Introduction
Essentially investment
risk is not a number. The price of risk failure is the foregoing of important
funding plans. In that light your risk is not the same as my risk. Not only because
we have different financial and personality resources, but also different time
frames, which is why I developed the TimeSpan L PortfoliosTM. These
help isolate the impacts of risk failures; e.g., a disappointing short-term
portfolio is different than one to help fund future generations.
No matter which is the
planning time horizon of a portfolio there is another major difference between
two similar portfolios. In this age of optimization many portfolios project
funding out of resources with little to spare for unexpected mistakes. For many
there are no reserves for mistakes because the investor or his/her manager has supposedly
identified all possible disruptions. Thus, they have created an expectation
risk. Thus, they need to examine what could go badly wrong with their
expectations.
I suggest the biggest
impact of an expectation risk is likely to be found in the very assets that most
investors have the highest level of confidence. Not only by nature I am a
contrarian, I am a student of history that gets uncomfortable when there is
excessive enthusiasm. My current worry risk is as follows:
- The
US $
- Large
Cap Stocks
- Treasuries-US
and some Others
- ETFs
and other market structure changes
These worries are not
generally recognized in market prices, which I think they should be. Therefore
I perceive significant market price distortions that don’t recognize that in
the future something could go wrong in most portfolios.
The
worries
Part of my worries is
that few if any professional investors are publicly concerned about the
concerns that are on my list.
The
(mighty) US Dollar
For those of us who live in a competitive price environment we are
very much aware of the price spread for similar, usually not truly identical,
items. There are always reasons why the bulk of buyers and sellers can identify
with the current price; e.g., availability, ease of transaction, easy to
service, and other qualities of merit. As an entrepreneur I always wanted to be
the high priced service sold to discriminating, great capital sources. My
approach was that my successful pricing was a badge of high quality. I was
conscious that this policy was holding up an umbrella over cheaper competition,
but in the institutional world quality usually trumps price, within reason.
Turning to the current
valuation of the US$, the widening price spread versus all other major
currencies suggests to me a leaky umbrella. Our current exalted position is not
due to our virtuous qualities of protecting the purchasing power of our
currency but rather it is due to the perceived decline in value of other
currencies. Some of the weaknesses in other currencies are self imposed by the
deliberate mercantile policies of governments to help sales of their exports to
the US. In a period of increasingly unpopular governments within their
countries and with their neighbors, people are choosing to store some of their
wealth in the US, behind its supposed two ocean fortress sitting on valuable
natural and human resources. Because the US monetary leadership is having
enough trouble attempting to manage the domestic economy and a current
Washington political establishment that would like to isolate the US from
others’ problems, there is no desire to establish the US dollar as the single
world currency. Thus, at some future point the unannounced but real weaker US
dollar policy is likely.
In the future various
economies will start growing again and become attractive places for investment
both by the locals and those from outside. Therefore it would be wise to hedge
one’s longer term portfolio against continued dollar strength. A number of mutual
fund investors have been doing this for some time. With the exception of the
five trading days ending December 24th, traditional US mutual fund
investors have been adding to their non-domestic holdings while redeeming some
of their domestic fund holdings. (The latter move could very well be a normal
pattern of mutual fund investors exiting for retirement and other needs. In
most cases the domestic funds are the oldest of their holdings.)
The
leaky large-cap house
If the US dollar is
being held up by a potentially leaky umbrella, the investment houses holding
large-caps may start to leak soon. We acknowledged in last week’s post that in
general large cap mutual funds in 2014 were performing materially better than
smaller market capitalizations funds. At present and historically there is no
solid evidence that large cap companies will do better than smaller caps. The
foreword of Charlie Ellis’s book, What
it Takes states that “None of the ten largest corporations in the
U.S. economy in 1900 still ranked in the top ten 50 years later and indeed only
three actually survived as companies.” In addition there is an article by JP
Morgan Asset Management that since 1980 the S&P 500 has dropped 320 stocks
or roughly 10 per year due to mergers, low volume, and an inversion of their
tax headquarters. The problems that caused these results were more widespread
with numerous large companies losing their advantage. Some possible victims of
these deteriorations today might well be General Motors, IBM, and Citigroup
among others.
Turning to the
large-cap stocks as distinct from the companies themselves there are significant
changes occurring. First the surge of stock price performance above the level
of earnings progress may well be a warehouse effect. In the past when
investment managers were concerned about not being invested in a market that
was gently rising to flat before a perceived decline, they hid from their
clients by investing in stocks of very large companies. AT&T was the best
of the warehouses with its $9.00 predictable dividend which hadn’t changed for
about 40 years. Today, many of the tactical players have shifted to using
Exchange Traded Funds (ETFs). In the week ending Christmas Eve approximately $1
billion flowed into two S&P 500 ETFs (net of their redemptions) out of
$23.7billion. Some of the inflows could be covering shorts. As of December 15th
the SPDR S&P500 ETF had the second largest short position of 240 million
shares. (The largest was our old warehouse name but applied to a different
company, AT&T.) More on the changing market structure through ETFs and other
derivatives below.
The current market
sentiment may well be changing from complacency to belief in a general recovery
starting in the US and haltingly going global. One clue that this could happen would
be that in 2015 Small Market Capitalization stocks once against perform better
than larger-caps. We could even see some flows from the larger caps into
smaller cap funds. Due to ETF players who are mostly faster trading
institutions we could see redemptions in various index funds as sentiment
shifts from avoiding losses to picking exploding winners.
Treasuries
discipline
Surprising the US
deficit is declining due in part to the sequester in 2013, but it is still a
deficit which does not include the off-balance sheet liabilities for various
government programs. We have not taken the pledge that except in times of war to
produce surpluses to retire our debt. One also needs to recognize our twin
infrastructures in terms of roads and bridges as well as our growing
educational deficit. We are not alone in our lack of discipline; most other
countries are similarly addicted to deficit spending. For those of us who can
choose not to invest in various governments’ securities this lack of discipline
is an additional imponderable. However, for our banking institutions it should
be a considerable issue as banks in most countries must own local government
paper. Often the various authorities treat government paper more favorably than
commercial paper in terms of the level of reserves required. Thus, to some
extent our whole financial system is exposed to the level of discipline applied
to our treasury deficit machine.
ETFs
and other market structure changes
Students of warfare
often note that changes of weaponry change how battles are fought and won.
Clearly the introduction of the English Long Bow and the Aircraft are two
examples. In the investment marketplace battles, some rely on the most current
weapon which is often not fully tested. The 1987 market fall is a good example
of a market collapse that was not tightly tied to an economic collapse. In a
somewhat over priced market after a multi year rising market, many
institutional investors felt secure because of their newly acquired weapon of
“portfolio insurance.” This procedure was based on locked-in trades of
securities and derivatives largely executed in Chicago. If markets were functioning
normally with other investors using the various tactics of the past, a limited
amount of portfolio insurance transactions apparently worked. However, as the
decline accelerated many institutions and some trading organizations withdrew
from the market and so the locked-in derivative trades were working against
each other in driving prices into a free fall.
In 2014 and beyond the
popularity of derivatives, particularly ETFs, have grown and now often represent
the bulk of trading in an emotional period. To put the size of the ETF power
into perspective the following points are worth noting:
- While the estimated net
inflow into traditional US mutual funds for the Christmas Eve week was $12.8
billion the highest since March of 2000, almost twice as much ($23.7 billion
net) came in through ETFs. As Blackrock’s Larry Fink has been warning for some
time, institutions are using ETFs instead of futures to speculate.
- There are roughly 250
authorized participants in the creation and redemption of ETFs. In many if not
most cases these participants are acting for institutional clients. Some of the
participants’ purchases may be to aid in setting up short positions or providing
securities to meet share lending
requirements. To put the importance of the shorting of ETFs shares in
perspective it is worth noting as of December 15th seven of the
largest forty short positions on the New York Stock Exchange stocks were ETFs.
As of the same day, nine of the thirty largest changes in short positions were
for ETFs. Because of particular interest in the S&P Biotech ETF the short
position would take 17 days to cover.
- The use of derivatives
in both fixed income and currency trading is extensive.
- Some of the regulators
and I are wondering whether several of these new weapons will blow up certain users
and possible counterparties in the heat of battle.
How
does one live with the worries?
One must recognize that
probably there has never been or never will be a period without worries.
Long-term investors need to be both flexible and diversified. In our four
timespan portfolio structure, I suggest that the Operational Portfolio (1-2
years) stay tactical and not take large losses. In the Replenishment Portfolio
(2-5 years) one should develop both tactics that can tolerate at least one to
two poor years. The Endowment portfolio (5-10+ years) should shift to a more
strategic view to take advantage of periodic declines. The Legacy Portfolio, needed to
feed multiple future generations has a need to separate current
fashionable thinking for expected future changes.
Question of the week:
Next week I would like to discuss opportunities for the Legacy Portfolio. To do so I need reasons to believe positively. Can you help me?
By the time I will be
sending my first 2015 post, I hope that each and every one of my blog community
has started a healthy and happy New Year.
__________
Comment or email me a
question to MikeLipper@Gmail.com .
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A. Michael Lipper, C.F.A.,
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