Sunday, June 11, 2017

"Smart Money" vs. the Weight of Money


One can divide people into two groups: the insecure and those that attempt to manage their insecurities. As we get older we all make physical, psychological, political, and financial mistakes among others. Almost all veteran investors are insecure to some extent about their investments. Because of our insecurities we look for guidelines to avoid making bad mistakes. Unfortunately we often ignore guidelines and signs with which we disagree. Instead, we search for guidelines and signs which we agree.

Smart Money

Due to our investment insecurities we search for and want to follow "Smart Money." Those people that are recognized as being successful as investors have so-called Smart Money in their investments.  One of the reasons in my prior life as a provider of mutual fund performance information that I was frequently quoted in the press was that the media and other pundits wanted to identify winning funds in order to focus on what those funds were doing at the time. Rarely was the discussion about how they were smart. 

As part of my investment management responsibilities for clients, when I interviewed various "winning " portfolio managers and some of their key analysts about both their thought processes and their selections, I was disappointed. All too often their research was shallow and focused only on incremental changes of significance. In many cases their current success was due to market rotation and relative value compared to then-popular securities. Some analysts and portfolio managers were truly perceptive and were deep thinkers. In my search for enlightenment I found a number of very smart investors who were not in the public eye. Often these and some of the portfolio managers of publicly traded funds did mostly their own research and were not reliant on brokerage research. On the other hand, I was unimpressed with those that followed the portfolio changes made by Warren Buffett, Peter Lynch, John Templeton, and John Neff. Their reported activity was sufficiently delayed from the time of transactions and at different than current prices. Further, their purchases typically fit their specific portfolios needs.

One approach to finding smart money is the basis for a good bit of technical market analysis. In a flat or down market a stock price (along with an increase in its volume) goes up, which can be recognized in charts, there is a belief that someone or a group knows something that the rest of the market does not. Therefore, they may be smart money. We will only know when the surge in its stock price ends.

Weight of Money

I was introduced to the importance that some professionals place on "The Weight of Money" many years ago as the leader of a group of analysts on a global trip largely focused on mining investments. When we were in Australia, one evening I got a call from a client of our firm from Tokyo who intently interviewed me as to the reactions of the analysts to various companies. After we talked for quite awhile I asked him why he was so interested about the analysts’ reaction rather than what I learned about the companies. He had a very good global internal research department and probably was the best single client of most institutional brokerage firms. Further, both he and I recognized that while my analyst companions on the trip were more than competent, they were not for the most part "the lead" analyst in the stock.

Our Tokyo-based client explained to me that the change in the amount of buying or selling in a stock could have a disproportionate impact short-term on the price. The weight of money rather than fundamentals could have more impact. As he was a manager with traditionally very high turnover in international markets, his focus on the aggregate views on a stock made sense to me.

The Weight of Money Can Mislead

Often what could properly be described as the weight of money is mistakenly labeled smart money. There were three instances in the last week when the weight of money might have given investors the wrong signal. The first two operate out of the best single investment laboratory that I know in terms of practical analytical skills. Early in the week it was reported that the British bookmakers had an 85% belief that the Prime Minister would get the mandate she wanted. This was foolishly taken as an analytical conclusion. Bookmakers have no particular forecasting skills. What the 85% represented was that 85% of the money wagered on the election saw a significant Tory victory. I suspect that the majority of the money bet came from in or around London and was not geographically dispersed. Bookies made a similar miscall in terms of the BREXIT referendum.

The second misread was the betting on The Belmont, the longest race for three year horses in the US. The beaten favorite came in second with final odds of 5/2. (Which means if the horse wins, the bettor wins $5.00 for every $ 2.00 bet.) The winner paid $5.00 for every $1.00 bet or twice the amount on the favorite and was the second favorite. At the racetrack, the pari-mutuel payoff is similar to the old bookmaker’s calculation of the different level of moneys bet less taxes and track compensation. This is a dollar weighted input. With only a cursory look at the local newspaper’s pre-race article, my intellectual choice was the eventual winner in part because he was more rested than the favorite and there was enough early speed in the race that the favorite and a number of other horses would be slowing down in the home stretch when the leading jockey in New York was giving a brilliant ride on the winner. Favorites don't win often enough to pay for their losses.

The final misread from those who rely on the weight of money argument occurred on Friday which may be an echo of a substantial decline of many years ago. Up to Friday the five following stocks: Facebook, Amazon, Apple*, Microsoft, and Alphabet (Google) represented 41% of all the gains earned by the stocks in the Standard & Poor’s 500 through the end of May. Thus 59% of the gain came a net basis from some 495 other stocks. While these five were not the most heavily owned stocks in the index, they were substantially owned. One study indicated that among large mutual funds, over 80% of them owned at least one of the five. Many probably owned Apple as it is the stock with the largest market capitalization. On Friday these five as well as many tech companies fell more than many other stocks, even though the Dow Jones Industrial Average was up a little bit. It is possible for awhile that the five may give up their performance leadership as part of normal rotation.
*   I have been a long-term holder of Apple shares in a personal account.

Perhaps the five are the modern equivalent of "The Nifty Fifty" which was a group of approximately fifty stocks that out-performed the general stock market from the late 1960s into the peak in 1973. As with the current five, The Nifty Fifty started their ascension coming out of a bottom. Most stocks reached their peak in 1968 but the averages did not top out until 1973-74 period. While there is some disagreement as to which stocks were in the fifty, the criterion was either a JP Morgan list of one decision stocks (only buy, never to sell) or the highest price/earnings ratios. There was a great overlap between the two lists. A number of the companies had very bad investment performances after the peak. Some were merged out and a few filed for bankruptcy. However most survived and a some prospered; e.g., Walmart.
I do not know what the future holds for this year's five leaders. I do know that if a portfolio has only a partial interest in the five, below the commitment in the various indices, it is the equivalent of being short that particular name if the name rises in price relative to the index. Historically, the stocks with the highest price/earnings ratios can fall the most. On an immediate basis Friday's decline closed the remaining price gap which made the best performing index, NASDAQ, vulnerable.

An Important Caution

S&P Global has lowered the credit rating of Massachusetts because it has not been building reserves that were required by the state legislature. This should be viewed as a general warning that eventually there will be a need for these reserves. It may be a number of years away from a significant economic recession with a market decline. I am sure that it will happen, as it always has as a correction from too much leverage in the system. I am not worried about the aforementioned five stocks, as most appear to have large cash reserves. I am concerned about others who often have an increased demand for their services when the general public are having difficulties.  In some cases this could cause partial or total liquidation of their investment portfolios. The time to add to one's fortress is when the sun is shining.

Questions of the Week:

1.  What Smart Money signals are you finding?
2.   Is the weight of money important to you?
3.   Are you building your reserve?
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A. Michael Lipper, CFA
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