“The Risk to Worry About” - Weekly Blog # 517.

Introduction

Recently I ran into an old friend at a cocktail party who is retired from being the managing editor of a trade newspaper. He expressed concern as to his own investments with the current volatility. I suggested that the time he should have been worrying about risk was during the fourteen months ending in January, after nine years of rising markets! He was much more comfortable with gradual gains and no declines greater than 3%. I said he should have been worried about risk when others were not, which is perhaps the best measure of the reciprocal level of certainty that a large number of pundits proclaim.

You never know about the future, but one can guess what you don’t know. While in the US Marines as an officer, we were instructed when planning for an operation to identify the essential elements of information (EEI). We quickly learned that it was rare to have as much as 70% of the EEI. Applying the same approach to handicapping at the racetrack, I was pleased to find 60% of the EEI. I feel the same today when selecting individual stocks and funds.

I suggest that in each of our attempts to measure risk, the largest single risk is the unknown and it rises when the pundits are more certain.

Is the Public Smarter?

“Americans Hold Off on Spending Extra Tax Dollars” was a page 2 headline in The Wall Street Journal on Friday. In addition, February was the third month that overall retail sales were slightly off from prior months. Consumer spending was up +0.2% compared to a rise in wages of +0.4%. This was not what was expected. I cheered this announcement as it demonstrates consumers are acting rationally. In the end, the article did point out that a number of consumers were using their tax benefit dollars to reduce their high interest loans. (Economists would label this as savings or deferred spending.) 

Consumers should be fearful of increased state and local taxes as well as increased fees paid to government agencies, and for business sales/use taxes. They should be saving and investing to reduce their growing retirement capital deficit. I don’t know whether it has yet entered into the public’s psyche that there is a chance that the purchase prices of their items will bear the costs mentioned and possibly the impact of tariffs.

A Second Example of Consumer Smarts

For the last several years American investors have been net buyers of “non-domestic equity funds.” I am guessing that these buyers are not largely the same fund investors that have been redeeming older domestic equity funds. I believe the redeemers are completing their expected retirement, estate building, and large purchase needs. To the extent that older fund investors are adding foreign stock investments, they are hedging their domestic equity funds. For a number of years the US dollar has been weak compared with other currencies and deservedly so. Despite foreign investors buying US securities for refuge, it makes sense for US investors to invest overseas. Often there are lower valuations in local markets, which makes sense when considering they are also in less liquid markets. They are also unique investments not found within US borders.

Traders are also buying more overseas investments while redeeming domestic ones. Each week my old firm, now a part of Thomson Reuters, measures the net flows of both conventional mutual funds and Exchange Traded Funds and Exchange Traded Notes. For the last week, ending on Wednesday, ETFs had net redemptions of $11.5 Billion in domestic equity vehicles while conventional mutual funds had $2.5 Billion. (Remember the assets of ETFs are much smaller than conventional mutual funds.) It is worth noting that just two ETFs had combined net redemptions of $10.6 Billion in S&P 500 invested portfolios. This suggests to me that the redemptions came from a small group of trading desks and not the general public.

The fallacy of the “risk on/risk off” approach

The financial media has gotten into the habit of describing market movements as either “risk on” or “risk off.” This is simplistic but can be a binary switch for a quantitative portfolio. It assumes that the investor has identified the risks. Perhaps, this in and of itself is a big risk.  Many can produce a roster of risks. Few can weight them. Fewer still can set the time when their impact will be felt.

The fallacy of the “risk on/ risk off” approach is that it is one directional. At all times we should be looking at both the opportunity for risk and reward. In this case those that invest in mutual funds have an advantage over those that use only individual securities. Mutual funds have flows that many individual investments don’t have. Flows drive buy and sell reactions which cause the portfolio to change. (Often a fund in net redemption benefits from pruning the least attractive current holdings and has an additional opportunity to switch into new investments.) 

Regardless of how one’s portfolio is structured, you should always be looking to add opportunity.

Quotes from Berkshire Hathaway’s Annual Report*

While Warren Buffet lays out their thinking about acquisitions of companies, the principles can be applied to selected individual stocks.

•     good returns on net tangible assets and a sensible price

•   “We evaluate acquisitions on an all-equity basis.”

•  “Betting on people can sometimes be more certain than betting on       physical assets” (I would include shown financial assets.)

•  Berkshire’s goal is to substantially increase the earnings of the non-insurance group through a large acquisition.

•   Berkshire has suffered four short-term price declines of 59.1%, 37.1%, 48.9% and 50.7%.

•  “An unsettled mind will not make good decisions.”

• “Charlie and I will focus on investments and capital allocation.”

Perhaps the single most important clue to Berkshire Hathaway’s long-term thinking is the following statement:

• “The Yahoo broadcast of the meetings and interviews will be translated simultaneously into Mandarin.”

*Held in client and personal portfolios

Question of the Week: What are the risks to your portfolio that others don’t see?

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A. Michael Lipper, CFA

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Paranoid? Compartmentalize.

Introduction

If you don’t know how to get some place, it is useful to know where you are. To be a successful investor over time, it is wise to guess whether you are early or late and which cycle are you playing.

Various commentators have described the current market in terms of “risk on.” The preponderance of those who are active participants are accepting more market risk as indicated through their buy orders.  There is substantial data to broadly support this view. While the popular stock market indices have been rising on relatively light reported volume, elements of both the bond markets and the commodity markets are showing significant strength. Non-energy related commodity prices are now showing mid single digit gains on a year to date basis which is also being translated into gains for many emerging market stocks. Commodities and emerging market stocks are normally viewed as more risky than general stock markets.

If one believes that in today’s environment institutional traders of all sorts see investing in high quality bonds in some form of a “carry trade” is another way to play a “risk on” game. In the past week an usually large amount of money has been invested through mutual funds and more significantly ETFs in high grade fixed income pools. This was not the case in high yield, lower quality securities as can be seen in the changes in their weekly yields. According to Barron’s, an index of high quality bond yields dropped to 3.42% from 3.58% the week before as distinct from intermediate quality bond yields slightly rising to 5.12% from 5.10%. The magazine believes the ratio between the best bond yields and the intermediate bonds is a good predictor of future stock market progress. This week the ratio was 66.8 vs. 70.2 last week and 75 a year before. Most of the time this confidence index moves less than one percentage point per week. A move of 3.4 is a dramatic indication of surging demand pushing high quality yields lower. A symptom of taking on more risk for investors is that Ireland can sell a century bond that follows a similar Mexican 100 year bond.

Clearly we have entered a “risk on” stage. The critical question for both the participants and those on the sidelines but with cash to spend is, “Does this move make me early or late?”  I am aware that my old friend Ralph Acampora, who worked with me on the board of the New York Society of Security Analysts, and who is the father of modern market analysis, has told clients that the correction phase is over. He believes that we have started a new market cycle. Thus he is in the camp of analysts who believe the current move is early in the cycle. He may be right as he has a good batting average on market calls.

One of my concerns is that many companies have become much more efficient in their human capital deployment. They have hired slowly and have used both technology and their external supply chains to keep their active employment costs low, particularly now in the face of rising healthcare costs. This works well in a flat to rising economy. This does not work well even in a modestly declining economy. 

I study the financial services business more intently than other businesses. One of the reasons many of these stocks did poorly in the first six weeks of 2016 was when revenues fell a little they did not have enough people to lay off to keep operating income flat. In one case the quarterly revenues of an important component of a financial services firm fell 3% and operating income fell 21%. In another case revenues fell one tenth of one percent and operating margins fell one percentage point. My concern is if we go into a stagnation phase, many managements will need to make draconian moves to generate cash to meet domestic debt service requirements. The current “risk on” attitude is not reflected in the stock prices of some managements that are unprepared for stagnation.

What to Do?

I rely on my approach of timespan diversification as captured in the Timespan L Portfolios^®. The biggest risk of not producing sufficient funding for current spending is in the shortest term Operational Portfolio. In this case if we see a quick reversal to a “risk off” attitude there can be a significant loss in prices before the next up cycle. Thus, as I have written previously, the operator of a short-term portfolio (and that includes many managers who can not tolerate under-performance for a single or even two years) should set up scaled orders to reduce the risk of disappointment on the way up.

Currently I do not see a significant risk in the longer term portfolios in the Timespan suite, now. The key word in the last sentence is “now.” At the moment most of the “risk on” players are confining their trades to the high quality portions of the market. Based on over fifty years of experience following the various markets I am on the alert for a switch in momentum from high quality to low quality in stocks, bonds, and commodities. Experience shows at sometime, (usually after a significant price rise) high quality issues disappoint and momentum shifts to lower quality. At that point some will remind us that over many long periods, low quality securities have better long-term performance than high quality. Not that they are superior vehicles, but that their entry points are significantly lower than when most investors invest in high quality paper.

The Key to Long-Term Investment Success

The critical key to long-term investment success is not primarily in security selection. The key is how to manage the investor. My approach is to break down or sub-divide  problems into bite size pieces. In effect what I am suggesting is to use compartmentalization to control the natural paranoia facing declining markets. Under this approach instead of using an overall asset allocation schedule, I let the assignment of funding needs dictate individual timespan portfolio compositions, accepting that most of the time the longer maturity portfolios will be consigned to “risk on” structures.

There may be help coming along the way. A recent paper produced by post doctoral students at Caltech and the University of Melbourne is studying contagion or the tendency of people to stampede into making hasty and often unhappy decisions. What they found was people are more likely to become victims of contagion if they have recently (directly or perhaps indirectly) experienced similar contagions in the past.

We should equip people with enough historical knowledge to know that those who participate in a stampede are likely to be trampled and investors improve their odds of survival with a more patient attitude on picking when to dismount the tiger that they are riding.

Question of the week: Where are we? 

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Copyright © 2008 - 2016

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