Practical analysis for investment professionals
29 January 2015

Who Protects You from Losses?

Governments pass laws and regulations to promote safety and to prevent themselves from being turned out by the abused public. If you examine prudential regulations, you’ll find that almost all of them are designed to avoid criticism of the regulators. Little or no real efforts are made to help investors make good investments or exit bad investments.

Gains and losses are the product of human behavior, driven by greed, fear, and sloppiness, with an accelerator of leverage thrown in to shorten the terminal period. This is the way it has always been and probably always will be.

A Historical Example

Jason Zweig, a columnist at the Wall Street Journal – but in reality a history scholar — mentioned in his 16 January piece that some 4,000 years ago, in Mesopotamia, there were legal regulations for futures contracts on silver and barley. (I wish I had read them before I tried to take advantage of the apparent mismatch between London Silver and US Treasuries on light margin.)

In one of the cradles of civilization, there was an attempt to keep the trading businesses thriving in order to prevent the losers from destroying the winners and the government. A pattern was ignited that has been repeated by many societies all over the world to “keep the game going.”

A Current and Controversial Example

When a large number of General Motors (GM) and Chrysler employees who normally vote with their powerful and high-spending unions were at risk of losing their high-paying jobs owing to mistakes made by management, politicians, and unions, it was decided that the government would bail out GM and Chrysler rather than let them do what other private companies would do: conduct an orderly bankruptcy. The US government loaned these and other companies taxpayer money through a pre-packaged bankruptcy that ignored the priorities in the Bankruptcy Act.

Because of this bailout attitude, the government followed a similar practice with the US banking system and at least one large insurance company. These bailouts ignored the history of similar bankruptcies, after which new organizations employed many of the former low- to mid-level employees at market rates. High-priority lenders received reasonable payments, lower-credit borrowers or vendors received much less, and for all practical purposes the equity owners were usually wiped out.

Quite properly, voters were incensed by the spending of their money in a way not intended when they voted. To prevent future criticism, the two administrations and Congress said that they felt trapped by “too big to fail” financial institutions. In practice, these politicians followed the old Pentagon approach of planning for the future by fighting the last war brilliantly.

Note that the current US administration and its immediate predecessor were repeating the failed strategy of the Mesopotamian rulers: protecting the government from criticism instead of preventing management and investor mistakes. Today, all are free to produce below-market-quality products at overpriced levels with inadequate research, just as investors are free to hide from their long-term investment responsibilities until the next series of crises, which, if history is any guide, are almost guaranteed to occur.

Where Are We?

As we entered this year, I stated that the odds involved a 20% or greater movement of price. That is, either a gain of 20% or a loss of 20% — or, in an extremely volatile year, both.

This is a year in which superior tactical skills will be needed for the first two of our Timespan L Portfolios of operational needs and replenishment capital. These portfolios should largely, if not exclusively, easily sell or redeem securities (funds) because prices are likely to offer more than the normal risks and opportunities.

Where Am I Looking?

I am first looking to sense the amount of investor enthusiasm that is present.

There are always isolated pockets of extreme enthusiasm and desperation. A great deal of enthusiasm will be needed to generate my 20% gains. (This level is also needed to create a top from which a major collapse can occur.) An example of this enthusiasm is the recent price of Tesla, which at one point was selling just shy of half the value of General Motors.

Tesla produces about 90 cars a day. GM makes about 90 cars every five minutes. On a full accounting basis, it appears that it will be some time before Tesla can report a regular profit. What is important is that some people are willing to project far beyond 2020, when Tesla is expected to break even and begin to show exponential growth. Tesla has believers. (As they say at the track and in politics, I don’t have a horse in the race: I own shares in neither GM nor Tesla.)

By the way, Tesla’s innovative manufacturing can be viewed in this clip.

I am searching for a similar level of enthusiasm for other investments in the years ahead. I might get sucked into investments by the Greater Fool Theory in hopes that I will be able to execute a separation in time. Greater volatility is expected. Last Tuesday, for example, the Dow Jones Industrial Average moved 424 points.

Because the market recently had five consecutive days of losses for the first time in quite a while, I am looking for the proverbial canaries in a coal mine that can signal potential elements of strain.

One such item is a much larger than normal decline in the Barron’s Confidence Index of the yields of high-grade bonds versus intermediate bonds. The index dropped almost three percentage points in mid January. Normally it moves by one percentage point or less. While it could be a warning because both yields declined (greater popularity), the best grade declined more: 22 versus 12 basis points. Are the bond mavens becoming worried about intermediate-quality paper? These are not the energy-related high-yield plays.

As strange as it may seem to most readers, I wonder whether there is a message in the price of gold. If you accept gold as a quasi-currency, it was the second-strongest major currency in 2014. Even before the Swiss National Bank (SNB) move, investors had been flowing into Treasuries and gold. Will these fearful investors prove to be ahead of the crowd?

Question of the Week: What are the signals you are currently using? Please share with me (not for publication or attribution).

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©iStockPhoto.com/Meriel Jane Waissman

About the Author(s)
A. Michael Lipper, CFA

A. Michael Lipper, CFA, is 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, he 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, Lipper has focused his energy 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. Lipper’s unique perspectives on world markets and their implications have been posted weekly on his blog since August, 2008.

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