Sunday, July 23, 2017

Emotional Preparations for the Next Markets Using Top/Down and Bottom/Up Thinking


To some degree we are similar to a group like teenagers enjoying our first kiss. This communication skill has set us up to be exposed to other kisses. Turning to our social, political, and investment lives we are regularly being planted with kisses. Unfortunately those kisses are from those who wish us to part with our approval, votes and money. As they besiege us with kisses as translated from their sales training exercises “Keeping It Simple Stupid” (KISS).

I am particularly turned off by oversimplified presentations or sound bites by various sales types, be they be politicians, salespeople, and especially client portfolio managers and other types from wealth management organizations. It is normally a mistake to interrupt them as they have to go back to their opening line and repeat their pitch. Don’t ask too many detailed questions. By the time one gets to the third level of questions or cross examinations they are out of their depths. The good ones will stop there and change the subject to more familiar topics. The others will guess which “solutions” can be amusing but have little lasting value. Nevertheless, these presenters do have worthwhile value. They are excellent at summarization and generating memorable quotes.

Before I select a mutual fund for my clients I need to spend time with the fund's primary portfolio manager. I ask lots of questions, some they may have not addressed before. The purpose of the exercise is to assure me that the portfolio manager, perhaps aided by analysts, knows more than I do and has some different views than I do. I buy funds when it is clear to me that they bring materially added value. Often these portfolio managers are not as memorable or glib compared with their professional presenters. I still remember spending close to two hours with a well performing fund manager peppering him with lots of questions. At the end of the time allotted I looked at my list of questions and did not have any answers to my questions. What was clear: I did not understand him well enough other than to appreciate his good record. Subsequently when as all good managers do, he had some less than stellar performance, he left the large fund group with a couple of accounts as it became clear that the group was only interested in good performance not the reasons for it. It took many years for me to return to this particular shop. On return the new group of portfolio managers were good communicators of their bottoms up  analysis.

The Necessary Three Inputs

One of the better market analysts that I know is asking his clients to be emotionally ready and to be prepared to act in the future when the markets become much more cyclical with major changes of direction.

In order to prepare for these changes I believe a good investor will need three inputs. The first is understanding the “big picture” scenarios of the top/downers. The second are the contrary indications from the bottom/uppers. The third is an individual risk management levels for different components of one’s entire investment and career portfolio. In this stew one will need to be judicious in what one eats and when, without the tempting need to consume all that is “on offer.”

Top/Down Stock Market Views

Charles Schwab’s team is expecting a pull back from current levels. This is overdue in that the S&P500 has not had a 5% decline in over a year. The only strategy in using elements in the “500” to decline in the second quarter was the S&P500 High Beta sub index. It was the second highest performer in the twelve months through June which clearly demonstrates the rotational or cyclical nature of the market. The level of enthusiasm does not yet fulfill a prerequisite for a major top; the American Association of Individual Investors' (AAII) consensus in its weekly survey had a bullish jump to 35.5% from 28.2% the prior week and a bearish count of 25.8% from 29.6%. Clearly most participants have a neutral view. This and other sentiment indicators are worth watching at least as coincident measures and when they go to extremes as contradictory signals.

Bottom Up Inputs

Contrary to popular views of many of the various pundits, mutual funds are beating “the market.” Each week my old firm, now known as Lipper Inc., an affiliate of Thomson Reuters, tracks fund performances of mutual funds around the world. For investors in SEC registered funds, it divides its list into various investment objectives. In the latest week it is tracking 69 equity oriented fund objectives. For the year to date period ending Thursday the average performance in each equity oriented fund investment objective was better than the performance of the average S&P500 fund in 39 investment objectives or 56% of the universe.

In the US Diversified Equity (USDE) group there were five better performing objectives, four were growth funds of various market capitalization levels. There were 9 sector objective winners, in addition  25  of out 26 world equity fund objectives were also winners.

The latter is not surprising as fund investors and their advisors have been buying non domestic funds for over a year while their older and more long-term fund holders were completing their USDE voyages to meet educational, retirement and estate needs. What is interesting and historically surprising is in the same year to date period there are 27 fixed income investment objectives with fluctuating net asset values. Every one of these averages were positive. One of these, the Emerging Market Local Currency average (with a gain of 11.45%) did barely beat out the S&P500 gain of 11.39%.  Often when stocks go up, bond and other fixed income securities decline in price.

An Important Breakout Despite Clues of a So-Called “Likely” Pullback

Some of the leading technical market analysts are pointing to the fact that both the S&P500 and the NASDAQ Composite have twice broken out on the upside with gaps. These are usually filled in before there is an extended move. This is underpinning to the belief that a pull back is likely.

A reversal to the reversal may be imminent. In the backing and filling of the NASDAQ composite index, NASDAQ created a classic “head and shoulders” reversal pattern which often presages a reversal of the former pattern, which was rising. However, instead of declining, the index is rising - if it continues for a little bit more it could create a reversal to the prior reversal pattern and predict an important breakout for the NASDAQ. This is of great interest to small cap and technology investors and could stimulate even greater enthusiasm for their holdings.

The level of naivety expressed by much of the various talking heads about the changes in US regulations and taxes is a bit breathtaking. If Congress is instituting the changes it is likely that the bill will be hundreds of pages long. If that is not daunting enough, the number of pages of specifics including contradictions will be a multiple of the legislative documents. For instance the controversial and badly drafted Dodd Frank Act (DFA) was 848 pages and the subsequent regulations totaled 22,000 or a ratio of 25 pages of regulations for each page that was finally passed into law. Remember currently the bulk of the employees that will administer these regulations are not sympathetic to the current US Administration. Further, when the new laws and regulations come before the Supreme Court or possibly the lower courts, they will review the testimony given to the relevant Congressional committees.

Thus, when and if we get a major piece of “tax reform” enacted, my fear is that the amount of taxes that my clients and I will pay will go up not down as the reductions of deductions and permissible expenses will cancel out any tax rate reductions.

Emotional Preparations

First I accept that I will not perfectly predict the peak or the beginnings of a major decline. Hopefully I won’t be too premature or too late. My primary defense mechanism is my TIMESPAN L Portfolio® philosophy where I can expect to be able to be defensive in certain parts of our holdings and are willing to continue to hold other parts having our large gains converted into significant unrealized losses. One can accept these unhappy results if there is sufficient capital (largely cash) in the operating component. Without scaring them too much, I try to get clients to do the same. I accept a certain amount of substantial career risk and position myself to be able to pick up bargains during the chaos.
Question of the week: How are you emotionally preparing for future economic and market declines?  They will certainly occur, perhaps sooner than expected.

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A. Michael Lipper, CFA
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