Time to Get out of the “Foxhole”? - Weekly Blog # 623

Mike Lipper’s Monday Morning Musings

Time to Get out of the “Foxhole”?

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

Quite possibly the biggest mistake in the world is not recognizing that some critical fundamentals are changing. This mistake rests on strongly held views of the future, that it will seamlessly extrapolate from the immediate past or quickly be governed by a new order that will make sense of it all. Good luck to all who believe this.

I start from the assertion that I don’t know what the future holds, either for us or our investment responsibilities. Nevertheless, we know that we cannot stay still in our present condition. Now is the time to recognize that there have been some small changes in the last two weeks that could be meaningful. They have already rewarded some double-digit returns.

In the weekly ranking of traded price changes, a minority of 24% are going up. Not surprisingly, the biggest gains were for those related to oil, which had a relief rally of 25%. However, several unrelated prices also rose somewhat. (Consumer Staples +3.46%, Copper +1.63%, TIPS +0.90%, 7-10 Year US Treasuries +0.79%, Gold +0.54%, +20 Year Treasuries +0.48%, and the Yuan +0.06%). I find the rise of both copper and the yuan hopefully significant. The commodity market players and economists often refer to copper as “Dr Copper”, because it is often an indicator of early demand. The minuscule rise in the Chinese yuan is another indicator that some things in China are improving.

Fixed Income Quandaries 
All too often people group investments with a specified maturity and expected interest rate into the same category, such as government bonds and other bonds with a high credit rating. This can be quite misleading, as evidenced in this week’s Barron’s. The Best Credit Bond Yield average dropped by 37 basis points, while the yield on intermediate credits rose by four basis points. (Remember, bond prices go in opposite direction of yields). The market was therefore pricing the safety of credit more than it was higher yield.

I was at a meeting recently where a money manager included the high yield portion of the portfolio with other bonds. I suggested that high yield paper normally travels parallel to stocks, not bonds, and he agreed.  With interest rates currently at historic lows, high quality bonds should not be counted on for income. They should be recognized as a source of capital to be reinvested into bonds at higher rates (lower prices). This is particularly true now as the yields on longer maturities are rising. (One of the reasons that retail investors with high yield mutual funds underperform total returns is that they spend the distributions rather than electing to reinvest them.) Many disagree with my view in last week’s blog that rising deficits around the world will drive inflation and interest rates higher, and in time a lot higher.

Market Structure Changes
There is some inconclusive evidence the US stock market has hit a bottom. Market analysts suggest that some time must pass for the market to establish a large base before a successful assault on prior record levels can be made. One reason this makes some sense to me is that recessions are meant to correct the excesses of a prior bull market. Perhaps the reason the previous long expansion did not go higher was too many old zombie companies not earning their cost of capital. If this was the case, the next expansion will likely be shorter.

There is plenty of “dry powder” that could fuel a big expansion. One metric Wall Street focuses on are the portfolios of individual investors and for years they looked to Merrill Lynch to provide this view. This now comes from Merrill’s new owner, the Bank of America. They have indicated that the amount of cash in their client’s accounts are at a ten-year high, with the amount in bonds at a seven-year high. Additionally, the large amount of uncommitted funds in private equity is blocking them from raising new funds. The recent market decline has brought the S&P 500 ratio of market price to book value to below 3 times, a level at which M&A deals are often considered.

Covid-19
The public, media, and politicians are looking forward to the “flattening of the curve”.  This may be occurring in Italy, Spain, and New York state in terms of death, not number of new cases. Much more important to me are the vast majority of those who died in both Italy and China having other medical problems. What I don’t know is what killed them, the virus and its complications or their other problems. The following table, provided by US authorities, lists the proportion of patients that had other medical conditions:

Chronic Renal Disease     74.8%
Cardiovascular Disease    61.0%
Diabetes                  54.7%
Former Smoker             49.4%
Immunocompromised         42.4%
Chronic Lung Disease      40.4%
No Underlying Condition    9.7%

Perhaps a positive spin on this tragedy is that it is causing us to rethink, not only our healthcare systems and personal relationships, but also the structures of business and educational organizations.

Hylton and I wish you and your love ones good health. We hope you are practicing good procedures to protect yourself, your loved ones, and the people you are in contact with. We will get through this together.

Question: From where we are today, how should we organize to make us all better?



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Investment Implications of the Week

Introduction

Last week’s post listed a number of elements that could have caused the big sell off on Friday, April 17^th. I questioned whether the relatively big decline was important. By this Friday the general equity market rallied back to the levels where the April 17^th decline began. Thus the simple answer to my question is that the fall of the 17^th was not important. As with most simple answers, they miss the point of relevance. Each of the five elements could become significant to the future value of our equity portfolios as discussed below:

1. The Chinese authorities expressed concern as to the level of speculation being done by somewhat affluent retail brokerage accounts which they were attempting to curtail.

(The prices of many Chinese stocks have doubled in a year while their economy is slowing. The strong desire of many Chinese is to get out of their large savings balances numerated in the Yuan. Securities makes sense for two reasons, first the government’s desire to moderate housing prices is driving the cost to borrow up and increasing the size of down payments. The second reason for the attraction of stocks is that they can now be sold through Hong Kong for HK dollars tied to the US dollar. The Chinese are thus joining the locals in many countries including the US wanting to partially escape their home currency and government control. This awareness of local concerns should not invite inflows into the markets where capital is being exported other than taking advantage of the late incomers.) 

2. Liquidity is becoming more scarce as capital requirements imposed on banking and other large financial concerns are limiting the ability of the traditional sources of liquidity to provide them to those in need at reasonable prices. Liquidity is not important, until you need it to exit or acquire a position quickly and discreetly.

(From a customer's viewpoint big is being viewed increasingly as muscle bound. Large players have had to deploy their capital against regulatory requirements leaving less and less capital to fund client needs or be able to quickly rescue a worthwhile competitor who is in dire straits. Thus there appears to be far less underpinning to current prices than what we used to have.)

3. The couple hour failure of the always reliable Bloomberg computer communications system highlighted how dependent many trading desks had become without sufficient alternatives to trade.

(For those of us who have relied on various machines to run our lives we are not totally surprised with occasional machine and people failures.)

For some, this week became a painful example of how one skilled computer operator can create short-term havoc for a brief period that was long enough to be a significant profit and loss opportunity in suburban London. Interesting, in all the talk about the flash crash, so far no one mentioned a similar occurrence in the US Treasury market. The longer term implications of these “sorcerers apprentice” actions drives home the fact that participants in the market should not count on various regulators understanding the current game or knowing who is playing what set of instruments. To some extent in the past we were better protected when marketplace members were the primary regulators. In a somewhat analogous situation described in Sunday’s New York Times, the diamond merchants have developed their own regulatory system with the main penalty for bad characters being that they won’t be welcome to trade.

4. Investors using academic models were not forewarned by the drop on April 17^th . They had been taught at universities and promoters of various statistical services that standard deviation and other measures of volatility signified levels of price risk in various securities. Thus, these investors were surprised by the speed and size of the drop. A number of more seasoned investors were not particularly surprised due to the relative thinness of the volume on the way up and the lack of traditional price corrections. 

(The importance of this drop is to reinforce that risk is not volatility, but rather the penalty for bring wrong to the extent that long-term spending plans need to be curtailed. Periodic changes in the direction of prices are to be expected. When they do not come, changes are in effect delayed which can be made up quickly.)

5. At the end of the trading day a week ago, there was some price recovery. The critical question was: as the selling pressure lessened, was the buying from those that are trading oriented or new fundamental buyers? 

(The markets did rise last week with the NASDAQ index up every day to a new high along with a number of international markets. The question remains whether or not this is fresh money coming into the market now. I will discuss the importance of the answer to that question shortly.)

Bottom line, the price drop on April 17^th was not immediately important, but it raised sufficient issues that should start investment policy reviews.

The oversupply opportunity

Commodities and industry capacity utilization are in ample supply which means that price inflation is a bit away. What are clearly needed are items that many people want to buy. I suggest that US-led companies as well as some others are brilliant at finding products that people and companies want to buy. In many ways, the US’s greatest natural resource is our advertising and marketing talent. We will be saved by our “Mad Men” and ladies. They not only create the initial demand but allow us to believe in continuing demand that will draw underutilized capital into the investment marketplace. All over the world people are desperately looking for investments in the private sector that can start to fill their retirement capital gap. The current incredible success of Apple^* will not be a one off, as others find the need for new products and services not now present.

^* I am long Apple Stock and have been for many years.

How do you balance your concerns and opportunities?

This question is exactly why I have developed this concept of Timespan Portfolios. The shorter term portfolios need to address the fact that the current regulatory picture is increasingly adverse to sound investing and so periodic and healthy drops may be more severe than history suggests. These will be corrected however, with different people in places of power.

The longer term portfolios will benefit from the successful mobilization of capital investing into more efficient companies, products and services.

I would be happy to discuss this dichotomy with our regular subscribers to see where the Timespan Portfolios work for you.

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Your Investment Gifts May Contain Good and Bad Surprises

Introduction

At this season of both sacred holidays and financial year-ends, we receive wrapped packages. Often we can guess what is in the package by its shape and/or wrappings, others are a mystery. When we closely examine the financial packages, some have surprises within them that will affect our portfolios in 2012 and beyond.

Byron Wien, my good friend and former fellow board member of the New York Society of Security Analysts, is world famous for his list of the surprises he sees for the forthcoming year. Over time, he has an above-average record. Often when he is right in some unexpected event, the returns are high; when he is wrong, not much damage is caused because most investors did not have the same expectations. On the basis that imitation is the sincerest form of flattery, I have hereby prepared my list of investment surprises, published a week before Byron’s. My list is more of an evergreen list than his, and I do not expect to have his winning average. The main purpose of my list of surprises is not to demonstrate my predictive talents, but to develop a list of items that sound investors should periodically review with their portfolios and business plans in mind. Because of my responsibilities for fiduciary accounts, the list generated contains more possible negatives than positives. Further, in the current market environment, it is easier to think about what can go wrong than right; which is probably another indicator that we will see the commencement of a significant upward move of global equity prices.

Surprise: The big money bets can go wrong

The history of huge collapses of market bubbles is that over time the remaining intact assets gravitate to new/different asset classes, often seeming to be more secure. In order to constrain the air coming out of the “Dot Com” bubble, the Fed and other government and non-government leaders became advocates and enablers in throwing money into residential real estate. We all know the results of this over-bet. By the middle of the last decade there were all the classic signs of over-investment by governments, financial institutions, and individuals. Five years later we are still dealing with the buried and yet-to-be buried corpses of this over-investment in supposedly “safe” assets. Where did the money that survived the residential housing collapse go?

The flight to perceived “quality” and safety has led to a situation where the only commodity that is now up in price is the US dollar. This is after the one credit rating agency broke its strangle hold on the highest credit rating, AAA. The other credit raters have not yet followed. If one looks carefully at the US, we still have no substantial effort to materially reduce our deficit production policies. At best, there is an attempt to hold the deficits back, but eventual rises in interest rates and almost guaranteed new overseas military-like commitments suggest that the existing budget plans from both sides of the aisle are naïve. A realistic assessment of our willingness to pay down our debts in “real” terms is no better than mid-to-low investment grade, only scoring that high because of a lot of valuable assets that could be sold. Eventually some of the other major countries of the world will make progress at their own deficits and could become “safe haven” currencies to absorb those dollars that need to be diversified, thus resulting in the price of the dollar going down and dollar yields going up. My contrarian conviction in this possibility was recently strengthened when the CEO of an investment bank was quoted as saying that the US Treasuries are the safest investment in the world. Extreme positions seldom work out over time. A number of Asian countries are agreeing with China to settle trade accounts in yuan rather than dollars; five years from now this could be a significant amount. Currently the only too-strong currency is the Japanese yen. At some point, investors may feel the need to view these two Asian currencies as additional “safe havens.”

The analyst’s nightmare surprise: bad numbers

As an analyst I will never be totally satisfied with the amount of numbers that I have. Part of this skepticism is that we must remember no numbers exist in and of itself in nature. Numbers are an abstraction of someone’s perception of reality. More numbers give me different slices of reality, which may reinforce the initial set of numbers or qualify the applications that the numbers can be used. For some, published numbers by governments, corporations, trade associations and even the specialized press are everything. These are the only actors on the stage of security prices. From experience, however, some of us believe that while numbers are important, they are not all important. In the end, qualitative factors can trump numbers at key junctions in terms of profitable decisions. All of these thoughts are based on the general belief that the numbers are being produced honestly.

For those who want to look, any history of mankind has to reveal that intellectual, spiritual and monetary fraud is a common occurrence. Too many people ask me whether Madoff and perhaps MF Global are the last of the frauds. They want to be assured that all the bad actors have been exposed. This is silly. I am afraid that every single day someone someplace is doctoring results to give a good impression. Most of the time these perpetrators are caught, with relatively minimal damage to most people except the historians. The historians suffer because the fudged numbers are not often replaced with the correct numbers. Thus all too often, the so-called “lessons of history” are based on incomplete facts, with potential damage to all of those that extrapolate from the past. All of this is to alert investors that there will be frauds in the future. The painful ones happen when investors have all or most of their money bet on certain numbers by a trend or manager. The only way I know to defend against such risk of loss of capital is to diversify into different investment approaches that don’t intersect through the same general numbers.

The portfolio managers’ nightmare surprise: hedging creates risk

Many investors and their managers wish to avoid volatility, rather than take advantage of it, or perhaps even better, ignoring it. One of the more popular methods of hedging today is through the use of Exchange Traded Funds (ETFs). The more advanced of these strategies is to use sector ETFs to counter-balance either individual securities or portfolio sectors. That would work well if the sector ETF chosen did truly represent the sector. In Saturday’s Barron’s, there was an advertisement for the nine sector ETFs titled SPDRs (Standard & Poor’s Depository Receipts), often called “Spiders” and managed by State Street Global Advisors (SSgA). The ad showed the percent of each Spider invested in each of the ten largest holdings in the sector. ETFs are often compared with actively managed mutual funds. By policy, most mutual funds do not invest 5% or more in any one stock. Applying the same screen to these sectors, one gets very different impressions as to the diversification in the ETF. For example in the Technology Spider, 47.91% was invested in the first six positions. In the materials Spider, 45.71% was invested in the top 5 positions. In the consumer Spider, the top 5 accounted for 45.04%, and in the Energy Spider, the top 3 were 39.71 %. Any one of these concentrated leaders can have specific risks or positives occur that are not representative of its larger sector. Thus, a gap will open up between the base that the portfolio manager was trying to protect and the hedging vehicle. This becomes important when the manager believes that he/she has reduced the total risk of loss, when that might not be the case. All too often we have seen investors unhappily surprised by these so-called safer vehicles, when the results were not what were expected. In general, I prefer to do my attempts at hedging in separate vehicles where I can track and attempt to understand what each side is doing.

The entrepreneur’s bad dream

With regulators regulating through press releases, aided a news media always hungry for bad news, each business person is fearful of reputational risk. A hard-earned reputation that has taken years (and in some cases centuries) to create can be tarnished or destroyed in a matter of a few days or even hours. Can an investor get ahead of this potential train wreck? No, but one can reduce the potential loss. One clue, particularly in a portfolio of “great companies,” is to cover the name and then look where the price/earnings ratio should be, based on the record. Then compare your theoretical P/E with the actual one. The difference is largely the size of the value that the market places on the firm’s reputation. One way to lessen the risk of sudden reputational loss is to have some preset limit in the portfolio of “great (recognized) companies.”

Surprise: Now, some good news

As regular readers of this blog know, I regularly visit The Mall at Short Hills, with its collection of glitzy stores many of which are part of European brands. Ruth and I visited the Mall on “Black Friday,” and were unimpressed at the shopping volume, as we were able to park easily and saw relatively few shoppers, most with only one or two bags. Today, Monday, is a work day for me, writing this blog and preparing for meetings later in the week. In the course of the day, I drove by the mall and had difficulty getting on to the adjacent highway; there were three jammed lanes trying to get into the mall and past the police that were restricting traffic. The lines to enter the mall were at least two miles long. My guess is that the crowd was not primarily returning unwanted presents, but attempting to buy advertised and unadvertised bargains. This certainly proves that at least some Americans will buy when they perceive value. In an article entitled “U.S. Stores Hope ‘Mega Monday’ Led to Brisk Sales,” Reuters reports that December 26 is expected to be the third-busiest sales day of 2011, trailing Black Friday and Friday, December 23, according to ShopperTrak, which measures retail and mall foot traffic.

Technological breakthrough Surprises

As some of you might know, one of my early roles in the investment world was that of an electronics analyst. Building on that experience and my exposure as a Trustee of the California Institute of Technology (Caltech), I always expect some wonderful new products and services will be introduced to our commercial world. I do not believe 2012 and beyond will be an exception. At one end of the extreme, the truly exceptional items will come from small developers, increasingly located outside of the US. They are the equivalent of the garages that spawned Hewlett-Packard and Apple. At the other end of the spectrum, advancements will come from giant companies with established research and development groups and facilities. The surprise coming from these large groups will be products and services that they were not looking to produce. The potential of this accidental re-purposing can be very large and happen at any time.

The new high: certain, but when?

Despite various twists and turns, any study of history and particularly of human development, leads one to expect progress to benefit many. When will this be translated into tradable market prices? I don’t know. We have been told history does not repeat itself exactly, but it does rhyme. The last reference is to indicate that there will be some similarity of the past stanzas to the new ones. From my technical analysis days of reading price and volume charts, I believe that we are in a long trading market that will unexpectedly either have an explosive rally or a sharp collapse. (These moves are often presaged by false moves, sometimes in the wrong ultimate direction.) From the time the Dow Jones Industrial Average hit one thousand points until it finally surpassed it in a meaningful way, it took sixteen years including a nasty bear market with periods of high inflation and deteriorating economics. Currently we are in the thirteenth year of another long, arduous trading market of reduced volume. As I am breathing optimist, I believe that when we do breakout we could see a substantial upside. If we measure the movement from 1983 to the current high, one can make the case of a 13-14 times gain with rising volume. With my financial services individual securities fund and my portfolios of other funds, I certainly hope this is the case.

What are the surprises you expect, both on the up and down-sides?
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Why Didn’t We Buy? Did the Game Change?

As by now, you and practically every other stock market oriented person on the face of the earth knows, that after a significant market decline earlier in the day last Thursday, starting a little after 2:30 in the afternoon and lasting for about for 43 minutes, stock prices collapsed with 997 points on the Dow Jones Industrial Average disappearing.

A Strategic Question

What caused this calamity? At this point, no one has produced conclusive evidence as to the specific cause or causes. My concern is much more strategic than what was the immediate cause of the decline, (which to me is similar to focusing on the assassination of the Archduke that started World War I, rather than the irreconcilable differences between Germany and its neighbors). My concern is why I and others did not buy at the depressed stock levels. While I won’t be able to be definitive for some time or perhaps ever, I do have some thoughts to share with this blog community.

Lead-up to May 6, 2010

Recently the bulk of the trading in many institutionally-favored securities has been driven by proprietary trading desks and other professional traders including some hedge funds, not by investors. In response to calls from investors and some dealers, regulators have been determined to reduce the monopolistic power of the New York Stock Exchange and NASDAQ. They permitted, (some may say encouraged) alternative trading sites and procedures to come into being. The institutions now have many places to trade.

This market dispersal in turn creates the problem that traders must find the natural other side of the order they wish to execute. One of the techniques they choose to use is to divide their orders. Prior orders of 10,000 or more shares were given to a single broker or dealer to execute. In traders’ search to find volume on the other side, block trades have been replaced with many multiple 100 share orders, placed rapidly through a number of different market sites. Because of the difficulty involved in executing these trades, some institutions reduced their participation in the visible marketplaces. In the partial vacuum which was created, traders saw an opportunity to get between natural buyers and sellers and earn a spread. To find these partial vacuums they employed statistical techniques using various types of algorithms developed by PhDs from universities like Caltech and others. They were, in effect, mining the flow of information captured in prices. To avoid the “Black Swam” effect of something occurring beyond the expected, with a stroke of a computer key they could cancel all their below-the-market buy orders, which was what I believed happened Thursday afternoon.

An Inflection Point?

More disconcerting was the absence of large value stock buyers on Thursday. In last week’s blog I shared my brief notes from the Berkshire Hathaway annual meeting. I saw a number of well known value fund managers at the meeting and I am sure that there were others there also. In theory, these managers always weigh price and valuation points as well as trends. With stock prices plummeting to levels that had not been seen for many years, why did they not rush in and commit all of their reserves? Tumultuous days in the market are often deemed to be inflection points. Was there some new vital information that caused a change in the valuation system used by these managers?

Market Intelligence

On Wall Street you don’t have to actually have superior information, you just need to act as if you have it. For many years when he was chair of the Federal Reserve Board, the market thought Alan Greenspan had better information than others because of his background as an econometrician. We now know, sadly, that his information, especially on housing, was not particularly accurate. Nevertheless, at that time, market practitioners tried to tease out the implications of his supposedly superior information.

Foreign Exchange Trading on May 6

Early on Thursday there was much concern as to most of the Mediterranean economies and the fate of the euro. There was a euro-yen trade early in the day which some took as significant. Up to that particular time most did not look to the yen as a safe-base investment currency. Did this trade suggest that the Chinese government’s attempt to safely cool-down their economy was working? Or did this mean that the rise of the US dollar against the euro was, in effect, causing the Chinese yuan to appreciate and thus reduce some politically sensitive trade imbalances? Was something else of significance occurring, causing sound, value-oriented investors to withhold their support from previously favored stocks?

A Non-Political Observation

From my standpoint a further complicating event happened this weekend. I am not making a political statement, but an informational belief. The good citizens of Utah chose not to re-nominate Senator Robert Bennett. Losing his knowledge as to how the markets work will be unfortunate for the country and particularly for investors. Next year’s Senate will have a lot to do with major regulatory changes that are likely to come.

Did the Game Change?

How should an investor, particularly a long term investor who uses mutual funds and hedge funds, react to Thursday and its aftermath? I suggest that some wise managers will be searching for the implications of this possible inflection point. If a number of successful managers start to do things differently, then I think that Thursday was important and our strategies should be adjusted. At this point I am weary of managers that think what happened was just an aberration. Be particularly careful until after the election.

What do you think?
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