The Golden Calf For Investors Weekly Blog

According to human experience as recorded in The Old Testament, in a period of great uncertainty many people look for certainty when faced with a tricky period ahead. Today's investors are in a similar quandary. In their search for a defined future, there is great appeal in simple tangible answers. Today, many investors have conflicting views as to the future direction of their investments. We are now facing a tricky market, and there is great appeal in simple declarations of faith or the lack of faith.

The one thing I am totally convinced of is that there are no good simple answers, despite what future market historians will condense for an impatient audience.

The Known Knowns

Without putting dates or time spans on when these conditions will become dominant and for how long, based on human experience there are two knowns.

1. Due to excessive expansions of capacity and credit, there will be future recessions. These could start soon or after various coincident changes. The base causes are what they have always been: imprudent expansion based on excessive enthusiasm. The coincident events or actions will not be the base causes for a period of unhappiness, but will supply a label to those looking to others for an explanation and not to themselves, in order to not get caught up in the tidal wave. Perhaps as an equity owner for clients and my family, I don't see a high level of an immediate risk. As long as the latest survey of the American Association of Individual Investors (AAII) shows that 42.8% of respondents to their weekly poll are bearish for the next six months compared to 26.1% bullish and 31.2% neutral, I am not too worried. Further, a major US-domiciled brokerage and wealth management firm is on record stating that investors should use rises in stock prices as an opportunity to sell. I would agree that it is an opportunity... for the firm to free up investors' capital, often held with large unrealized gains, which might lead to future investments, often in packaged products with favorable economics for the intermediary. (There is always a risk for all contrarians that a popular view will be accurate. This is a lesson that gets reinforced at the racetrack.)

2. The second "known" is the human survival instinct. Greed and fear drive all of us. Our primary driver is greed to obtain at least minimum subsistence and beyond to higher and higher levels of security. Fear is the worry that we and our loved ones will not survive without the appropriate levels of financial, intellectual, and health resources. The solution to both primal drives is to secure sufficient resources beyond our subsistence levels. The excess beyond consumption is savings, including debt reduction, and investments for longer-term needs.

Unlike the first known, which is periodically important, the second is a global constant in all of our lives. For the moment, it appears that aggregate corporate and personal revenues will be growing beyond the AAII six-month focused period, and way beyond for those of us who believe that we will grow on a secular basis. (Note I did not mention corporate earnings, which will be discussed shortly.)

One of the long-term reasons to be bullish on the future level of global investment is China. As of May 1st (May Day) China will, for the first time, permit the commercial sale and operation of pension plans. Contributions to the plans will be tax-incentivized and open to foreign insurance companies which the Chinese government has authorized. In most of Asia, beneath the level of stocks owned by International Index funds, the valuations appear to be cheaper than those found in the US. However, a detailed accounting and operational comparison is needed to show that they are more valuable to own, although we tend to think so.

Near-Term Debt Worries

Because of the insistent drive for current yield, almost every financial institution or intermediary is selling a credit-focused product which will hold direct loans rather than tradeable bonds. Three quotes from the Financial Times on the views of S&P sum up our concerns:

  • "S&P warns of risks in leveraged loan sector as private equity deals surge."
  • "We've already seen weaker (covenant) terms deteriorating over the last couple of years."
  • History shows us that the worst debt transactions are done at the best of times."

Another long article published in the weekend issue of the FT is entitled "The volatility virus tells the history of turning volatility into an investable product." The article mentions that today there are at least forty exchange-traded products (ETPs), funds and notes that alone trade VIX elements. This comes to the heart of a concern of mine. Too many of the media pundits treat ETFs and ETNs as retail alternatives to conventional mutual funds, when in reality, they have become cheap trading vehicles for professional speculators. The available ETPs have replaced the more expensive futures as the derivative of choice. Not only are they cheaper to transact, but they are more easily marginable or borrowed against. I suspect that a significant portion of the trading, particularly near the close of the day's trading, is to facilitate short sales in "pair"-like trading, which entails being long another index derivative or an individual stock or bond.

There are still a lot of derivatives being used in fixed income, currencies, and commodity trading. These are global markets with individual country banking rules. All of these vehicles are used as collateral to support trading positions with call loans that can require immediate repayment of the supporting loans. Rarely are these loans repaid with existing cash, but they are paid with securities that are not immediately price-sensitive. These trading and lending activities are conducted by trading groups and banks that have to maintain given levels of capital. If there is a sudden fall in the level of collateral, other assets will often have to be sold without sensitivity to current prices. We have seen this occur in the past.

Equity Concerns

If one pays complete attention to the media prognosticators, the only thing in the end driving stock prices are earnings per share, or if you will, the rejuvenation of the biblical Golden Calf. The followers, including a number of university professors, would have achieved losses on Friday. According to them, the market was going to be led by the earnings reported by three major US money center banks on Friday.

In each case, their announcements stressed the favorable comparison to their reported earnings compared to those of the prior year. Thus, the stock market should have gone up. It didn't, which was not a surprise to me. Ruth, my good wife, asked me after I got off the first of the earnings calls what I thought. I replied that the announcement was quite positive, but I saw problems when I went through the detail of the announcement. By the end of the day, the stocks of the banks and a good bit of the market were down 2-3%. It was not a case of buy on the rumor or expectation and sell on the news, which often happens.

My concerns were first that the market price assumed that the tax-generated savings were a growth element rather than a one-time benefit, (the expected state and local tax increases plus higher sales and use fees one might expect with a bigger tax rate going forward). An operating concern was that the reported earnings benefitted from buybacks and the release of some credit reserves and similar adjustments.

Revenues were largely up, but not spectacularly. Often, these reports brag about relative investment performance versus peers, which was missing, but not their selective inflow comments. Bottom line: The results did not trigger additional buying or selling in our long-term accounts. The level of operating pre-tax earnings was acceptable.

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