By A. Michael Lipper, CFA
Often the price battle between buyers and sellers is described as the battle between fear and greed. I see the conflict as being between two vastly different sets of fears, with very little greed involved. The focus is not whether the proverbial glass is half full but, rather, what forces will change the water level?
Today’s buyers are afraid of 2013. They are fearful that the near-term stock and bond markets will accelerate, and once again, they will be shut out of producing index-like returns. One can label this as a competitive threat that another period of underperformance will cause investor accounts to move.
While hedge funds are not a separate asset class in reality, the popular image is that they represent highly sophisticated, smart, aggressive managers. In some cases, this is an accurate description of managers who have richly rewarded good long-term records. The above-average gains of the general markets in 2013 surprised many who significantly underperformed. They don’t want this to happen to them again in 2014. The markets have incrementally advanced this year. Last week, the S&P 500 closed above 1,900 for the first time. To avoid a competitive repeat of 2013, certain managers are increasing their use of historically low interest rate leverage. We see this in the different directions of net flows in exchange-traded funds (ETFs) and similar portfolios of mutual funds. In April, equity ETFs attracted $17.6 billion compared with $12.6 billion in March, and all of the gain was in global equity ETFs.
Large ETF positions in hedge funds include those that invest in emerging markets, gold, and long-term bond indices. In April, small-cap mutual funds saw over $2 billion in net redemptions as compared with net sales in March. Normally, small caps are favored by some institutional investors, including hedge funds, because it takes less money to move these stocks. The hedging method favored in the past by some funds fearing price slumps in the S&P 500 was the purchase of VIX contracts. In the latest week, these contracts hit their low for the year, clearly indicating little fear of declines.
Adding to buyers’ fears, Germany’s DAX Index reached an all-time high on last Monday’s holiday when the US markets were closed.
Normally, buyers are more future oriented than sellers. After all, since the beginning of the history of the Dow Jones Industrial Average, the market has gone up two years out of three. Thus, for the buyers, when the future came, it was positive. The sellers today look at the future and see the past. They see many of the elements that led to the 2007–09 financial market crisis. They can be persuaded to slowly sell some of their long-term positions as market prices rotate upward.
Manipulation by Governments and Central Banks
Once again, we see activist governments and their central banks attempting to offset slowdowns in their general economies by pushing up the demand for housing. US federal agencies just recently have been urging the underwriting standards for residential mortgages to be lowered. Combine this with artificially low interest rates and the result is the residential housing market getting injected with venom that can be dangerous to the markets as well as the whole society. Based on past experience, it is reasonable to expect that an increasing number of these mortgages will default. When faced with large unpaid debts, the past practice of these activist governments was to socialize the losses through various forms of bailouts financed through higher tax realizations. They ignore past financial history that shows that after a collapse, new and/or sounder financial organizations come into being to provide the necessary functions to replace the overburdened legacy organizations.
The fundamental problem with artificially low interest rates is that they underprice both credit and inflation risks. Within the payment of interest there should be, in effect, an insurance payment for slow payment or nonpayment of the loan and interest. At the current low rates, credit risk premiums are not being effectively paid. Americans can get away with this for a while because the huge underfunding of global retirement needs is driving savers to chase yield. (CCC rated paper and bonds are being urgently sought after.) This is a long-term problem; many Americans are estimated to be saving for retirement.
Investors appear to be fearful that the central banks will eventually succeed in creating enough inflation that their nominal economies will expand at an acceptable rate. The goal of many central banks is to have a 2% or higher rate of inflation. To protect themselves, institutional and individual investors are plowing into TIPS (Treasury Inflation-Protected Securities) to such a degree that the price on 10-year TIPS is now yielding 0.297%. Clearly, current interest rates are not covering credit and inflation concerns.
A Time Span Portfolio Solution
My favored approach is to divide the investment responsibilities into four time spans based on funding needs and goals.
Under the current “new normal” interest rate environment, the shortest-duration portfolio (the “operating portfolio”) will run out of money sooner than expected. The second portfolio (the “replenishment portfolio”) has to carefully trade off liquidity for current yield. This could mean lengthening the duration from three to five years. I recommend investors search for reasonably well-protected and growing dividend streams. The third time span portfolio, the “legacy portfolio,” should be all equity that can survive a normal recession and still build purchasing power in excess of spending. The fourth portfolio, or the “endowment portfolio,” should be positioned to recognize and take advantage of commercial disruptions that can lead to outsized returns after inflation, expense creep, and relevant taxes.
A question facing all of us is, what are we going to do with the capital liberated by selling that won’t be sucked into either spending or chasing prices?
Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.