Stock Prices Up with Economists/Analysts Unconvinced

Introduction

There are no perfect rules about investing. Everything we think we know should carry with it a notation of a margin of error.

One of the advantages that I had growing up was to learn that one could have a winning day at the thoroughbred race track by cashing tickets only on one third of the races; in other words by picking one’s bets carefully and knowing when not to bet. The big advantage, in theory, that individual investors have over most fund managers is that individuals can be like me and not bet every race because of a lack of conviction as to its outcome or that the odds did not have an appropriate risk/reward ratio imbedded in the bet. My long-term analysis of the historical records of investors who stay in the game is that they are right on the order of 50% of the time and if they wind up by having more of their money on winning positions, can come away a monetary winner being right only 40% of the time. I believe most fund managers that have long-term records of ten or more years are right around 60% of individual quarters and years. The great ones are right perhaps two-thirds of the time.  With all that as a statistical prelude to indicate that being wrong is part of the game, I turn my attention to the remarkable first week of January trading. US stock prices were up roughly 5% in the four trading day week. One of the favorite market tales is that there is a “January Effect” which states that as January prices go, so goes the year. The believers in this theory are encouraged by the first day’s trading and the first week’s as well. Historically the “January Effect” does work, as do most months in most years. (The US market goes up over time most of the time.) There is some reasoning behind the belief in the “January Effect.” In early January many pension funds, 401(k) and similar plans get their money destined for the equity market and therefore they are buyers. Despite all the dour headlines and pundits’ chatter, the first week is actually a continuation of the halting rise in market prices that was evident in the fourth quarter of 2012. Nevertheless, the purpose of this post is not to jump on the momentum train, knowing full well about error rates and that optimism is contagious and often leads to unfulfilled results. The purpose of this week’s blog is to understand the dichotomy between the rising market prices and the very subdued comments of well-known and somewhat learned economists and investment strategists.

The focus of economists and analysts

1.    The recent tax bill is being celebrated by the media as saving the country from entering another recession. (My personal point of view is that it will hurt the economy long-term.) The tax bill did not address the causes for the deficit and actually added to the deficit. The real losers from this bill will be the lower and middle level income tax payers as well as those who pay no income taxes. All of them will suffer from an increase in the rate of inflation as capital owners will attempt to offset the increase in their tax costs through raising prices and slowing any hiring plans, particularly to reduce the impact of Obamacare on their income. What is probably the worst thing about the tax bill is a continuation (along with the central banks of the world) in attempts to manipulate the economy. After a generational expansion of the US economy, we need to materially improve the management of our own spending as well as to maximize our  productivity.  From time immemorial we have had economic cycles. Attempts to delay the cycle have often led eventually to a much worse result.)

2.    The tax bill included a number of benefits to particular special interest groups. This was evidently needed politically to get enough support or was a “due bill” to be paid. Mohamed A. El-Erian in his latest piece points out that politics drive economics in Italy, Japan, and the United States whereas in China, Egypt, Germany, and Greece economics drive politics. (I believe the second group are much closer to dealing with their structural problems than the first group.

3.    The US Federal Reserve, the Departments of Labor and Commerce, as well as the SEC have publically admitted that they do not have the correct statistical tools to fully understand what is happening within their specific areas of regulation. If they don’t have the right tools one has to fear their regulatory policies and recognize that it will be unlikely that the Congress or the White House can come up with appropriate policies.

4.    Some economists are pessimistic as to the long-term growth for the US. They cite the record levels of operating margins and expect less in the way of major economic benefits from innovation. (Ironically Professor Krugman believes that some are underestimating the growth potential from wider adoption of robotics.)

5.    Analysts have significantly lowered their current estimates of soon to be released 4^th quarter 2012 earnings, with particularly lower estimates for tech and financial companies.

6.    The expected growth within the US of electricity use is expected to be below 1% even with all the new electronic gadgets in-use. This is important for two reasons. First, if the electric utilities cannot grow their bottom lines they will be unable to directly pay for either major upgrades to their transmission grid systems or the new energy sources that the government is pushing. If these new expenses are to be mandated, either utility rates will have to rise and/or the government will have to subsidize these efforts. Neither will help the consumers or a struggling economy. The second reason is that slow growth in the US use of electricity is an issue for those of us who are concerned about the growth in China. One of the departing leaders from the top group of government officials publicly indicated that he felt the quality of the data for their own GDP calculation was “soft.” He preferred to use data on electricity usage and bank loans as more accurate indicators of their growth. If the Chinese eventually follow our pattern, their growth in the use of electricity per person will decline which may possibly hurt our ability to understand what is happening in what will be a major market for our goods, services and capital.

What do these market prices indicate?

1.    The first week’s surge, which cannot continue for long, may have had three unusual inputs. First, those with too much cash un-invested felt they had to get in, for the realization of the impact of the tax bill was turning their cash into trash. Second, those who had large accumulated losses without much near-term hope of getting even wanted to recognize their higher tax value losses. Third, US investors wanted to protect the dollar value of their portfolio by moving some of their money into multinational stocks.

2.    Lipper, Inc., now a part of Thomson Reuters has international, global, and largely domestic mutual fund categories for the various types of funds. On average the international funds performed better than the global funds which in term did better than the domestic oriented funds. Most of the superior results, particularly in the fourth quarter, were due to translation gains. The foreign currencies, euro, yen and pound, rose relative to the US dollar or if you prefer the dollar declined relative to its investment competitors, just as the Fed wanted.

3.    The yield spread between high yield bonds relative to treasuries of similar maturities is the narrowest on record, below 6%. The owners of these “junk bonds” are betting on an economic recovery with a relatively low default rate. As some of the buyers of this paper are essentially “yield hogs” rather than sophisticated analysts, this may be a danger signal. One indicator that I have quoted before may show the growing confidence in taking risk. The Barron’s Confidence Index published each week is a comparison of the yields of higher-quality bonds to mid-quality bonds. The index typically moves about 1% point a week, This week it rose  2 percentage points which normally is favorable for taking risks in stocks and therefore "junk bonds."

4.    The movements of the stocks of financial services companies are important to me for two reasons. First, in our global economy we transmit our wishes through financial channels; so the health of those channels is important. Second, as most of the readers know, I manage a private financial services fund along with much larger portfolios of mutual funds that I also manage. As mentioned above, some analysts significantly lowered their 4^th quarter earnings estimates for the financial stocks. The prices of these shares have been rising and particularly in the first week of the year. I believe one of the reasons for their gains is that the committee proclaiming the Basel III agreement has wisely become more flexible as to what is to be considered good capital for banks’ liquidity reserves and delayed its full implementation to 2019. (I suspect moving away from a reserve made up of sovereign bonds was viewed as slightly risky compared to a collection of high quality securities including some mortgages and even equity.)

5.    The markets reacted strongly to the publication of the latest Fed meeting minutes, where for the first time in the minutes (but not the first time in individual governor's speeches), there was concern expressed by some with the continuation of their various “quantitative easing” policies expanding their balance sheet. Possibly we won’t see their attempts to manipulate interest rates forever. As already mentioned, the Fed recognizes it may not possess the right tools to understand the economy. (I am wondering if in the future our “normal” level of unemployment will not be deemed to be closer to 7% with lower rates touching off higher inflation fears.) Further, I suspect that in examining the labor force participation one should look at six sub groups: employees at small, medium and large enterprises plus federal government workers, state and municipal workers excluding teachers. I would suggest that each of these groups have different needs and impacts on both our economy and more importantly our society.

6.    Later this coming  week my good friend Byron Wien will formally present his thinking about the surprises he expects for 2013. One of the reasons that I like Byron is that he has a strong streak of a contrarian in him, as many survivors do. He has a good batting average on being right on his surprises. As a contrarian myself, I hope that this year he will not do as well as usual, as many of his pre-published ‘surprises’ are already uncomfortable to me.

Please share with me how 2013 looks to you.

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Copyright © 2008 - 2013   A. Michael Lipper, C.F.A.  All Rights Reserved.

Too Much Gloom and Too Many Opportunities

There are two relatively standard question clichés about travel experience, “Are we there yet?” And, “are we rearranging the deck chairs on the Titanic?” As this post is being composed on Sunday afternoon, the 30^th of December, we don’t know whether we are ‘there’ (a solution to the fiscal cliff) yet. We don’t know whether the political leaders in the US Senate can come to an agreement that the President and the majority of the members of both Houses of Congress can agree on prior to Tuesday. There is little reason not to be gloomy as to the result.  The gloom is not on the chances of an agreement, but rather on the probability that whatever agreement is made will not address the problem.

The problem is that the solution did not begin with the originator and popularizer of the term “fiscal cliff.” The Chairman of the Federal Reserve, a professor of economics from Princeton, was warning that monetary policy as controlled by him could not solve the shortage of domestic demand and that fiscal policies had to address the problem. His plea to the politicians was correct according to Stephen Roach’s latest letter, in the sense that experimental monetary policy has not worked in the US, Europe, or Japan. As I discussed in last week’s post, our economic problem is that we are suffering from a cyclical binge of too much debt combined with a multi-generational deficit.

The second question as to the rearrangement of the deck chairs on the Titanic actually may well be focused on a much bigger fundamental question. Often the deck chairs on the open decks of a cruise ship are assigned to various price classes for the voyage; the higher price tickets get the better seats, etc. In earlier days, epitomized by the Titanic, the crew and the management of the cruise line were more concerned about proper deck chair configurations than the absent life boat drills; actually there were too few life boats for the passengers and crew.

The current Presidents of the US and France want to redistribute the wealth among the passengers, akin to moving the chairs on the Titanic rather than paying attention to the life-saving needs for life boats and safety drills. Also like the Captain of the Titanic, the Presidents are not focusing on where they are going and having the best available communication equipment and personnel on board. History will determine whether the parallel is appropriate.

Staying with the ill-fated travel of the Titanic, one should point out that other ships made the crossing that night without running into an iceberg. Cruise ships have provided safe and pleasant travel to many thousands since then. The telling point is that with the correct management one can avoid some major, predictable crises. The key to that belief is the word predictable. One of my favorite Wall Street Journal columnists is Carl Bialik who writes interestingly and perceptively about statistics. In his latest column he writes about some of the pet peeves of professional statisticians. The first of Bialik's two pet peeves is that in too many cases, in the popular press and mindset, a single number is predicted without an accompanying statement as to the margin of error. The principal owner of the Titanic, his navigator, and single radio operator did not recognize a margin for error in their actions. Perhaps even more perceptively, Mr. Bialik mentions his second peeve, that the absence of evidence is not the same as the evidence of absence. (Those of us who live in New Jersey were victims of this misunderstanding when NJ Transit did not move its rolling stock to higher ground when the super-storm Sandy was approaching, for their preferred locations had never flooded. Because something hasn’t happened, doesn’t mean it can’t. The damage to the railcars will take hundreds of millions of dollars to repair and will interfere with commuter travel for many months.)

Many opportunities

I get out of bed in the morning, therefore I am an optimist. I believe that there are many opportunities offered to us every single day. Because of our own preoccupations, particularly about today’s problems, we don’t see the opportunities. In preparing for this blog, I saw information on three such opportunities.

Opportunity #1:  The growing middle class

The President of the US and his political cohorts are focusing on protecting middle class Americans from paying their share of the accumulated deficit. What he should be focused on is that there are already 500 million middle class Asians and it is expected by some to be over one billion middle class Asians in the foreseeable future, as mentioned by Kishore Mahbubani in the Financial Times. This is a  market that is currently crying out for the perceived quality of western brands. The US middle class can earn its way out of its share of the deep fiscal hole it is in by focusing on products/services marketed to this growing segment. Most of our investment portfolios recognize this opportunity by investing in multinationals and indigenous companies through selected mutual fund portfolios.

Opportunity # 2:  Net cash generation

Chip Dickson's daily letter from his firm Discern focused on US (registered) non-financial corporations that are in the longest period of sustained excess cash generation in history. I suspect that companies all over the world are awaiting similar investment opportunities. Most of the US corporate spare cash is being kept where it was earned, overseas. Often commentators blame the uncertainty of tax rates for the unwillingness to spend cash. This is not completely true. In the US, we have had changes in taxes about every two years. The retarding issue is that there is a lack of vibrant demand in the US. In the 19 quarters since the beginning of 2008, again quoting Stephen Roach, consumer spending adjusted for inflation, has been growing 0.7% per year, compared to a more normal 2-3% in the recent past, and over 4% in our halcyon days. Some of this decline is due to deleveraging by consumers, particularly in housing. These people are scared about their future and I suspect they sense the current anti-capital mood emanating from the Beltway. As shown by online buying, they want to spend wisely. The opportunity comes when they feel more confident and start spending. At that point, so will the corporations of the world.

Opportunity #3:  Technology helps

Exxon periodically produces an incisive look at the future for energy many years out. Not surprisingly, it sees growth in the demand for all elements of energy consumption and therefore production. Most of the growth relates back to the first opportunity listed (the growing middle class in Asia), but also in Latin America and Africa. What I found of interest is that this substantial growth will only be partially offset by an increase in energy efficiency. Exxon fully expects that improved technology will help produce, transmit and consume energy. This is another testimonial to the likelihood of growth in demand for technology. My guess is that in an aggregate sense, spending on technology will grow at close to double the rate of growth in the overall global economy. This growth rate is not fully discounted in many technology stock prices.

How are you going to handle the fiscal cliff, or more properly the fiscal slide or slope? Please share your thoughts.  

Clarification:

In last week’s post I compared the ratio of various nations’ debts to GDP.  Further in the paragraph, I referred to “Europe’s deficit as a unit.” I should have written “Europe’s debt as a unit.”

Ruth and I wish a happy, healthy and prosperous New Year to all members of this blog community.

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Did you miss Mike Lipper’s Blog last week?  Click here to read. 

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Copyright © 2008 - 2012   A. Michael Lipper, C.F.A.  All Rights Reserved.

 

Four Investment Quandaries for 2013+

·       Debt, a four letter word

·       Killing off the Individual Equities Investor

·       Asset Allocation: Correlations?

·       Learn from today’s investors

Investment analysis is like a narcotic or a very difficulty habit to kick.  At the beginning of the week, I may not have an idea about what I will post the following Sunday night.  Though I am exposed to a myriad of communications, in many ways the most valuable inputs are the conversations I have with investors and investment professionals.  This week I will focus on four suggestive thoughts, or quandaries for 2013.

The worst four letter word

Growing up I was told that it wasn’t nice to use certain four letter words like F*@k or S*#t. What my Mother never told me was the worst four letter word of all; a word that has bedeviled mankind for centuries. That great economist William Shakespeare put the following words into Polonius’s mouth, giving guidance to his son Laertes, “Neither a borrower nor a lender be.” The four letter word is debt.

There are three essential problems with debt. The first is that it must be paid back, often at inconvenient times. The second is the additional payment of interest, which can be either fixed at the time of the loan or flexible, but each is based on the assumption that the rate is high enough to pay the lender to forgo spending and has a sufficient risk premium that is an accurate gauge of the odds on getting repaid in full and on time. The issue here is what appears to be the appropriate lending rate at the beginning of the period may not be the right rate at the end of the period when conditions have changed. The third problem is collateral that in theory guarantees to the lender that he will get his money back in full and on time. Securities can often provide the margin for a loan. Of course, if the securities go down in price the value of the collateral may become less than the size of the loan. Some upstanding people, companies, and nations have been able to borrow based on their good names. J.P. Morgan is reported to have said that he loaned money on the basis of a man’s character. There is a problem with this as fittingly portrayed by Shakespeare again, in “The Merchant of Venice,” in the legally sanctioned, but inhumane attempt to collect on the collateral on a defaulted loan.

The main purpose of debt is time-shifting. The borrowers want an asset that at present they cannot pay for, and the lenders are willing to delay their own spending if they get paid for this indulgence. Unfortunately what has become the custom is that new debt is raised to pay off expiring debt. The question facing both the borrowers and the lenders is what is the optimum level of debt that can be added on top of a given level of assets? This is called debt capacity. It is usually calculated on the basis of assets and/or income that are not encumbered by other debt. What is usually done for nations is to compare their outstanding debt, most often without concern for future debts, to the their Gross Domestic Product or GDP. This number is the estimated annual generation of goods and services within the country. (Two weeks ago, I blogged on the approach of looking to a more complete analysis of both the assets and liabilities for the US.) Nevertheless I will stay with the convention of looking at a nation’s debts as a ratio of its GDP. Europe’s deficit as a unit is now 131% of its GDP. China has a 120% ratio, all of Asia excluding Japan is 104%. (Hong Kong 275%, Singapore 137%, Malaysia 117%, Indonesia 33%) These reported ratios include personal and corporate debt as well as sovereign debt. Thus globally there is too much debt. 
 

In the US, as is often the case, the private segments of the economy are moving differently than the government sector. The private sector is deleveraging its debt structure whereas the federal government is adding to its debt by issuing bonds that are largely being purchased by the Federal Reserve System to neutralize their impact on the level of interest rates. The combination of the private sector deleveraging and the Fed’s increased borrowings leaves the US debt level, according to one source, at 62% of the GDP which is down slightly from prior readings. 

Translating the economic figures into the bond market, the following three facts are of interest:

1.    Some Investment Grade (corporate) debt is yielding less than some sovereign debt. This would indicate that the market believes that corporates are safer than some nations. One possible reason for this is that Europe, with 7% of the global population,  spends 50% of global social spending.

2.    The yield on the S&P 500 is higher than an index of BAA bonds. Again, the market is suggesting that lower investment grade credits are safer than dividends on the S&P 500 stocks. At the same time this represents an unusual opportunity to view large cap stocks as a more productive source of current income than investment grade bonds.

3.    We may not be out of the sub-prime mortgage mess. The Federal Housing Administration (FHA), is by far the largest guarantor of conventional mortgages. Not only does it already in effect own a number of defaulted mortgages, but there is pressure from Congress and the Administration for the FHA to loosen its underwriting standards. Only a significant recovery in house price and possible individual incomes will bail out the taxpayer liability.

“Who killed Cock Robin”

The somewhat shotgun wedding of the New York Stock Exchange and IntercontinentalExchange (ICE) publicly demonstrates the fact that while derivative trading particularly not based on stocks is very profitable for an exchange (and therefore broker/dealers), trading in individual stocks is not. As an analyst and owner of brokerage firm stocks, for some time I have taken the position that listed equity agency business for brokerage firms is not profitable. Try to get a brokerage account opened to buy 100 shares a quarter of General Motors. What you will quickly find in a broker (if one will talk to you at all), he or she will attempt to sell to you some complex structured product or a high fee fund or possibly introduce you to using a margin account (interest bearing and securities loan revenues). This reaction by the peddlers of our business has been successful in discouraging individual investors from buying and holding individual stocks. Thus, the title to this section, “Who killed Cock Robin” is an English nursery rhyme, but the real killer of interest on the part of individual stocks is the regulatory agencies, particularly the US Securities and Exchange Commission (SEC). In 1968 the Commission forced the beginning of the end of fixed-rate brokerage commissions, which were totally replaced in 1975. Prior to those dates there was a vibrant and useful retail research and individual sales business by brokerage firms. Institutions received tons of reasonably high-quality research and other services from “Wall Street.” Continuing this trend of not understanding the impacts of its actions, the SEC permitted multiple locations where a trade could take place which denuded the central marketplace’s liquidity. Carrying this approach further, the substitutions of penny decimals for fractional prices made professional traders withdraw their capital from the marketplace. The way all markets work is that there has to be a perceived profit potential for the professional participants to play. Without the professionals in the game the market will shrink in size and its use as an important economic indicator will be vastly reduced.

I do not mean to be negative on the announced deal, because the holders of my private financial services fund and I benefited. Our holding in NASDAQ OMX rose 3% on the day of the announcement. My guess, the thinking is that NASDAQ itself may be in a merger situation or that the change in control of the NYSE means that it will be a less fierce competitor for new listings and daily trading. While this may benefit my fellow investors and me, it won’t do anything positive for the individual investor and could hurt.

Is asset allocation really about correlation?

At this time of year, institutional investment committees have meetings to decide on the appropriate mix of assets for their portfolio responsibilities. Historically this was a decision made for them in that the initial funds in both the US and UK were balanced funds with a reasonably fixed percentage in bonds and stocks. Balanced Funds and their modernized versions are still an important part of the mutual fund business. The whole excitement about asset allocation was generated by a flawed study of corporate pension funds that showed that funds with a higher percentage in equities did better. For the most part there were only two asset class accounts, bonds and stocks. Later on other classes were added in terms of venture capital, private equity, international securities, commodities, gold, timber and various forms of real estate. Then 2008 came along, with the exception of US Treasury Bonds all the other asset classes declined and often in roughly the same percentage declines.

My approach to this question is first to have an opinion as to how closely the correlations of the asset classes will be over time. Using US mutual fund investment objective averages over ten or more years, most fall within 100-200 basis points in terms of annual returns which suggests to me that on a long term basis it is difficult to pick winning asset classes.

Jason Zwieg’s latest piece in the Wall Street Journal on a young 107 year-young investor and manager, Irving Kahn, takes a different point of view. At his age he is invested approximately 50% in well-researched global small caps and the rest in cash. I have worked with Irving for many years on analyst society activities. He and his late wife Ruth were on an analyst trip with my wife Ruth and me in Italy more than 25 years ago. They both set a blistering pace which was a challenge for us younger types to keep up. Out of all of these experiences, I have developed a real respect for his acumen; besides he is one of the very few people alive that remembers my grandfather’s Wall Street firm. If the committees have Irving’s research skills, I would approve of their allocation if not some other forward looking approach was warranted. We should be watching and listening.

Learn from today’s investors

Most individuals do not have CFA certificates or have logged more than 50 years as an investor, but we can learn from what they are doing as shown in the following examples:

1.    As already indicated, on a personal level they are paying off their debts. If one disregards student loans, consumer debts are declining. Savings as calculated by the government is rising a bit. Individuals are slowly, but I believe surely are going through their own austerity program particularly in terms of being more astute shoppers.

2.    While retirement flows are continuing to benefit from 401(k) and similar salary savings plans, the purchase of mutual funds for individual retirement accounts through directly marketed mutual funds is well off  peak gross sales. This may be in response to investors' own actual or feared employment picture. Possibly they are using what would have gone into their IRAs to reduce their debts or to improve their homes for a future sale.

3.    The most intriguing demographic trend of all is that there is a substantial increase in the number of singles. In many cases these are, according to Gary D. Halbert, white women who have made the decisions at least temporarily to forgo Children and Marriage.

The young appear to be worried about their future and they should be. Our debt burden and less than wise investing will make their lives more difficult. However, after worrying in American fashion, they will find innovative ways to improve their condition. This is one of the major differences between Americans and Europeans.

You can’t agree with everything I have said.  Please discuss your thoughts with me by reply email.

I hope on Tuesday you can relax with family and friends, not worry about these quandaries and that the rest of the week won’t be too eventful.

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Did you miss Mike Lipper’s Blog last week?  Click here to read. 

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