Introduction
I will be the first to admit I don’t know for sure which way the
current market will move. However, my clients expect me to have a useful view.
Most of the time if the majority is correct in its beliefs, prices
generally reflect that accuracy and subsequent market moves are relatively
small. That is why often I take a contrarian view. If I prove to be wrong there
will not be much damage, just egg on my face. However, if I am partially right
I may have saved my paying clients and my pro-bono clients some money.
Two types of declines
My study of global stock markets suggests that there are two types of
declines. The more normal so called “bear market” occurs at least once each ten
rolling years. These declines are on the order of 25% from top to bottom in
terms of the major stocks or capitalization-weighted indices like the
S&P500. Most investors will stay at least partially invested during this
cyclical behavior along a secular growth trend.
Once a generation a much more dangerous decline occurs to teach new
investors that markets are multiple, two way winding streets. These falls are
more on the scale of 50%. The real damage of these devastating declines is that
too many investors revert back to savers, pulling their remaining money out of
the market and swearing “never again” will they trust the market. If kept, this
decision means that they will not participate in the eventual recovery. More
significantly, their long-term beneficiaries will be missing the future growth
of capital or possible new high levels of the market.
The upside risk
As regular readers of these posts may appreciate, I have been
concerned that we were setting up a pattern that was similar to the historic “once
in a generation” type falls. Before calling for such a possibility I believe we
needed to see a sharp increase in prices for a narrowing number of securities
sucking in all the available sidelined cash as well as various leveraging
techniques; i.e., margin, futures, options, and increasingly, ETFs. This has not
happened yet. So if we now get what some so-called experts are calling for, a
20% drop, we have escaped a much worse decline.
What could cause the parabolic price tangent that would complete the
standard elements of a major decline? I suggest that the answer is the very
thing that is currently causing a number of stocks to rise in price, the
current wave of mergers and acquisitions.
As someone who has participated in both sides of these transactions as
well as a shareholder for clients and my personal accounts, I suggest that many
(and some may say most) of the M&A transactions will not add value in the
long run. Definitely some can work out very well, but they need to have certain
characteristics. In general, most entrepreneurs who have built companies
understand the Make vs. Buy calculus. One of the big advantages to be derived
from an acquisition is that if it doesn’t work it can be buried quietly. The
big disadvantage is the supposed loss of time spent on building rather than
buying. Assuming that the potential acquisition is going to be integrated, the
acquirer needs to believe that the acquisition brings in an order of importance,
particularly the following positive elements:
· A corporate leadership not currently being
used to full potential
· A culture of seeking excellence in people and
products with an important emphasis on service levels and metrics
· Loyal and understanding clients
· Cost advantages gained through efficiency
rather than historic accidents.
What makes the current spate of deals different is that normally the
price of the shares of the acquirer goes down on the announcement. This is in
recognition of three elements:
· A premium price to induce the seller
· The direct and indirect costs of integration
· The recognition of the need to do the deal.
The warning sign of excess enthusiasm is that after the announcement
the prices of the shares of both sides are rising. There is also a sense that
in some cases the cash and borrowing power of the acquirers are burning holes
in their pockets, and the Street or the City will accommodate.
The Law of Gravity reversed
The standard law applied to prices is that what goes up must
eventually come down. The reverse at times may be true such as now. If current
prices do not materially fall, the congenital bulls will trumpet that we have
appropriately discounted the nasty news we have been reading. If a small single
or low double digit decline is experienced, then supposedly we can rejoin the upward
secular growth trend.
We are already seeing some elements of this thinking in last week’s
tumultuous market. On Monday the price
of JP Morgan Chase* closed at $59.19 not far from its high for the
week of $59.26 with a volume of 12.4 million shares. By Friday the stock closed
at $56.48 up a little bit from its low for the week of $55.97 on 23.5 million
shares. Almost twice as many shares were bought at slightly lower prices. This
suggests to me that there are some “bargain hunters” ready to move in. They
possibly believe that in the future JP Morgan will sell at record prices. If
enough buyers believe similarly, we could see a rapid advance in some prices on
increasing volume which will fulfill the remaining element to a major top.
Clues to watch for are both volume and cocktail party chattering to catch the
surge.
*Stock owned by me personally and/or by the
private financial services firm I manage.
The potential downside is for real
Historically market cycles were primarily a reflection of agricultural
and business cycles. The bringing on of excess productive capacity (often with
borrowed money) forced by competitive pressures to lower prices produced dire
results to the producers and in many cases the lenders.
Today we have only some of those tendencies present, mostly in the
commodities arena heavily influenced by fluctuating Chinese demand. The markets
could probably handle these imbalances. Currently the force that is preventing
normal rules of the economy to work efficiently is government.
Going back to Lord John Maynard Keynes, if not before, a view was
developed in academia that enshrined in the unwritten constitutions of many
developed countries that government was responsible for the creation and
maintenance of jobs. Keynes lost
fortunes as well as made money in the market place, but he never ran a
business.
The poisoned chalice
For centuries the use of fiscal (taxes) policies did an okay job for
most economies. The political leaders of governments were not reasonably
equipped to manage their societies without high criticism. Thus increasingly
they in effect passed the buck to their servants, the central banks.
This emphasis was strengthened in the US by giving the Federal Reserve
a dual mandate to keep the value of money sound (relative to inflation, not the
level of governmental debt and fungible assets) plus to produce an acceptable
level of employment. Somehow the original purpose of being the window of last
resort to the banking system was buried. Note that the comments by the current
chair of the Federal Reserve Board are almost exclusively about the level of
employment, underemployment and unemployment. I would suggest that the
politicians need to recognize that they passed a poisoned chalice on to the Fed,
which is not staffed or equipped to make social policy decisions. With uncertain
and inefficient tax regulations, monetary policy is insufficient to be a driver
of employment.
The historic failure of using the central banks as the engine to drive
policy has led to the use of bailouts to protect employee voters when
commercial interests get overextended.
The risks of a major market collapse
The fundamental risks
of a major collapse of the markets are caused by the fragility created as these
two unnatural forces (maintaining monetary stability plus the promulgation of
social policy) collide within the financial world. In the misguided attempt to
create jobs through the use of manipulated low interest rates, central bankers have
robbed the world of the traditional structure of interest rates.
Combined within a
single rate there is the pure cost of money, usually the interest rate paid by
governments, plus the cost of credit which recognizes the risk of failure to
repay fully and on time. (There is also
an element to cover administrative costs.)
Because general
interest rates are now so low there is no credit or administrative expense
cushion. To illustrate this fragility, European markets slumped when it became
apparent that the holding company that owned a majority of the Banco Espirito
Santos** (BES) shares was having problems; one of its affiliated banks in
Angola was having difficulty getting repaid on a major loan. The concern in the
market was that Spain, its home country was still dealing with its financial
support from the ECB. The real concern throughout the world was whether this is an
isolated event or whether there are more loan problems.
**In my opinion, BES is the source of
the best global daily bond desk letter
If
interest rates have sufficient credit cushions and there is no incipient
bailout overhang, these problems could be isolated and not be a possible
systematic problem.
Fears of credit
problems
Both high yield mutual funds and loan
funds are experiencing net redemptions after long periods of receiving inflows
in a “TINA” (There Is No Alternative) market. The yield spreads vs. US
Treasuries have widened a bit, but are still historically too narrow. The back
up in yield may be caused by a short-term rise in interest rates. However, I
believe some portions of the redemptions are due to fears about credit
problems.
If it weren’t for the low general rates
there would be sufficient credit cushions to absorb normal defaults, but they
are not at that level now.
Bottom line
Most of the money that we have a
responsibility for is long-term in nature with some very long-term. Because I believe that there is an odds on chance
for a meaningful decline over the next five years, I will be trimming my
current risk exposure.
Utilizing my Lipper Time Span
PortfoliosTM, I would reduce the
maturity in the operating portfolio to one year. In the recapitalization
portfolio I would reduce risk elements to 50%. The long-term portfolio risk
elements should be 66% and the legacy portfolio 75%. I am looking forward to
raising the risk components to higher levels in the future. For descriptions of the Lipper Lipper Time
Span PortfoliosTM email me at MikeLipper@gmail.com.
How are you prepared for the next
market phase?
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A. Michael Lipper, C.F.A.,
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