Introduction
There should be much
to learn from the last six weeks that could influence our investments going
forward. Unfortunately, these inputs do not lead to a quick sound bite, which
isn’t bad. “Sell in May and Go Away”
with a return in November, might help equity traders, but would be of little
help for long-term investors who are tasked with paying a long stream of future
bills. To aid our diverse audience I have divided my focus into three buckets; equity, debt, and inflation.
Equity Prices
Analysts tend to
utilize tools which they are most familiar with. In my case, the main
investment vehicle is mutual funds, particularly actively managed funds. Each
week, my old firm publishes the average investment performance of 8,452
diversified mutual funds largely invested in the US (USDE). After fourteen
straight months of gains I saw that the USDE had a gain of +4.37% for January. By
the 15th of February the gain for the first six weeks of 2018 had shrunk to
+1.53%. Disregarding the effect of
compounding, if that gain was to continue for calendar year 2018, it would be a
gain of +13%. That is still too high relative to its past history of +8.41% for
the past three years or +8.12% for the past ten years (through the end of January).
These eight percent moves are within the long term range of 9% since 1926 for
the S&P 500 Index, so are believable. Contrast that with the 12 months
performance of the USDE to the end of January of +21.34% or twelve months
through February 15th of +14.73%. Thus, there is room for those who expected a
continuation of last year’s growth rate to be disappointed. Near term, some of
my market analyst friends would only believe the February recovery if there is
a meaningful test of the recent low points.
I have an additional
concern that the majority of portfolio managers did not actually experience the
1987 decline and recovery and they won’t be attuned to additional insights from
that experience. Almost all of the words written about 1987 are about the
failure of so-called “portfolio insurance,” not only to protect institutional
portfolios but more importantly the contribution to massive sales of equities
and derivatives into a weak market.
There are two other
insights that have value today. The first, as pointed out to me by a client
during the onslaught, was that while our domestic economy was shrinking due to
the Volcker-administered high interest rates created to break the
inflationary spiral, corporate earnings were growing smartly through a
combination of exports and foreign subsidiary earnings. I suspect that these
trends are even stronger today.
The second missed input
was that one of the best and strongest specialists went to the wall (bankrupt)
using his last equity and borrowing power to absorb some of the selling.
Because of regulatory changes, there is even less capital positioned to absorb
selling today. Also, little has been written about the beginning prices of 1987 being similar to
the year ending prices, the market was flat. Thus, the market system actually
worked and provided the basis for a long bull market that extended many years.
Hopefully we can look
for useful lessons from our immediate past that we can apply to our current and
future investment policies.
Credit Concerns
These past few weeks we
have seen some reversal of the more than a year long global rush into fixed
income funds. Due to global central bank downward pressure on interest rates,
investors have been in a scramble to find higher income yields without a great
deal of concern for principal risk. It is not yet clear if the sizable
redemptions in High Yield funds are a display of concern that the inevitable
rise in interest rates will make the refinancing of high yield debt more
difficult or the beginning of a concern that some of the debt won’t be paid off
as scheduled. At the moment we are not seeing the institutional market reflecting
the same reaction to bank loan/floating rate vehicles. However, a number of
private equity managers have noted that they are seeing an increase in the use
of leverage globally.
It is important to
understand the impact of a defaulted loan or delayed interest payments on the
financial system. Loans from various financial institutions are treated as
earnings assets which produce income to pay bills. If these experience slow or
no payments, the expected users will have to change, usually by restricting
their ongoing payments. In addition, if the defaulted loan was an earning asset
for a financial institution, its capital is involuntarily reduced. Perhaps, the
most insidious element of defaults is that they cause rumors to fly within the
global financial community and beyond. This causes the institution with the perceived
bad loan to quickly restructure its loan and other portfolio elements,
magnifying the impact of the rumored or real defaulted loan. Loans can go into default for lots of reasons,
mistakes in judgment as to the extent ion of credit to clients, bad product
and pricing decisions, acts of nature, and loss of integrity anywhere along the
payment line. Unfortunately, as interest rates rise the pace of activity
accelerates, which can lead to an acceleration of the problems listed. More
exposed fraud becomes visible as rates rise.
There is a strong
connection between a threatened credit community and the equity market. Many
equity based financial institutions are vulnerable, including money mangers,
brokers, and liquidity providers such as market makers, authorized participants
for ETF/ETNs, and credit extenders. Most often they function with borrowed
money, usually in the form of call loans (which can be called at anytime
without reason). The firm that went to the wall in 1987 and Lehman Brothers
could have been saved if instant credit was available to them. I am not aware
of such a need today, but the rumor or the reality of such a need can come very
quickly anyplace in the world. As we are
so interconnected globally, it is conceivable that on any given morning we will
be forced to react to such a happening.
Inflation
Hardly any investment
meeting that I have attended in the last couple of months has not included a discussion
on inflation. I believe that these discussions, along with the purported
discussions at various central banks and by most pundits, have been focused on
easy and incomplete data. The focus has been on prices, including reported
wages. Not only does the data not deal with changes in quality, terms of trade,
and non-reported wages, it also does not deal with the “informal economy.”
I am becoming increasingly concerned that the strength of deflationary trends is not fully understood in assessing spending habits of consumers at all levels. One of the major deflationary trends is technology under Moore’s Law. Each year the power of our cell phones and other technology grows. This can be measured easily, but what can’t be is its value in terms of what we can now do that we couldn’t do last year in terms of commerce, enjoyment, and better health.
I suspect that one of the reasons for the declining number of auto deaths is due to the large number of computers in each new car. It has also led I believe, to less time in the repair shop. This is caused by two trends. The first is that the modern repair shop is equipped with its own computer set up to interrogate the car’s system. And second is a trend we see in all of our mechanical devices, of replacing rather than repairing. (How many young repair people do we know?)
When economists look at wages, they look at it from the workers' take home pay level and exclude payments the employers are making to benefit the worker in terms of social security taxes, health insurance and retirement contributions, all of which have been growing faster than take home pay. I wonder whether the increase in quality of what we are wearing is included. We are no longer wearing cheap, poorly made imports. Walmart and other supply systems are selling much better quality, which is often delivered by Amazon. In the competitive era that we have been going through, the terms of trade are often more important than price e.g., delivery time and conditions, payment schedules, advertising support, etc.
I am becoming increasingly concerned that the strength of deflationary trends is not fully understood in assessing spending habits of consumers at all levels. One of the major deflationary trends is technology under Moore’s Law. Each year the power of our cell phones and other technology grows. This can be measured easily, but what can’t be is its value in terms of what we can now do that we couldn’t do last year in terms of commerce, enjoyment, and better health.
I suspect that one of the reasons for the declining number of auto deaths is due to the large number of computers in each new car. It has also led I believe, to less time in the repair shop. This is caused by two trends. The first is that the modern repair shop is equipped with its own computer set up to interrogate the car’s system. And second is a trend we see in all of our mechanical devices, of replacing rather than repairing. (How many young repair people do we know?)
When economists look at wages, they look at it from the workers' take home pay level and exclude payments the employers are making to benefit the worker in terms of social security taxes, health insurance and retirement contributions, all of which have been growing faster than take home pay. I wonder whether the increase in quality of what we are wearing is included. We are no longer wearing cheap, poorly made imports. Walmart and other supply systems are selling much better quality, which is often delivered by Amazon. In the competitive era that we have been going through, the terms of trade are often more important than price e.g., delivery time and conditions, payment schedules, advertising support, etc.
For the above reasons I
have little confidence in the value of the published inflation numbers and hope
that the Fed and the other central banks will be slow in reacting to reported
trends. The consumer and commercial worlds are much better at adjusting to
change in conditions than people sitting in capital cities.
Conclusion
We are in a new era of
more rapid changes. Dividing one’s portfolio by various timespans can minimize
the risks to your total capital.
Question of the Week;
Have you materially changed
your 2018 portfolio?
__________
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