March 2015

……………….Thoughts And Comments

Will Rates Rise and Why it Matters

Three to five years ago, I expected, as I think most investors still expect, that interest rates would likely return to normal before too long.  In the U.S. that means interest rates of between 5% and 8% depending on the maturity.  Financial plans were based on this expectation and I am sure that plans being developed today still utilize the same interest rates.

This is a mistake and I expect that those who planned using such numbers will be in for a rude awakening when they find that in reality, the rates they are able to achieve are half of what they expect. This is because the goals of politicians and the bank policy makers is in direct opposition to most investors’ goals these days.

Politicians realize that they stay elected leaders by giving away money. For large corporations this comes in the form of taxes and regulation; for individuals it comes in the form of transfers of wealth via government support programs.

Regardless of the form of the government largess, the fact is that this country now has in excess of 18 trillion dollars in debt – not including long term responsibilities like social security.  Last year the interest on our national debt was $430 billion, at an average interest rate of 2.5%.  If interest rates were to go back to normal, then the interest on the debt would balloon to almost $1 billion a year – or almost 67% of what the government collects in taxes each year.  And as high as the debt is here, it is still worse in Europe and Japan.

For this reason, no one in government wants to see interest rates rise – even though this actually hurts a large and growing portion of the citizenry – retirees – who depend on reasonable interest rates in order to maintain their standard of living.  And of course, by keeping interest rates low and announcing there is no inflation (government officials apparently do not shop at a grocery store), this keeps the lid on social security payments.

Investors need to come to grips with the problem.  If interest rates are low due to artificial stimuli, then investors will be forced to find other ways to generate what they need.  The first step is to move out the yield curve and then into riskier assets like stocks.  So far, that is exactly what the Fed has accomplished and what the EU and Japan hope to accomplish.  But what happens when stock prices are artificially high because of this government intervention?  We have gone three years without a correction. Has the Fed found the investors’ equivalent to eternal youth – markets that do not go down?  Or, have they simply increased the risk so that when economics finally exert its influence again – which it will inevitably – that many investors are going to get hurt, maybe even badly?

Perhaps, then, this is why some 80% of active managers have underperformed the markets in the past several years. Perhaps they recognize that doing what is right is not always what is popular (politicians don’t agree) and doing what is responsible is not always obvious until much later.

Q4 Earnings and 2015 Expectations

Wall Street is lowering expectations for Q1 2015.  While comps should be very easy given the weakness last year that was blamed on weather, expectations, according to Barron’s, are for revenues to be down 2.2% year over year.  Now, companies typically guide down so that they can more easily beat expectations, but we haven’t seen negative growth in earnings in many quarters.

At the same time, stocks are priced for very bullish growth rates. As can be seen in the charts below,





there has been a dramatic slowing in the growth of revenues, operating and net income for the past two quarters and yet P/Es are at highs.

Furthermore, the economic numbers have not been great.  Productivity was almost flat last year and unit labor costs have been rising all year.  Factory orders have been dropping for seven months now and personal spending is not increasing.

As the 1960’s Lost in Space Robot used to say, “Danger Will Robinson!”

ETF Research

Exchange Traded Fund Funds (ETFs) were developed as a way to provide a more liquid, more tax efficient platform to invest in a portfolio of securities than was available with mutual funds.  As the first ETFs were passive investments, the fees were lower than most mutual funds as well.

As Wall Street came up with ways to expand the ETF universe, they started to change the basic strategy of ETFs.  With actively managed ETFs as well as ETFs on all sorts of esoteric securities and/or strategies, fees went up and the tax efficiency often went down.

Now it has gotten to the point where one has do intense research to really understand many ETFs.  As an example of what it takes, we have been researching foreign country ETFs.  This should be pretty straight forward.  It would be logical that an ETF whose goal is to reflect a country’s economy would pick a very logical index, such as that country’s primary stock market index or possibly the equivalent MSCI index.

But the first thing you would find is that the majority of country funds do not track that country’s stock market at all.  In many cases, the indexes the ETFs are supposed to follow are custom indexes specifically created for the ETF.  There is nothing improper about this, but it makes executing the strategy much more difficult.

Next one has to try and figure out why so many of the ETFs have been underperforming the stock market index of the country of interest.  One of the reasons turns out that often times the concocted indexes don’t reflect the country market index very well.  Some times this is due to a lack of liquidity of the stocks in the index, sometimes it is because the index just is a bad representation and sometimes it may be because of currency fluctuations.

System gaming is another problem with many ETFs.  In a recent Barron’s article on the performance of the Russell 2000 index (a well-known small cap index) versus other small cap indexes.  In it, they discussed their belief of why the Russell under-performed their competitors.  The reason, they believe is because of the way they rebalance their portfolios over at Russell.  It wasn’t that they are rebalancing wrong, but rather, because everyone knows when they are going to do the rebalancing, that many professionals try anticipate the changes and thus run up the prices of new additions and sell down the prices of stocks being removed thus effectively manipulating the index.

The same can be found with ETFs that invest in commodities on a standardized basis.  Traders, knowing exactly when and how the ETF is going to roll the futures contract simply do the same thing in advance, raising the prices before the ETF purchases the new contracts and lowering the prices of the contracts they are closing.

Many institutions use ETFs as a way of hedging other investments they hold.  Because of the liquidity of ETFs they can be very effective baskets for hedging.  This of course, puts abnormal pressures on the ETF, making it move in directions different from the indexes they are trying to track.

None of this is immoral or improper, but it means that ETFs are not necessarily the simple investment strategy that one supposes.  Make sure you really do your homework – what is the index you are trying to duplicate and back test it to see if it really replicates what you think it does.  Your work is not done then, either.  You must continually monitor the ETF to be sure that it is doing what you expect and if not, what has changed.

If you don’t do the constant work, you make wake up to a rude surprise, even when the concept was supposed to be simple.

Don’t Fight the Tape But Don’t be a Lemming – Investors’ Conundrum

We are forever reminded not to fight the tape.  In other words, if the market is going up, don’t argue.  And yet, we all know what happens to lemmings, especially when there is a cliff nearby.  It is times like these that investors start to wish for split-personalities.

Yet, there are times where an investor has to be willing to stand away from the crowd and fundamentals are usually a good indication of when to try this.

We are currently in a market, as we noted above, that has started to delink from the realities of the global economy.  There has not been a correction is over three years, where we typically see one every 18 months.  Leverage is at near all-time highs as are P/Es.

The point of our discussion on ETFs is two-fold.  To alert investors to the quagmire that exists even while Wall Street is telling you how simple they have made things for you, but also to remind investors that those who unwilling to think for themselves rather than just listening to the talking heads on investment television shows, are likely to encounter pain.

“Everyone is making money now.  It is so easy, just invest in an index.” “You are a fool if you aren’t making a fortune in the stock market.”  If it really were that easy, everyone would be wealthy, and there would be no reason for anyone to spend long hours doing research – and yet, the most successful investors over time spend many, many hours studying the markets.  No one has ever heard Warren Buffet say that he only needs to work for an hour a day.

The indicators are flashing red – there are serious issues ahead.  This does not mean the end of the world is here, or is even around the corner.  But is does suggest that caution should be exercised.

The Bottom Line…

So what to do?

We continue to stay diversified. We have added some fixed income more recently as opportunities to buy while others panicked presented themselves. We have added some energy company notes which are producing close to 3.5 x the rate of treasuries at one third of the maturity time frame and with little default risk. This protects us from rising interest rates if that happens. At the same time, there is potential for appreciation when oil prices stabilize.

We have added to certain foreign sectors that will benefit from: 1) a strong U.S. dollar; 2) money printing by the EU and Japan.

In the U.S. we are looking for companies that do most of their business domestically, pay above average dividends and are growing faster than the markets recognize in their stock prices.

Finally, when we do see a correction, we are prepared. We have a list of companies we would love to own or add to when prices are reasonable and we have the cash available to be able to act.

Well managed companies, paying good dividends and reasonable prices combined with bond opportunities and patience equals long term success.


Alan E. Rosenfield, Managing Director

March 2015




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