Watch Energy and Guns on the Trip to the Peak by A. Michael Lipper

Unlike drones and more like electrocardiogram plots, investments rarely go in straight lines but rather undulate, frequently reversing directions, which is normal.  As has been stated in my past posts, I believe that our current journey will take us to peak equity prices. Unlike Irving Fisher did in 1929, I do not believe that when we reach the peak in the future that we will achieve a permanent price plateau. After the peak, there will be a measurable decline whose fall will in part be a function of how extended the rise is above a reasonable value base. Beyond the decline we will also have future rises to other peaks.

This seesaw pattern is why I am a firm believer in subdividing one’s portfolio into time horizon and perhaps other components to protect the ability to accomplish the majority of one’s investment goals

Signposts

No two market cycles behave exactly alike. Nevertheless, there are a number of indicators that I watch and compare with previous cycles. One of the best contrarian indicators is bond prices. A decline in bond prices is caused by the current owners not wanting to own their existing merchandise and/or refusing to buy newly offered bonds. This will lead to the need for higher yields both for the existing and new offerings. The year 2013 was the first time in a long time that prices of bonds and the performance of bond mutual funds declined, which in turn led to bond fund redemptions. When stock prices drop, some of their owners may flee the fall and buy into bonds and bond mutual funds. This is not happening now.

A second important indicator is commodity prices. At any given moment, the quantity of a commodity in the hands of buyers and sellers available for immediate shipment, including movements from or to warehouses, fluctuates. New production from newly planted crops, new mines, and new refinery and smelting capacities will not be available immediately. Rarely will new supply come to market at prices lower than current prices. Thus, falling commodity prices are a sign of both reduced demand and reduced expectations. These lowered expectations, along with regulatory changes, are the reasons why major Wall Street brokerage firms are exiting the commodity brokerage and dealing businesses. (This reduction in commodity capacity at some point will lead to shortages and strong commodity prices, but that time is not now.)

A third current indicator, and a very volatile one, is the level of stock trading. The folk law of “The Street” is that as the first trading week predicts January activity which in turn is a good, but not perfect, guide for the year. The thinking behind these views used to be based on when Wall Street bonuses were paid out, but in a more modern era of a shrinking financial community, the new flows are expected to come from defined benefit and defined contribution retirement funds, which would have just received their cash contributions. For whatever reason, including weather or market volume, this last week was lackluster and most prices moved very little. Some of this sleepy behavior could be attributed to a strong December and a way-above-expectations 2013. On a purely technical basis, the ratio of shares sold short to the average trading volume theoretically generates the number of trading days that would be needed for the shorts to purchase enough stock to cancel out their short position. With the NASDAQ market producing much better returns than the other organized markets, some shorting, hedging, or tax management activities were done in December. This year the short ratio of the number of trading days needed to cover declined approximately 21% from the prior month to 3.79 days. This has the potential impact of fewer shares being needed to cover and therefore less demand.

Sages

One of the many blessings I have is that I know a number of very thoughtful and accomplished people. Some of them share their views in writing with others. Two in particular have said or written pieces of particular interest at this time. Jason Zweig in The Wall Street Journal (subscription may be required) suggested that we were not in a bubble. He described a bubble as similar to the South Sea Bubble of 1720, which was based on the presumed ability to become the principal trading partner between Europe and the New World. This is the bubble that sucked in, as prior posts have mentioned, Sir Isaac Newton. In the bubble, some investors temporarily made ten times their initial purchase in the unlikely event that they got in early and sold at the top quickly. I agree that I do not see a bubble on today’s scene, but this does not reduce the risk of an eventual meaningful decline.

The second sage that I (and a lot of others) pay attention to is Byron Wien. Each year for many years he has come up with a list of ten possible surprises. While these are clearly not meant to be viewed as predictions, he believes that his surprises have better than a 50% chance of occurring (while other people would not give them more than a 33% chance). A good example is his prediction that the price of West Texas Intermediate crude will exceed $110 a barrel. He is correct that others would find this to be a surprise. A recent panel of investment “experts” were almost unanimous with predictions of $80–90. All of these people are more expert than I am on the price of oil and energy in general. However, in the search to find sources of capital to invest, it has occurred to me that large portions of capital invested in energy are good sources for re-circulating capital.

The energy trap<

As global GDP grows, there is little question that the use of energy will grow with it (if not ahead of it) as people become greater users of energy as they get wealthier. Therefore I do not doubt the long-term demand side of the equation. What I am doing is raising the question of excess supply and flat or falling prices. There is no question as to the increase in US production benefiting from horizontal drilling for oil and gas. Hardly a day goes by that the US’s or other countries’ claims of large reservoirs of gas are being published. The costs to develop all of this production are very large. For political reasons, almost every government is adding to the operating costs structure. One of the better global investment managers that I know is a great believer in the capital cycle, which in its essence is that building too much capacity too quickly will lead to lower prices. I raise this concern as a potential problem for those with large energy holdings on a longer-term basis.

In my model, if you have at least three time-horizon components to your portfolio, you should do all of the following:

  1. Utilize rising prices this year to reduce some of your equity commitment for your shortest-term portfolio.
  2. For the intermediate portfolio, recognize the cyclical nature of the market and upgrade the quality of your holdings in both the stock and bond elements. You will suffer less when the decline hits.
  3. For the truly long-term portion, you should keep focused on likely future markets when you intend to convert your securities holdings to spending requirements.

Guns can shoot down asset allocation

The past year has been difficult for many who practice the art of asset allocation. For those who use domestic and international equities and debt, plus commodities, real estate, venture capital, and private equity, there were too many negative or single digit returns, particularly if these investments were housed in a hedge fund or a fund of hedge funds. Smart asset allocation works well if a patient investor will allow the various cycles to work out to the advantage of a long-term relationship. However, I fear the normal cycles will be interrupted.

President Ronald Reagan noted that every war that the US got into happened when others presumed the US was weak and lacked political will. The black flags flying over Ramadi and Fallujah, two cities in Iraq that US Marines and others fought hard for and managed well for the inhabitants, are the latest instances of weak US reaction to a significant threat to the world. Syria and Libya are other elements of concern. As an accidental offset, Iran may become somewhat less of a problem, as it may fear that it is being surrounded by battle-trained Sunni warriors. Russia, China, and a good bit of Europe and Africa may become unstable due to these conflicts and our collective lack of response.

Perhaps some additional reserves are warranted in our investment portfolios. What do you think?

This was previously published on Inside Investing at the CFA Institute.
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Copyright © 2008–2013 A. Michael Lipper, CFA
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A. Michael Lipper is a CFA charterholder and the president of Lipper Advisory Services, Inc., a firm providing money management services for wealthy families, retirement plans and charitable organizations. A former president of the New York Society of Security Analysts, Mike Lipper created the Lipper Growth Fund Index, the first of today’s global array of Lipper Indexes, Averages and performance analyses for mutual funds. After selling his company to Reuters in 1998, Mike has focused his energies on managing the investments of his clients and his family. His first book, MONEY WISE: How to Create, Grow and Preserve Your Wealth was published by St. Martin’s Press. Mike’s unique perspectives on world markets and their implications have been posted weekly at Mike Lipper’s Blog since August, 2008.

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.