ICI mutual fund data: old habits resurface

individuals’ fund buying patterns over the past four years

Perhaps the one constant in the behavior of individual investors in the US during the recession and subsequent bounceback has been their fervent embrace of bonds and equally ardent shunning of stocks. Within that overall orientation, it’s clear that individuals have preferred taxable bonds to municipal ones and foreign stocks to their domestic counterparts.

True, there were several months of pure panic after the Lehman collapse in September 2008.  At the fund-flow nadir, in October of that year, individuals withdrew over $128 billion from mutual funds and put the money into federally-insured bank deposits.  Less than a third of that amount, however, came from bond funds.

during the bull market

By June of 2009, investors were settling into the pattern that has marked their behavior through most of the entire spectacular rise in stocks of the past two years:   net investment of around $40 billion each month, $30 billion of that into bond funds, the rest into stocks–virtually all the equity money going into foreign securities.

late 2010

As 2010 was coming to an end, two significant departures from this norm emerged:

1.  As the big problems state and local governments are having with their finances became better known, individuals started a steady stream of withdrawals from tax-free bond funds, and reinvestment of that money in taxable fixed income.  That continues. to the present.

2.  January and February 2011 saw $32+ billion of new purchases of stock funds, the largest allocation of money to equities since early 2007.  At the same time, investors, quite uncharacteristically, put the lion’s share of their equity money into domestic securities.

At the time, I remember asking myself how to interpret the fact that an investor class that happily watched a near-doubling of stocks without showing a flicker of interest suddenly started piling in–and in a big way.

In this case, would it be unfair to characterize individuals as the “dumb money”?  …no.  Was it a good sign that they’re beginning to buy?  …not at all, since having the last bear capitulate is usually a sign of the top.  On the other hand, US stocks were still cheap then, in my view. (For what it’s worth, I think they remain so.)  My conclusion was to worry a little more, but not alter my pro-cyclical portfolio stance.

the past two months

In this context, the most recent data on individual investor actions from the Investment Company Institute are very interesting:

–municipal bond withdrawals continue

–taxable bond funds are receiving net additions of $3+ billion weekly

–money flowed out of equities in March, although April has seen modest inflows resume

–investor preference for foreign equities has returned.  In five of the past eight weeks, money has been withdrawn from domestic funds.  More than 100% of the net new equity money stock funds have received in March and April has gone to non-US funds.

In other words, we’re back to the pattern of equity avoidance that has characterized individual behavior during the best of the bull market.  Interestingly, the S&P has continued to go up in March-April, although at a more sedate pace than during January-February.

what to make of this

Theory says that as people get older and richer they become more risk-averse.  I think that’s true.  What I don’t get is why individuals, who are usually a shrewd lot, think at today’s prices and in today’s economic circumstances that bonds are a low-risk investment.

Exhibiting the perverse mindset that characterizes much of Wall Street’s thinking, I’m kind of relieved that individuals have lost interest in stocks.  That probably means that the S&P 500 still has legs.

US unemployment: structural or cyclical?

I’ve been in the structural camp for a long time.  Yes, as always, there’s a definitional problem–if you’re going to haul out fifty- sixty-year Kondratiev cycles, there isn’t much space left for anything structural.  But if you take a common-sense distinction between jobs that are going to come back soon, in line with economic recovery (cyclical), vs. ones where there’s very little chance of near-term improvement (structural), I think there are clear structural elements affecting the US job market today.

I’d like to offer two new reasons why I think so.

Up until now, my thoughts have been:

–excess supply of housing and retail space mean that construction jobs aren’t going to come back soon.  In fact, in some respects, the construction situation is getting worse, as big box retailers who are under attack by internet sales work out that they have (much) more retail square footage than they need.

–as anyone who has worked as a manager in a big corporation knows, there has always been, say, 1%-2% of the workforce that adds no value but is very hard to fire because sub-par performance has been tolerated for too long.  The fine art of foisting such “dead wood” on other departments entails writing semi-glowing performance reviews, which, as each new one is typed, increase further the potential for wrongful termination lawsuits, thereby entrenching the dead wood deeper into the company.

To me, the fact that even debt-free, cash-rich companies made layoffs during the recession means they saw a once-in-a-lifetime chance to clean house and a significant portion of those workers are now gone.  The slow accumulation of unaddressed hiring mistakes is likely beginning again.  But the counter has been set back close to zero.  And no one is going to rehire the dead wood.

–a related point:  I think many managers have been surprised by their ability to continue to function at a high level with fewer workers.  They won’t forget this overnight.

–by providing lots of jobs for manual workers, the housing boom delayed the adjustment of the economy to the fact of foreign competition for five-ten years.  Instead of the creation a decade ago of a group of out-of-work forty-somethings with little education/training and no computer skills, we have a group of out-of-work fifty-somethings currently needing retraining.  That’s harder.

My new thoughts:

Time magazine (I can’t find a link, sorry) has a recent story about the changing role of secretaries.  Among other things, it mentions that two million secretaries and related clerical workers were laid off during the recession.  They’re not coming back.  And that’s 1.3% of the workforce.

–older workers aren’t retiring as fast as normal.  Why?  I think the financial meltdown, which included temporary 401k and IRA vaporization, brought home to many that retirement doesn’t mean going to the mailbox periodically and finding a pension check.  It means managing your own money and making it last for thirty years (maybe more).

Sixty-somethings know once they retire there’s zero chance they’ll be able to get a comparable job again if they change their minds. And they realize that, while they may know how to save, they don’t have the slightest idea of how to manage their own long-term investments.  So they’ll stay in their jobs until forced out…or until they find and start reading this blog.

To gauge the order of magnitude of this factor, assume the typical worker has a fifty-year career and that the workforce is distributed evenly across all ages.  Then, 2% of the workforce should be retiring each year, opening positions for new workforce entrants just leaving school.  That’s a lot.

Investment implications?

The Fed’s quantitative easing is a political/social program, not an economic one.  Keeping interest rates at today’s low levels will eventually make the housing situation better, but won’t affect anything else on this list.  The other factors are tasks for Congress.  (Good luck to all of us!)

the Lex column on Macau gambling

The Lex column of the Financial Times is noted for its pithy–and very accurate–assessments of current economic or financial matters.  In its commentary about the Macau gambling market a couple of days ago, however, I think Lex has made a rare miss.  In particular:

–the column does note that the advent of casino gambling in Singapore has not diverted business from Macau.  On the other hand, there’s no reason it should be.  Singapore has only two casinos.  Of them, one is oriented toward the mass market, leaving a single venue–run by LVS–catering to the high-roller baccarat players Macau specializes in.  LVS has little incentive to market Singapore to its Macau clientele.  Past evidence in Las Vegas suggests that offering multiple venues to big customers doesn’t increase the portion of their business that a casino company gets.  It just runs up costs.  (In any event, to my mind, if LVS were to sell another location, conflict of interest  worries aside, it would more likely be ailing Ls Vegas).

Also, the Macau market is closely linked with junket operators, who help collect markers in mainland China.  Singapore is not a fan, and has already barred some from the island’s gambling palaces.

–Lex also worries about overexpansion of the type that is now plaguing Las Vegas.  But Macau appears to have absorbed that lesson as well.  The government has made it plain that it wants every operator in the market to be profitable.  It stepped in a couple of years ago to set maximum levels of compensation to junket operators (the key metric for profits in the high roller market) when weaker casinos seemed bent on starting a price war.  There’s also a cap on the total number of table games allowed in the market.  The government controls the supply of construction labor carefully.  And it has already turned down LVS’s request to begin building on a site where the company had spent $100 million on preparation work–presumably because it was concerned about the rate of floor space additions.

–the column is, as usual, a bit vague about investment advice.  It suggests that in a time of excess capacity (which I think is unlikely anytime soon) one should buy the stocks of firms that are growing at above average rates but trading at below the sector multiple.  If only it were that easy.  All the firms now public are family-controlled enterprises (although as/when MGM goes public, that may change).  In my view, they are all tigers who are unlikely to change their stripes.  If so, market laggards are likely to stay that way-with lower growth rates and lower PEs.  Aside from the “usual” problems of working for a family-owned firm, competent international casino executives may be hesitant to risk the reputational damage that may go along with working for a firm that has encountered regulatory problems elsewhere in the world. My guess is that this is a market where turnarounds won’t happen.

crude oil production contracts: a simple overview

Financial commentators have been pointing out recently that neither the large international integrated oil companies’ profits nor their stock prices are rising in line with the upwardly spiking price of oil.  This has to do with the changing nature of production-sharing agreements in the development of sovereign oil deposits.

There’s a ton of jargon in the oil business used to describe the often complex process of deciding how revenues and costs from a project are split up among the parties involved.  This is a highly simplified outline (but still good enough, I think, for a stock market investor) of how it works:

Generally speaking, an oil company (or group of companies) leases oil and gas rights to a specified block of acreage owned by a government through a competitive auction (in the past, colonial-style political or military coercion could easily have been the real key, however) .  In some cases, the winner will pay a large up-front fee.  In all cases, he is obliged to pay for and drill a specified number of exploratory wells over a specified time period, or else forfeit the lease.

If economically viable quantities of hydrocarbons are found, the oil firm must begin commercial development, again within a certain period of time.  The company “carries” the government, that is, it pays all development expenses.  Typically it can gradually recover these costs once production begins by being allocated an extra share of output until it has been recompensed.

Sometimes, the oil company takes physical possession of some or all of the oil and can do what it wants with it, sometimes not.  This can be a big deal in times of shortage.  For companies designated as “national champions” in nations like China or Japan, and asked to find supplies that can be sent back home in a pinch, it’s always a big deal.

three frameworks

I’ve seen three major contract frameworks, one following after the other, since I began watching the international oil industry in 1978:

1.  When I became an oil analyst, the typical arrangement called for the ol company to pay a fixed fee, say, $.50 or $1 a barrel, to the government that leased the mineral rights to a major international oil firm.  The oil company owned the oil, and might resell the crude immediately or refine and market it.  Such a firm made a good profit even when oil sold for under $2 a barrel.  But when prices rose in the early Seventies and again later in that decade, reaching as high as $35, the oil companies enjoyed the entire windfall.

This was a mixed blessing.  The contracts were seen as so unfair and one-sided that many oil-producing countries nationalized their oilfields and threw the majors out.

2.  In the 1980s, new contracts retained the general form of their predecessors but were renames production sharing agreements.  They called for a sharing of production revenues in specified percentages, say 70/30, with the oil company receiving the smaller portion.  That worked for a while.  But as prices rose from $12-$15 a barrel to $25-$30, and the majors began to make huge profits relative to their invested capital once more, the same problem of perceived onesidedness arose again.  Producing nations reacted in a somewhat similar vein as earlier, but either levying new taxes or simply unilaterally mandating more favorable terms to contracts.

3.  During the past decade or so, a new type of contract has emerged.  Again, the general form of the original contract has been retained.  But the production sharing arrangements call now for the oil producing country to receive an escalating percentage of revenues as the oil price rises.  While the contract terms tend to be expressed in this manner, the intention, I think, is to cap the returns to the oil major from a given project at, say, 25%-30% yearly.  The producing country basically retains everything above that.

Are the oil companies okay with this latest development?  Well, they continue to drill.  Of course, a lot depends on the riskiness of a specific project, but I think the oil company investment conclusion is that getting a 25% annual return for the life of a twenty- or thirty-year project is better than getting a 100% return for two years and then losing the project entirely.

stock market implications

For individual stock market investors, though, it’s important to realize that professional portfolio managers, or at least the oil analysts who work for them, understand the rules of the new order.  So they won’t chase after the stocks of companies that they know have large proportions of newer contracts.

John Taylor’s WSJ op-ed column

John Taylor, professor of economics at Stanford, former Fed official and formulator of the “Taylor rule” for money policy, wrote an op-ed piece in last Friday’s Wall Street Journal

The article has a very simple message, illustrated by an accompanying chart, which I’m paraphrasing as follows:

1.  The government budget was equal to around 18% of GDP in 2000, and had risen to about 19% by 2007.  This compares with Federal tax receipts of 18%-19% of GDP.  A problem, yes, but a small one.

2.  In response to the financial crisis, government spending has been upped to between 24% and 25% of GDP over the past three years.

3.  The Obama budget of February 14th, ignoring the recommendations of the commission on deficit reduction the President appointed, called for the deficit to remain at about 24% of GDP for the next decade.  A big problem!

4.  The Ryan budget passed by the House on April 15th reduces the deficit to 20% of GDP by 2016.

5.  Obama offered a second budget proposal on April 13th.  It pares back the original budget proposal, but still leaves the deficit at more than 22% of GDP ten years from now.

The virtue of Professor Taylor’s message is simplicity:  deficit reduction can be done.  And it seems to paint President Obama in a very unfavorable light, which, I suppose, is why the article appeared in the WSJ and not the New York Times. 

I understand that talking about political positioning risks diverting attention from the essential point, but I think several factors should be pointed out:

–according to the Congressional Budget Office, the main reason the original Obama budget proposal keeps the deficit so high is that the administration wants to keep applying a high degree of stimulus to the economy.  By itself, this increases the deficit.  But it also results in the return of a full-employment economy sooner than otherwise.  That brings with it higher interest rates and higher interest payments on the federal debt, creating much of the deficit blowout.

Of course, if history is any guide, the stronger the economy the greater the chances of Mr. Obama’s reelection, and vice versa.

–around 2015, large amounts of extra government spending on entitlement programs–especially medical care–begin to kick in, putting upward pressure on the deficit.  Congressman Ryan’s budget deals with this issue by more or less eliminating medical support for the poor.  Not so great, unless you’re sure you’ll be wealthy when you’re old.

–neither proposal touches the military, implicitly assuming that the country will be involved in a foreign war someplace elseor at least that the military will be paid as if we are.

To my mind, it isn’t just that today’s positions of the two major parties are so deeply rooted in partisan politics as they are.  It’s that both the Republicans and Democrats seem to be in a time warp.  What they are battling about and see as essential are issues from the 1940s and 1950s, which have long since been settled–or discarded as irrelevant–in the minds of average Americans, who are living their lives in 2011. 

Not a pretty picture.

There are some grounds for hope, however.  Most Americans want the deficit issue to be settled, so current elected official realize that their jobs are on the line.  S&P’s recent credit downgrade threat has highlighted the need for action now.  And, deep down, most citizens are aware that the country can’t pay for all the entitlement programs that Washington has promised to deliver.

For once in my investing career, I think that what Washington does is relevant.  Legislative action over the next couple of months will be interesting–and important–to watch.

AAPL’s 2Q11: more records, another big positive earnings surprise

the results

After the market close on April 19th, AAPL announced earnings results for its 2Q11 (AAPL’s fiscal year ends in September).  The company made $5.99 billion, or $6.40 per share, over the three months, on revenue of $24.7 billion.  These figures were up 95% and 83% year on year, respectively.   Wall Street analysts had expected eps of $5.37.

the details

AAPL sold an eye-popping 18.6 million iPhones, 113% more than in the comparable period of 2010.

It sold 3.76 million Macs during the quarter, up 28% year on year.

In a transition quarter, the company sold 4.7 million iPads. There’s no year-ago comparison, but sales were down by about a third from the December period’s 7.3 million.

The iPod, which in its heyday was around half the company, sold 9.0 million units, down 17% year on year.  iPod now represents only 6.5% of APPL’s revenue.  I see this as less a comment about MP3 players than one about how incredibly the rest of APPL has been growing.

Geographically, Asia-Pacific, up 151% year on year, was the star; Europe, “only” up 49%, was the caboose on the AAPL train.

items to note

Greater China (the mainland + Hong Kong and Taiwan) are now accounting for 10% of AAPL’s sales, up from less than 2% a few years ago.

AAPL is now guiding to a lower full-year tax rate, meaning it’s expectations for the share of revenues coming from lower-tax foreign areas have risen.

Of the 18.6 million iPhones sold, 1.7 million went to build telecom carriers’ inventories rather than into the hands of consumers.  Part of this probably represents the rollout of the iPhone to VZ in the US.  But I think it also likely indicates that carriers sense strong demand for AAPL phones and want extra insurance they won’t be out of stock.  …more problems for Nokia?

Although AAPL made around 7 million iPad1s in 1Q11, it produced only two-thirds of that number of iPad1s + iPad2s during 2Q11.  This comes despite AAPL’s assertions that it has had no supply problems from the earthquake/tsunamis in Japan, and its comments about “staggering” demand for iPad2 and the “mother of all” backlogs for the device.  This may simply be the way that the inventory rundown of the older model and the rampup of the new are playing out.  It may also be that AAPL isn’t able to get all the resins or components or other raw materials it needs company-wide and is allocating them to higher-margin smartphones.  Or it may be that AAPL wants to cultivate an it’s-hard-to-get mentality to heighten interest in the device, since consumers have as yet no effective alternative.  This isn’t a bad thing, just something to note–and watch.

the stock

Investors bid the stock up–but not by a lot–in trading on Wednesday and Thursday.

There may be a technical reason for the tepid response.  Early this month, NASDAQ announced that it is rebalancing its NASDAQ 100 indexThe weighting of AAPL, the largest index constituent, is being reduced from about 20% of the index to around 12%.  This has generated short-term selling pressure from index-tracking investment pools.

Why do this?  When NASDAQ 100 ETFs were launched a decade or so ago, these vehicles had difficulty meeting SEC-mandated rules on maintaining a diversified portfolio, since then-giants like MSFT or CSCO were so large a part of the index.   In order to be sure of adhering to SEC guidelines, NASDAQ slashed the relative weights of MSFT et al  and beefed up those of then-minnows like AAPL.  Now it has the same problem again, only with different names.  So it’s applying the same process to today’s titans.

Yes, AAPL is scarcely an undiscovered gem.  And, yes, reversion to the mean does happen.  But at 14x fiscal 2011 earnings, AAPL’s stock is trading at right around the market multiple.  That looks way too low to me.