get out of hand and began peace time deficits that continue to this day, which has led to a relative decline in the US standard of living.

Favorable patterns that may not hold up.

All humans look for patterns in everything they do. Even well-trained analysts look for what they hope for is certainty in patterns. Being a contrarian by nature I look for a reversal of trends, but currently markets are accepting the following patterns:

1.  On a year to date performance basis the Dow Jones Industrial Average is up +2.2% and its Utility average is up + 15.5%. This suggests that focusing on sectors is more important than the level of markets.

2.  Many portfolios are centered on various market capitalization levels which S&P provides. However the best performing S&P level is its 500 Index up +6.2%, and its worst is its Small Cap Index +2.1%. This suggests that market caps are relatively insignificant. We will see if this is true in the next major moves, particularly on the down side.

3.  Low perceived quality as measured by those stocks listed on the American Stock Exchange gained + 16.3% compared with those of the New York Stock Exchange + 5.5%. In 2014 (and for the last several years) higher quality, particularly of balance sheets has hurt relative performance. I doubt this trend will continue in an economic downturn. (Keep an eye on the default rate in high yield bonds.)

4.  Enthusiasm for various political leaders’ statements as to the future of their economies going through restructuring has driven their markets to possibly unsustainable comparisons. The Indian Sensex index is up +18.6% and the Japan’s Nikkei is down -3.5%.

5.  David Herro in his search for economic trends noted that the old indicator, an increase in lipstick sales, is being replaced by an increase in nail polish as an indicator.

6.  The trouble with following patterns slavishly is there is no room for a “black swan” occurrence.

Pattern Analysis can be useful

In a recent report Standard & Poor’s compared the performance of Large-Cap mutual funds to their respective S&P Benchmarks, showing in each of the last six years that the majority of funds beat the indices. The range of beats goes from 81% in 2011 to 51% in 2009. I found this data set interesting in that it shows actively managed funds can perform as well as the benchmarks. More significant to me is the extremes of performance. The low number occurred in a sharply rising market and the high number in a market that was declining in many sectors. My explanation for this result is that the indexes do not hold cash reserves where mutual funds do. Coming off a bottom, “cash is trash” and hurts performance, whereas in a falling market cash acts as a cushion. As I believe that this pattern will continue in our managed accounts, I have been cutting back on our use of index funds as a preparatory move for a future decline. (The impact of this move is to slightly raise our overall expense ratio.)

Moody’s^*  believes “Exceptionally thin spreads typically credit cycle slumps.” As the yield spread is historically small between low credit instruments and high quality ones, I believe that this is a pattern worth noting. This is particularly true as we are seeing a concerted push on the part of both mutual fund houses and brokers to invest in unconstrained fixed- income funds. Even various government agencies are concerned and have discussed an idea of trying to put some redemption constraints on bond funds, which I do not believe will happen politically. Further to the discussion is a comment by a former Federal Reserve Governor in referring to bond fund redemptions as “liquid claims on illiquid assets.”

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

Perhaps, my searching for the top of the stock market that precedes a major decline is misplaced, possibly the top will be caused by a malfunctioning fixed-income market. After all, the last major decline was caused by Lehman’s inability to fund itself in the short-term market. 

What patterns do you use?  

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All Rights Reserved.
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