Matthew 25

The Wall Street Journal this past Friday had an interesting article entitled "Is Wall Street Meeting God's Expectations?" by David Weidner which discussed the use of scriptural passages by financial advisers in their business descriptions.  The author examined the parable of the master and three servants from the Gospel of Matthew 25: 14 - 30 as "the most cited scripture on Wall Street when it comes to validating the investing and trading with the spiritual life." 

The master in the parable leaves "talents" or ancient coins made of precious metal with three servants before departing on a long journey.  The number of coins each servant received was in accordance with their individual abilities from greatest to least.  As noted in the article, the beauty of a parable in wisdom literature is the many layers of meaning and instruction.  At its core, this parable deals with a trinity of relationships - relationship with God/universe/divine (spiritual and eternal), relationship with others/neighbors/clients (worldly and practical), and relationship to self (emotional and persona).  The benchmark for each of these relationships is provided by the master when he congratulates the two successful servants, "Well done, my good and faithful servant.  Since you were faithful in small matters, I will give your great responsibilities.  Come, share in your master's joy."

In the worldly or practical realm, the standard of care expected of a financial adviser or steward in the parable is good and faithfulness.  Good means competency, consistency, doing the work to the best of your abilities, and meeting or exceeding client expectations.  Faithfulness is being trustworthy, credible, reliable, and devoted.    

Understandably, the Securities and Exchange Commission (SEC) through the Investment Adviser Act of 1940 established minimum competency requirements for individuals in the business of giving investment advice and standards of ethical business conduct. Registered investment advisers must act in a fiduciary capacity in their dealings with clients.  A fiduciary duty is the highest standard of care at either equity or law. A fiduciary is expected to be extremely loyal to the person to whom he owes the duty (the "principal").  The adviser must not put his personal interests before his fiduciary duty, and must not profit from his position as a fiduciary, unless the principal consents.

The Investment Adviser Act of 1940 like the parable is well intentioned but has not prevented several scandalous lapses in fiduciary duty over the years on Wall Street, including most recently Bernie Madoff and Jon Corzine.  It should come as no surprise that some financial advisers would incorporate scriptural doctrines in their investment and service philosophies to distance themselves from this infamy.

Paradoxically, the third servant's failure in the parable was not a violation of trust or his fiduciary duty as one might expect in the modern world.  He did not steal the precious coin.  He kept it safe.  His failure was one of competency and faith in his own abilities as he explained, "Master, I knew you were a demanding person, harvesting where you did not plant and gathering where you did not scatter; so out of fear I went off and buried your talent in the ground.  Here it is back."  The third servant's over analysis and worry led to his paralysis and failure.  He didn't take even modest risk and so received no measure of success or joy from a job well done.  

As the WSJ article concludes, the frightened servant was only admonished because he hid his treasure.  Nelson Mandela addressed this universal fear when he said, “Our deepest fear is not that we are inadequate. Our deepest fear is that we are powerful beyond measure. It is our light, not our darkness that most frighten us. We ask ourselves, Who am I to be brilliant, gorgeous, talented and fabulous? Actually, who are you not to be? You are a child of God. Your playing small doesn’t serve the world. There is nothing enlightened about shrinking so that other people won’t feel insecure around you. We are born to make manifest the glory of God that is within us. It is not just in some of us, it is in everyone. And as we let our own light shine, we unconsciously give other people permission to do the same. As we are liberated from our own fear, our presence automatically liberates others.”

Kudos to David Weidner for allowing me to expound upon Servant Financial's mission to provide good and faithful investment advisory services.

 

  

R.I.S.E XII

On March 29, 2012, I attended the R.I.S.E. XII investment conference sponsored by the University of Dayton in association with the United Nations Global Compact.  R.I.S.E. – Redefining Investment Strategy Education – is the largest student investment conference in the world.  The two and a half day seminar brings together students, faculty, and leading investment professionals to share knowledge and best practices. The first day of the seminar was open to investment and financial advisers, some of whom like me were visiting a family member matriculating at the University of Dayton. 

Day one of the conference included keynote presentations and expert panelist discussions by internationally renowned finance professionals from Wall Street and mutual and hedge fund portfolio managers.  The seminar contained thoughtful and informative commentary on the economy, domestic markets, alternative investments, and international and emerging markets. The keynote presentation by David Darst, Chief Investment Strategist of Morgan Stanley Smith Barney, best captured the stated conference theme of “redefining” or challenging consensus investment strategies.

The following summarizes David Darst’s more transformational ideas.

1. “Markets change when beliefs change.”

The market sell-off in late summer and fall of 2011 occurred because the markets believed that one or more of three events would occur – Europe would implode, China would experience a hard economic landing, and the United States would go into recession.  The extraordinary rally since the fall of last year was born of the belief that all three of these threats had safely passed.

2. “You make more money investing when things move from horrible to bad than from good to great.” 

The absolute best time to invest historically has been at the beginning of a secular bull market.

3. America must embrace structural reforms to ensure its long term economic success.

a. Invest in education and infrastructure - Parents and educators need to teach our kids right from wrong in addition to their ABCs and 123s.

b. Reduce the national debt and fiscal deficit - When Standard and Poor’s removed the United States' AAA credit rating, it concluded that our Federal deficit and fiscal spending levels were unsustainable, and there were limited prospects of these structural issues being properly addressed due to the dysfunctional political process in Washington.

c. “America is becoming Brazilified as Brazil is Americanized.” 

America needs to address its growing income disparity. The Occupy Movement is one visible sign of the widening gulf between the haves and the have-nots in American society.  America's middle class is shrinking as the income distribution of the U.S. becomes more and more of a barbell shape.  Meanwhile, Brazil's middle class is growing and thriving.

d. Keep an eye on the U.S. dollar and its role as the world's reserve currency - Darst noted incipient rumblings of a global dollar riot. The risk is growing that the Fed may be forced to raise interest rates to defend the U.S. dollar.

4. "You want to date equities today.  Do not get married to them.”

Secular bear market conditions will prevail.  The typical 18 year secular bull market will begin when the following conditions are met:

a. Attractive valuations – Valuations today are not compelling and may be a quite rich depending on the direction of corporate margins (at historical peaks) and earnings. Investors should wait to load the boat on equities.

b. Revolt against the status quo and political revulsion - The United States and its democratic form of government once again finds itself in the spotlight on a world stage.  United we will stand or divided we will fail.  Darst believes America will ultimately rise to this challenge just as we have done in the past.
 
c. “To him whose elastic and vigorous thought keeps pace with the sun, the day is a perpetual morning.” Henry David Thoreau 

A new sun will rise in America.  The structural reforms outlined above will engender an American renaissance led by our most valuable assets – the college students and youth of our nation.

 

On Frail Wings of Vanity and Wax

The beginning of a new year brings with it the promise of a fresh start and resolutions for reform. This annual ritual has ironic relevance for the hedge fund and financial industry.  Clearly, the hedge fund industry would rather forget 2011 and happily begins a new performance and incentive compensation period.  According to Barclay's Hedge Index, the average 2011 hedge fund return was a pitiful (5.3%).

Meanwhile, many financial industry titans have renewed their pledge to continue to work as if they are gods in the face of rising investor and stakeholder contempt.  This capitalistic philosophy declares that material self enrichment is the truth and of prime importance.  Frequent industry and media references to financial titans as "Masters of the Universe" suggest that man is god to the financial pantheon ('of or for the gods'). This caricature was ridiculously manifest in October 2011 with Jon Corzine's Icarus-like belly flop at MF Global.  Who knew MF stood for 'Missing Funds?'  More than two months after its bankruptcy regulators and the bankruptcy trustee are still looking for the $1.2 billion in missing segregated client funds. No criminal prosecution has yet been initiated.  The financial sector ETF (XLF) dove (17.1%) in 2011 led by the MF Global meltdown from $8.36 per share at the start of 2011 to mere pennies at year end for its carcass.



 

The image above shows the epic failure of Icarus from Greek mythology. He is surrounded by lamenting sea-nymphs. His father, Daedalus the craftsman, made wings out of wax so that he and his son might escape from the island of Crete. But, overcome by pride, Icarus flies too close to the sun, the wax melts, and he plunges to his death. His sensible, god fearing father flies safely to Sicily. There Daedalus hangs up his wings and builds a temple as an offering to Apollo, the god of light, the sun, and truth.



Time will tell whether the failure of MF Global was due solely to the vainglory of its CEO or whether nefarious acts were involved.  Let's hope that no one places a fat thumb on the scales of justice.  Let justice be served.

 

Shine Some Light Please

A regular blog reader calls me a “gloom and doomer” because of my often cautious outlook on the economy and markets. This issue has less to do with viewing the glass as half empty rather than half full.  As an investment advisor my duty is to maintain an alert and watchful perspective like a sentinel in a watchtower.  In that light if from that vantage point the glass is filthy, it matters little how full it is.  This consistent, healthy skepticism arises from my upbringing.  My mother seemingly had advice for every difficult situation I found myself in as a young lad. Her admonition that “It’s better to be safe than sorry” corresponds with the Servant Financial’s investment management philosophy. 

Recent developments in the financial and hedge fund industries prompted these additional maternal words to live by – “The exalted will be humbled and the humbled will be exalted.”  The exalted (people of great wealth, power, prestige and celebrity) are being humbled in the hedge fund and financial industry due to mediocre performance and blatant ethical lapses.

Hedge funds are private pools of capital actively managed by investment advisers.  By regulation hedge funds are reserved for wealthy individuals and sophisticated institutions.  Most hedge funds are marketed as having proprietary investment strategies and deep investment expertise.  These competitive advantages purportedly allow the funds to achieve positive returns whether markets are rising or falling.  The volatile trading ranges of 2011 would arguably be an optimal performance environment for hedge funds.  Such has not been the case as the hedge fund industry has fallen short of their lofty sales and marketing assurances.  In fact, the average individual investor may be outperforming the hedge fund industry in 2011.    This revelation was discussed in a recent global market commentary from The Mad Hedge Fund Trader investment research report written by John Thomas.

Although I don’t have the hard data to back it, I bet the average individual investor is outperforming the average hedge fund in 2011. With such heavy weightings of bonds and cash, how could it be otherwise? While the current yields are miniscule, the capital gains have to be humongous this year, with yields plunging from 4% to 2%... (When bond yields drop bond prices increase generating unrealized capital gains.)

Thomas believes the average investor has benefitted from more conservative asset allocation decisions in the aftermath of the 2008 financial crisis.  Individual investors have shifted more of their assets into cash and fixed income securities from equities.  John Q Public has also done well by paying down debt and deleveraging rather than keeping funds in the market. 

Increased market efficiency is due in part to intense competition within the hedge fund industry as Thomas explains.

The problem is that hedge funds are no longer peripheral to the market. They are the market, and therein lies the headache. How are you supposed to outperform the market when it means beating yourself? As a result, hedge fund managers have replaced the individual as the new “dumb money, buying tops and selling bottoms, only to cover at a loss,” as we witnessed on Monday (November 28, 2011).

Hedge fund returns have been declining for a decade. Hedge fund industry returns have been pathetic in 2011 with Barclays Hedge Fund Index declining an estimated (4.8%) through the end of November.  This hardly justifies the 2% management fee and 20% share of investment profits paid by hedge fund investors.

The growth in hedge fund industry assets under management supports Thomas’s observation. Industry assets mushroomed from $118 billion in 1997 to $1.7 trillion at the end of the third quarter of 2011. 

Source: Marc Faber, Limited; GloomBoomDoom.com

Coincident with the enormous growth and influence of the hedge fund industry, the correlations (measurement of the relationship of interdependent variables) of global equity markets have almost doubled from about 50% in 1997 to more than 80% today.

Please allow me to introduce myself I'm a man of wealth and taste.
  Rolling Stones

Source: The Trends Journal, August 2011 www.trendsjournal.com

Like other walks of life where the economic payoffs and the egos are inflated the human weaknesses of greed and pride have led to cheating in the hedge fund industry.  Cheaters in the hedge fund industry do not use steroids or human growth hormones as was common in professional football, baseball, and the Tour de France.  Rather illegal trading on insider information was used to “juice” hedge fund performance. 

Reuters reports that since October 2009 there have been 50 people in the industry who have been convicted or pleaded guilty to insider trading charges.  Hedge fund billionaire Raj Rajaratnam is perhaps the most infamous hedge fund manager implicated in the probe. Rajaratnam was convicted in May of trading on illegal stock tips that produced fantastic results for his Galleon Group. He was sentenced to 11 years in prison.

The recent highly speculative collapse of MF Global, the largest Futures Commission Merchant in the U.S., is another example of ethical lapses in the financial industry.  Readers interested in a no holds barred discussion of MF Global’s collapse should read the following transcript at Financial Sense. In this interview host Jim Puplava is joined by Ann Barnhardt, who recently closed her commodity brokerage firm Barnhardt Capital Management after the MF Global collapse. Barnhardt believes that her client monies were no longer safe in the futures and options markets, and that the integrity of this market has been 'utterly destroyed' by the MF Global collapse. I had similar concerns and sold the sole ETF in client portfolios with any commodities futures or options exposure on November 27, 2011. Any future investments in commodities within Servant model portfolios will be limited to physical markets until appropriate regulatory and exchange actions have been taken to restore the integrity of the system. An example of a physical commodities market would be shares of the Central Fund of Canada (CEF) which holds physical gold and silver in a secure vault rather than paper futures contracts.

What does this all mean for the hedge fund and financial industry and you as investors?  Thomas expects that individual investors will flee markets dominated by hedge funds and migrate to those markets where hedge funds are not present, such as smaller, less liquid and more pedestrian markets.  Hedge fund managers will continue to slug it out in liquid equity and debt markets until their investors abandon the rich fee structure and take their capital with them. 

This dynamic is already in motion.  One of the most lucrative investment markets today is the purchase of hedge fund limited partnership interests in the secondary market.  Hedge fund secondary interests trade at discounts of up to 40% or more of managers' net asset or carrying value, return investor capital fairly quickly, and generate net returns of 30% plus.  This attractive opportunity set was identified in the course of providing investment advisory services to a Chicago family office.  Unfortunately by regulation this market is restricted to accredited investors – wealthy individuals and institutions. Nevertheless we will remain alert for other attractive investment opportunities that may arise from positions contrary to Wall Street and take advantage of dislocations in the hedge fund and financial industry.  Potential examples include investment funds that directly provide liquidity to stressed and distressed sellers or lend to small borrowers with limited access to traditional financing sources.

The 99% Declaration

Strategas Research recently published a report that showed that historically low growth periods (data analyzed for the years 1950 to 2010) have been associated with higher volatility in the S&P 500.  When nominal GDP growth is 4% or less as it is today,  the volatility of the S&P 500 averaged 45.5% as compared to roughly half that when GDP growth was 4% to 8% (23.8% volatility) or greater 8% (24.4% volatility).   As this study portends, market volatility continued into October, but this time to the upside with a gain of 11% after two straight losing months.  The markets reversed course on November 1, 2011, with the S&P 500 off (2.8%) on uncertainty over the end game for Greece and the Euro zone.  This manic depressive "Risk Off" to "Risk On" behavior of the stock market is not conducive to peace of mind, or social tranquility in Europe or our backyard in the U.S.  Serious global economic, geopolitical and monetary risks and imbalances prevail, fostering mass social issues and revolutionary populist movements like Occupy Wall Street and the Occupy movement.  These demonstrations have generally been peaceful to date, but at some point a fanatic on one side or the other will make a regrettable error in judgment.   

The Occupy Wall Street and broader Occupy movements are worth monitoring because of their potential to dramatically change the economic, political and monetary agenda in this country. The group's slogan “We are the 99%," is a protest of the trend since the 1970s for wealth and income to be concentrated in the top 1% of the United States population. According to the Congressional Budget Office, between 1979 and 2007 incomes of the top 1% of Americans have grown by an average of 275%, versus just 40% for the 60 percent of Americans who are in the middle of the income scale. The top 1% of the American population controls about 40% of the total wealth of the country and the top 10% controlled 73% of wealth. In 2010, of the 100 highest-paid chief executives in the U.S., 25 took home more pay than their company paid in federal corporate income taxes.

Dr. Marc Faber, renowned investment manager and strategist of the Gloom, Boom and Doom report,  discussed one potentially critical driver of the decline of the American working class in his November investment newsletter entitled "The Strongest Principle of Economic Development Lies in Human Choices." 

…it is important to understand the role multinationals played in the destruction of jobs in the Western industrialized countries. Small and private companies are largely local, serve customers in their immediate surroundings, are unable to take advantage of all kinds of tax avoidance schemes, and have some loyalty to their own communities. They create jobs when they wish to expand. Multinational conglomerates, on the other hand have the tendency to migrate their production facilities to the lowest cost location in order to maximize profits. Therefore, large multinational companies tend to destroy jobs in Western Europe and the US and fuel employment growth in emerging economies in order to reduce their costs, which partly explains as to why in the wake of high unemployment and hardly any economic growth at home their profits are at record highs.

 By fueling employment growth in emerging economies (notably in China), they also boost economic growth rates in the emerging world and the profits they derive from the emerging economies (foreign earnings now account for about 45% of total US corporate profits).

 It should come as no surprise then that the Occupy protests are largely focused on issues that contribute to the growing economic disparity in the U.S.  Some may view this group as being unstructured, leaderless and largely comprised of people seeking their 15 seconds of fame on television or You Tube. One of the group's goals is to be as inclusive as possible and achieve consensus whenever practical.  The Occupiers typically form working groups to govern themselves with committees to oversee cleanup, security, food, media and other issues.  Early indications are that the movement is technologically savvy and has excelled at organizing themselves, maintaining media relevance, and generating national debate on issues of economic inequality, high unemployment and the hardships of millions of Americans, and the influence of corporate and special interest groups on government. 

The Occupy protests have been described as a "democratic awakening."  However, the movement is having difficulty distilling its message to a few core demands.  The group has drafted The 99% Declaration which outlines their social and political agenda.  The declaration claims to be founded on the immutable democratic principles set out by Thomas Jefferson, "Educate and inform the whole mass of the people.  They are the only sure reliance for the preservation of our liberty."  The following is a summary of The 99% Declaration beginning with its introductory paragraphs.

WHEREAS THE FIRST AMENDMENT TO THE UNITED STATES CONSTITUTION PROVIDES THAT:

Congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof; or abridging the freedom of speech, or of the press; or the right of the people peaceably to assemble, and to petition the Government for a redress of grievances.

BE IT RESOLVED THAT:

WE, THE NINETY-NINE PERCENT OF THE PEOPLE of the UNITED STATES OF AMERICA, in order to form a more perfect Union, by, for and of the PEOPLE, shall elect and convene a NATIONAL GENERAL ASSEMBLY beginning on July 4, 2012 in the City Of Philadelphia.

The Occupy movement declaration seeks to do an end around the established government processes by forming a non-partisan National General Assembly to be held on July 4, 2012 in Philadelphia.  The people will elect two delegates, one male and one female, from each of the existing 435 Congressional Districts.  The National General Assembly will then petition the government for redress of grievances - the Senate, House of Representatives, the Supreme Court and the President.  The following is a draft list of the grievances prepared by an Occupy working group.  The declaration will no doubt change and evolve around consensus issues.  Grievances that relate more directly to the Occupy movement's fundamental issue of economic disparity and political influence have been highlighted.  My commentary on grievances is in parentheses.

1. Elimination of the Corporate State - immediate ban on all private contributions to all politicians for federal office and switch to public financing of political campaigns.
2. Abrogation and Rejection of the Citizen United Case - decision equated the payment of money to politicians with the exercise of the freedom of speech.
3. Elimination of All Private Benefits and "Perks" to Politicians - politicians and public employees may only collect their salary and generous healthcare and pensions.
4. Term Limits - House of Representatives - four 2 year terms; Senate - two 6 year terms.
5. A Fair Tax Code - complete reformation of the U.S. Tax Code to require ALL citizens and corporations to pay a fair share of a progressive, graduated income tax.
6. Healthcare for All - Medicare for all or adoption of a single-payer healthcare system.
7. Protection of the Planet - new comprehensive regulations to expand EPA powers.
8. Debt Reduction - reduce national debt to a sustainable percentage of GDP by 2020.
9. Jobs for All Americans - passage of a comprehensive job and job-training act like the American Jobs Act.
10. Student Loan Forgiveness - reduction of interest rates and deferral of interest and principal payments during periods of unemployment.  Principal forgiven over time by phasing in a graduated corporate tax surcharge.  (Also recommends amendment of the Tax Code to provide tax deduction for employers that pay off employee student loans which would contravene Grievance no. 5)
11. Immigration Reform - immediate passage of the Dream Act and comprehensive immigration and border security reform.
12. Ending of Perpetual War for Profit - recall all military personnel at all non-essential bases and focus on 21st century national defense threats.
13. Reforming Public Education - eliminate tenure and pay teachers a competitive salary.
14. End Outsourcing - offer tax incentives to businesses to remain in U.S. and hire our citizens rather than outsource jobs (Another conflict with Grievance no. 5).
15. End Currency Manipulation - implement legislation to encourage China and other trading partners to end currency manipulation.
16. Banking and Securities Reform - immediate reenactment of Glass-Steagall Act.  (This is an absolute no brainer.  Why hasn't our government already done so?)
17. Foreclosure Moratorium - have the privately owned Federal Reserve discontinue its favorable interest rate on loans to banks and instead have it buy all underwater or foreclosed mortgages. (This is the bail out the mortgagees rather than the banks provision.)
18. Ending the Fed - transfer functions to United States Treasury Department.  (This would make the monetary games too transparent.  With the Fed gone, who bails folks out of their underwater mortgages?)
19. Abolish the Electoral College, Comprehensive Campaign Finance and Election Reform - switch to a popular vote for presidential elections.
20. Ending the War in Afghanistan - immediate withdrawal of combat troops.  (This trumps Grievance no. 12 in case Afghanistan war is deemed essential.)
21. Repeal of the Defense of Marriage Act - all human beings have the right to love and marry another human being regardless of gender or sexual orientation.

Many Americans may feel that several of these draft grievances have little merit because they go beyond the scope of redress for economic disparity and the removal corporate and special interest money from politics.  The credibility of the movement is diluted by the inclusion of indiscriminate grievances.  That said this fledgling movement's plan to give the masses a more direct voice in a government for the people and take direct aim on the money interests that often debase our democratic system is something few Americans would denounce. 

The Occupy movement began less than two months ago in New York City on September 17, 2011 with Occupy Wall Street.  As of November 4 the movement seems to be going viral with the Meetup page Occupy Together listing Occupy communities in 2,353 towns and cities worldwide.  We will continue to monitor the Occupy movement because it has the potential to cause disruptive social, political and economic changes and impact markets.