Sunday, April 2, 2017

Reading What is There and What Isn’t


We are all information junkies. I am always questioning trying to find out what might be important. Thus I am absorbing both hard and soft data in my investment diet. I never know what can turn out to be a good source of facts, knowledge, or perspective; for instance my dentist, who is something of a data hound about his practice. While I was a captive in his chair and being a bit upset he was not streaming the daily programs from Bloomberg TV as usual, we were instead discussing the importance of data. He then gave me a bit of insight. On the cover of his data notebook there was  the following quotation:

“Everything that can be counted does not necessarily count; and everything that counts cannot necessarily be counted.” -Albert Einstein

Not only did this make sense but I am a bit addicted to Dr. Einstein as a great mathematical physicist. My wife Ruth and I have stayed in the rooms that were used by the good doctor at the Athenaeum, the faculty club at Caltech where he visited regularly. In thinking about what Albert Einstein contributed it occurred to me it was not new data that he discovered, and not only to recognize the meaning of what was known, but also what was not captured in the data. He identified what was missing.

If only the pundits who were wrong about the outcome of both the BREXIT referendum and the last US election knew how to look at the data that was and wasn’t, they wouldn't have been so embarrassingly wrong.

I am going to review a set of investment inputs which cross my desktop screen to seek to extract both their meaning and what is missing.


To my mind there is no more important topic for long-term investors to track than China. Many believe that it is only a matter of time before China will become the largest economy in the world and all that occurrence implies. We would be badly misled if we applied the lessons from our own history to China. First, we come from political cultures where our leaders for the most part were trained in law, military, or farming. Most of the current leadership in China spent time learning engineering. As part of that experience they were indoctrinated into rigorous planning as a dominant discipline. While there may be periodic disruptions there, their life is much more orderly than is what is experienced in the developed economies. 

When Premier Li, states that there will not be a hard landing as their economy shifts to fulfilling internal demand for goods and services from being export driven, I am reasonably confident that the record, as published, will show that the Premier was correct. His was not an idle boast. The Chinese political school attempts to study every conceivable possibility. They want to be good generals that are never surprised (or defeated) like Julius Caesar who claimed a great victory in what is today's France and then spent the next three days burying his dead. Also as Steve  Roach from Yale University has written from his long experience in China, the leaders know that shifts in global leadership are gradual not abrupt. Their planning doctrine allows them to be patient as long as they are making progress every day.

In the real world not everything goes as planned. For instance the public traded price of Huishan Dairy  dropped 85% in one day. From what I have been reading, many successful entrepreneurs are involved with many different activities. These men and women, are often highly leveraged, possibly with bank loans from friendly local/regional banks which they have significant stock positions.

What was not there? First disclosure, in this case the entrepreneur was missing for at least one day. Second, there was no market mechanism to slow or halt the decline, (nothing exists in China and other places like the old US specialists on the floor of the New York Stock Exchange) or in this case similar to other markets after a ten or fifteen percent drop, trading is suspended. Third, there is no equivalent to the Glass Steagall and similar Acts to avoid commercial interests affecting loans and stock purchases of banks. I suspect in a still planned central economy we will see these holes filled. Nevertheless, Western investors need to recognize the practical differences between their home markets and the newer markets in China. (This is why my accounts prefer to use mutual funds that are managed by specialists who have been trained locally.)

While in the US we are still waiting on the surge in infrastructure spending to repair our railroads, roads, bridges, tunnels, and airports, China is well ahead in its construction phase. What is quite different is that in their drive for the "One Belt, One Road" strategy they see it as a way to export their overcapacity in steel and related industries. They want to do this for trading purposes and bringing other nations and markets closer to them. Perhaps more importantly it would somewhat lessen the reduction in heavy industry jobs. I also believe like with the Eisenhower Interstate Highway system in the US, the "one road" program would aid the shifting of military people and goods where needed quickly both internally and to the borders.  All of this is dependent upon detailed planning and a high level of engineering.

United States

Applying Dr. Einstein's approach to two US focused factoids may give us some pause for thought:

Credit Suisse notes that the number of publicly traded stocks in the US has dropped in half from 1996 to the present, 7300 to 3600. (I think that is an over-simplification and could be those stocks just listed on the exchange; nevertheless there is not doubt that the number of public companies has declined.) Whatever the actual number except in industries where there is significant capital risk (technology and consumer demand for fashions) entrepreneurs are preferring to stay private until they receive an appropriate bid for the company. I know that was my idea. Not only are investors disadvantaged by this trend, it is quite possibly the economy will suffer also, as private companies with less debt will tend to be smaller in terms of revenues and job creation. The current Administration wants to reduce regulation to address this problem. I suggest they also need to focus on death taxes on private companies. There have been too many family farms and businesses that had to be sold to pay death taxes. This was a concern for me.

Combined with the reduction of the number of publicly traded companies there has been a twenty-fold growth in the number of CFA® Charterholders (Chartered Financial Analysts) which did not serve as a barrier to entry that some may have wished. If the number of eligible securities is down and the number of analysts is rising, the odds of analysts discovering new worthwhile investments is declining.

One of the results of the difficulty of finding a lot of new worthwhile investments is the growth in popularity of Exchange Traded Funds and Products. Some analysts, portfolio managers, and security salespeople have gravitated to ETFs and ETPs.

The theory behind this was that the markets move in broad trends and the prices of ETFs would mirror the performance of the underlying stocks. Increasingly this is not exactly the case. Starting with July 8th 2016, my birthday and the birthday of the Dow Jones Industrial Average, the yield on the 30 year US Treasury went up 48%.  An ETF that was meant to mirror  the move in the 30 year Treasuries was up only 43%. The 5% difference was attributed to fees, interest expense, volatile derivatives, and a shorter bond life. Admittedly this is an extreme occurrence.  If there is an increase in volatility, as expected by some, it may be difficult for the ETF managers to exactly mirror the index they are meant to be tracking closely. All of life is cyclical. At times market prices will track very closely to the center of their universe and this is called concentration. At other times the target universe experiences more diversity. I think we have entered such a phase and we will see an increase that various passive products are not tracking  the performance of their universe because they don't own enough of the winners and too many of the relative losers.

Question: What are sensible investors missing?

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