October could be a tricky month–but for unusual reasons

October selling

Seasonal weakness usually hits the US equity market in late September and continues through the first half of October.  The reason is tax selling by mutual funds and, to a much lesser degree, ETFs.

mutual fund/ETF tax planning

A mutual fund or an ETF is a special kind of  corporation that is exempt from income tax on any profits it makes, provided that it sticks to portfolio investing and distributes to shareholders basically all realized gains.  These payouts become taxable income to their recipients.

For every mutual fund or ETF I know, the fiscal year ends on Halloween.  That’s when the fund has to figure out its gains and make the required distributions.  This has nothing to do with trick or treating.  It’s October so the fund can close its books and send out the distributions before December.

Funds typically begin to prepare for their yearend in late September.  They either sell winners so they can make a distribution (for some reason, shareholders regard distributions as a good thing), or they sell losers, to use the tax losses this creates and to keep the distribution down to a reasonable size.

Not this year, though.  In fact, not since 2009.  As far as I can see, most mutual funds/ETFs still have considerable accumulated tax losses on their balance sheets.  Those resulted from the massive panic-induced redemptions that occurred at or near the bottom of the market in early 2009.  The losses, which offset realized gains, will swamp any profits funds may have made this year.  So there’s no point to doing normal year-end tax selling until past years’ accumulated losses are either used up or expire.

this year’s issue is different

It’s budget negotiations in Congress.

spending power

One negotiation, whose deadline for action is tonight, is over Congress giving the administration authorization to spend money to run the Federal government.  Talks are deadlocked.  Absent a last-minute compromise, an estimated 800,000-1,000,000 government workers will be furloughed effective tomorrow.  That’s out of 2.1 million Federal employees.

The furloughs would add about .6% to unemployment in the US.  They would also have negative economic ripple effects, as corporations that do business with Washington defer spending plans while they wait for the situation to develop.

According to USA Todaythe Federal government has shut down 17 times since 1977, though usually only for very short periods of time.

borrowing power

The second, and more important, negotiation is on raising the Federal debt ceiling.

Washington currently borrows about 20¢ of every dollar it spends.  The Treasury estimates it will reach the limit of its current borrowing authority from Congress in mid-October.  Without an increase, the government will be reduced to spending only money that comes in the door from taxes and other payments.

At some point, it’s possible that the Treasury wouldn’t have enough money on hand to make interest payments on the Federal debt or redeem Treasury securities that come due–meaning the US would be forced to default on its debt.  That would be awful.

Wall Street worries

I don’t think Wall Street–and any other world stock market–will find it easy to move up during a period of uncertainty like this one.

The main issue, of course, isn’t the looming government shutdown.  The longest happened during the Clinton administration–twice.  The S&P fell modestly, and quickly regained lost ground after the shutdowns ended.

It’s the question of whether the crazy behavior of Congress in causing the shutdown will be repeated in the debt ceiling talks, where the stakes are much higher.

Personally, I can’t decide whether the Tea Party Republicans who are at the core of the disputes are content to bring the government to edge of disaster before compromising, or whether they want to go further.  After all, in March 2009, a group of similar-minded Republicans voted against the bank bailout, saying they would prefer a repeat of the Great Depression of the 1930s to pumping money into bankrupt financial institutions.  The S&P fell by 7% on that news.  Then the Republicans changed their minds.

That was a great buying opportunity for stocks.  Hopefully, we won’t have another one.  But uncertainty will likely keep a lid on the market until the debt ceiling issue is settled.

what I’m doing

From a strategic point of view, I think the best course is to believe that politics will eventually work itself out and to not change portfolio positioning.

My tactical view is a little different.

In times like this, short-term traders tend to argue that if the market can’t go up, there’s only one direction it can move in.  So the lack of upward potential implies downside pressure.

That make me a buyer on weakness.

J C Penney (JCP) issues stock

the JCP offering

JCP filed a preliminary prospectus with the SEC indicating it is selling 84 million shares of common stock to the public at $9.52 a share through Goldman Sachs.  (In a typical provision of any offering called the “overallotment,” Goldman has permission to sell another 12.8 million shares if it can.)

Let’s say Goldman gets a commission of $.22 a share.  That would mean proceeds to JCP of $781 million – $900 million.

business stabilizing

Just in advance of the red herring, JCP filed an 8-K in which it said it expected comparable store sales to be positive during both 3Q13 and 4Q13.  The reason?  …merchandise that JCP customers want to buy is now in stock, and in the sizes that JCP customers fit.

three aspects of the offering

I hadn’t intended to write so much about JCP, but I think there are three interesting aspects to the offering.

1.  the size

This is a big offering, amounting to over a third of the shares already outstanding.

2.  why a stock offering?

For companies like JCP that want to raise a lot of capital, their first thought is to borrow.  It’s easier to do.  Transaction costs are lower.  Also, Americans firmly believe that debt is a lower-cost form of capital than debt, so borrowing is more beneficial for shareholders.

There comes a point, however, when lenders perceive the capital structure of a firm has become too lopsided.  When that happens, they will refuse to lend any more until the firm demonstrates Wall Street’s confidence in it by raising equity capital.

I assume we’re at that point for JCP.

why not six weeks ago?

After all, the sales projections JCP made in the 8-K are better, I think, than Wall Street had been assuming.  So it’s unlikely that JCP’s need for cash is greater now than it was a few weeks ago.

It’s also hard to think that a big company like JCP would not do continuous financial forecasting of its future cash flows that would indicate when it would need fresh funds, and in what amounts.

I don’t know the answer.

One obvious difference between now and the end of August, however, is that in the meantime two insiders, Pershing Square and Vornado, have unloaded their entire stakes, 52 million shares (!!), at a reported price of about $13 each.  That’s 36% higher than JCP itself is getting today.

I guess you might argue that everyone knew the two activists would be selling, and that this overhang would be enough to scupper a potential offering by JCP.  Seems pretty lame, though.

Me, I’m nonplussed (the first time I’ve used that word in my life).  If I were a JCP shareholder, I’d be stunned.  Maybe we just chalk this up as one of the perils of riding the coattails of latter-day robber barons.  But if I were a shareholder, I’d want to know how the board allowed this to happen.

On September 20th, JCP’s controller left the company.  Is this connected?

two lessons for analysts from JCP

JCP  in the press again over the past two days.

I’ve only seen the headlines, which assert that:

–JCP is trying to sever the 10-year $200 million agreement the previous CEO, Ron Johnson arranged with Martha Stewart.  Why?   …the MS merchandise isn’t selling

–JCP is looking to raise new funds

–a Goldman analyst has used the “B” word (bankruptcy) in warning clients to avoid JCP stock.

I want to make two relatively narrow points:

1.  Analysts are extremely reluctant to speculate on a possible corporate bankruptcy in writing.  They may mention the possibility on the phone or in meetings, but not in print.

A boss of mine years ago at Value Line did this once.  He wrote about a small-cap magazine company that if weak advertising trends continued for the following twelve months, there was a risk the firm would have to close its doors.  Advertising dried up almost immediately on publication of the report.  The company was out of business in three months.

Raising the prospect of bankruptcy is like shouting “Fire!!” in a crowded theater.  It has consequences.

Also, if the firm survives it will never forgive the analyst who made the call.  The Goldman analyst who wrote the report must either be very young or extremely confident that the prediction won’t come back to haunt him/her.


2.  In graduate school I spent a year at the university in Tübingen in southwest Germany.  For a while I lived with a family where we all went mushroom hunting on weekends.  What we found made up at least one or two meals the following week.  That’s where I learned about the deaths head mushroom.  Eating it is most often fatal; symptoms only emerge after it’s too late to get treatment.

The obvious course of action–learn what the deaths head looks like, and don’t eat it.

There’s an analogy here.

In the case of JCP, the symptoms we’re seeing now are the direct result of corporate decisions made two or more years ago by ex-CEO Ron Johnson and defended for a long time by Bill Ackman.  Oddly, both seem to have been thinking–contrary to all experience–that falling sales could be remedied by applying a double does of what was causing them.  What’s equally surprising is the the JCP board let the situation go unaddressed until it had reached crisis proportions.


My second point:  many times corporate strategies, once put in motion, are difficult or impossible to reverse.  So we, as investors, have to be constantly scanning the horizon for indications of possible weakness. Normally, the early signs of deterioration are found on the balance sheet (rising receivables and inventories) and the cash flow statement.

For JCP, though, there was nothing subtle about its difficulties.  Sales fell apart almost as soon as Ron Johnson took the controls.  Another reason it”s so hard to understand why the board let the situation get so out of control.


Baby Boomers: wounded by the Great Recession

Yesterday I wrote about Tyler Cowen’s semi-apocalyptic vision (if semi-apocalyptic is possible) of the US in the upcoming years.  His bottom line is that a small minority of tech-savvy Millennials will prosper while everyone else stagnates, distracting themselves all the while with their smartphones and video games.

A bit over the top?   …probably.  But maybe I should be nicer to my children, just in case.

There is, however, a much more straightforward way in which the economic environment since 2008 has been damaging to the Baby Boom and beneficial to Generation X and to Millennials.

It’s monetary policy.

When times are good, savers/lenders get a positive real return on their money.  That is, they receive interest income that compensates them for the effects of inflation + an extra percentage point to three or more, depending on how long the loan is or how creditworthy the borrower is.  When times are bad, the central bank steps in and pushes interest rates down below the rate of inflation to encourage borrowing and spending.  So returns on loans shrink, both in real and nominal terms.

Put another way, the central bank stimulates economic activity by taking money out of the hands of people who are loathe to consume and putting in into the hands of ardent spenders.  Senior citizens and the wealthy get dinged; the young and the willing-to-become-indebted have a field day.

That’s just the way macroeconomics works.  The elderly suffer for the greater good of the overall economy.

Three things are unusual–and unusually damaging to the Baby Boom generation–about the Great Recession:

1.  the biggest is the length of time fixed income yields have been depressed.  In a garden variety recession, the pain lasts a year or so.  But we’re now in year five of depressed interest interest rates, with the prospect of normal returns not reappearing until 2018.  Ouch!!!   That’s a decade of the old subsidizing the young.

2.  there’s also the amount by which yields have been depressed.  On the 10-year bond, it’s 300 basis points; on the 2-year note, it’s 350+bp.

3.  finally, there’s the fact that short-term rates have been reduced to zero.

Yes, arguably a real return of negative 2% is a real return of negative 2% whether the nominal return achieved is 3% (meaning inflation is 5%) or zero.  But there’s at least a sharp psychological difference between getting a monthly check for $2500 and one for $20.  And I’m not sure how people generally feel or behave when they’ve got to sell assets to meet living expenses–whether people can mitigate the negative effect on well-being by making substitutions.   Certainly you can’t substitute your way into making $20 go as far as $2500.

My point?

The money policy consequences of the Great Recession are just one more factor hastening the changing of the guard, in economic and stock market terms, away from the Baby Boom, and toward younger consumers.




is the American Dream over?

Average is Over

I’m going to write about a book I haven’t read.  Not good form.  And I can’t even say I own it, which is pretty close to having read it.

I’m reacting to a review of Average is Over by Tyler Cowen, a Harvard-trained economist who teaches at George Mason University.  It appears in the September 21st edition of  The Economist.  

Professor Cowen is a prolific, and controversial author (the latter being the economic key to high book sales).  I’ve just snagged four of his other books on Abe Books (like almost everything else, a division of Amazon) for less than $17.  They haven’t arrived yet, so I really shouldn’t talk about them either.

the big picture

On the other hand, it’s the idea of Average is Over that I’m interested in–which is:

–that the dual forces of globalization and the ongoing internet/computing revolution have barely begun to exhibit their effects on the US economy, and

–that only 15% of American workers have the education, training and insight to position themselves on the right side of these trends.  Everyone else is a loser.

Scary, huh.

Of course, if Mr. Cowen had said 20% of Americans will be left behind, that wouldn’t be too far different from where the US is now–and no one would buy his book.

Maybe we have to take the 15% winner percentage with a grain of salt.  But suppose he’s directionally correct, even if he has the exact magnitude wrong.  What are the consequences for stocks?

consequences for stocks

I can see several.  You can probably see more.  Please feel free to comment.

1.  Interest rates won’t get back to “normal” for a real long time, as the Fed continues to try to battle continuing high unemployment.  Washington could change the situation with effective fiscal policy.  But it seems to me that neither party has anything to offer.  I’m assuming the federal government will continue to be a net GDP-subtractive burden.

The political commercial aside, rates could remain surprisingly low.  That would imply better upside for stocks in general.  Bad for bonds.

2.  There’s already considerable grassroots pressure for improvement in education.  This will intensify.  Existing publicly traded for-profit education companies can be a bit on the sleazy side (Title IV problems).  And they face increasingly effective competition from the online divisions of state-owned colleges.  Startups?

3.  Anything to do with the internet will continue to expand rapidly.  Again, startups are a reasonable area to explore.  But even old warhorses like MSFT (assuming they have competent management) may get a new breath of life.  (Hard for me to believe I just wrote that.)  At the very least, IT firms will act as a hedge against Mr. Cowen’s predictions coming true.

4.  The economic gap between haves and have-nots will expand.  If you’re positioned like I am, with my domestic consumer exposure focused on firms that cater to average Americans, the issue of when to flip back to companies that have mostly affluent customers is an important one.  It’s not time yet, however, in my opinion.

5.  Lots of M&A.  Old-economy firms will consolidate.  New-era firms will buy technology expertise when they think building it themselves takes too long.  An investor who wants to play the M&A game should be holding the target companies.  A little risky, though.

6.  Millennials who have skills/jobs are the big winners if Mr. Cowen is right.  Baby Boomers and the retired are big losers–they want what they won’t get, i.e. high interest rates on their fixed income and no cuts to Social Security or Medicare.  Therefore, traditional companies that cater to the latter group will be in a longer-term weak position–that’s jewelry, cruises, retirement communities.

7.  Higher growth will come outside the US.

I’m sure there’s a lot more.  Let me know what you think.






taper on, taper off, taper on: what to do?


Months ago, the Fed hinted that it was warming up to start on the long road to money policy normality.  No, it had no intention of raising interest rates from the current level of zero (the plan is to start in 2015)   …but it would soon begin to “taper” the size of the extra money it is regularly pumping into the economy at the rate of $85 billion a month.

The consensus expectation was that the Fed would officially announce the start of tapering, and the size of the initial reduction ($10 billion less?), last Wednesday.  Instead, the Fed said it would prefer to wait for more positive economic news and was going to do nothing.

The S&P rallied by 1.5% in the minutes after the news broke.

It gave back all but .2% of the advance when Fed officials clarified that all they meant to convey was that tapering will probably begin next month.

what to make of Wednesday-Friday trading

In one sense, the large market moves are just typical short-term trader craziness.  As individual investors with a longer time horizon, we can’t allow ourselves to be distracted from the fundamental fact that we are now entering a period of rising interest rates.  So we should basically ignore what’s going on.

In another, however, a sharp swing in short-term sentiment like this, followed by a reversal, may give us a look at more permanent patterns in market money flow that might otherwise remain below the surface.

what to do

Take your equity portfolio, stock by stock, and look a how each issue performed over the three-day period.

This is relatively easy to do if you have the tickers for your stocks entered into a service like Google Finance  (the one I use, even though Yahoo Finance charts are better).  Just right-click on the ticker to open the stock chart in a new tab, set the chart to the past three days and compare the stock to the S&P.

If a stock outperformed when the market was going up and also when it was going down, that’s a good sign.

If the stock outperformed during one period and underperfomed during the other, and it ended up more or less unchanged, you have no information.  A big net plus is good; a big net minus is bad.

If the stock underperformed when people were bullish and underperformed again when people were bearish, that’s a reason to rethink whether the positive investment case for the stock remains intact.  The stock may well be perfectly fine, but this is a red flag.

the overall market

To give you some context for thinking about last week, over the three days only on S&P sector, Telecom (the smallest sector) lost ground.  The stars of the index were:

Utilities (also a small sector)          +1.1%

IT          +.8%

Consumer discretionary          +.5%

Growth stocks (as measured by the Russell 1000 Growth index) gained .6%.  Value stocks (Russell 1000 Value) were flat.

Small stocks (Russell 2000) marginally underperformed large (Russell 1000).


Among my holdings, WYNN and LOW were up, GIL and HOG were down.  I’m a little surprised about LOW, since it should be very sensitive to rising interest rates.  I’m slightly concerned about HOG, but only because I would have guessed it would be an outperformer, but for now I’m just going to put it on a somewhat shorter leash.



securities analysis in the 21st century: where the companies stand

two communication theories

1.  When I entered the business in the late 1970s, the attitude of publicly traded companies toward their actual and potential investors was personified by a Mobil Oil public relations executive named Herb Schmertz.

Herb’s view was that brokerage house securities analysts were a specialized kind of newspaper reporter.  If his company wanted to tell the financial community some tidbit without the information hitting the press, Schmertz would call in/call up favored analysts and let them know.  Their obligation, in his view, was to faithfully relay the company’s information–spun the way the company wanted–to their clients.  No actual analysis, no contrary conclusions, needed.

That’s not quite today’s view, though.

2.  I remember vividly a time in the mid-1990s when I held a large position in Sony (embarrassing but true–although I’m one of the few portfolio managers who can truthfully say he made money holding Sony).  I went to E3 in Los Angeles that year, where Sony Computer Entertainment was having a briefing for securities analysts.  I arrived at the meeting room and sat down.  A SCE official came up to me and told me to leave.  Why?  that Sony (Kaz Hirai) was going to be discussing sensitive information about strategy and upcoming products.  Only sell-side analysts were allowed to participate.  Everyone else, including shareholders (i.e., company owners!!!) , were barred.  I refused to leave and the guy left me alone.

Blend #1 with #2 and you get the way most companies act today.

what’s wrong with this picture?

Post Regulation FD (Fair Disclosure), the company behavior I just described is, to me, clearly illegal.

It seems a little crazy to me, as a shareholder, that a company may refuse to communicate with me directly, but will give information to a brokerage house analyst from whom I have to buy it.

Most important in a practical sense, the old system is broken–and most companies don’t realize it.  It’s broken in two ways:

–most brokerage houses have gutted their research departments because they believe research loses them money.

–I think the equity market swoon that accompanies the Great Recession has marked a key turning point in the way individual investors behave.  I think that as a group they’ve soured on mutual funds and have begun again to invest in a blend of index products plus individual stocks that they research themselves.  They instinctively know that active managers generally have no edge any more, and that brokerage research is threadbare.

clueless in Delaware

(that’s where most publicly traded companies are incorporated)

My experience over the past few years in dealing with investor relations departments is that they exhibit what one might call an “emperor’s new clothes” attitude.  They don’t want to acknowledge that the world has changed, and that the communications protocol they’ve used for decades no longer works.

what to do?

For companies, it seems to me a basic rethink of communication strategy is in order:

–previously analyst-only meetings should have a provision for individual shareholder participation.  This might be at the same physical location.  The very least should be a webcast with interactive chat and ability to participate in Q&A sessions.

–same thing for appearances at broker-sponsored conferences, including breakout sessions.

–investor relations departments should become more responsive to queries from individual shareholders, or potential shareholders.  This isn’t as glamorous as coast-to-coast travel to talk with big institutions and brokers, but both of those constituencies are withering on the vine.

For our part, if/when a phone call (or several) to a company isn’t returned, a letter to the chairman is in order–explaining why we think the policy of not responding to shareholder inquiries is misguided.  I think the key points are that it isn’t fair to give information to non-owners but not to owners, and that it’s doubly unfair to give it to brokerage intermediaries who then force us to pay for information about our own companies.  (A word about how the world has changed may be in order;  pointing out that current practices violate Reg FD will probably get you, at best, a form letter from the legal department (i.e., nowhere).)