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August 2015

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“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” ― John Maynard Keynes

After years working as a trader at various investment banks in New York and later Tokyo, my wife and I decided to pack up our bags in August of 2013 and make the move back to our hometown, San Francisco. The main motivation behind our relocation was the birth of our daughter Sascha, and the desire to raise her closer to family. A not too distant second however was the lifestyle that I had come to take for granted having been raised in one of the most beautiful regions of the country. The weather in the Bay Area is near perfect most of the year, favorable to outdoor activities for those that enjoy sports and recreation. Hiking, mountain biking, surfing and sailing are some of the activities popular among the locals and in this regard, I have been doing my best to make up for lost time. Note to self: take sailing lessons.


Life, as we are all aware is not without risk in terms of one’s both physical and financial security. With that in mind, it has been difficult not to notice the attention man-eating predators seem to be getting in the media lately. Sharks and mountain lions are appearing a bit more often in the places that many of us frequent. Various news sources have dubbed 2015, as “The Summer of the Shark” while in the Bay Area, county officials have been actively responding to sightings of mountain lions in both San Mateo County and San Francisco.


Of course the chances of being attacked and killed by either a shark or mountain lion is infinitesimally small, but that doesn’t offer many of us a piece of mind. Maybe the reasoning behind this emotional thought process is that we assign a much higher weighting subconsciously to the horror of going out in this fashion. I don’t know, but I am guilty of being irrational myself when it comes to this.


With that said, there are no shortage of things to worry about from a financial or geopolitical perspective either. Greece has been in the news since December 2009, the Chinese stock market is down significantly from its recent highs and appears in free-fall again, Russia and China continue to test the U.S.’s resolve regionally, terrorism won’t go away, while the Middle East consistently appears to be just one spark from all out havoc that takes everyone down with it. Debt to GDP ratios of some of the developed worlds largest economies (Figure 1) look unsustainable and many experts rightly worry about global asset prices should easy money become less easy. I can go on and on... this wall of worry type of thinking comes easy to me.


But many of the above risks blowing up on any given day would be considered statistical outliers. On a day-to-day basis they are unlikely to occur. And that is why it is so hard to make consistent money selling stocks short, owning options (insurance), or betting on calamities to occur in general. They make good copy and they sell newspapers but they are low probability events.


People generally make money taking financial risks, be they measured and intelligent or all-in and aggressive. There is no other natural way. We can minimize our risk and maximize our return over the long term by owning assets that are empirically cheap to where they are priced in the market. This “value” style of investing provides a sort of cushion if things don’t go as expected early on in the investment. Unfortunately, all the low hanging fruit seems to have been picked clean and as a consequence forced people out the risk curve in search of returns.


Byron Wien of Blackstone who has been a household name on Wall Street for decades had this to say in his June 30, 2015 market commentary about the search for returns. “It is not easy to make money these days. In the past, if you had the right asset allocation, you could do well for institutional investors. Now most asset classes are fully valued. The bond market is expensive, equities are not cheap anywhere, gold is dead; other commodities are in bear markets, the emerging markets are generally not attractive, China is dangerous, and Europe and Japan are reasonably priced.” However, he later went on to say, “Everyone is looking for a big correction in the U.S. equity market, but while it looks somewhat expensive to me, so much money in the world wants to have a position in American stocks that I don’t think the indexes will decline much. The vigorous merger and acquisition activity will continue, and I think that will help the markets.”


Mr. Wien could be right but I do not believe it is prudent to run portfolios at full risk given the run our stock market has had over the past few years or based on current valuation metrics. The Wall Street Journal’s July 27, 2015 Breakfast Briefing had this to say on the topic. “Some market internals are flashing yellow. As the Wall Street Journal reported Sunday, investors are growing concerned that a lack of breadth behind this year’s stock gains echo the market tops of 2007 and the dot-com bubble when fewer and fewer stocks lifted the broader market. Amazon.com Inc., Google Inc., Apple Inc., Facebook Inc., Netflix Inc. and Gilead Sciences Inc. account for more than half of the $664 billion in value added this year to the Nasdaq Composite Index, according to data compiled by brokerage firm Jones Trading. Amazon, Google, Apple, Facebook, Gilead and Walt Disney Co. account for more than all of the $199 billion in market-capitalization gains in the S&P 500. In another sign that rocky times may be ahead for stocks, last Monday, as the S&P approached a record, nearly as many stocks hit one-year lows as one-year highs, according to Ned Davis Research. As Money Beat pointed out last week, new lows have outpaced new highs for much of the past three weeks, according to MND Partners managing director Tim Anderson.”



Visualizing flashing yellow lights, in my view does not mean converting a large chunk of ones portfolio to cash, but it does favor defensive positioning and investing in liquid assets. Clients with high equity allocationscould benefit by increasing their non-credit fixed income allocation. Although for years the world has been expecting higher long-term interest rates, the fact is they have not moved much and have been pegged in a lower range for some time (Figure 2). Now, with the possibility of the Fed moving overnight rates higher over the coming months and a continuation of the strengthening US dollar, I would not be surprised to see long rates hold steady or even go lower as a result. This bodes well for 10- 30yr treasuries and I expect they still have juice to make returns and also provide both diversification and stabilization benefits to portfolios. Remember the quote I led with above attributed to the late John Maynard Keynes? In this case the perceived higher risk bond alternative (long duration US Treasuries) is actually the choice which makes the most sense.


On the equity side, Japan looks interesting. The Nikkei 225 has been responding to a weakening Yen since 2012 and is still almost 50% below the 1989 highs (Figure 3). I believe this trend will continue. Their well- documented Debt to GDP ratio of 240%+ adds fuel to the fire and makes the weakening Yen the path of least resistance. Rationally what other choice do they have to pay down debt? Anyway, as long as the move is orderly I believe Japanese stocks will continue to benefit.



The key message I’d like to highlight is that nothing appears cheap, however standing on the sidelines investing in cash at 0% is not going to cut it with rising housing, education, and health care costs eating into disposable income or the value of your dollar. We must invest, but we must do so with caution.


Finally, I’ll end this note with another video clip of my recent favorite market personality and hedge fund manager Carl Icahn from the Delivering Alpha Conference televised on CNBC. Icahn speaks his mind to Larry Fink CEO of BlackRock (here) regarding the various problems related to high yield credit ETF’s as investors continue to reach for returns. I whole heartily side with Mr. Icahn on this topic not only because his concerns make sense to me, but because I have a natural distrust for big institutions such as BlackRock and conversely hold admiration for entrepreneurs such as Mr. Icahn. Enjoy.


Sincerely,

Justin Kobe, CFA Founder & Portfolio Manager

Securities and Advisory Services offered by Protected Investors of America, an SEC Registered Investment Advisor. Member FINRA/SIPC. The views expressed in this commentary are the personal views of Justin Kobe of Pacificus Capital Management and do not necessarily reflect the views of Protected Investors of America. There is no assurance that the investment process will consistently lead to successful investing. This commentary does not constitute an offer to sell any securities or the solicitation of an offer to purchase any securities. Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.


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