Sunday, October 29, 2017

3 Potential Risks - Weekly Blog # 495



Introduction

Contrarians are useful even when they prove to be wrong. In forming an investment committee for a non-profit institution of professional investors, I felt it was incumbent on me to somewhat balance the committee, largely populated by generic optimistic money managers with at least one contrarian that was well skilled in finding good shorts. While it would have been inappropriate for this institution to sell short betting on falling prices, the answering of some bearish views were useful in appropriately constructing our long portfolio which did well. We were better prepared to be long-term investors on the long side for reviewing and appreciating contrarian views.

Current Thinking Process

Stock markets around the world are rising well ahead of current sales and earnings, even adjusted for modest growth projections. The buyers are enjoying what could be called a “melt up.” Economic sentiments are moving higher.

While I do not know how long these trends will last - be it a day or multiple years - I believe it is critical to consider the potential risks that are currently apparent to this long investor and manager.

First Risk: Simplistic Decisions

On October 26th The Wall Street Journal published a multi-page critique entitled “Morningstar Mirage” which purported to show that the firm’s various ratings were not helpful in making decisions as to what mutual funds to buy. The article decried the marketing power of Morningstar’s ratings, not recognizing that at least since the 1930s funds that performed well attracted the most sales if they were known. In the same light there was no real discussion of the questionable mathematical processes used to reach its conclusions.

The biggest risk to investors is not the Morningstar Mirage. The biggest risk is that the financial community believes that investors want simple answers to complex questions. Sales people who can get very limited time with both their prospects and their accounts are trained to use the KISS principle, (Keep It Simple Stupid)” in their communications. It has never been clear to me whether the communicator or the investor was stupid.


Often people spend more time at a sporting event or preparing a special meal then they do making investing decisions which can have significant impact on their lives and those of the beneficiaries. At the game each play, each course or each critical ingredient is thought about deeply. As the readers may be aware I learned the basis of securities analysis at the racetracks, spending hours on each race. I am told that one of the most successful racehorse owners in the last 30 years in the UK spends a great deal of time on the races and the breeding of her horses. We should do no less than Her Majesty.

When Hylton Phillips-Page, my VP of Fund Selection and I analyze a mutual fund we spend a long time getting to understand how the fund, its managers, and supporting organizations impact the past results. A much more difficult task is guessing how we think the past will not be simply extrapolated into the indefinite futures. The term futures is a recognition that there will be interruptions of past trends as conditions change.

The risk of simplistic decisions is much broader than choosing mutual funds.  Not only investment decisions, but all types of other decisions, including political, career, and other personal decisions are put at risk when given only cursory attention. The past is useful as to what happened and more importantly what didn’t.  Most studies of human decision-making involve a number of biological organs. The brain and our senses are very complex and they interact differently when conditions change, and they are always changing.

Second Risk: Credit Withdrawals

In each of the general write-ups of major stock market reversals almost all the attention is devoted to stock prices. In truth almost every major stock market decline was slightly preceded by the withdrawal of credit support. Since we are not out of October, we should first start with October 28, 1929, the biggest single day drop in the Dow Jones Industrial Average up to that point. On that day, the index dropped 12%. Most recounts do not include the fact that the market had been dropping since August and a good bit of the buying was done with borrowed money called margin. The borrowed money came from the major banks who issued it to the brokers, who in turn offered it to their clients on the basis of their portfolios. The banks used call loans to the brokers using their clients’ collateral. As the market declined in the late summer and early fall of 1929, the value of the collateral fell, reducing the safety for the banks that were starting to call their loans. The brokers called their margin accounts to put up more collateral which most didn’t (or were not able to) and were rapidly sold out of their holdings. This is an example of a non-price sensitive insistent seller.

A similar thing happened in 1987 where in one day, October 19, 1987, the DJIA fell 22.6%. European stocks were down about 10%. Portfolio insurance used futures to hedge long institutional positions. Many of the futures contracts were margined against the long positions owned by financial institutions. In Chicago there was no requirement to be able to short on a price uptick as there was in New York. When New York opened there was a wall of sell orders.

A somewhat similar occurrence happened with the collapse of Lehman Brothers when the “repo market” to finance its fixed income inventory was closed to Lehman due to a different set of rules and expectations in London.

Trying to avoid a future similar event, the Dodd Frank Act focused on what banks and others owned, not the risk in their loans. I suspect that most of the inventory owned by the Authorized Participants, (the market-makers for Exchange Traded Funds and similar products) are highly margined. At some point the providers of these loans may get nervous as to their collateral cushion and may want instant repayment which could create a problem.

There may be similar potential problems in both the US Treasury and Foreign Exchange markets where high leverage is available.

Third Risk : Career Risk

If investors are guilty of simplistic investment decisions, professionals live in fear of being fired either by clients or employers, This is a particular risk if someone needs to publicly report performance or work for publicly traded companies. Thus, despite reasonable long-term results, near-term absolute and even more importantly - relative results - drive terminations. This is normally a mistake on the part of the terminator for two reasons. First, most of the time there is a partial or complete recovery. Second, and much more dangerous to the investor is the choice of the replacement, often a manager that has good long-term results which are appropriate for a decline, but poor results in expansions.

Bottom Line

Risk is always with us and it is the highest when least expected. Drive on two-way streets, they are safer.
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A. Michael Lipper, CFA
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Sunday, October 22, 2017

The Most Important Trade: Switching - Weekly Blog # 494



Introduction

Almost all investment advice is framed primarily as buy recommendations and to a lesser extent sell recommendations. For the sake of brevity and complexity these recommendations are at best incomplete and in many cases misleading. Even when we start with cash and expect our estates to be settled in cash, we are dealing with at least with a two-step process.

Cash

Nothing can be simpler than cash or it may seem so on the surface, but it is actually a series of decisions that can be a major influence on the ultimate performance of any other investment. The single most important characteristic of cash is that it has the burden of opportunity cost. The decisions to accept or reject the opportunity to make or lose nominal amounts of money is borne by one’s cash pile. In an inflationary environment any uninvested cash will see its purchasing power decline. If the central bank’s desire for 2% inflation is achieved on average for ten years, most of the current purchasing power of cash is wiped out. While there is a low probability that our custodians will disappear with our money, a few have done so in the past, thus there is risk entrusting our cash pile to any single custodian (and some may say in any one currency or location).

Asset Allocation Switches

Most asset allocation, after costs of the transaction including taxes, produces dollars that are moved from one asset to another. Even a move into or out of cash could be viewed as a time or possibly price allocation when one side is immediately executed and the other side is delayed until perceived conditions change. The opportunity cost of the delay should be assessed. Perhaps a long-term reasonable approach to this assessment is a figure between the inflation rate and a generalized accrual pension target of seven to eight percent. Bear in mind that the current fifty two week gain for the average general equity fund is 20% which is highly unlikely to continue. However, it does show that the size of opportunity cost is variable as well as cyclical.

Motivated Switches

Most switches are motivated by either a strong desire to buy or sell an investment and almost all the emotional attention is spent on that motivation. I want to own “X” or I must get out of “Y.” Far less attention is spent on the other side of the transaction, the funding vehicle or the receiver of the proceeds. When one thinks of the longer term impact of the transaction there is some chance that the less-desired part of the equation will be more important than the initiating desire. Remember any decision could be wrong both in terms order of magnitude and direction of any swap. This is not a clarion call to be passive and let market, economic, and political events dictate results. Just consider both sides of any transaction in making one’s decisions. One approach is a quote from my old data and consulting client Sir John Templeton when he said his transactions were motivated by choosing “better bargains.” This suggests a reasoned analysis of both what one owns and what one may want to own.

Portfolio Driven Switches

In truth most individuals and some institutions actually own a collection of investments that were chosen only for the attractions of the individual investments. One of the reasons that I use mutual funds for clients is that they get judged on how well the entire fund performs not any individual investments. The long-term compensation of the portfolio management team and the owners of the management company is based on how well they perform compared to their peers.

For the managers of portfolios, the weighted mix of investments is critical to the ultimate results. Today I see too many portfolios of institutions and individuals owning some or all of the ten most popular stocks. Unfortunately while they own the names of currently winning stocks, they own less of these names than they occupy in the popular market indices. Thus when the indices rise they are underweighted in the winners and so lose out to the market, which can be costly in terms of marketing to outer-directed investors. They get some relative benefit when the market goes down, but probably lose absolutely.

I am attracted to portfolios that pay attention to their total opportunity and risks. Many of these use cash or equivalents to partially de-risk portfolios. At times it may be difficult to assign all of the cash to de-risking as many funds that have an easily stampeded audience carry redemption reserves. (Unfortunately in rising markets reserves of all types hurt near-term performance.)

Another important factor to me is how much investment sensitivity to long-term currency risks is in my clients’ base currency (which is currently in US dollars). As there is practically no US investment that is not directly or indirectly at risk or benefit from the movement of the US dollar, this is an important consideration for me and my clients. There are numerous ways to address this opportunity and risk. One can own foreign currencies, own foreign securities that are primarily owned by local investors and multinationals that are themselves operating globally and measuring currency and other risks. The funds to avoid are those that are not paying attention to both the risks and opportunities.

Are We Approaching a Tipping Point?

Almost all professional investors and many sophisticated individual investors are thinking or obsessing about the next major decline that could begin in a day, by year-end, after the 2018 Congressional elections or the 2020 Presidential election. I will let others focus on the timing of a major decline. I have suggested that unless we see a great deal more enthusiasm for equities, the next decline looks to be in the “normal” variety of around 25%. A review of fund history and those of many individuals, shows there are very few investors that can sidestep a normal decline and recommit at lower prices and deliver an investment performance better than the majority that held through the round trip.

However, with this week’s focus on the 22.6% decline on October 19th 1987, it reminds me that thirty years has passed and beyond the normal decline there is a once in a generation (which is normally about twenty five years) a 50% market decline. Some may feel the 2007-2009 decline represents the needed 50% decline. Perhaps they are right, but I see enough similarities in both declines to put me on my watch.

My Watchlist

1.  Both declines started with fixed income markets weakening due to excess speculation. I am wondering whether we are seeing that in both the US Treasury market and the number of new credit funds being established.

2.   The infamous South Sea Bubble was created by almost universal belief in the forthcoming riches from Latin America. Today the fast growing asset classes are Emerging Equity and Emerging Debt Funds. Bear in mind some concerns about the existing Chinese debt structure and probable expansion as it attempts to build its “One Belt One Road Initiative.”

3.   Not the cause, but a primary accelerator of the 1987 collapse was the regulatory mismatch between Chicago and New York stock futures markets. Is there a potentially similar accelerator in ETFs and ETNs?

4.   There are twenty mutual fund investment objectives tracking the diversified, general equity market. On a year-to-date basis, five are performing better than the S&P500 funds, but in the last four weeks eight are performing better, with three of the Small Cap investment objective joining the leaders. Until very recently, the NASDAQ composite has been out-performing the larger cap markets. One can’t help to question whether this is a late stage speculative surge.

Bottom Line

Think through your allocation switches as to what you are buying and selling and also pay attention to parallels with history.  
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A. Michael Lipper, CFA
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Contact author for limited redistribution permission.

Sunday, October 15, 2017

Rational Investing is not What You Think - Weekly Blog Post # 493



 Introduction

The recent press accounts of Richard Thaler winning the Nobel Prize for Economics are ironic as to the outlook of the general media, politicians, and many academics. The New York Times headline was “Nobel Goes to Expert in Irrational Behavior.” The truth is irrational behavior is in the eyes of the beholder, not the individual performing the supposed irrationality.

All of my investment life I have been puzzled by how often some very intelligent people have consistently made bad investment decisions (and probably political ones as well).  The classic sign of poor judgment is people being on the wrong side of market tops and bottoms. The definition of market tops and bottoms are when the markets are massively out of balance, with insistent buying or selling pressure.

For years I have been asking the very learned professors at Caltech involved with Neuroeconomics why people make bad decisions. It appears that there is a portion of our brain where we make our judgments, and it is closely linked with our memory. In most cases our decisions are aided or driven by past experiences that produced good or bad results for us. I suggest that this the way humans and animals make decisions. Thus for us individually that is the rational way forward.

Benefitting From Others’ Irrational Behavior

One day sitting in the second semester Economics class at Columbia University, I contrasted the young assistant or associate professor conducting the class with the first semester’s professor, C. Lowell Harris,  a full professor and a consultant to Standard Oil. Harris was a Conservative thinker and was our first teacher of the murky science of Economics. On this particular day, I leaned over to my neighbor and said I wouldn’t trust the second semester teacher to run a newsstand. The new instructor’s pitch was equilibrium pricing, his argument was achieved with the aid of  an “X” marked diagram of where supply and demand met. In the real world, I concluded that different customers were willing to pay different prices at different times and conditions for the same product or service. I was proud of my analysis.

I was very wrong and it took me a number of years to find the real value of the experience. The study of economics began with the study of philosophy, but actually had major lessons that could have been drawn from the Bible.  Academic economists had in effect “Physics Envy” with their mathematical equations and reproducible laws. Thus many texts teaching economics became loaded with laws that worked some of the time and equations which collapsed when applied to reality. To them and their students, humans were meant to solve economic and investment problems with the use of equations if they were to be considered rational.

In the standard liberal arts education there was often a requirement to take a course in economics and this was particularly true if one was concentrating on political science, These requirements led to at least two generations of students expressing themselves in adult behavior believing in top-down thinking and that people would make decisions using formulas.

The recent Brexit elections and the 2016 US Presidential election and possibly the Austrian election are samples of voters not voting in favor of their current economics, but based on their feelings for change.

In an interview in this week’s Barron’s, one of the more financially successful Professors of Economics, Robert Shiller, sees the need for narrative economics. I agree. One example of the need to capture the critical elements of a change in direction is the study of the 1987 one day decline of 22.6% in the Dow Jones Industrial Average, the biggest one day decline in DJIA history. Very few of the reports on the day revealed that the Chicago’s future market did not have an uptick rule for futures to be shorted and that the New York Stock Exchange did. It was in the Chicago market that the automatic, non-price sensitive futures were executed as part of the portfolio insurance programs. Thus at the opening, the NYSE could not short to absorb the Chicago selling. This is an example of regulatory arbitrage, some of which exists today.


Rational Worries

We all know that there will be major stock and bond market declines in the future, perhaps coordinated with economic recessions/depressions. What I don’t know is when, how deep, and the proximate causes. Since I don’t know these, the best I can do rationally is to look at conditions that have led up to other major disruptions. My Blog Post 488, Seven Steps to the Big One outlined my concerns. If you would like a copy, email me at Mikelipper@gmail.com.

 

On my watch list is the battle between creeping enthusiasm and complacency as noted below:


  • ETF/ETN markets dominated by trading entities, particularly in sector and countries.
  •   Short interest declining on major exchanges.
  •   China’s successful managing of the internal debt structure, can it last?
  •   There is no recognition that at some point the US dollar will decline vs. others.

A Rational Move I Have Not Made Yet

I am assuming that when we experience the next major decline it will be largely cyclical and most investments will survive and endure the inevitably poorly-written new regulations. Looking beyond that point for the eventual benefit of younger beneficiaries, I am considering secular investments that will pay off in twenty or more years.

During that time we will have three key trends:
  •  The population will grow particularly in Africa and South East Asia. The rest of the world will get older and some sicker.
  •   The amount of farming land will shrink.
  •   The price and quality of our food will rise.

On the basis of these trends I am looking for investments in the agricultural commodities arena. There are a number of funds in this classification who have an average year-to-date performance of minus 7.12%. At this point I have not done the work to select funds. What I have done, some time ago, is to buy Man Group plc. This is not a recommendation as I don’t know enough, but it is the largest distributor of trend-following commodity funds, and could be of interest to our professional audience.

Two questions of the week:

1.  What are you watching for a top, and are you planning to do anything?
2.  Do you have any knowledge on investing in farms and/or commodities?  
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Did you miss my blog last week?  Click here to read.

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Copyright ©  2008 - 2017

A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.