The Dangerous Law of Small Numbers

Introduction

As numbers absorbers we are all aware of the Law of Large Numbers. That is the law that indicates that it is difficult for a large number to grow at the high rate of smaller numbers. For instance the population of the World in the short run is unlikely to grow at the same rate of increase as a bunch of newlyweds. Much less recognized is a law, (perhaps one that I am inventing), the “Law of Small Numbers.” Both laws are designed to prevent fellow numbers absorbers from getting their expectations wrong. Enough about math and on to investing, both for others through institutions or individuals including us.

Plus or minus 20% for 2015

What is behind such a bold statement? The answer is “the Law of Small Numbers.”  Both the investment media and various year-end treatises are full of small numbers in terms of growth of earnings, sales, margin improvement, inflation and interest rates. Most of these currently have two things in common. They are expressed as mid to low single digits and they are being revised downward. I cannot dispute the math of the calculations, but I do their scenarios.

A single small number, particularly when it includes a decimal point, screams of its painstaking accuracy. Most economists and analysts probably forgot most of their history and only remember key dates, but not the underlying movements. One of those elements, the power of surprise to change the equation of various battles, one learns from military, including naval, history.  While Certified Public Accountants do not allow for contingencies in their audited statements, I have in various businesses, including non-profits, always insisted in the mathematical recognition of uncertainty about the future, and created at least in my mind or in operating statements, reasonable reserves for things that could go wrong. Occasionally, reserves may be needed to pay for an upside breakthrough or other development opportunity that requires immediate funding before revenues are generated. In the US Marine Corps it is standard to hold back part of one’s forces on line, keeping one combat unit in reserve to relieve and support the front line elements. Even after these reserves are committed, a secondary reserve is created out of the headquarters staff, including the band and other support elements. Thus in the Marines, I was always taught to have reserves ready to deal with contingencies or surprises. I believe this kind of thinking is necessary for long-term investment survival. Thus, I look askance at small number future estimates.

Why 2015?

While I acknowledge I do have a well-honed contrarian streak, the current year may well be one of surprises not built into the small number estimates. On the upside various US consumer sentiment surveys are showing that in 2013, 35% of consumers believed that they were better off  than before, and in 2014 the number jumped to 47%. Carrying this sentiment further, 65% responded that they expected their finances would improve. (Interesting that 2013 was a better than average year for equity investing; 2014 was good but less than 2013 and considerably less for most managed money portfolios. The year 2015 so far is nervously flat.) I believe that it is likely that the two US political parties will dwell on the upside, albeit with different views of the future, in the run up to the 2016 election.

I have mixed views as to this rising sentiment. For some time I believed that the US stock market has been building toward a dramatic peak. One of the missing elements that presage a peak that will bring on a major decline is a bout of great enthusiasm which could lead to a parabolic stock price explosion. While I might enjoy the experience, my responsibilities for my related accounts will require extreme timing prudence which is not easy during periods of great excitement.

The 20% downside is less frightening to me as we have experienced these in the past and survived and prospered. Nevertheless, we need to be aware of negative surprises caused by nature, political miscalculations, misplaced military adventures, and market structure issues; e.g., counterparty problems unfortunate court cases, etc. These are not built into the small number estimates which are floating around.

Perhaps naïvely, I currently perceive that there are more risks outside of the US than in it. The US is expanding despite the structural damage of bailouts and quantitative easing instead of fiscal policy. Too many European and some Asian countries will be burdened by top-down economics rather than bottom up efforts of a striving population. (Over the next fifty or more years, it is just possible that some Southern Hemisphere countries will be more productive in terms of investments than the average in the Northern Hemisphere.)

Bottom line

The year 2015 may be more exciting than 2014 and many former years. We should be able to tolerate a cyclical decline from today’s levels but the emotional absorption of a surprise major market gain could create a nasty hangover. For our accounts we will be guarding those with relatively short-term time horizons and likely to be more active in terms of trading. Our longer-term investment accounts focus on selective secular growth should be relatively quiet except to follow Sir John Templeton’s instructions to look for better bargains. (John was a very much valued client both of our data and consuming services and we enjoyed being a shareholder in his funds and company when it was relatively briefly traded publicly.)

Question of the week:

Please share with me your views as to what are the odds of a 20% gain and what are the odds of a 20% fall.

__________    

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Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2015

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Are We Safer?

Introduction

Some people consider me an expert, thus I get lots of investment questions. Usually I can divide the questions and therefore the answers by identifying the depth of investment knowledge and experience of those asking the questions. I find it useful to divide those asking the questions into three broad groups with lots of sub-divisions.

The first group, are often the managers of the funds we choose to consider for investment.

The second group are people who devote little time and effort into financial and investment matters; e.g., the general public.

The third  group includes gatekeepers or members of investment committees mixed with pros and others.  In many ways this is the most difficult group; those who pose as members of the first group, but in their heart of hearts, they are much more like the public that watch general news or read mass publications.  Thus, when I get a question from this third group, looking for a simplistic answer, I don’t know where to start other than saying most specifically ‘No’ or in less than polite society ‘H… No!’ This is followed, if they are really interested, in a discussion of human nature and doses of history and why they are vital investment considerations.

Safe for whom?

Governments pass laws and regulations to promote their own safety and to prevent themselves from being turned out gently or violently by the abused public. If you examine almost all prudential regulations, they are designed to avoid criticism of the regulators. Little or no real efforts are made to help investors to either make good investments or to at least avoid bad exit investments. Bottom line: 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 who is a columnist at The Wall Street Journal, but in reality is a history scholar, mentions in his weekend piece that some 4000 years ago in Mesopotamia there were legal regulations as to future contracts on silver and barley. (I wished I had read them when I tried to take advantage of the apparent mismatch between London Silver and US Treasuries on light margin.) At one of the cradles of our culture, there was an attempt to keep the trading businesses thriving to prevent the losers from destroying the winners and the government. Thus 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 employees who normally vote with their powerful and high spending unions could have lost their high-paying jobs due to mistakes made by management, politicians and unions, it was decided to bailout GM and Chrysler rather than let them go through what private companies would do (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 that after similar bankruptcies in the past, new organizations sprung up employing many of the former mid to low level employees at market rates. High priority lenders received reasonable payments, lower credit borrowers or vendors 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 at the time when they voted for President and members of Congress. To prevent future criticism the two administrations and Congress felt they were 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.

Notice the current US Administration and its immediate predecessor were repeating the failed strategy of the Mesopotamian rulers of protecting the government from criticism, not preventing management and investor mistakes. Today all are free to produce below-market quality products at over-priced levels with inadequate research just as investors are free to hide from their long-term investment responsibilities until the next series of crises. Based on history they 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 possibly in an extremely volatile year, both. This is a year that superior tactical skills will be needed for the first two of our Timespan L Portfolios™  of operational needs and replenishment capital. These portfolios should have largely, if not exclusively, easily sold or redeemed securities (funds) because prices are likely to offer more than 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 some isolated pockets of extreme enthusiasm and desperation. A great deal of enthusiasm will be needed to generate my 20% gains. (Also, this level is needed to create a top from which a major collapse can occur. ) An example of this is the recent price of Tesla which at one point was selling just shy of ½ 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 way beyond 2020 when Tesla is expected to break even and begin to show exponential growth. It has believers. (As they say at the track and in politics, I don’t have a horse in the race either as an owner of either Tesla or GM cars or shares.)  

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. Possibly I might get sucked into investments falling for the greater-fool-theory trap and hope that I will be able to execute a separation in time. Greater volatility is expected; e.g., on Tuesday the Dow Jones industrial Average moved 424 points.

Since for the first time in many years the market had five consecutive days of losses, I am looking for proverbial canaries in a 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 3 percentage points this week when normally it moves 1 percentage point or less. While it could be a warning because both yields declined (greater popularity), the best grade declined more, 22 vs. 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 in 2014, it was the second strongest major currency. Even before the Swiss National Bank move, investors have 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 that you are currently using? Please share with me (not for publication or attribution).

__________    

Did you miss my blog last week?  Click here to read.

Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2015

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Three Bad Bets: Recency, Overconfidence and Volatility

Introduction

One of the main differences between many brokers and a fiduciary investment manager is the focus on the time to reward. The broker gets rewarded for transactions. The ultimate rewards for the fiduciaries are the successful spending programs of the beneficiaries of their work. I am a professional member of the second tribe. Thus, I think about structure as well as selectivity as they evolve over time.

With the US and many other stock markets on balance going up more often than going down, one of my tasks is to avoid unforced declines. If the long-term secular pattern of rising stock market prices remains, my beneficiaries will receive payments for their reasonable spending plans. That is, if I as their discretionary manager avoid unforced mistakes. Three mistakes that I try to avoid are Recency, Overconfidence, and the misinterpretation of Volatility.

According to a study mentioned by Gene Epstein of Barron’s done by Professor Jeremy Siegel of Wharton and his former student at Wisdom Tree^*, in the last 144 years there has never been a 15 year period when an investor who invested in the popular indices of the US stock market lost money supporting the argument in favor of the positive secular trend. Almost all of the accounts that I am responsible for have a current belief that they will need to meet their payment obligations for 15 years or longer.

Recency

Like many of our readers of last week’s post I was surprised to find that recency is an acceptable word in our language. The word was listed in a long list of biases that have hurt investors over time. Almost all discussions about the outlook for the future of the stock market devote a lot of time to the very current situation. In theory, that is what is known. (Actually all we know is the outline of what happened not what made it happen; more on this later in the discussion on volatility.)

Very little time is devoted to the terminal prices of a considered investment.  What does the current price of say $10 per share tell us as to the odds that we will terminate our position at $5, $15, $ 50 or $100? Most brokers shy away from guessing future prices over an extended period of time, while investment managers need to ponder.

The question as to future valuations is exactly why I have developed the concept of the Timespan L Portfolios. I am aware that tomorrow the market could start to decline. Based on history beyond the Wharton study I am prepared for a periodic correction of at least 10% even though we have not had a five day consecutive period of decline since 2009 and no 10% decline since, I believe, 2011. I believe that it is reasonable to expect a 20% + decline at least once every 10 years and roughly a 50% drop once a generation.

In the Time Span Portfolios construct, the shortest duration portfolio to fund operational needs should have an excess over planned spending of 10-20%, depending on when the last decline occurred. Whenever the Operational Portfolio has completed its funding mission (which may be in two years), just as a good US Marine Corps general does after he commits his front line troops, he immediately reconstitutes a reserve element to replace the tired-out or expended troops. Thus, I have created the Replenishment Portfolio which will provide the next series of funding needs. Because the Replenishment Portfolio has a longer duration of possibly five years, it is reasonable that it may have to deal with a stock market decline of 50%.

Having the first two portfolios in place, the third or Endowment Portfolio would have a duration of 15 years or possibly a little more and should be able to tolerate an all equity-like risk. The general expectation for this portfolio should parallel the return on equity that the major market indices generate from their components.

Recognizing few if any of today’s leading stocks are likely to be the better performing stocks well into the next generation, a portion of the final or Legacy Portfolio should be crammed with potential disrupters of the present structure of our economy. Smart technology creators and probably more importantly, smart technology users, will be predominate in this all equity portfolio.

Each of the four Timespan Portfolios can be managed aggressively or conservatively as long as it stays focus on its designated timespan.

Overconfidence

Overconfidence is a risk that can grow exponentially the longer the period when doubt is appropriate. Or, as Berkshire-Hathaway^* CEO Warren Buffett said, until everyone else recognizes the nakedness of those skinny dipping or in the next parade of dignitaries when the king is marching naked.

My Grandfather who spent his working life running a successful carriage trade brokerage firm used to warn his grandchildren to stop being so certain. This was a difficult message for me and I believe the others to digest. After all, we had just learned a particular “fact” or relationship. Therefore, we were certain about something and our Grandfather just was not hip enough to get it. Only with age did I get to understand and appreciate his wisdom. When I see or hear the various media pundits or others selling their wares with 100% positive statements my risk avoidance mechanisms kick into my judgment apparatus.

Where are we today? Liz Ann Sonders of Charles Schwab^* quotes the late, great, an old friend and consulting and data client, Sir John Templeton saying that “bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” She thinks we are now in the third phase. Other sentiment indicators are in agreement with positive ratings of 50-70%. She is probably right, but my Grandfather’s caution comes to mind when I see the only Dow Jones stock price index that is up for this short year is the utility index. This is a continuation of the superior performance achieved in 2014. The only nagging problem is that utilities at least three times before enjoyed good performance on the basis of expanding price/earnings ratios which preceded a general market decline. I remember that from a portfolio construction standpoint utility stocks were generally used as bond substitutes.  Long-term treasuries were the best single large asset class in 2014 and so it is understandable about utilities performance. While I hope Liz Ann is correct, I am not retreating from my belief that if enthusiasm boils up we can see both a 20% gain and 20% loss from current levels based on past history.

^*Held by me personally or by the private finance services fund I manage

Volatility

Volatility, either as the price of the VIX or standard deviation, is not a measure of the potential loss of capital. They are useful descriptors of price movement. The fundamental problem is that they don’t explain price movements. In a prior post I warned about the tyranny of the single last trade of the year.  I find it somewhat ironic that traders from at least two major banks have had their bonus expectations cut by about 10% due to the market performance in the last two weeks of 2014. The reason this is ironic is that most traders believe they can make money out of volatile prices. That is if their bosses permit them to trade the market. A substantial portion of many trading desk’s profits do not come from executed trades but “marks to market” of the securities in their inventory. A number of financial institutions want to be early in their public reporting cycle; thus they are, in effect, restrained from trading at the end of the calendar year. Keen market observers noted that in the last half hour of the last day there was still some insistent sellers, probably for tax or statement purposes and little in the way of buyers, so in a 30 minute period market prices declined enough to make December a slightly losing month as compared to a probable winning month.

The reason for dwelling on the short-term price movement is that too many investors will interpret the fall in December and now the newly crowned peak of the market at the close of December 18^th  as having lasting meaning rather than understanding it as an imbalance of buyers and sellers in the last half hour

Question of the week:

Are we entering a new market phase?

__________    

Did you miss my blog last week?  Click here to read.

Comment or email me a question to MikeLipper@Gmail.com .

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2015

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.