Three Bullish Presents for Investors

This is the holiday season of giving presents. I have three ideas as presents for long-term, fiduciary oriented investors. These ideas are both presents for those who may need them as well as thoughts that should have presence in an investor’s mind while looking into the future.

1.       Waiting for the big drop

At a recent dinner with a knowledgeable member of a charity’s investment committee, he indicated that he was out of equities for his personal account which is to fund his living expenses for the next twenty years. Yet he was perfectly comfortable with our use of equity funds for the charity. In terms of estimating future returns, I believe my actuarial friends will see little difference in a twenty year and a theoretical perpetual return for the charity. While I recognize and expect the past price patterns to continue, this suggests that in any ten year period, there will be three 25% declines from peak levels. Further, once a generation there is likely to be a drop of 50%. Having experienced these in the over fifty years I have been an investor as well as serving other investors, I know very few market participants that totally side-stepped these declines. I have found it to be more difficult to accurately guess how big a drop will occur once a decline is underway. I have looked over my notes and recollections of my judgments at or near past bottoms. In every case I convinced myself that a deeper bottom was required to bring the market to a bargain basement level. There were always lower estimates of earnings, unfounded rumors of firms, institutions, or well-known individuals that were in dire straits which would become known soon. As difficult as it is timing a bottom price, the decision to buy early on the way up is even more difficult. Because at the time of the sharp decline there was no market-clearing event which would signify the end of the bear market, most lacked sufficient courage to be an early participant on the rise. Often this rise was described contemporarily as a rise in a bear market caused by successful short covering, not the beginning of a new bull market, or at least a sustained stock market rise.

While some may have all the skills of identifying a major decline in advance, recognizing a bottom, and being an early participant in the recovery rally, along with most other professional investors, I do not have these capabilities.  As with many extreme sports, and other dangerous pursuits, I choose not to engage in market timing strategies.

Perhaps more importantly, there are a number of positive features I see on the investment horizon which can be summarized as follows:

A)      The largest gains come from investing into opportunities when others retreat from challenges.

B)      A careful listening to the press conference given by the Federal Reserve Chairman will reveal his view that the monetary policies being followed have not lowered unemployment (and underemployment by those seeking full time work or discouraged workers). I would suggest other countries’ quantitative easing also has not produced significantly positive results. I believe that market and credit rating declines will eventually curtail the need to sell more government bonds to the central and commercial banks. As usual the private sectors, including individuals, are ahead of the government sectors. While governments are issuing more bonds, the private sectors are deleveraging. In the future we may see the private sectors expanding while the government sectors begin to contract. One of the lessons for an equity investor is to look to the bond market for clues to the future.  Each week Barron’s publishes a confidence indicator that measures the ratio between the yields of mid-quality bonds versus high-quality bonds. The index normally moves 1% or less in a week. When the index goes up, which means mid-quality bonds are going up, it is bullish for stocks. In the last week the indicator rose by +1.4%. Bottom line: I would be leaving cash for equity.

2.       Economic bears like stocks

As is often the case, Jason Zweig in his Wall Street Journal columns, reports on thoughtful pieces he has read. This week he reviewed the opinions of two astute thinkers on the economy who see that the US progress will labor to grow at half our historical rate since the Civil War. Nevertheless, both are investing in high quality US stocks. One of them, Jeremy Grantham of GMO believes that such a portfolio will grow for the next seven to ten years at an annual rate of 5% plus inflation. This is a very satisfactory rate as it exceeds many institutional and endowment minimum spending rates. Many conservatively managed pension funds will be able to meet their needs with such returns.

3.       The biggest potential present from Singapore

One of the investment managers that we use for our accounts is Matthews Asia. As one would expect, they are long-term bullish on Asia. In their well-reasoned November Asia Insight letter, entitled “Emerging Asia’s Rising Productivity,” they focus on the smart way to use labor rather than the initial low wages, which are now rising. Part of the reason for the rising labor productivity is the attitudes of the local governments. The Singapore Department of Manpower has a vision statement which states the department “embodies the aspirations of lifelong learning and the need of Singaporeans to adapt, learn and re-learn skills, attitudes and competencies for lifelong competitiveness.”  Now compare this view to that of the US Department of Labor’s mission statement: “To foster, promote and develop the welfare of the wage earners, job seekers, and retirees of the United States; improve working conditions; advance opportunities for profitable employment; and assure work-related benefits and rights.” While we can understand the historical political development of each institution, the US Department of Labor raises lots of hurdles to generating high productivity in the US labor force. Indonesia, which has a population that is much larger than Singapore’s, has a similarly charged Department of Manpower. Some of the US Department of Labor activities are good for labor (and in the long-term, capital), but many are anti-competitive. Maybe we will make some future progress by following the emerging market leaders as we recede.

Investment Implications

·        Don’t attempt to time the market.

·        For the long-term, equities are better than cash.

·        Some of the emerging markets understand how to produce long-term value and selectively belong in many portfolios.

Please share your views.   

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The Shapes and Shadows of Things to Come

As I have stated numerous times in these posts, it is the job of a good analyst to explore impossible thoughts. Too much of the focus of the media and the politicians is on the immediate future. Good analysts, particularly those like me who try to divine future secular trends, need to look to the furthest time horizons that are visible and to understand what might be beyond the horizon. With these thoughts in mind, the following topics are presenting themselves for recognition, interpretation, and investment implications:

1.     The Bernanke-labeled “fiscal cliff” is an income statement problem not a balance sheet problem. We must all recognize that this is a multigenerational challenge.

2.     There is no consumer strike, just a lot of caution.

3.     Multinationals think globally as to where to store up cash and borrow money.

4.     Problem solving by attempts to change the laws and not behaviors is illogical.

5.     Two illuminating front page articles in the Sunday New York Times next to each other, “Clinton’s Countless Choices Hinge on One: 2016” and “Tax Arithmetic Shows Top Rate Is Just a Starter.”  

Fiscal Cliff:  Income statement vs. balance sheet

All of the current focus in Washington on the “fiscal cliff” is focused on changes to current tax rates vs. ten years of budgeted expenditures. This is governmental math. We have never seen a balance sheet for the federal government and for that matter most governments. The expenditure for payrolls is treated the same as for buildings and equipment that may have some value after the money is spent, as distinct from payroll spending. If the government was a business there would be charges to depreciation and amortization accounts. Further the government does not recognize future liabilities, particularly contingent liabilities; e.g., replacement of existing facilities, impacts of changing health expense inflation, technological obsolescence. To be fair we have not seen even a list, let alone a valuation of governmental buildings, lands, mineral rights, and what intrigues me the most, intellectual property. Because of these assets I am not now worried that the US government will be forced to default on any of its loans. Nevertheless, I believe that its practice of being a slow payer will continue and accelerate. Please bear in mind our possible forerunner in terms of debt repayments, Greece, is having difficulty in selling some of its assets, but at the right price the Greek government will trade. I believe that the US has better quality assets and could raise substantial capital through sale or lease programs. The rating agencies have threatened another round of credit rating chops if there is not a discernible political willingness to address the spread between US revenues and expenditures.  I am guessing that the global bond market has already discounted on the prospect of another rating cut.

Consumers vs. governments

As regular readers of these posts may remember, my good wife Ruth and I regularly walk and observe in the very glitzy Mall at Short Hills. Today it was raining and parking was directed by security people. By far the biggest line was for pictures to be taken with Santa. Some stores had reasonable crowds, including the Apple store. Others were quite empty. When a clerk at J. Crew was asked about some out of stock merchandise, he volunteered that we should try the website. Internet shopping is filling many FedEx, UPS, and US Postal trucks. These observations suggest to me that consumers are not on strike but are being cautious. Whether they are buying now because they feel that their after-tax income will shrink next year or that prices will rise because of some scarcities, including the need for price relief from higher taxes, I don’t know. We will be watching for trends in early 2013.

Global vs. national

During the week there was news about Emerson Electric borrowing in the US to pay dividends, possibly special dividends, while they had significant cash sitting overseas. The history of Emerson Electric is that it is a prudent Midwestern US company who has a major share of the world market for small motors which drive many machines and equipment. The media commented that this was a strange act to borrow when it had a pile of cash. I believe that the press reaction is also mirrored by this Administration, members of Congress, and the Fed. They all miss the point; that business, consumers, and increasingly investors live in a global world rather than a national location. While I am not privy to the thinking of Emerson Electric, it appears to be rational. The company made money overseas and probably sees opportunities to make more by investing outside of the US. Emerson’s own treasury may feel that the interest deduction is worth more in a high tax state like the US, particularly when they may feel that the Fed has guaranteed inflation so they can repay the debt with less valuable dollars. In setting our economic policies, the leaders of this country should be thinking globally, particularly recognizing the economic problems of other governments and peoples,

“Raise the bridge or lower the water” won’t always work

There is an old saying from Venice, Italy when it was one of the leading city-states of the world, and a leader in financial transactions, that when an overloaded barge could not fit under a bridge they could either raise the bridge or lower the water. Modern governments are attempting to change the rules of commerce to accomplish the same goals of forcing a solution to problems. Many times the solutions are short-term until they come up to a bridge that can not be raised or the water lowered. The only way to move the vessel, or if you will the government, is to off-load some of the burden. While that might help navigate a particular obstacle, it will have no lasting impact without a change in behavior. In order to lower the tonnage that the government is carrying, we must ask the government to carry less and shift some of the perceived necessary burden back on to the people. As with any meaningful behavior modification, it won’t be quick or easy, just look at the attempts to eradicate cigarette smoking; a difficult task, but not an impossible accomplishment to achieve.

Is the front page editor of the New York Times a political prophet?

As mentioned earlier, Sunday’s New York Times had two timely articles next to each other on the front page. The first and somewhat expected article due to the newspaper’s political orientation, explored the possibilities of what will occupy Hilary Clinton’s time  when she steps down from a somewhat impotent position as US Secretary of State. In her next phase she will be able to espouse policies that she has personally developed whatever they happen to be. Even those who have opposed her in the past are very conscious of her own political skills as well as those of her husband.

The Clintons are pragmatists and are good at making political judgments. Whether we will vote for Hillary or not, her attention (or lack of) to the fiscal problems in the run-up to the 2016 is something we should watch.

The second article, somewhat surprising in the New York Times,  deals with the need for substantially more revenue than would be generated by the President’s proposal to tax the wealthy. This is the beginning of an analysis of how difficult it will be to quickly and meaningfully reduce the size of the deficit. In my opinion, our deficit as well as those of many other countries began two or three generations ago. We collectively wanted more from the government than we were willing to pay for in taxes or user fees. My guess is that if it took two or three generations to build these deficits in relatively low interest rate environments, it will take at least as long to eradicate the deficits.

Implications

As investors are reading of these shapes and/or shadows, they should recognize that these conditions drive longer-term portfolio choices. At this point while pure US stocks, if there are any, may be cheaper than similar issues overseas, significant global holdings make sense. While European opportunities are enticing trades, selective Asian and Latin American companies are more appealing. Both Mexico and Canada could make sense for some portfolios. In all cases, unless you have specific expertise, I prefer to use funds or management company securities.

Please share your views.  

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For Political Types, Traders, and Investors

Recently, the US markets have been headline-driven, focusing only on the so-called fiscal cliff. This fixation is unfortunate, as there are many other (and in the end, more important) issues to focus on than the dances in Washington, D.C. Nevertheless, it is an important subject and I wish to share my ruminations with you.

For political types

The real and present danger is not going over the proverbial cliff.  My fear is “the sausage.” That is how the process of passing pieces of legislation has been described; stuffing together different points of view without any overall or in-depth understanding of what the new law actually dictates. When the current ruling party had control of the White House and effective control of the two houses of Congress, they gave us two classic examples of this phenomenon.  Both the Affordable Care Act (Obamacare) and the Dodd-Frank bill are structurally very important pieces of legislation that are so long, complex, and poorly drafted that to this day the American public does not understand how they work and what implications they have upon the rest of our lives. In the month before we in theory go over the fiscal cliff, and become a victim of the Budget Control Act or “sequester” of mandated overall tax and expenditure dictates, there does not appear to be the will or perhaps the ability to make major progress as to our habitual deficit production. Some believe that there will be a last minute compromise on enough items to get an agreement to “kick the can down the road,” delaying enactment of any meaningful reforms. Based on past legislative history, my deep concern is another omnibus “solution,” written largely by aides and lobbyists that few if any fully understand.  

The fundamental issues facing the dancers in Washington are very deep and are similar to those facing most nations with democratically elected governments. For a number of generations we have been spending too much of our personal money and permitting governments to spend too much of our money. With the example of Greece and possibly France before us, America now needs to begin a very long process of getting out of debt to one another. Without an immediate behavior modification we will bring the sword of Damocles down on our grandchildren. Our personal sufferings should be shared with our children so that their children can better control their lives with the resources required to build a sustainable future. The willingness of politicians to attempt to put their opposition, to use a wrestling term, on their hip in order to bring them down, is very understandable, however lamentable in the face of these multiple generation challenges.

One of the jobs of a good analyst, be it a securities analyst, a political analyst, or a budget analyst, is to think through the so called impossible thoughts. To some extent the fear of going over the fiscal cliff is media made with help from the lead currency manipulator at the Fed. Only very few have examined what would happen if we subject ourselves to “sequester.” Often one can get a different and at times better perspective in listening to those overseas. From its London base, Marathon Asset Management (an institutional manager with large US holdings and a prestigious book of US endowment clients) and Brendon Brown, an economist with Mitsubishi UFG International believe that if we went over the cliff it would lead within a year to an expanding US economy. Nassim Taleb, the author of the famous book “Black Swan,” has similar views. Interestingly enough, even the Congressional Budget Office (CBO) has stated that if we go over the cliff that unemployment would rise from the present 7.9% to an unhappy but not devastating 9.1%. (What the CBO does not say is how many of these newly unemployed would be ex-government workers.) But further along in the CBO’s analysis of the post-cliff period, it claimed “short-term pain would be followed by long-term gain.”  What the people in Washington are neglecting to ponder is the multiplier impact of returning to the private sector the capital that is being absorbed by the deficit-producing government.

Thus, I am more concerned about a poorly crafted set of compromises than a reallocation of the country’s resources. I am looking at this problem not only as an analyst, but also as a human, mindful of the pain any major adjustment will entail for many rather than a few.

For traders

There are many microscopes one can use in examining market actions. Because of my background as a global mutual fund analyst, I pay particular attention to the flows into and out of mutual funds and their kissing cousins, exchange traded funds (ETFs). To my way of thinking the latter are much more important now from a trading perspective and mutual funds remain very important to longer-term investing. Though there is some interest on the part of retail investors in ETFs, there is much more interest on the part of institutional investors. My usage of the term institutional investor includes the traditional definition but also hedge funds, commodity trading accounts and some retail relationships that are part of “wrap accounts” with either an internal manager of the brokerage house or an external one that is making the decisions. Performance measurement is important for all of these investors. I believe this is one of the reasons that we are seeing something of management fee war among the major providers of ETFs. I view ETF flows to be a pulse rate for the short-term focus of the enlarged institutional community. That is why I found the flows in October vs. September of interest. In October, net new issuance of ETFs was $ 1.9 billion compared to the month before when there was issuance of $ 37.7 billion or a drop of 95%. The sharp contraction of sales is understandable as the total net assets of equity related ETFs declined by $17.4 billion on a month-end base of $1.03 trillion. Most of this decline was in the domestic broadly based category ($18.6 billion and $5.4 billion in the sector/industry category). Global/international and fixed income assets rose. Perhaps more significant is the short position in various ETFs of the 13 largest short positions on stocks traded on the New York Stock Exchange (NYSE); 4 were ETFs and 2 were in the largest 7 names. A lot of the ETFs are narrowly focused and 6 of them have more shares sold short than the size of their capitalization. Clearly these are trading vehicles most of the time used as part of a complex strategy.

Harking back to my recent post on our annual walk through a glitzy shopping mall, I commented on the lack of shopping frenzy and lower price points on merchandise at Tiffany. One of the fears in making a specific investment in a stock like Tiffany is that to some degree it is at the mercy of the general economy. One way to protect against the general economy/general market would be to be to short a broadly based ETF index like the Vanguard 500. Unfortunately, Tiffany had other problems with rising silver prices and shrinking gross margins which were revealed this week. I suspect that while the theoretical hedger made some money on the short of the ETF, it was less than the loss for the week in Tiffany shares.  

For the long-term investor

As a member of three investment committees of various sized institutional endowments, I try to avoid following the news accounts of what endowments, particularly large ones, are doing with their investments. First, like the classic picture of a small investor, institutions often follow a herd instinct and could be accused of being wrong at turning points. To be fair, news articles about endowment flows tend to be quite dated and may not represent current prices and conditions. Second, to understand why an endowment makes major decisions it is important not only to know about its spending policies, but also about the overall organization’s financial conditions and future obligations. Third, almost all investment committees are made up of people who are primarily focused on giving the money away and another group who are focused on building the capital base for future and perhaps unspecified needs. Thus the actions of the committee will be a compromise. With these thoughts in mind, I would not be rushing into private equity, unless one thought there would be a sharp increase in smaller merger & acquisition activities and an increased appetite for initial public offerings (IPOs). I would also be careful about quantitatively driven funds primarily investing in the difference between the short-term performance differentials of published indexes.

What would I be looking for as equity investments? In the long run it is believed that there will be 2 billion more people on this earth in 35 years. In order to feed them we will need to produce 70% more food than we are doing now. I believe that this increased production will come from capital and technological resources and probably less from human labor. At some point in the far future more food from the sea and perhaps other planets will play a role.

Back on earth and much more immediate, I would be looking for disruptive companies that are changing the cost, supply and demand curves in our world. These may be tech start-ups or more likely companies that use technology in a different way to create dynamic change. An example of this is the impact of mobile phones in the deeply emerging markets that are radically changing cultures. Most of these investments won’t fit well in many indexes which could be an opportunity for the astute investor. No review of potential investments should exclude the impact of improving economic conditions in China. In my mind the way to participate in this phenomenon is very much open to discussion.  How would you now play the China card?

It is your turn to share your thoughts on the Fiscal Cliff, ETFs and short-term trading signals, Long-term investments and China.

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