Sunday, December 18, 2016

Short and Long-Term Unseen Implications


Being solely a contrarian is insufficient to be a competitive investor. There are instances when the majority is correct. To improve the contrarian's odds the search for seeing elements that others don't is essential.

Since the presidential election there has been a dramatic blast of enthusiasm for US stocks and a disdain for high quality bonds and emerging market securities. While the positive effects of rising interest rates have been present for a number of months, the equity acceleration began almost immediately after the election. One might be accurate in believing that all those who were so wrong about the outcome of the elections at every level were attempting to play catch-up by doubling down their bets. In both cases their views were narrow and lacked fundamental knowledge.

Early Contrarian Training

In the 1960s I was a journeyman electronics analyst. The technology to produce color television had been known since the 1940s if not before, but the projected retail cost for a set was over $1000. My analyst peers focused their time on getting up to date on all the technological advances in components for the set. Unlike them I spent time with the marketing research people of the major set producers. In turn, they were very focused on how middle market consumers were spending their money. By the mid to late 1960s, the portion of consumers’ budget devoted to auto purchases had peaked as the post WWII replacement surge had peaked.  Thus they were ready to buy their first color television at prices over $600, and some up to $1000. That perception allowed me to be early in recommending color set producers and some of their component suppliers before my more technologically-oriented competitors were waiting on new breakthroughs.

There are Two Important Elements the Enthusiasts are Missing

The people that were so wrong about the Republican surge in the election are making the same mistake again. They are taking what Donald Trump has been saying as a concrete plan for his and the party's actions, just as they misread the polls for two generations wanting an outsider to have someone to listen to them. It didn't matter whether they were on the right or the left of the political spectrum. To some extent Mr. Trump's fellow elected Republicans have not fully accepted the implications of the recent elections.

The issues for the Republicans comes down to how they will vote and how will they manage their attempts to "drain the swamp." I believe (somewhat naïvely) that the investment bulls believed explicitly in the words of the candidate and President-elect in terms of both corporate and personal taxes. One needs to remember how tax proposals become laws and regulations. The House Ways & Means committee, after what will be strenuous debate, will eventually report out a bill to the full House where there will be further debate.

Any reductions in the net tax realization of revenues will increase the size of the deficit unless one accepts dynamic scoring that suggests that tax reduction will expand tax revenues through growth. The political problem facing the Administration's desires is in the House where there are a significant number of Republican deficit hawks who probably feel that they can not get re-elected if they vote in favor of an increased deficit. It is quite possible before a tax bill can pass the full house some Democrats will need to be in favor of it. Traditionally this support is purchased with some very specific policies favored by the Democrats which the Administration would have to signal approval. Subsequently the Senate will pass it's own bill setting up a joint congressional committee to work out the differences so that both Houses can approve the legislation. Both houses' majority leaderships will appoint members to the conference committee from both parties. These will likely be their most senior tax aware members. Eventually a compromise bill will be agreed to in the small hours in the morning between as few two members and a small number of their staffs. Due to their exhaustion and some lack of familiarity of the wording of tax regulations, the committee will get help from selected lobbyists from the deepest part of the swamp  will suggest the actual language to be used.

At this point hopefully the majorities in both houses will vote to pass the tax bills on to the President for enactment. For the investment bulls to believe that they can guess both the timing and the actual impact of the legislation on specific corporations and individuals is naïve. 

In many ways the easiest part of the governing process will be the passed legislation. Particularly for the incoming Republican cabinet the much more difficult process will be the actual administration of the ensuing regulations that the multi-generational government workers will write and administer. Just look at how almost every government body is actually managed by career people from "the swamp." Good luck without substantial help from "K Street" lobbyists to guess the actual implications for various taxpayers.

The chattering classes are assuming that by a swipe of the pen the President can in the long run effectively change regulations through executive action. Regulations were initially put into place because of perceived problems; some valid problems will need to be addressed for the protection of certain groups. The tradition in government is that even when totally free market people are put in place they will drift to the bureaucratic tendencies of command and control policies. In all likelihood those that will be actually administering the regulations at the local level will believe in the command and control philosophies.

The Second Misreading

The general rise in stock prices in many markets is being taken as the public' s affirmation of the results of the election. I believe that far too many people are not looking carefully at the underlying data and drawing, at the moment, the wrong conclusions. Most of those that wanted to be labeled "the smart money" were totally convinced that the US would have its first female president. Recognizing that probably meant at best a continuation of slow growth in a market that was close to being fully priced on election eve. They were short the market or  at least a number of stocks. When they woke Wednesday morning these "investors" became traders and quickly attempted to cover their shorts in a relatively thin market at higher prices. Soon thereafter to make up for their losses they went long the stock market and short the bond market.

The faulty analysis of the US stock market, at least in part, was due to the headlines that mutual funds received substantial inflows and therefore would be heavy buyers. As usual people should carefully examine the underlying data. The quoted numbers combined traditional mutual funds with Exchange Traded Funds (ETFs). Utilizing the data from my old firm, one could see that for the month of November traditional US Diversified Equity funds had net redemptions of $+38.6 Billion  up from $+22.3 Billion in October. On the other hand for the same types of equity portfolios,  ETFs had net sales of $+33.2 Billion up from $+11.2 Billion on October. Perhaps, even more significant ETFs investing in specific sectors had net inflows of $+13.4 Billion up from net outflows in October of $-1.3 Billion.  

The significance of these divergent trend is that due to the length of time many traditional mutual fund holders have owned their funds they are approaching a period of their lives that are choosing to either becoming more conceived conservative with their money and/or their need for cash has been rising. Judging by the volatility of ETFs transactions most of the transactions are from trading entities often hedge funds or professional traders. Some of their transactions are part of "pair" trades where they take a position long or short on a specific issue, but also hedge either general market or a sector against their primary choice to reduce general market risk. Thus, the main motivations of the owners of traditional mutual funds and ETFs are in terms of likely timespans of their holdings are different. Mutual fund holders own their shares for more than four years, often for twenty, where as the ETF holder is probably focused on the month's or quarter's performance.

Thus, I do not believe that there is a general affirmation of the policies of the incoming administration at this point.

Short Term Views

It is quite possible that this last week was something of a mild turning point in the market. Each week I look at the mutual fund performance of our clients' fund positions. I compare their quintile rankings versus their perceived peers. In most periods for most funds there is relatively little movement. However, among the many funds we follow, in this week, eleven of our funds (after doing among the best in the four weeks ending December 8th) did relatively poorly in the week ending on the 15th. On the other hand we had four funds that materially beat their four week average. What this pattern suggests is not that there were materially changes in the funds' portfolios, but that the market is questioning the very recent strength.

In a piece on the views of ten well-known investment strategists picking their favored industrial segments, eight picked financials which clearly have been doing well. As a portfolio manager of a private financial services fund, this near unanimity of opinion makes me nervous. Bob Farrell, one of the all time great market analysts was quoted in Barron’s saying, “When all the experts agree, something else is going to happen.”

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