Markets in Motion

Pick your poison: no return on safety or more risk on your return. 

Lower oil prices are beneficial for oil consumers whether they be oil-consuming countries or consumers in the US filling up at the gas pump.  That does not mean they are beneficial to financial markets.  The price of a financial asset is determined by the return one expects to earn from holding the asset and the amount of risk or uncertainty associated with that return.  A rapid change in any environmental factor increases the uncertainty associated with the return and therefore reduces the value of the financial asset.

There have been numerous articles about the falling fortunes of the oil sector.  On January 19, 2015 BARONS presented a summary of one analyst’s estimates of how much the earnings of the S&P 500 would be reduced by the reduced earnings of the energy sector.  The estimates do not seem worth quoting since they were developed without addressing the issue raised by the first sentence of this posting.  While the energy sector’s earnings will be reduced, earnings in some other sectors will benefit.  The net result is the introduction of considerable uncertainty into any forecasts of the profitability of a large number of companies.  That uncertainty will repress stock prices.

Thus, the uncertainty introduced by rapidly changing energy prices definitely has stock market implications.  However, the December 17, 2014 posting entitled "Oil Prices" pointed out that the greatest macroeconomic risk associated with falling oil prices would be their impact on foreign exchange markets: “The foreign exchange markets are so big that a major dislocation there can have all sorts of unanticipated consequences.”  The financial market implications of foreign exchange

Furthermore, it is quite conceivable that foreign exchange markets and oil markets could reinforce each other.  They could reinforce each other in terms of their financial market impact even when their macroeconomic impact diverges.  By introducing instability, they both could be contributing to lower stock prices by increasing the risk associated with holding stocks.  That can be true regardless of whether they have a positive or negative impact on the return.

The December 17, 2014 posting went on to note: “One should keep in mind that financial institutions make markets in both currencies and foreign bonds.  If a major financial institution gets caught with excess inventory of the wrong currencies or bonds, dislocation to the financial system could be significant.” One could argue that financial institutions also make markets in commodities such as oil, and therefore, that risk should be noted.  However, as big as it seems, commodities markets are small compared to foreign exchange markets. 

On Jan.16, 2015 WALL STREET JOURNAL was full of stories illustrating just how disruptive unanticipated foreign currency fluctuations can be.  However, the foreign currency fluctuations were only very indirectly related to oil prices.  The topic du jour was an action by central banks, current action taken by the Swiss central bank and anticipated actions by the European central bank and the Fed.  Between in following articles: “Swiss Move Roils Global Markets,” “Bankers, Traders Scramble to Regroup After Swiss Move,” “Fallout From Swiss Move Hits Banks, Brokers,” “Europe’s Smaller Central Banks Likely to Cut Rates After Swiss Move,” “Swiss Shock Tarnishes Central Banks,” “Swiss Bank Shares Plummet After SNB Move,” “Gold Shines as Traders Seek Safety From SNB’s Shock Move,” “Swiss National Bank’s Franc Move Buoys Dollar,” “U.S. Government Bond Yields Fall for Fifth Straight Session,” and “UBS and Credit Suisse Earnings Get a Swiss Finish,” one gets an idea of just how important foreign currency fluctuations are. 

The scope includes non-oil commodity prices (e.g., gold), earnings of banks, pressures on central banks in countries like Denmark, impacts on the economies of many nations, government bond yields, stock market prices in some nations, and the reputation of central bankers.  The disruption is not just restricted to turbulence in all those markets, it also involves financial institutions closing their doors (e.g., Global Brokers NZ Ltd.) or having to raise additional capital (e.g., FXCM Inc.).

On January 17, 2015 the WALL STREET JOURNAL reported estimates of the losses of a number of financial institutions.  The article entitled “Surge of Swiss Franc Triggers Hundreds of Millions in Losses” included estimates for Deutsche Bank and Citi.  While the hundreds of millions of dollars involved might seem significant, for US banks they pale compared to the regulatory risk pointed out in the March 5, 2014 posting entitled “The Widows’ and Orphans’ Portfolio and US Banks.”  Nevertheless, they are just one more reason to avoid US banks in a portfolio designed to have a low volatility and a stable return.

Even when addressing issues that seem totally unrelated to foreign currency, it is impossible to ignore a market as large as the foreign currency market.  A good illustration occurs in an article published on January 16, 2015 in the WALL STREET JOURNAL.  It was entitled “What’s the Matter With Canada?” The major thrust of the article concerns Canada's manufacturing sector, but it was impossible for the article to thoroughly address that issue without discussing the impact of oil prices on the Canadian dollar.

It may well be that the decline in US stock prices so far in 2015 is an adjustment to the uncertainty introduced by the volatility in oil prices and currency markets.  It certainly is consistent with the increase in uncertainty or risk associated with holding stocks.  However, when foreign currency fluctuations are involved, there is a significant increase in what is known as “tail risk.”  Countries can default, financial institutions can go broke, and governments can be forced to support their financial system and their economies.  Such shocks are often viewed as exogenous and therefore impossible to predict.

It is true; they are impossible to predict and this posting in no way constitutes a prediction that they will occur in the US.  However, they are not totally exogenous and the ground is fertile for them to occur.  Just that fact will impact the return on financial assets.  The first half of 2015 will provide significant opportunities to investors as companies adjust to the recent volatility in oil prices and currency values.  The next few postings will address their portfolio implications, but what is apparent is that regardless of what adjustments are made in a portfolio, the risk associated with any asset has increased.

 

When the Emperor Has No Clothes.

Government supported scammers

The WALL STREET JOURNAL had an interesting opinion piece by Gerald Walpin on Jan. 6, 2015.  The title “How to Stop a Class-Action Scam” undoubtedly caught the attention of most investors.  The column noted that, “If you own any stock, you know the frustration of getting a notice announcing settlement of a lawsuit, commenced by a lawyer on behalf of a class composed of all shareholders—you included.”

The article points out that generally the members of the class received little or nothing as a result of the suit.  At the same time, the members of the class have to pay the lawyers filing the suit millions of dollars in fees.  The class gets to pay for suing itself.  In essence, the class-action racket is set up to add injury to insult.

The author talks about the class-action abuse in general terms and then goes on to use a specific example: “Case in point: On Nov. 10, 2014, I received a class-settlement notice regarding my Verizon stock.”  Verizon was one of the stocks identified as a part of the “Widows and Orphans Portfolio” in a posting at the beginning of 2011.  It is a part of a core portfolio that has been discussed a number of times since then. 

It is no accident that the suit was filed against the type of company that would be in a portfolio for widows and orphans.  Large-cap, widely-held stocks are the perfect target for these class-action criminals.  The management, constrained by their fiduciary obligation to their stockholders, will settle in order to avoid a costly defense.  In addition, the wide dispersion of stocks ensures that it is unlikely any single shareholder will find the expense of objecting to the outrageous legal fees of the class-action lawyers worth the cost of intervening.  In short, widows and orphans make good targets for this extortion racket.
 

As someone who has managed a portfolio of common stocks for many years, The Hedged Economist has probably been defined as a class member a couple of dozen times. The experience has provided an opportunity to read through many class-action notifications.   It is amazing how totally corrupt and absolutely imbecilic the process is.  In fact, it is so bad that it is difficult to figure out where to start in terms of any thoughts of how it could be reformed. 

What is worse is that the process has been set up so that an individual is unable to protect oneself.  The simple solution would be if government, in its infinite wisdom, would recognize that perhaps individuals are able to judge whether they are victims of the abuse the class-action lawsuit supposedly addresses.  However, instead the government has set things up in such a manner to make it inconvenient to avoid being defined as a member of the class that has been selected to pay the class-action lawyers their ransom. 

In fact, in some instances opting out of the lawsuit requires providing confidential information that an investor may reasonably choose not to disclose.  Clearly, disclosing information such as Social Security number, brokerage account number, name and address (despite the fact that they have already mailed items to you) is not something that should be undertaken lightly.  Especially, when the disclosure is to individuals who have demonstrated that they are probably crooks willing to undertake frivolous lawsuits for personal gain.  At a minimum, they have demonstrated that they are not acting in your interest, and disclosing information to such individuals is more likely to result in harm than benefit.

Since our elected officials have known about this corruption of our legal system for years, one would be foolish to assume that they will address it.  One can hope, however, that the consumer watchdog organization for financial products created as a result of the Dodd-Frank legislation would recognize that stocks are a financial product and stockholders should be protected from this sort of extortion.

A Quick Comment on the Jobs Report

It is unfortunate when ideology blinds observers to the obvious

Friday's jobs report showed a drop in the unemployment rate, a growth in payroll employment, and a decline in the average wage.  Many observers cannot understand why the wage would go down when the unemployment rate and pay-rolled employment indicate a tightening labor market.  The reason is obvious.  However, before one can see it, one has to discard the notion that there is an aggregate labor market.

Unfortunately, many observers, especially economists, are blinded by the Marxist notion that there is a great lump of something called labor.  If you assume all labor is homogeneous and all jobs are homogeneous, then a tightening labor market should increase wages, but no such homogeneity exists.  The theory was wrong when Marx advanced it and it is still wrong.  People are individuals.  Each job requires a different set of skills and contributes a different amount to the output of the organization hiring the individual.

It never occurs to observers that as markets tighten, they increasingly draws in individuals who are less productive, less willing to work, and less skilled.  Not surprisingly, those individuals cannot command the same wages as the individuals who are already employed.

What is surprising about this inability to see the obvious is that there has been considerable handwringing about the loss of skills attended with long-term unemployment.  Also, anyone paying attention has noticed that the unemployment rate among the prime working age population has been consistently lower than the unemployment rate of demographic groups more marginally attached to the labor market.  The young and those with less education, as well as those most inclined to just drop out of the labor market, represent a disproportionate share of the available labor.

Also, as the economy expands it becomes profitable to employ people to work on things that would not be worth it if the economy were not expanding. There is also what is referred to as the composition issue.  Put simply, the composition issue is the question of what firms are hiring and whether those firms are in high wage industries hiring for high wage occupations.

For those who love to see a political issue in any economic data, there is also the impact of the incentives our government provides to employers to avoid hiring people for full-time jobs.  Part-timers tend to earn less than full-time employees.  Finally, lest we forget, wages are quite different from employee compensation, and we have enacted legislation that mandates the substitution of health insurance for higher wages in many instances.

So, let the handwringing continue; it is easier than giving up an obsolete theory.

“It's a Wonderful Life” versus "The Interview"

Get serious

Washington and media are all aflutter about Sony's movie "The Interview."  One has to wonder what they are thinking.  No one has ever represented "The Interview" as worthy of serious minds.  Of course, at this point nobody who's talking about it has seen it.  So naturally, they can speak with authority about the political and social implications of the movie’s setbacks.  Such is the thinking of Washington and the media.

One doubts whether anyone, in Washington, the media, or the general public, thinks, even for a minute, that they would be better informed if they were allowed to watch "The Interview."  By contrast, ever since the very first posting on the Hedged Economist, at about this time of the year “It's a Wonderful Life” has provided a source of wisdom relevant to Washington and the general public.  Perhaps, rather than fretting about "The Interview," we should insist that policymakers take a break and go watch “It's a Wonderful Life.”

Just perusing the WALL STREET JOURNAL on December 20th provided two good examples of instances where “It's a Wonderful Life” would have provided policymakers with guidance they clearly need.  As we all know and are constantly reminded by the media, about six years ago we had a liquidity crisis.  Since we haven't had a change of administration since then, we still have a lot of people in Washington running around like chickens with their head cut off trying to fix whatever led to the last liquidity crisis.  Alas, they seem to have learned nothing from the actual experience of that crisis.  So, my hope is that if they view “It's a Wonderful Life,” the experience may help them to understand what happened.

The news is not encouraging.  For example, one of the lead stories on the 20th was “Bank Bailouts Approach a Final Reckoning.”  It summarized the experience of the Treasury as it completed the sale of its last holding from the assets it acquired during the financial crisis bailout program.  One has to love the media that can describe an investment that makes billions of dollars as a “bailout."  It would seem more realistic to refer to it as a low-risk, low-return investment for the Treasury.

To quote the above article: “The U.S. government closed a chapter in financial-crisis history Friday when it sold its remaining shares of Ally Financial Inc. and shuttered its auto-bailout program, ending the last major pieces of a $426 billion rescue package that saved a swath of U.S. companies but never won public support…. netted a small profit, returning $441.7 billion on the $426.4 billion invested in firms.”

“It's a Wonderful Life” contains a classic scene of the impact of a liquidity crisis.  While in the 21st century their form will change, in the 19th and 20th centuries they took the form of bank runs.  Bailey Building and Loan experiences a bank run.  When George Bailey decides to turn back from his honeymoon and go to the Building and Loan to manage the run, he finds the crowd there waiting for their money.

It seems that Washington wants to join the crowd in the lobby at Bailey Building and Loan.  First, remember when TARP was initially raised in Congress, Congress voted it down.  As circumstances would have it, I was on vacation and watching it with a friend as the vote was taken.  My comment at the time was that just the act of voting down TARP would extend the recession by a couple of years.  The vote would have to be reversed, but it was the sheer folly of Congress’s failure to address the “crowd in the lobby” that would extend the recession.  

As has been pointed out by Mr. Obama and Mr. Bush, TARP helped avert an even more severe recession following the financial crisis.  But, by demonstrating their collective ignorance, Congress raised serious doubts about whether that objective would be achieved.  That kind of uncertainty assured that the financial crisis would be deep and have lasting effects.

That's history.  Perhaps Congress has learned from its experience and realizes there is a role for a lender of last resort.  However, I wouldn't recommend getting one’s hopes up.  It seems Congress missed the little back room conference between Uncle Billy and George Bailey.

When George enters Bailey Building and Loan during the panic, he finds Uncle Billy a bit distraught.  Uncle Billy takes a strong drink and pulls George into the back room where he explains, between stammering that “we’re in a pickle,” that the bank called their loan and has drained their entire cash position.  Congress and a number of our national figures seem to have missed the point.  They believe that the Federal Reserve Bank's efforts to provide liquidity during the financial crisis put Wall Street’s interests ahead of Main Street’s.  Perhaps, Congress thinks it would be good to have such loans called. So, Congress outlawed future taxpayer bailouts as part of the 2010 Dodd-Frank law.  One can't find a stupider law or one that will do more to impede the response to the next liquidity crisis.

Since Congress reversed itself on the TARP vote and will come to recognize the stupidity of placing obstacles in the way of future responses to liquidity crises, what's the harm?  Well, as “It's a Wonderful Life” illustrates, liquidity crises are temporary, ephemeral phenomena.  Once George meets the liquidity demands of the first depositor, he then asks the next depositor what he really needs.  The response is $20.  Clearly, with the simple act of demonstrating the folly of the demand for liquidity, George has shifted the mental state of the depositors from one of panic to a more rational focus on what they actually need. 

If George had to wait for Congress to recognize the liquidity crisis before he would meet withdrawal requests, Ms. Davis would never have asked for only $17.50 and Bailey Building and Loan would have failed.  Alas, because Congress will have to scrap the Dodd Frank restrictions on bailouts before liquidity can be injected into the financial system; Congress may have ensured that there will never be a Ms. Davis.

Many of national leaders didn't realize from the start that the so-called bailouts would make a profit.  They didn't hear Bagehot’s advice echoing across the centuries.  Bagehot’s advice, “to lend freely against good collateral during times of financial crisis and you always make a profit,” has been demonstrated to be successful over centuries of experience.  But perhaps, if our leaders can't learn from history and can't learn from the recent financial crisis, they will learn from watching “It's a Wonderful Life.”

Mary and George recognize a liquidity crisis, identify the opportunity to invest, and as a consequence they save Bailey Building and Loan.  More important than saving Bailey Building and Loan is the fact that their action saves their borrowers from foreclosure and results in a wonderful life.

However, as the article notes: “Criticism has persisted that TARP put Wall Street ahead of troubled borrowers whose housing woes were at the root of the crisis….Less than $15 billion of $75 billion promised for homeowner assistance has been spent.”  It is worth noting the subtle change in terminology associated with that quote.  Note that the author presents the $75 billion as “promised.” That's quite different from the terminology used when discussing other parts of the bailout.  The difference between a guarantee to pay and a promise to pay is important.  A promise is much more likely to be viewed as an obligation that must be met while a guarantee is simply a promise that the obligation will be met if needed.

When discussing TARP loans to banks, one should remember that the Congressional authorization was over $700 billion.  The article reports the actual use of the lower expenditure, $426.4 billion.  One can get lost in the details of the accounting, but clearly the cost of TARP would have been far greater if the Fed hadn't essentially guaranteed liquidity.  Witness how European markets responded to the simple statement of their central bank that they would do “whatever is necessary." 

“It's a Wonderful Life” is more subtle as an explanation of why bailing out the banks worked but mortgage relief wouldn't.  One has to remember that many of the people clamoring for mortgage relief didn't lose the equity in their home.  They never had any equity in their home.  One can't lose something one never had.  By contrast, George Bailey can pay the first of his depositors and insist that it is just a loan, because he knows that the depositor has good collateral, the equity in his home.  Similarly, the TARP loans to the banks made sense if they were backed by good collateral.  The fact that the vast majority of the loans were repaid with a slight profit indicates that the collateral was good.  What collateral could underwater homeowners provide?  Using that simple criteria the Treasury lent to banks against good collateral, and as consequence, they were repaid.

That the Treasury demanded good collateral is apparent from the fact that some of the same people who criticize the Treasury for "giving" banks bailouts also complained that it didn't demand enough from the companies.  The contradiction doesn't seem to bother them.  For example, the article quotes Christy Romero, the TARP special inspector general,  as complaining, dare I say whining, that the Treasury did not get concessions from banks taking funds. “There were no strings on the money,” she said.  Perhaps, she forgot what happened when too many concessions were demanded from Lehman Brothers.  One has to wonder at the audacity of those who can feel that the intervening six years have not influenced their perception of the value of the collateral.

There is considerable potential for fault when it comes to the terms banks were forced to accept under TARP.  Bagehot makes the point that during the crisis the lending should be done at usury rates.  It's a legitimate argument that interest and a claim on future earnings in the form of a warrant wasn't adequate usury.  However, one has to wonder whether those complaining about banks receiving the loans would have been willing to accept similar terms.  It's also well worth noting that many banks wanted to opt out of the program.

Nevertheless, one has to admit that attaching a value to collateral during a financial crisis is a difficult task.  It's well worth noting that George Bailey when bailing out Bailey Building and Loan doesn't bother to try.  He does recognize that Potter’s offer of $.50 on the dollar is a disservice to his shareholders.  Potter has just taken over the bank at this point in the movie making him the perfect evil banker for the rest of the movie.  Perhaps, those who criticize TARP as not having inflicted enough pain on the banks view themselves as modern-day Potters.  The point is George Bailey is proved right in that $.50 on the dollar might clear the market but it hardly is justified once the liquidity crisis passes.

A second article in the Wall Street Journal on December 20th illustrates why this will always be a contentious point.  The article entitled “MetLife Vote Wasn’t Unanimous” discusses the decision of the Financial Stability Oversight Council to give the insurer the “systemically important” label.

Insurance does have a role in “It's a Wonderful Life.”  It is the asset (i.e., collateral) that George Bailey can offer to Potter when George is desperate for liquidity because of a lost deposit.

The Financial Stability Oversight Council’s reasoning is designed to explain their interpretation of “systemically important.”  It reveals much more.  It makes clear why regulators are totally unable to assess collateral during a liquidity crisis. 

So, one is left to wonder: what is the concern?  How could MetLife become systemically important?  The Financial Stability Oversight Council cites as reasons for the designation “the scale of MetLife’s investments and also the extent to which the value of that portfolio can fall.”  In other words, they're using mark-to-market accounting during a financial crisis.  Nothing could be less appropriate, unless, of course, they are going to force mark-to-market accounting on MetLife at a time when it's totally inappropriate.  If that's the case, it is the Financial Stability Oversight Council that presents the systemic risk.  Unfortunately, that seems to be the desire of many of the people who complain that TARP didn't impose sufficient costs on its recipients.

In summary, perhaps the next time Ron Paul or Elizabeth Warren are tempted to go into one of their rants about the evils of the bank bailouts they should instead take a deep breath, go to a quiet place, and watch “It's a Wonderful Life.”  The only thing that would be better would be if instead they would restrict their comments to the evils of Sony's decision concerning "The Interview." Wouldn’t that be a wonderful Christmas present?

 

Oil Prices

So, a simple question is what do we now do with cheap oil?  What to sell?  What to buy? 

I would suggest buying gasoline but only if the needle on your dashboard gets close to E. 

The widows and orphans portfolio that was posted on this blog a couple of years ago included Exxon and/or Chevron.  The logic behind holding them is that the dividends would be superior to what one could get in a savings account and would grow faster than inflation or rising interest rates.  The logic still holds.  So, someone who owned the widows and orphans portfolio would not do a thing.  On the other hand, if someone were constructing a portfolio, the current price of Exxon and/or Chevron would present a good entry point. 

As commentators have pointed out, the Saudi's might continue supplying enough oil to keep prices down, what they refer to as “a big sweat.” They have done it before in order to drive out higher cost producers.  If they do, Exxon and Chevron's stock could go down more, but their current prices looks good.  Exxon and Chevron will not be the producers that the Saudi's drive out of business.  It is very unlikely that the Saudi's will even be able to force them to cut dividends.  For a very good analysis of the issue of the dividend safety of various oil companies I'd recommend “Which Big Oil Dividends Are Safe?” published today on seekingalpha.com.

There is one wrinkle.  US is now the second-largest oil producer.  A fair share of the high cost production the Saudi's are targeting is in the US.  Today General Electric outlined the effect of lower energy prices on its energy divisions.  We should anticipate more of those secondary effects on firm supplying the energy industry. 

ECONOMIST magazine had an interesting cover two weeks ago.  The title was "Sheikh vs shale."  It showed a picture of a sheikh and a roughneck standing back-to-back with their gas pumps drawn.  It is an interesting concept.  Shale producers are in many respects the swing supply.  However, unlike the high-cost producers of the past, shale production does not require a huge upfront fixed cost to develop the field.  In addition, although shale may be the swing production, it is not necessarily the highest cost production.  Consequently, shale production can gear up and down fairly easily.  Highly leverage producers may go under and have to sell their fields to that less leverage producers during periods when the industry is gearing back.  But, if prices go back up, those less leverage producers will quickly restore production.

If prices stay down long enough to reduce the drilling activity in shale fields, it may also cause extreme duress for other higher cost producers.  The Canadian tar sands are clearly vulnerable especially given the one-two of the Saudi's unwillingness to support prices and environmentalists success at delaying increases in efficiency of the transportation sector that would allow their production to reach global markets.  However, the greatest risk to the global economy may result from governments that own or have strong links to producers.  That affect is already shifting foreign exchange rates.  The Russian ruble has been an early casualty, but the risk to Venezuela, Nigeria, and to a lesser extent Brazil and Mexico are very real. 

The foreign exchange markets are so big that a major dislocation there can have all sorts of unanticipated consequences.  Today PIMCO’s emerging-market fund is showing the stress caused by significant holdings of Russian bonds.  We should expect more of that.  In fact, a default by one of the government's that has nationalized its oil resources, and thus the risks associated with energy production, is not out of the question.  It is worth keeping in mind that the vast majority of oil reserves are owned by governments.

There will also be many winners and losers among European companies that export to Russia.  For US investors in US corporations, exports to Brazil and Mexico may be more important than Russia or Venezuela.  However, the major risk is not from slower exports.  One should keep in mind that financial institutions make markets in both currencies and foreign bonds.  If a major financial institution gets caught with excess inventory of the wrong currencies or bonds, dislocation to the financial system could be significant.  That is a far greater risk for European banks than US banks.  However, some US banks, such as Citi, are so global, and the banking system of the developed economies are so linked, that financial dislocation is not out of the question.

Does Algorithmic Trading Make Sense for Small Investors?

Should the small investor play Wall Street's game?

Jason Zwieg’s column, The Intelligent Investor, is always interesting.  His book YOUR MONEY AND YOUR BRAIN is a delightful read, both interesting and informative.  The column in the March 8 WALL STREET JOURNAL entitled “The Incredible Shrinking Management Fee” was a good report on a new type of asset management company.  However, it left much to be desired if it was intended as a presentation of the phenomena for potential investors. 

First, the subtitle, “If a new company has its way, the cost of portfolio management could be zero,” reflects the problem.  The article discusses the number of companies, including WiseBanyan, Betterment, and Wealthfront that bill themselves not as portfolio management, but as investment advisers.  One thing to note is that Wealthfront does not seem to be a fiduciary.  The article contains no reference to whether Betterment or WiseBanyan are fiduciaries.  In other words, they do not have a legal obligation to act in the investor’s interest. 

They have a business obligation to do so, but not a legal obligation.  That is true of most investment companies like mutual fund companies, but it is unusual for someone who is taking financial management responsibility not to be a fiduciary.  Turning over asset allocation decisions to a financial manager who is not a fiduciary should make an investor uncomfortable.  However, there are some mutual funds that retain some asset allocation control, and The Hedged Economist has invested in and has recommended some of them when they were appropriate for an individual investor.   They were, however, well-established companies with a track record.  Further, they are explicit about limitations on the variability of the asset allocation.

The second thing to be aware of is that these companies are venture-capital financed.  The Hedged Economist has nothing against startups and has invested in over half a dozen at various times and currently has positions in three.   They have been the subject of a number of postings addressing topics ranging from the important roll they can play in diversification to how they are affected by regulation.  (The most recent posting on the topic was entitled “Angels and friends. When it rains, it pours.”  It provides links to most of the other postings on startups.)

The important thing to remember about startups is that the majority of them will not survive.  Some will go bust, some will just return investors’ money, some will be ho-hum investments, but it is the return on the remaining ones that justifies the investments.  If one in 10 is very successful that is good because they are owned directly by the investor.  So, the one in 10 can return enough to offset all the others. 

Investing through a startup as opposed to investing in a startup is a different story.  There is no potential for that really big payoff if the company is successful because the investor does not have an ownership stake in the company.  At the same time, if these startups do not succeed, that could have implications.  These companies are entering a very competitive industry.  So, it is important to be extremely confident about the success of the business model and the individual company which the investor chooses to have manage the money.  The implications of the failure of one of these businesses would require a lot of research to understand.  That, in-and-of-itself should be a powerful deterrent for some small investors.

Third, whenever one turns money over to someone else to manage, it is very important that the investor trust the money manager.  Since the companies seem to be exclusively web-based, there is less of a basis for establishing a judgment about their honesty.  Plus, because these are new companies, there are no track records on which to base judgments. Not surprisingly, the senior executives at some of the companies have venture-capital backgrounds.  Perhaps, information about whether they made money for investors in their venture-capital firms would be relevant, but even that is only indirectly indicative and would have to be interpreted very carefully.  It should be a concern to investors even though it is more than likely that the senior executives are honest, hard-working individuals. 

The point is that trust is a judgment the investor has to make.  In the case of these companies, there is very little information on which to base the judgment.  One cannot count on anyone else making that judgment.  For example, the Securities Exchange Commission completely missed Bernie Madoff‘s fraud.  Similarly, one cannot rely on the Financial Industry Regulatory Authority, a self-regulatory body commonly called FINRA.  A recent WALL STREET JOURNAL article had the telling subtitle “Analysis Shows More Than 1,600 Stockbrokers Have Bankruptcies or Criminal Charges in Their Past That Weren't Reported.” 

Fourth, given the companies’ descriptions of their investment approaches, the investment will probably work well under normal circumstances.  However, how well it works for an individual investor depends upon the quality of the analysis of the investor’ risk tolerance.  The firms probably have a questionnaire to determine one’s risk tolerance.  What they are trying to do is apply Modern Portfolio Theory (MPT) to the asset allocation based upon the results of the questionnaire.  They use trading algorithms to try to maintain the risk-return level continuously. 

As was discussed in a previous posting entitled “A Core of Mutual Funds: Part 1,” modern portfolio theory has been around since the 50s.  It is a very good theory if one assumes that individuals’ risk tolerances are easily measured and consistent over time.  However, there is considerable evidence that individuals do not have stable risk tolerances.  Jason Zwieg’s book and many of his articles, especially those reporting on the research of behavioral economists, have pointed out that risk tolerance is neither stable nor independent of investment performance.  Consequently, it is a bit surprising that he does not point out this problem with the approach that the companies are using.

One could reasonably argue that the principal advantage of an algorithm over a human adviser is that the algorithm has no emotions.  The problem is when the algorithm, which has no emotions, interfaces with the investor who does.  There is no reason to believe that investors would not systematically move in and out of this investment with detrimental timing.  Investors have shown that they do that with other investments.  That is a problem that no investment vehicle can overcome.  However, ignoring the issues related to measuring risk tolerance is only the tip of the iceberg.

Fifth, there is a basis for suspecting that algorithmic trading encourages an incorrect assessment of risk.  The Hedged Economist has occasionally made reference to an article written by The Numbers Guy in the WALL STREET JOURNAL.  The article entitled “Don't Let Math Pull the Wool Over Your Eyes” makes the case that many people, including holders of graduate degrees, professional researchers and even editors of scientific journals, can be too easily impressed by math.  Since that is the case, it is likely that the investor and the companies offering the service do not understand the limitations of their approach.  Thus, it is unlikely they correctly assess the risk.

Sixth, the marketing pitch that is quoted in the Zwieg article: "Investment management can be more expertly done by an algorithm than by a human adviser," should be cause for concern.  It could illustrate overconfidence and hubris on the part of those developing the services.  It also might represent a cynical willingness to use the tendency for people to be overly impressed with math.  Finally, as discussed below, it represents an incredible level of naiveté on the part of the developers.

Seventh, anyone who works with models is aware that they are models.  They have limitations and are based on assumptions.  The algorithm is simply a model of how the market functions.  All algorithms that stress diversification across asset types are applications of Modern Portfolio Theory.  Modern Portfolio Theory is an excellent theoretical framework for making asset allocation decisions.  It has been referenced frequently in The Hedged Economist and much of the financial literature to justify asset allocation decisions.  It is an excellent theory, but that is all it is.

Asset allocation can be made to sound complicated.  However, it is actually a lot simpler than advocates of Modern Portfolio Theory make it sound.  It is just asset diversification.  The problem with algorithmic application of Modern Portfolio Theory is that it is based upon the correlations and covariances between all asset classes.  It assumes they are stable.  Nothing demonstrated the fact that they are not stable better than the recent financial crisis.  (Technically one might argue that they do not have to be stable.  They just have to be measurable and forecastable.  However, the combination of discontinuities and the tendency for nonlinear models to be unstable – – one has to forecast the derivative; in some cases the second derivative – – which necessitates adding even iffier assumptions than stability in the correlation matrix).

So, the theory works well under normal circumstances, and it results in a theoretical improvement in returns for any given level of risk.  When put into practice, any improvement in return is very, very slight.  Consequently, frequently professional managers try to take advantage of the slight improvement by increasing the leverage.  That, of course, creates its own risk.  However, the most common problem with the approach is that, as the saying goes, “it works as long as it works and then it doesn't work.”

There is an eighth point that was missed in the article. Algorithmic trading is much the rage with many on Wall Street.  What is not clear is whether there is any return to continuous, algorithmic trading in-and-of itself.  The largest firms involved in the activity also are accessing information not available to the general public or only available to the general public with a delay.  Research that separates the returns due to the information advantage from the return due to their trading algorithm is sorely needed. 

Further, and this should be a major concern, if these new firms serving the small investor are trading with an algorithm that is similar to those used by one of the larger firms but only receives the information on which the trades are based after it has been available to the larger firms, there may be no advantage regardless of how rational the algorithm is.  In fact, the trading by these firms may only enhance the returns of the larger firms which have better information.

Ultimately, most individual investors will do better by just avoiding continuous trading as a method of reducing volatility.  Volatility between the beginning date and the ending date of a trade is actually quite irrelevant to the return from the trade.  It is important in Modern Portfolio Theory, but only matters to the individual investor if he or she is willing to accept short-run volatility as the definition of risk. 

Continuous trading strips individual investors of one of their strongest advantages over professional traders.  The individual knows how long he or she intends to hold the asset whereas the professional investor has to continuously worry about the mark-to-market value of their assets.  For the individual investor giving up that advantage in order to conform to the tenants of Modern Portfolio Theory seems like a foolish choice.

A Different Approach for a Different Objective.

What if it is the stock not the portfolio?

In a previous posting entitled “The Widows’ and Orphans’ Portfolio and US Banks” the composition and objectives of the portfolio were used to identify a particular reinvestment plan for 2014.  However, the portfolio objectives outlined in the article include the diversification of risk to the capital (management of the size of the holdings) and diversification of the income streams they generate through dividends.  They are not the only potential portfolio objectives.

An equally acceptable alternative objective would be growth in the total portfolio based on combined capital gains and dividends.  That approach is particularly appropriate for an investor in the accumulation phase.  Individuals in the accumulation phase are usually younger and may be willing to take a little more concentration risk.  This second approach necessitates more attention to the price of individual stocks and the timing of individual stock purchases.  That will be the topic of this posting.

Verizon

The portfolio holds a significant position in Verizon (VZ).  While the dividend represents an appropriate portion of the portfolio, the amount of Verizon stock held in the portfolio could be increased without undermining the portfolio’s design.  An investor who is just building the portfolio might want to begin accumulating Verizon now.  The same might be true of any investor with different portfolio weights. 

The portfolio’s design is for all the stocks to be potential long-term holdings.  However, as has been discussed in this blog, the market will occasionally provide an investor with an opportunity to purchase long-term holdings at a discount.  The first thing is to determine whether there is any reason to believe that such an opportunity currently exists in Verizon stock.

After the financial crisis, there was a deluge of books and articles about the investment mistakes made by many of the larger money managers.  Back in April of 2010, The Hedged Economist included a number of postings analyzing some of those mistakes (e.g., “Sometimes Wall Street provides more entertainment than Hollywood: PART1 the winners” and “PART 2 the losers”). Looking at these mistakes was an extremely useful exercise.  It is always more fun to try to learn from other people's mistakes instead of making them yourself.

One thing that was particularly interesting was how often investors were burned because they failed to analyze the motives of their counterparty.  (If they were buying, they forgot to look at why their counterparty was selling, or vice versa).  An analysis of counterparties’ motives has become a frequent and often very useful supplement to the traditional financial and technical analysis.

In the case of Verizon, such an analysis is possible.  One knows that the Vodafone acquisition resulted in the distribution of Verizon shares into the hands of a number of individuals and financial institutions that never explicitly chose to purchase the shares.  More importantly, some of the institutional investors may be operating under portfolio guidelines or institutional charters that require them not to own foreign stocks.  Consequently, it is reasonable to assume that there are sellers of the shares who are not expressing a judgment about the future of the company.  The phenomenon described is sometimes referred to as “post-acquisition blowback.”  If that line of reasoning is correct, the recent decline in Verizon's stock is an opportunity to purchase at a discount.

There is a second reason to believe that a purchase now is appropriate for the long-term investor.  This blog often makes reference to a posting entitled “Wall Street doesn’t run the world.”   The reason is that the posting makes the important point that Wall Street is largely composed of investors with very short-run horizons.  It is not at all difficult for an investor to take advantage of any difference between his or her investment horizon and the typical investment horizon of Wall Street.

It is easy to see how that may apply to Verizon.  With its earnings release, Verizon ruled out stock buybacks for at least two or three years as it aims to slash that debt.  Impatient investors do not like that sort of behavior.  They had bid up Verizon stock based upon the increased earnings expected from their purchase of Vodafone.  Verizon's announcement of what it was going to do with those earnings was accompanied by selling of the stock.

Wall Street's time horizon makes that response totally understandable.  If Verizon used the increased earnings to purchase shares that they issued in connection with the acquisition, it would increase earnings per share.  The increased earnings per share would occur at the time the purchases were made.  It is a reasonable strategy, but not a long-run strategy.

If Verizon purchased back shares it would be influencing per share earnings before interest, taxes and amortization.  However, the interest paid per share would increase.  By reducing debt instead, Verizon does not directly influence earnings before interest, taxes and amortization per share.  Rather, by paying down debt, it decreases the interest expense.  Thus, earnings after interest, taxes and amortization will increase “other things being equal.” Ultimately, in the long run, it is earnings after expenses that the investor should be seeking.  Consequently, foregoing the short-run increase in earnings before interest, taxes and amortization should result in a greater return after interest, taxes and amortization, but it may be a slower process.

Thus, there are at least two reasons to think that Verizon stock may temporarily represent an opportunity: post-acquisition blowback and Wall Street impatience.  The next step in determining whether the stock represents such an opportunity is traditional financial analysis.  Using traditional measures, there is no compelling case for adding Verizon right now.  It is worth noting, however, that acquisitions sometimes create a situation where traditional analysis looks ambiguous.  As already mentioned, Verizon's stock has underperformed.  The Hedged Economist is not an expert in technical analysis.  However, the underperformance could represent an opportunity.  It is an opportunity that could continue to exist or even become more inviting.

Stepping back and analyzing the business, there are both pros and cons.  Verizon operates in increasingly competitive markets.  That is true of the cell phone business and FiOS.  However, Verizon has a long history of being able to flourish in competitive markets.  In addition, the reason the markets are competitive is that they are attractive and growing.  It has been many years since Verizon made any major strategic mistakes in approaching the markets, although future mistakes are always possible.  From a strategic perspective, Verizon made a couple of very forward-looking decisions a number of years ago.  If Verizon can continue to anticipate consumer and technical trends, its business should prosper.

A reasonable conclusion would be that the current period of underperformance represents an opportunity to accumulate the stock.  However, that conclusion is highly dependent upon the investor’s timeframe.  There is no need to do it all at once, and it may best be done by selling cash-covered puts at lower strike prices.

Exxon.

The situation at Exxon (XOM) is, in some respects, analogous to the impact of Verizon's statement in connection with its earnings release.  Exxon’s problem does not relate to debt, but like Verizon’s, it involves details about the company’s use of capital.  Exxon announced that it would be lowering its capital expenditures.   Since Exxon has not been growing reserves, this decision has caused concern, and it resulted in a selloff of the stock.

Given that Exxon is one of the largest companies in America, the decision to reduce capital expenditures received considerable attention.  For a summary of the details and illustrations of the attention it has garnered, see “Are ExxonMobil's Reduced Capital Expenditures Cause for Concern?” or “Is Exxon Mobil Heading for an Inflection Point in 2014?”  Those two articles provide excellent background on the issue while “Exxon Performance, Spending Cuts Rattle Investors' Nerves” is an excellent description of why investors were concerned. 

The bottom line is that the cut in capital expenditures was very minor when compared to capital expenditures over a long-term period of time.  Interestingly enough, the increased capital expenditures in past years brought on an equal number of concerns among investors and selling pressure.  The long-term investor might be very tempted to dismiss both as simply management decisions made in the course of doing business in an area that requires large, long-term investments.  That, in fact, seems like a very reasonable conclusion at this point.  Thus, the current selloff presents an opportunity.

However, a recent article on Seeking Alpha entitled “Exxon Mobil Needs A Big Dividend Hike This Year” touched off a stream of very interesting comments.  As many of the comments on this thread make clear, if Exxon does not raise its dividend, there are large numbers of investors who may sell and present an investor with an even better opportunity to purchase the stock. That could be a wonderful thing. Imagine being on the same side of the market as one of the most capitalized companies in the world, as well as with investors like Warren Buffett.

Although the stocks of Verizon and Exxon presented opportunities, those opportunities should be viewed in the context of the total portfolio and the investors’ objectives for the portfolio.  If the issue were simply to pick the stock that will appreciate the most over the next six months to a year, neither company would probably be the winning candidate.  As discussed in “What is to be learned for 2014 planning?” one would probably want to focus on PPG.  However, current developments in both companies’ stocks present opportunities to those focused on constructing a long-term portfolio.