Independence Day: A Chance to Re-think Our Portfolio Structure

• Independence
  
• Interdependence and Insights
  
• Items of Interest

In the United States we celebrate July 4th as Independence Day. Many countries celebrate a Nation Day, observing the date when they became independent from an occupying power. The US appears to be an exception. We celebrate the date we published our Declaration of Independence (actually agreed to on July the 2nd). Thus, we are celebrating a document of principles that we hoped would separate us from what was our Mother country. At the time in 1776, the wish would not have been considered a good bet. The British had the best army and navy in the world, and we had thirteen colonies of very different backgrounds and policies. In at least three states the delegations to the Continental Congress were split and many of our people remained loyal to the Crown, fearing the disruption that would be caused by this new form of government. They were right to be afraid. A number of those successful men who signed the Declaration, who survived capture, torture and death in battle, died bankrupt because of their loss of property during the war. They could not agree among themselves how to govern, even if their independence was won. After twelve long years of debate, a compromised Constitution was passed. Viewing this arduous procedure from today’s vantage point, one of the key political decisions was to create a currency union by assuming all of the outstanding debts of the individual states, and agreeing to make payments in the discredited national currency of the US dollar. I am particularly proud that the driving force behind this and the other financial matters of the new government went to the same college as I did. Alexander Hamilton attended what is today Columbia University. (I need to assure the young in my family that we were not classmates.)

The currency union rested on the ability of the federal government both to raise taxes (largely through tariffs), and to muster a standing army that was under the President’s command. The current problem with the fiscal conditions in Greece, Portugal, Spain, Ireland and Italy are subject to the weak currency union of the Euro. One of the lessons from the American Revolution is that while ideals can flow across borders well, commands do not. I am not suggesting that our various mother countries follow the American experience, but they should use it as a base for their thinking as moderated by local conditions. We also need to apply some introspection to our own activities and thinking, including our investment portfolios, which is the focus of this blog.

Interdependence and Insights

While some early Americans may have thought that they could be independent of the “Old World,” we now know that our very existence and markets are dependent on what is happening both in the Old World of Europe, but even more importantly, China and other countries that we label, somewhat incorrectly, as “emerging.” Perhaps it is my intellectual inheritance from Alexander Hamilton, but I view the world through the prisms of financial lenses. Hamilton, first as the Secretary of Treasury, was very concerned in paying off the war debt of both the country and the assumed debt of the states. He was aided by the development of an active bond market. Only after he left the government did he become involved with the stock market, in part by founding the Bank of New York. (BONY was my first employer after leaving active duty with the US Marine Corps.) Even today investors should first be conscious as to what is happening with the various fixed income (debt) markets. These markets are much more sensitive to changes within the economy than the longer-term focused stock market. Too many stock investors today are not paying attention to the signals from the bond market which can be highlighted as follows:

1. The interest rate spread between US Treasury securities and Treasury Inflation Protected Securities (TIPS) is widening to 2.7%, indicating that market participants over the next ten years expect inflation to be 2.7% or possibly higher.
   
   
2. A number of the bond dealing desks of banks are shedding both people and capital invested in making markets. This is causing some lack of liquidity with prices becoming more volatile with reduced volume. A similar pattern is expected on the stock side of these dealers. To some degree the use of Exchange Traded Funds (ETFs) is providing additional liquidity for the stock market, on both the long and short sides of trades. Lack of liquidity, at times can lead to sudden, large price movements.
   
   
3. High Current Yield bonds and their bond funds are marching to a different drummer/different direction. While we do not just yet have the final numbers for the second quarter fixed income performance, my friends at Lipper, Inc., to which I am no longer connected, estimate that High Current Yield funds will show the only declines in the fixed income averages. These small declines should have been expected. Again, as estimated, these funds had net redemptions of $1.3 billion for the second quarter. The enthusiasm for these “junk bonds” reached a peak in March, when close to $16 billion was purchased at the time of significant issuance by corporations taking advantage of low interest rates. By May the gross flows into this category of funds had dropped to $6.4 billion, which was lower than 14 out of the last 16 months. One of the reasons for the enthusiasm for these bond funds is that in May, Moody’s* estimated that no more than 2.7% of rated bonds defaulted, and they expect by year end this number could be lower than 2%. I have two reactions to the above elements. First, I view high current yield paper as essentially equity with interest payments due and are really a form of stock investing. When these become less popular, I am concerned that stock investing in time will become less popular (which we may be seeing now). Stock markets have difficulty sustaining a big rise without increased volume. My second reaction is that I believe most things follow a cycle pattern. While Moody’s may be correct that we will be in an era of low bond defaults, I have my long-term doubts and would expect as interest rates rise and there are more high-priced deal financings, that the level of defaults, will unfortunately also rise.
   

*Moody’s is a position in our private financial services fund.

Items of Interest

One of the benefits of serving on important tax exempt institutions’ boards of directors/trustees is sharing different points of view. Recently, one particular board was asked about the outlook of the various organizations represented. The concerns of the management were first, that during poor times the needs for its services will rise. Second, fund raising is more difficult when the economy, particularly the local economy, is not expanding. Third, could the endowment be expected to raise its contribution to the operating funds? Much of the answers could be expected if one read the local newspaper. However, there were two expressed views that were interesting. The first was from an accounting firm that was increasing its hiring at the entry level. (Considering the training cycle for the firm, this was a bet that business was expected to be expanding in 2012 and beyond.) The other view held by a number of financial types, excluding me, was a bit dour focusing on this country’s debt problems. One could say that the view from these elements of the financial community was already expressed above, in the drying up of liquidity and smaller staffs on trading desks.

Those who know me would not be at all surprised that I had a different point of view. I expected that the near-term would be a period of increased volatility filled with opportunities. Some companies will do unexpected things that they never considered doing in the past. I believe that there is more proven executive talent available now than at any other time. I saw sufficient long-term growth ahead to warrant investment of reserves above the level of contingencies. A few days after the above-mentioned board meeting, I read a survey conducted for Chase Bank (JP Morgan Chase) indicating that 72% of the companies polled expected higher revenues, 62% expected higher earnings, and 50% said they would be hiring. The difference between the Chase survey and my board’s comments was that Chase’s was a national survey and the board was New York centric. The Chase survey did show some elements of concern. First, with revenues expected to grow but less than earnings, raises questions as to a margin squeeze. Second, with revenues expanding, the expansion of employment is less robust.

Two inside baseball statistics hit me as perhaps significant regarding the changing structure of the fund marketplace. First the net sales, (sales vs. redemptions) in the institutional channel was, in aggregate, greater than the combined net sales in the first five months of the direct marketing, sales force, and variable annuity channels. Most of the money recorded in the institutional channel comes from the institutional shares used by salary savings plans, e.g., 401k, 457, 403b, etc. The second and somewhat related statistic was that US Diversified Equity mutual funds had net redemptions of an estimated $4.9 billion in the first half vs. net sales by similar ETFs of $7.8 billion. The impression I draw from these factors, mirrored by slow volume at retail brokerage firms, is that the investing public is disengaged from the stock market, and is only investing involuntarily through employers’ savings plans. While this is very understandable in view of investors’ experiences over the last ten years and what they read/hear from the media, in ten or more years from now they will look back regretfully at what they could have bought.

With the second half beginning Tuesday what are your views?
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Your Investments Right Now: Hold or Fold?

One of the techniques a former Director of Research of a major firm used in interviewing a candidate for hiring or promotion was to play poker with him/her. How the player handled him/herself, he believed, told him a lot about the person’s analytical abilities, risk-reward sensitivities, and to some extent, their integrity. In the modern era, poker has become both a casino and an electronic game. Regardless of how the game has evolved, there comes a point when each player has to decide to hold his or her position in the game by at least matching the last bet, or declining to do so by folding.

The investing game

While investing should be, and is for most people, a serious activity, some of the thinking that permits players to walk away from the table with their (hopefully augmented) chips, is useful. At every minute in the trading day the investor has the choice to stay in the game and accept today’s risks or to fold, perhaps to play on another day.

Okay coach, what do I do now?

As long as you don’t tell anyone, I will admit I do not know which way the market will go. I join both Peter Lynch and the late Sir John Templeton, who professed not to know (or to particularly care) about short-term movements in the market.

The rest of this post is in response to some members of this blog community who feel under pressure to do something.

The stock markets have been declining throughout the second quarter, which is about to end. The quarterly reports will attempt to focus on the first half results, which will be for the most part positive. Nevertheless, a lot of pessimistic comments are being generated by the single digit losses in the second quarter, and constant focus in the press on bad news. Uncertainty is a word that will be used by various political and economic commentators. Some may believe that there will not be sufficient clarity until after next year’s US elections for the Senate and President. (I placed the Senate first because in my mind it is more important in the long run as to the structure of the US, and to a lesser degree, international political and economic structure.) Some may feel that too much can and will go wrong, and want to exit or fold on some of their investments now. A good coach wants to win the current particular contest, but a great one wants his players to achieve long term success.

Don’t do “It” now

By definition, the optimal time to sell is when something is priced at an unsustainable level. With the exception of a limited number of new issues and some commodity plays, we are a long way from prior peaks or future valuations based on “normal growth and conditions.” Some with large unrealized profits may be concerned about the end of current capital gains tax rates. (If that were to happen, it would be in 2013.) For the ultra high net worth among us that are building inheritance and trusts for future beneficiaries, there is the after-tax risk of timing the re-entry into the market. Most of my clients are more concerned about the long-term future of their capital than the current size of their piles of poker chips.

I need to sell; what do I do?

The following is a series of thought patterns to guide the current seller:

1. If you believe that we have rolled over into a bear market, examine the history of your fund or securities in the last couple of bad markets. We have recently done that on a list of funds of interest to a particular client. While we did find some funds that were in the lowest quintile in the last two bear markets (2000-2003 and 2007-2009), the reason they were on the list of funds of interest is that they had spectacular bull market performance. Thus, if you believe we are much closer to a bear market that might last until after the elections, one might choose to exit these funds. Be careful, getting the timing right near a bottom is very difficult. Most people come in to a subsequent rise late, after the easy money has been made in the early part of a recovery.
   
   
2. If you believe that the current market recovery is getting old, you may want to look at your portfolios for your best performers. Have they done so much better than other investments to make their stock prices vulnerable? For some time small market capitalization stocks have done better than large-cap stocks. On average, Small-cap Growth funds are up +6.02% year-to-date through last Thursday, June 23rd, compared with the average Large-cap Growth fund being up +1.88%.
   
   
3. Popular investments experience a crowd effect, with many of the well known pundits in or out of the media calling attention to particularly good results and/or intriguing personalities. People join the crowd late and usually take the pundits’ word that the touted security is a good investment. As expectations are not met quickly, the crowd dissipates, perhaps causing a redemption run. So if you must sell, look at the former media darlings.
   
   
4. If you invest in sector oriented funds, keep in mind they can move much faster in both directions; and if you want to reduce your downsides you could cut back on these leaders, e.g., Gold and Silver oriented securities. At this point, one of the underperforming sectors is the Science & Technology group. Currently, there is much happening that may change the nature of competition among these companies, which creates both outsized risk and rewards; thus extreme selectivity is warranted. The worst performing sector in the US (and elsewhere) is the financial sector, with the average Financial Service funds down -5.27% year-to-date. As a manager and investor in a private financial services fund, I have mixed emotions. I am unhappy with the performance of the sector, but I can understand it, as can my long-term clients. On the other hand, any additional massive selling of the sector is likely to create bargain prices that we have not seen in many years.
   
   
5. I believe the biggest risk to many portfolios is their high quality and short-term fixed income holdings. Except for TIPS (Treasury Inflation Protected Securities), the risk to your purchasing power is high and going higher in the other securities. At this point in the cycle I would suggest that there is more credit risk than current prices can accommodate. If you are cutting back on your equity exposures, I suggest you cut back on their “kissing cousins,” high yield securities and funds. The higher the current yield, the bigger the risk according to the market.

Twin Conclusions

Long-term oriented investors should hold on; this particular period of uncertainty will be over relatively soon. For those who feel they must exit some of their portfolio, do it wisely. Be willing to cut back on some of your outsized winnings.

As a paranoid spectator, I wonder whether there is any long-term significance in the fact that the plane crash earlier this week in Russia had five nuclear scientists from Iran who were purported to be working on the peaceful use of an Iranian reactor.

____________________________________________

Add to the Dialogue:

I invite you to be part of this Blog community by commenting on my blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog .

To subscribe to this Blog, or to refer a colleague or family member, use the email box or RSS feed sign-up on the left side of www.MikeLipper.Blogspot.com