July 2015

…………….Thoughts and Comments

Investing vs. Speculating

What is the difference between investing and speculating? Both try to accomplish the same thing: earning a return on investment. Both require taking a risk. Both can be accomplished utilizing almost any type of asset.  Merriam-Webster’s Dictionary defines investment as “the outlay of money usually for income or profit” and their definition of speculation is “to assume a business risk in hope of gain; especially: to buy or sell in expectation of profiting from market fluctuations.”

Based on the dictionary definition, they sound pretty much the same.  But there are two main differences – one is time and one is level of risk/reward.

Investors typically think in terms of months and years, speculators typically in terms of hours and days.  This is where the concept of long-term investing comes into play: the idea of investing for a potential return based on the outcome of a business enterprise over time. Outcomes take time, and one doesn’t expect to see the results immediately.

The shorter one’s time frame, the more the outcome may be affected by a temporary situation, whether expected or unexpected.

The second factor – the level of risk/reward – is typically much higher for speculators in comparison to investors.  Typically, speculation requires the risk of losing a substantial portion of one’s invested capital.  This does not mean that investors cannot make or lose considerable amounts, but rather, they typically are willing to earn a smaller return because they are less accepting of risk.

A simple example would be two people at a casino.  One chooses to play Roulette while the other chooses Blackjack. The investor is likely to play Blackjack because the odds of winning are pretty good compared to most games, about 43%.  This means that a good player, who has studied the game, can play for many hours without losing all their money (which is the best that can be expected when going to a casino in the first place!).

The speculator will chose to play Roulette because the payouts are the best.  By picking a single number, if they win, they can win 35 times their bet!  But of course, the odds of winning are only 2.6%.

Put simply, and investor is looking for a return that provides limited downside and a more assured upside whereas a speculator is willing to risk big to win big.

Why are we spending so much time discussing this? Because we believe that many of today’s stock and bond market “investors” are actually “speculators” and do not realize it.

Danger, Danger Will Robinson – The Global Markets have Become Casinos!

The concept of an open market is that governments regulate processes but leave the marketplace to determine proper pricing.  However, as central banks around the world have started manipulating markets by setting interest rates and printing money, they have converted open markets into casinos.  The longer they continue trying to manipulate in ways that cannot be sustained, the more they are increasing the risk of the losses.

Most casinos offer blackjack, poker, slot machines, roulette, craps and baccarat. The same games are also going on in the Global Markets Casino. Greece, of course, is our roulette area. The chances of Greek citizens “winning” is astronomically low. They have been playing with their money and other people’s money and they are down to their last couple of Euros. We all know that their chance of landing on 00 is less than 3%. But what has not been taken into account is when they go broke, all of their lenders will be holding worthless loans.

China is our baccarat table. Baccarat is usually played by high-rollers and is the game of choice in Asia. China has been printing money for a decade to create their massive growth. First their government financed (both directly and indirectly) the real estate market boom. But as that market staggered under the weight of the debt for massive projects, many of which are completely empty, China opened up its stock market and allowed leverage.  The speculators moved to this new game, and once again, a boom was created.  As of June 12, 2015, the Shanghai Index was up 151.81% over the prior year and up 59.72% year-to-date—dwarfing the returns of every other market.

However, this boom has not lasted as long (as is typical when everything is artificially pumped by “free” money).  In the past three weeks, from June 12 through Friday, July 3, the Chinese index is down 28.64%, making it the worst performing market.

To counter this reversal in economic fortunes, the Chinese government has come up with numerous new ways to pump money into the market, including new laws that forbid their largest pension (the equivalent of our social security pension) and large shareholders (holders of 5% of a stock, plus directors and management) from selling stocks.  Finally, they have threatened anyone who shorts stocks with jail.  At the same time, over 1400 stocks on the exchange (better than 40%) have stopped trading due to the downward spiral.  This hardly reflects any definition of an open market – it is much more like the rules set up by an all-controlling casino which has locked the doors once the gamblers are inside.

If China is baccarat, then Puerto Rico must be the slot machines. For years now, Puerto Rico has been paying their debts by issuing more debt and then trying to raise taxes, while at the same time paying huge amounts for welfare. The odds at a slot machine are terrible – they typically have the worst odds anywhere in the casino, and typically are the most profitable area for the casinos because people sit and play for hours. But in the end, you know you are walking out of the casino with no money in your pockets.

While everyone knew about the problems in Puerto Rico, nobody seemed to mind, as they kept playing. Not much more than six months ago, we had brokers pitching us PR bonds because the yields were so high but there was no chance that they wouldn’t pay. I am glad to say we passed – and haven’t purchased PR paper in well over a decade.

However, the markets seem to be ignoring this $72 billion problem. How will the U.S. make this disappear?

Sweden is the craps table. Most people who play craps don’t get very sophisticated. They just but with or against the new dice roller. The odds are pretty good, which means that they only lose a little, and if they are lucky, they may take some money home.

Sweden just lowered their interest rates again – from -0.25% to -0.35% and they raised the amount of their QE (quantitative easing) by $5 billion. They started both of these programs back in February of this year and are finding this isn’t working.  Similar to what China is finding: the more people who print money, the less it helps anywhere.  Interest rates have risen since they started. Sooner or later they will figure out that printing money won’t work: oh crap!

Illinois is the poker table. They can’t afford the pensions they have promised all their government workers (I wonder what the Greek word for Illinois is?). They tried to change the rules governing pensions but the state Supreme Court said they couldn’t. Once the state finds that raising taxes will reduce their revenues because people and companies will leave for lower-tax states, bondholders will find they will be the ones left holding the bag. “If you don’t know who the sucker is at the table, then it’s you.”

This is just a small, but important, list of economic issues around the globe. Yet market participants seem to be ignoring all of the signs. Stock markets are over-priced, bond markets are over-priced, and there is too much money available at too low an interest rate everywhere.

The central banks of the world have pushed savers into becoming speculators in order to push up inflation and in the hopes that feeling wealthy, these savers will spend more and pull us out of the economic malaise that seems to be everywhere.

There are a couple of problems with this, however. First, pumping up consumption instead of encouraging investment leads to short-term increases in GDP but long term declines. Look at how public companies have been spending money in the past several years. They have borrowed money to buy back stock or pay dividends. Capital spending levels have barely grown at all. So businesses are either not interested or don’t believe they can add value by building their businesses and have resorted to account gimmicks.

Second, most savers are not wealthy enough to afford to spend their savings – they are barely earning enough on the savings to pay their bills. And in the U.S. we keep adding new taxes in the form of regulation (healthcare, minimum wage, overtime, energy efficiency) which makes the cost of living even higher.

Third, those who are wealthy enough were already invested in the markets and those that added have done it with leverage and are speculators by nature – they will run away when problems surface (and they will surface) which will leave the markets even lower and those that have been forced to speculate even poorer.

Fourth, when the global central banks get their wish and have inflation, how will they pay the massive amounts of debt they have created? The bonds they have purchased will go down in value and the interest rate they will have to pay will go up. They will not be able to pay off their debts – just like Greece.

Early Earnings Evidences

While it is very early in the earnings season, it is still interesting to note that the S&P 500 earnings reports have started out much more negatively than they have in several years. This is not a one-time issue however, as revenues, operating earnings and net income have all been slowing for each of the past four quarters. This quarter, the slowdown has become much more distinct – having dropped more than 40% so far (see graph #1 below).

It is too early in the earnings season to extrapolate these results, but it certainly is a warning for the industries that have reported: technology, retail and restaurants.

Graph #1- Data supplied by S&P Capital IQ


Inflation – Do You Hear the Train Coming Around the Corner?

We all know the central bank has been claiming, for many years, that there is no inflation on the horizon. We all know that the central bank does not feed, house, nor clothe itself. It doesn’t travel, nor does it own household items. We know this because if it did, it would know that housing prices, rental prices, food prices, clothing prices, gasoline and airfares, electricity and laundry soap and bath soap prices are all up. In fact, the one sector where prices are lower is for electronics.

But on top of this, we are starting to see another type of inflation start to rise – wage inflation. The Federal government has pushed for higher minimum wages and overtime rates to cover those earning up to $52,000 from $26,000.

More than a dozen states and several cities have independently increased minimum wage levels over the next several years and a number of companies including WalMart, Target and Panera Bread have announced that they will raise wages both this year and next.


No, this will not show up in inflation numbers this month – but it is coming. As this grows, more companies will follow and this will lower their profit margins which are at highs.

Add to this that healthcare cost are estimated to rise on average 12% in 2016 and that the Federal government is trying to implement a number of regulations that will add to energy costs.

What this all adds up to is that companies are not growing as fast as they were two years ago, margins are likely to compress and stock prices and multiples and margin are all at highs. This certainly is not a tailwind for stock prices.


The Bottom Line…

We have been cautious for a long time. One could easily argue for too long and they would have a fair argument. But as we have stated in the past, that there are two types of money managers: one that manages for maximum returns within their parameters (a mutual fund is an example of this type of manager) and one who manages based on a client’s risk parameters (an RIA managing separate accounts is an example of this type of manager).

I have been a mutual fund manager, and in fact was ranked #1 in my category by Morningstar and Lipper when I was the manager. I have been an RIA managing separate accounts for far longer and for a reason. I prefer to manage based on risk rather than reward regardless of risk – it is simply my nature. It does not fit all types of clients, but it does fit those seeking a return without gambling their life savings.

My clients typically have already taken their risk by building a business – they want me to make sure that they aren’t taking excessive risks now that they have capital. Not all of my clients are worth tens of millions of dollars, but they all want to keep have the wealth they do have. Therefore, we worry about what we see as investment risks, and while we have been early, it is not because the risks weren’t there, it was because people were ignoring them.

I can’t say that everything is coming to a head right now, but the risks have grown and more people are figuring that out, albeit, some, way too late.

We have been reducing our equity exposure for several weeks now. We have removed holding where we felt that the valuations were excessive. We have also been adding short positions in areas where we have maintained that “investors” (yes, I use that term lightly) are overly bullish and are not seeing reality.  These areas include shorts on oil prices, semi-conductors and the broad markets.

None of these are large shorts (the biggest positions are about 5%) and in total they are less than 10% of portfolios. But by combining a reduction in stocks, a reduction in long bonds, and some shorts, we are trying to hedge the risks we see all around us.

We continue to hold high quality companies that are undervalued based on the economics of their businesses and which pay good dividends while maintaining strong balance sheets. We have a little in gold miners (many of which pay high dividends) and we still have individual fixed income (bonds) that have short maturities, good balance sheets and above average returns.

We will have plenty of cash available to step back into the investment markets when they open up and the casinos close down.  The S&P 500 has not suffered a 10% correction in close to four years now.  With the historic leverage in place, such a correction could possibly be larger.  Such a correction would provide plenty of good investment opportunities for those with cash available, and that, is exactly our plan.

Alan E. Rosenfield, Managing Director

July 2015


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