Shaping a Portfolio for 2010 (II)–Where We Are Now

The first step in figuring out how the economy develops from here is to try to describe the forces that are shaping it today.  I think the most significant are:

1.  For almost two years, we have been in a domestic housing slump.  This is the aftermath of a long housing boom fueled in it last days by extreme levels of speculation–by individuals buying houses they couldn’t afford (or intended to quickly sell to a “greater fool”), and by banks making mortgage loans to unqualified borrowers.  There are signs that the worst may be over for single-family homes, but not for apartments.

2.  Last year, the public, the regulators and the financial companies themselves discovered that the securities trading desks that the financials had established over the past ten years were not the immense profit centers that the company accounts had portrayed.  Instead, these trading desks had lost so much money, with top management unaware of what was going on, that they had driven their firms–big institutions like Citigroup, AIG, Lehman or Merrill Lynch–into bankruptcy in all but name.  Since many of the securities being traded were either backed by worthless mortgages (para. 1) or were IOUs from the now-defunct firms, even the “winning” side of these trades were money losers.

The realization, late last year, of the extent of the losses made financial companies effectively stop making new loans of any type, shutting off the life blood of economic growth.  This is by far the largest problem we have. Since then, governments around the world have been taking all sorts of extraordinary measures to restart the normal process of credit creation.

We’re probably well past the worst.  From a stock market perspective, several issues remain:

the credit creation process still isn’t back to anything near normal.  Lack of credit continues to send negative ripples through world economies

the north-east US, the epicenter of the problem, will likely struggle economically for a considerable time

confidence in US institutions has been damaged.  This is not only the banks.  Investors seem to regard Congress as dysfunctional and to worry that, as a result, the government will not be able to fix the banking problems.  I’ve never seen this kind of lack of confidence before, so I find the phenomenon tough to evaluate.

in the longer term, the financial losses will be underwritten by taxpayers

3.  The internet continues to do its work of creative destruction.  The economic downturn has accelerated the pace of change.  Newspapers and local TV stations are the current focus of rapid change.  Book publishing may be next.

4.  The Detroit-based “Big Three” car companies have been losing market share for thirty years.  For almost that long, they have been standard studies for MBAs on how not to run a business.  Ford appears to finally begun restructuring a few years ago.  It appears restructuring will be forced on GM and Chrysler.  I don;t think this is the significant stock market issue it might have been four or five months ago.  But Michigan will likely find the economic going hard over the next few years.

To summarize:

Bad News:       credit crunch

housing slump

decline of paper-based communication

problems will take some time to fix

Good News:      the problems are out on the table,

their rough size is understood, and

the government is working to fix them

stocks are cheap

we can guess economic growth will resume in late 2009

the economy in the US isn’t doing as badly as feared

a perverse plus:  anger at bank bailouts = less political

pressure for a potentially disastrous bailout of


Shaping a Portfolio for 2010 (I)

The most important practical thing an investor can do at any time, but particularly during a period like this of great emotion in the markets, is to step back and try to take a longer view of events.  We are highly unlikely ever to be able to out-execute a hedge fund that concentrates on short-term trading.  On the other hand, that approach brings with it enormous pressure to focus on near-term results, leaving the much more fertile field of seeking long-term winning companies and economic trends for us to try to exploit.

In a series of posts under the title of “Shaping a Portfolio for 2010” I’m going to talk about what I think are the key factors to consider.  The idea is to develop a set of conclusions about what the future will look like and use them as the basis for a stock market strategy.  These conclusions should be regarded as working hypothesises to be monitored and tested.  But articulating what they are and how to judge whether they are correct or not will give us a key to altering strategy as events develop.

The Overall Market–Up or Down?

Perhaps the most basic question about investment strategy, but the one portfolio managers never talk with their clients about, is whether the economy most important for their stocks (i.e., the US, Europe, the Pacific, the world…) is likely to be expanding or contracting overthe next couple of years–and therefore whether stocks are likely to be going up or going down.  (Why this is so is the subject for another post.)

Yes, I think it’s true that successful investing is not about timing the market, that is, trying to sell at the top, hold cash for a while, and reenter the market at the bottom.  But the strength of the overall economy has a profound effect on what kinds of stocks do well.

If the economy is expanding, for example, then profits are rising and the more economically-sensitive stocks, like those in consumer durables, technology, and industrial sectors, are likely to be outperforming.  If, on the other hand, the economy is contracting, defensive areas like consumer staples, medical services or utilities are typically the market stars.

Not only that, but relative market shares within industries can shift considerably with the business cycle.  In good times, the #1 supplier may not be able to meet all the demand from even its best customers.  So, out of necessity,  orders flow to second- and third-tier vendors.  In bad times, #1 may have spare capacity.  If so, orders will shift back to the perceived higher quality and service, possibly hurting lower-order vendors severely.

Also, companies with very high operational or financial gearing (therefore, very high fixed costs to cover before they can show a profit) can show huge profit swings in response to small changes in demand or pricing.

Where are we now?  I think that in stock market terms we’re just past the worst of a vicious downturn.  (Global economic growth won’t resume until late this year, at the earliest; some industries won’t recover for much longer. Remember, though, the stock market is a futures market that discounts economic performance in advance.)  This would mean the next significant move for the markets is up.  The markets are in the earliest stages of preparing for this, but expressing guarded optimism in only the most generic way by selling defensive groups and buying more aggressive ones.  I think this is more an unwinding of a fear-driven excessively defensive posture, and calculation that such a posture is unlikely to provide outperformance, rather than strong belief that resumption of earnings growth is close at hand.

Today’s Market

I think we’re entering an important time for the market.  We’ve crawled, maybe “sprinted” is a better word, out of the hole the market made for itself in February and early March.  Some of the bank stocks are starting to slow down.  We’ve had a couple of yo-yo days, where stocks have been both up and down a lot.  Yesterday, not only were smaller stocks strong outperformers, but small laggards did a lot of catch-up.  In other words, the patterns that have shaped the market action during the rally seem to be changing, and at a point where a load of selling has occurred in the recent past.

Today may tell us a lot.

Typically, the first surge in a new up market is a mad rush to cover shorts and get money back into stocks.  Buying is relatively indiscriminate, but with a significant tilt toward larger market cap stocks, for no other reason than they can accept large amounts of money.  After that phase, however, buying becomes more focused and new leadership areas emerge.

For us, several questions:

1. are we at that stage now?

2. if we stall at this level of the market, do we have to reverse direction and “test” the early-March low?   

3. what are the new market themes?  In particular, how badly have irresponsible bankers weakened our future economic prospects and out reputation in the world?  and what implications are there for stocks?  has the clueless behavior of Congress in the crisis added to the damage?  (Answers shouldn’t involve any ranting.  The key  issue, I think, is how heavily does one want to be exposed to the US economy in the next year or two:  do we concentrate on American icons, or look past them for niche  names with unique products serving a world market; how seriously do we look at non-US markets, given that the epicenter of banking destruction is the US?)

More on these topics over the weekend.

I’m in Florida watching spring training, so this will be brief.

The market continues its strong rotation away from defensive stocks and toward economically sensitive stocks.  This pattern is very evident in almost every day’s trading.

Financials have been the stars, but one must ask when this will end.  Why?  Balance sheet losses show the historical growth rate of profits was actually much lower than the companies reported.  Future growth may be slower still because of stricter regulation.  Bailed-out banks will likely be forced to compete against each other in the home market, lowering margins.  Also (not a really good reason), leadership in a new bull market rarely, if ever, includes the leadership of the prior bull market.

Why the furious rally in financials so far?  Typically, in times of national economic stress, the market declines, fearing the worst economic outcome,, until the government announces it recognizes the problem and intends to deal with it.  The market immediately rallies.  Not this time.  It’s clear investors feared the government in the US lacked the competence to understand and address the banking crisis.  So the market waited until many concrete plans were already under way–including the original plan to reomove toxic assets from bank balance sheets–before bidding the banks back up.  

A new bull market requires credible belief about upcoming eranings growth.  I don’t think we’re there yet.  I read the current market action as investors slowly moving away from extreme defensive positioning.  So I think the current market rotation and a gradual upward drift of the markets will continue.

At some point soon, this very general idea won’t be enough to guide an investment strategy.  The key questions, as I see them, are:  how badly has the continuing demonstration of cluelessness by our legislators damaged investor pereceptions of the attractiveness of investing in the US?  (it’s bad, but is it life-threatening?), and where will the strongest earnings growth be in 2010.?  More on these topics later.

The Stock Market Is Getting Less Efficient–Good News for Individual Investors

The Financial Times reported today that the Capital Group, one of the largest money managers in the US, and one traditionally strongly dedicated to in-house research, is cutting jobs for the third time in six months.  Here’s the link:

It’s not hard to understand the reason.  Given a roughly 50% decline in world stock markets from the top, plus possible redemptions by mutual fund or institutional shareholders, management fee revenues for this month could easily have dropped to 40% of their level at the top two years ago.  Profits could now be a quarter of their high water mark.  The situation is doubtless worse at smaller firms.  Companies less dedicated to doing their own research than Capital will likely lay off proportionally more analysts and portfolio managers.

The equity market downturn is only the latest in a number of developments that have tended to reduce the amount of sophisticated analysis in the hands of institutional investors.

The most important are:

 *Many years ago the question of which brokerage house employee gets credit for generating commission revenue from clients–the research analyst or the trader–has been decided in favor of the latter.  As a result of their diminishing share in company profits, seasoned analysts have been gradually leaving the brokers for a long time.  This movement has accelerated over the past few years as hedge funds have sought this expertise for themselves.

*At the same time, it seems to me there has been a long-term tendency among institutional money managers to deemphasize in-house research.  This has two short-term benefits.  It makes the business simpler.  It also means part of the cost of obtaining specialist investment information is no longer borne by the manager and paid for from fee income, but is paid for by the manager’s client through “soft dollar” “research commissions” that the manager directs to brokers and third-party research services.

Why is any of this good?  The breaking down of established institutional information gathering an analysis networks, long in train but accelerated by the market downturn, will probably make world stock markets less efficient.  But this gives the serious amateur the best chance he’s had in the past twenty years at finding out and acting on information before the market does.

About AIG’s Business Products

Early in my career I remember hearing stories about a fellow portfolio manager who fancied himself an expert billiards player.  He regularly trounced the salesmen from brokerage houses he dealt with when they met socially for dinner and a game or two.  Then he changed jobs, to become an investment strategist for a broker, that is, a colleague of his billiards buddies rather than a client.  As I heard it, he never won a game again.

Stunningly Large Losses…

I don’t know very much about AIG other than what I’ve read in the  news.  But the sheer magnitude of the losses AIG’s Business Products division rolled up implies operating ineptitude of heroic proportions.  As my story above suggests, it’s a standard strategy for a trading counterparty to downplay his own competence and inflate your ego.  After all, you trade more often and less cautiously if you think you’re outsmarting the other guy, rather than worrying that he knows more than you.   But everyone on Wall Street should know this and try to apply a little objectivity in assessing business relationships and one’s own job performance.  Apparently AIG didn’t. 

If AIG was such a bad trader, why did counterparties overload it with losses and kill the goose that was laying golden eggs?  It’s possible they saw the big bonuses AIG traders were collecting and misread the extent of its losses.  It’s also possible they thought the AIG people were so bad as to be beyond saving, and that if they didn’t take AIG’s money someone else would.


..But A Bonus Plan Where Losses Hardly Counted

I’ve also just skimmed, courtesy of the government, the AIG bonus plan.  (Here’s the link, if you’re interested:

Several things strike me about it:

1.  The plan is called a “Retention” plan.  Employees were to share 30% of Business Products’ profits, with no cap set on the maximum paid, and with a minimum guarantee.  That guarantee, which presumably was the amount paid out for 2008, was set somewhat below the amount paid out for 2007.

Any realized losses above $225 million are not applied against 2008 earnings.  Instead, they’re carried over to following years and reduce a given year’s bonus pool by a maximum of 30% of that number, or $67.5 million.  The minimum guaranteed bonus is also reduced by the overhang of past years’ losses, again at a rate of $67.5 million per year.  Given that this unit appears to have realized losses of, in round numbers, $200 billion in 2008,  the guarantee shrinks to nothing in at most two or three years.  The overhang of losses looks like it lives on, depressing bonuses, into the twenty-fourth century.    All the plan really seems to do is to allow one more round of large bonuses, before encouraging anyone who can get another job to leave.  So it is a “Retention” plan only in the sense that it “retains” a final year of undeserved incentive pay.

2.  The plan is dated December 1, 2007, and replaces an earlier plan.  The differences are not described.  I would bet, however,  the main change is that the earlier plan did not limit, as this one does, the extent to which realized losses could shrink the bonus pool.

3.  Bonuses are based, not on economic profits, but on realized gains and losses, that is, on transactions that were closed out during the year.  I find this very unusual.  The bonus pool can easily be inflated by cashing out profitable trades and keeping losers on the books.  The plan specifically states that unrealized losses are excluded from the bonus calculations.

4.  It’s hard to see why AIG’s management would okay a plan like this, other than that 70% of the Business Products’ so-called profits become earnings of the parent company, on which presumably top management’s bonuses are calculated.

5.  It’s also hard to see how former Secretary of the Treasury Paulson, a veteran Wall Street manager, did not hear the alarm bells that this bonus plan sets off.

An Ugly Story

The losses are huge.  The bonus plan is shameful.  No one in government or new management caught on.  Retroactively changing the tax code may be emotionally satisfying, but  it doesn’t seem to me that punishing Wells Fargo or JPMorgan employees for something AIG did helps the country a lot.  A better direction of attack might be maintaining that in trying to “game” the system with this bonus plan, AIG violated its obligations to shareholders.

One more thought on the House action.  Is the House really being as hysterical as its rhetoric and voting make it appear?   Doesn’t it realize it is putting at risk any future private-public cooperation in rebuilding the financial system?  Or is it calculating that it can be as bombastic as it wants, because the retroactive tax increase doesn’t have the votes to pass in the Senate?  My guess is that our representatives are relatively unaware of the risks, but are actively betting that nothing they resolve will survive the Senate.  The coming week will most likely tell.