Michael Lipper: the logic behind the 'wall of worry'

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During a stock market phase when stock prices rise and conventional thinking suggests that the economy is in weak shape, pundits may explain that the market is climbing a “Wall of Worries.”

Another way to phrase this phenomenon is that market prices are narrowing their discount of future better prices. After all, the market for future dividends and earnings is what today’s prices are meant to be about.

Since the break in 2008, many of the markets around the world have been assessing the chances of further declines due to potentially large financial failures, deep economic recessions (some said depressions) and political turmoil.

These are challenges that make governing difficult to impossible and inhibit the ability to address the long-term structural deficits facing many “developed” societies.

Five years after the markets’ bottoms, on the surface we have experienced no major financial failures in part due to the shifting of financial leverage from the private and commercial sectors to the government sector.

This feat of legerdemain was done by artificially lowering interest rates by ignoring credit concerns. Removing the impact of deleveraged debt from the surface economy reduced the strains on the economy.

In addition, a number of the major governments went through an election which did not produce panic selling by disappointed investors.

In the mind of investors, institutions and individuals, if market prices didn’t go down, they should go up. One rationally might disagree with this “logic,” but in truth that is what happened.

Newer risks

If the old worries did not cause a double or triple dip in market prices, then as one comic book character queried years ago, “What me worry?”

As a professional investor that is exactly why I am getting a bit concerned. In my most conservative accounts that enjoyed a good 2012 (and 2013 looks positive), I am beginning to address our stock/bond ratios.

Stocks have done well and they now account for way above normal asset class guidelines as a per cent of the total accounts.

The concern is that when the periodic declines hit the stock market, potential gains from fixed income holdings will not be large enough to hold the value of the account to a comfortable level.  

Analytically I see at least three potential concerns that could get worse and put sharp pressure on prices.

My concerns are for the potential permanent loss of capital which I call risk; which is quite different from the variability of prices or volatility which many consultants and academics mistakenly call risks.  

Three concerns

My three areas of concerns which could lead to permanent loss of capital are:

1.    As regular readers of these posts have learned, I believe the fixed income markets with their more limited potential returns than the equity markets can send important early warning messages to stock and equity fund buyers. I particularly pay attention to High Current Yield or if you prefer the more pejorative term, “junk bonds,” which in effect are stocks with coupons and maturities.

According to Moody’s*, the yield spread from low grade paper to higher quality bonds is larger than at past bottoms. Mutual fund investors, despite being warned, have been pouring money into High Yield Bond funds. What is of particular concern to me is that a good bit of this money is going into what is called “covenant lite” bonds that don’t have the usual protective covenants.

My fear is that the combination of somewhat imprudent investors piling into funds with significant covenant lite bonds could lead to serious disappointment, which in turn could lead to massive redemptions. Often if a corporation’s low quality bonds drop it can hurt the firm’s stock prices as well.

*Disclosure:  My financial services private fund has a long position in Moody’s

2.    There are surface signs of complacency toward the stock market with relatively low volumes of transactions, particularly by public investors. The VIX measure of the presumed fear of option price declines is flat and near its lows for the year.

The structure of capital markets around the world has changed over the last couple of decades by removing the shock-absorbing middlemen as well as agency brokers, replacing them with dealers who have little, if any, responsibilities for an orderly market. Thus a sudden surge of market orders could stampede a market in either direction creating a significant impact.

3.    I am increasingly concerned about the spirit of integrity in the marketplaces around the world, but primarily in the US. I have already mentioned the growth of covenant lite bonds that may have been sold to unaware individuals and institutional investors. Another tendency that is bothering me is a practice of taking publicly traded firms private in a management buyout.

To me the only justification for the relatively low price being offered for Dell is that is the cost to remove the present management, which has presided over more than a 50% drop in the price of its shares. We must take better care of our investors if we want to have viable markets.    

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, he created the Lipper Growth Fund Index, the first of today’s global array of Lipper Indexes, Averages and performance analyses for mutual funds.

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