Fundamental Changes Occurring – Weekly Blog # 755


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People are changing their attitudes about what they do with their money and investments. Failing to define their changed concerns about the future, they are not happy. They appear to fear more fundamental changes than just a relatively simple, shallow and quick, cyclical recession.

Without fully defining the cause of their fears, they are moving their cash and investments around slowly. Third-quarter statements for leading commercial banks are showing increased deposits and the purchase of fixed-income securities and loans. For their own accounts, leading banks are raising their bad debt reserves.


Jaime Dimond, the CEO of JPMorgan Chase, is worried about a possible future stock market decline of 20% due to credit concerns, concurrent with liquidity concerns in domestic and international markets.

Most non-trading investors are unconcerned about the amount of capital on trading desks. This capital is needed to provide immediate support for transactions resulting from sudden and sizeable events. Last week, a well-known, high-quality financial services stock had quite a day. After closing at $98.07 the prior day, it opened at $94.99 after a bad earnings report, then dropped further to $93.53 before rising to $102.66, finally closing at $101.96. Trading volume on the NYSE was higher by 1 million shares for the day. While the earnings report was less than expected, the closing price was roughly in line with prices paid over the past couple of weeks.

The price action of the stock suggests the NYSE market makers did not have enough uncommitted capital to cushion the opening trade and early morning trading.

This is an indication market makers are undercapitalized. This is a worry for all institutional-sized investors owning shares listed on the “big board”.

Stock Strategy

Most of the time investors select stocks similar to each other, regardless of market capitalization. This is not currently true, with large-capitalization growth stocks leading the way since the June lows. However, smaller-caps have been led by “value” stocks. This dichotomy is probably based on the belief that large-caps are more liquid than smaller-caps. Additionally, the average small-cap value stock is cheaper in terms of price/earnings ratio.

However, if one sees the next market as essentially a recovery from the decline, you would be attracted to large-cap growth, now selling under stock prices of two years ago. International mutual funds on average have three years of poor performance to recover from.

If you believe the next major move is a recovery, then large-caps make sense. People currently find the low S&P 500 price of 3583.07 attractive. I am not such a believer.

Odds favor the next “bull market” having a largely different leadership than the last. In part, leadership will come from corporations positioned to be providers of products and services to a restructured world.

Public vs. Private Investments

Since the sailing ship days, investors have profited from “carried interest” earned by ship captains and others on solid land. They benefitted from the price spread between what the owners of the ship paid for the merchandise and the price the captain negotiated upon landing. Carried interest is the source of wealth for Italian cities and Boston financiers nurturing the owner’s and captain’s wealth.

The same procedure was used by these firms when they invested in private companies. Boston law firms also used the same approach when they began investing in “privates”. When I started visiting these law firms in the 1960s, they had more money under management in their trust-departments than mutual funds. They also had professional security analysts on their staffs.

Carried interest was used to connect portfolio people and salespeople with their wealthy families. The private equity business was founded through this union and grew significantly to include wealthy individuals and non-profit institutions.

Two other aspects beyond capital gains tax treatment aided their growth. A forty-year bond bull market generated capital to invest in private equity and private debt at very low interest rates. The privates also had a second advantage, their investors were trained to wait three to twelve months to see their investment returns. (By then their poor performance was not as painful, as publicly traded investments reported with a one-to-ten-day delay.)

All of this is in the process of changing. There are now many providers of private funds with lots of spreadsheets. Interest rates have risen on leveraged capital. Many private funds are now investing in public securities, and an investor or prospect can somewhat triangulate the private fund’s results. Private funds typically launch a new vehicle as soon as they can, often before the prior fund is fully invested.

I believe a handful of these funds will continue to produce good results. However, even these funds will be pressured by higher interest rates, competition for talent, and stronger negotiating people in operating companies. Only a few will produce exciting records.


Use dollar-cost averaging to invest in good companies not already represented in your portfolio. The slower the better.

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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