Sunday, September 24, 2017

Cyclical and Secular Concerns Vary with Time Horizons - Weekly Blog # 490


“Horses for Course” is a racing expression which indicates that horses run differently at different racetracks. Not only different courses but different lengths of race. As is often the case, what is true in the analysis (or handicapping) at the track is also true in the selection of managers, securities, and investment strategies. These concepts were the genesis of my developing different timespans to be used for managing investment portfolios.

In the first two timespans, Operating and Replenishment, significant financial losses are difficult to overcome and thus cyclical considerations dominate. The longer term Endowment and Legacy portfolios assume periodic declines, but that long-term secular trends will dictate their future performance.

As we appear to be entering a period of switching gears from complacency or frozen in place, to one of growing enthusiasm, the prudent investor should increasingly wonder what could go wrong. Of the myriad of possible future events it is unlikely that one can accurately predict what will happen. At the current time I feel an obligation to point out possible unanticipated problems.

I will first focus on possible cyclical problems that can impact investment performance through an intermediary period of roughly five years and thus cyclical factors. In the second part of today’s blog I will focus on Asian, African, and Latin American factors that could impact the longer term secular trends.

Cyclical Factors for the Intermediate Term

As Professor Robert Shiller points out, almost everyone acknowledges that a recession will happen. He further states at the moment that not too many investors are concerned about a future recession. The popular securities indices are regularly reporting new high levels. However, the best performing of the three indices, Dow Jones Industrial Average (DJIA), Standard & Poor’s 500 (S&P500) and the NASDAQ Composite (NASDAQ) is the last one by a considerable margin, as small companies particularly those involved with information technology including Apple* performed well. While the NASDAQ is slightly reporting new highs, it is not demonstrating a major breakout after hitting a new high and thus it may be questioning the strength of the move. This is not particularly upsetting because as in the past, Apple shares sell off after new product announcement run ups. As a long-term owner of these shares I am much more focused to see the level of sales and deliveries in its fiscal second quarter ending in March 2018. While some market rotation is healthy if it does not include a strong NASDAQ performance, it would be demonstrating the “animal spirits” are getting tired.
*Held personally

Market leadership rotation is normal and expected, but when one or more of five sectors or asset classes lead, it will be an indication that investors are deserting the central forces of the economy. If you possess trading skills the five sectors could be very productive. If you are like the most of us who move in and out late, be very careful. The five in alphabetical order are Bonds, Commodities, Energy, Gold, and TIPS. If you are an accomplished player, play. If not it would be time to build reserves, particularly if you are managing a current or replenishment account.

As mentioned last week the gains in earnings being reported for the first half of 2017 are due to expanding profit margins. Earnings per share are growing faster than revenues which are growing slowly and in some cases very slowly in the second quarter. To create sustainable earnings and employment we need to see revenue generation pick up.

The potential expansion in the level of enthusiasm for stocks may be heralded by the decline in neutral sentiment in the latest AAII survey, dropping from 36.7% last week to 32.7% this week, and a roughly similar increase in bearish attitudes. This suggests to me we can see an important increase in volume which in and itself engenders more volatility.

My real concern for the intermediate future centers around the bond market which is larger than the stock market but can be much more sensitive to short-term events. I don’t know what can create a bond market bear market, but the following are thoughts that needs to be understood:

·       The little understood bank for central banks, the Bank for International Settlements, has noted that many governments, including the US, are only identifying contingent liabilities in their financial statements. These include unfounded pension and medical costs. One potential concern of mine is a large size of unprofitable investments by China in building its One Belt One Road Initiative (OBORI) in neighboring and other Asian countries.

·       Yields on high grade corporate bonds are rising which means prices are falling slightly, showing some lack of demand. At the same time yields on lesser quality bonds are holding up, showing an increase in demand.

·       Just as yields go in the opposite direction, the contrarian in me suggests that flows follow performance late and stay too long. In almost every country that has a mutual fund business there is an increase of substantial size in the flow into bonds. They are easy to sell to people in view of the low manipulated rates dictated by central banks that impact commercial banks’ deposit rates. This excessive flow is augmented by the large number of financial groups offering new credit funds without sufficient experience in non-bank lending.

In sum, I grow increasingly wary in crowded markets.

For the intermediate term investor I see more performance/career risk than we have seen in sometime. Perhaps, we will escape but by the next US Presidential Election the odds are that we are going to be tested.

Secular Concerns for Longer Term Investing

For only long-term investors to consider in their third (Endowment Timespan) and their fourth (Legacy Timespan) portfolios are some surprising inputs from a two day visit to Mumbai, India. To fulfill two speaking engagements at a very busy time of year, my wife and I flew into Mumbai Thursday night and left on a redeye Saturday night. The purpose of the two speeches was to have discussions with Indian mutual fund CEOs, portfolio managers, independent investment advisors and distributors of funds. There are forty fund houses with thirty four reporting their net asset value in the paper. I made the point that they have only penetrated 3% of the households where in the US the penetration is over 40%. In addition to focusing on mutual funds, I had hoped to find some good long-term investments for our family accounts. I knew it to be a long shot in that the Indian stock market for the year to date is the best performing large country market. I was impressed with the quality of the Indian professionals that inhabit their market and compete with a relatively small number of foreign funds that are devoted to investing in India.

As with many adventures and experiments, there are surprises generating from some disappointments in the initial objectives. On Saturdays there are two major financial newspapers published in India, (The Economic Times and Financial Express) which have articles of interest that could impact future investing in India, China, Africa, Latin America and other Emerging Markets.

The following are briefs from the points of views expressed without any additional research or separate opinion from this traveler:

“Africa Sees India as Key Growth Partner” is the title to an article that contrasts with the way India is viewed as compared with China as a source of development spending. According to the article "Recent media reports have carried allegations that Chinese business houses are treating African workers as slaves...." India on the other hand is viewed as a collaborator with the locals. The article mentions an Indian-Japan-Asia-African Growth corridor as an alternative to China's One Belt One-Road Initiative (OBORI). Apparently the Chinese focus is natural resource development for export principally to China. The Indian-Japanese-Asian effort focuses on rural development and agriculture, energy, and  education. In addition they are interested in quality of life issues and within the region, connectivity. This is similar to the development practices that are found also in Latin America. (India itself is beginning a campaign to improve the lot of its farmers through the application of technology along with capital.)

The Indian Post Payments Bank next year expects to equip a large portion of its postmen with equipment including biometric readers, a debit and credit card reader, plus a printer. Thus home dwellers will be able to quickly and safely pay various bills.

"Chinese Government Plays Cupid to Help Youth Get Married" is an article about 100 million young people in China that are not married. The government is sponsoring a blind date service. It specifically suggests that marriage will aid in future development.

SBI Life this week had an IPO and produced two interesting details, for this the largest life insurer in India. The first is the offering was oversubscribed by a 3.58 times ratio led by institutional buyers. What was of interest to me is that High Net Worth Investors only utilized 70% of the allocation available to them and retail investors used just 85%.  From my standpoint the most interesting numbers were that in 2016 the Indian Life Insurance industry penetration was 2.7% and this compares with 7.4% for Korea, 5.5%  in Singapore, and 3.7% in Thailand.

Can you imagine what more I could discover if I spent another week, month, or years in India? Seriously, my very brief visit highlighted to me that investors should not isolate the impact of single nations in making decisions. China, India, Africa, and Latin America as well as the rest of the Emerging Counties are linked in many ways that need to be understood for successful long term investing. 
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Sunday, September 17, 2017

Three Concerns: EPS/Golden Calf, the Next Dip, Indexing is Faulting - Weekly Blog Post # 489


Most individual and institutional investors are in essence outer directed. Either consciously or not they follow what others do and have a fundamental belief in “smart money.” For extended periods of time this philosophy has worked. Perhaps, it was my brother’s experience in the US Marine Corps Reconnaissance as the leading point for wartime patrols to avoid walking into an ambush. Or my experiences at the racetrack where betting favorites won only about one-third of the time. I look for instances where the “crowd” is wrong. Not to be just a contrarian, but looking at the profit opportunities when the generally unexpected occurs. Some of these opportunities are just plain random, others can be perceived ahead of time. Each of this week’s concerns has some evidence backing up the views as to future changes. Whether you agree or disagree let me know.

Is EPS our Golden Calf?

Throughout my investment career I have heard earnings, actually reported earnings per share, drives the market. In the 1960s I was told all one needed to know was the growth rate of earnings to determine the appropriate price/earnings ratio. Recently I heard a very well known and respected Portfolio Manager explain in a long cable news interview that “earnings drive the market.” The first thing he said about each of his five buy recommendations was their earnings per share. The analyst in me rebels at this kind of over simplification.

In a period where much of senior managements’ compensation is based on in order, EPS, sales, and market price - do you think that they attempt to show the best possible record? I don’t want to proclaim that they are totally manipulated or are the equivalent of “fake news” but it makes you wonder whether it is a true reflection of the value and future potential of the company. One of the first lessons from my Professor David Dodd, who wrote the five editions of Securities Analysis with Ben Graham, was to reconstruct the financial statements of the company under study. We laboriously went through each line in the income statement and balance sheet adjusting for removal of non-recurring elements and questioned the accounting techniques that produced each item. We were quickly taught that in various cases the results in the press release or Management’s letter did not give a totally accurate picture.

When professionals discuss the valuation of various Merger & Acquisition deals today, comparing them to others, the metric that they use is EBITDA. This stands for Earnings before Interest (net), Taxes (paid or accrued), Depreciation (based on what schedule), and Amortization (what were the write offs?). The drive here is to understand what was the operating earnings of the company. Net Interest is the result of the financial condition  and policies of the company and might not be followed by a new owner. One of the simplest techniques that I learned at a trust bank was to put all the steel companies held in trust accounts on the same tax rate. This deprived some of the companies of their tax management skills, which were often transitory, but would be different under different ownership.

Depreciation charged is a function of the weighted ages of the plant and equipment with no adjustment for critical future expenditures. Amortization could be an orderly way to recognize the deteriorating value of intellectual property purchased and/or other write downs. To some degree I think all of these items plus debt service obligations are more important than reported earnings and so do the “M&A” troops.

Notice that a good portion of some companies “earnings improvement” comes from profit margin expansion. What this really means is that reported earnings are growing faster than sales. This is favorable when the company is increasingly earning more over its fixed cost base. However, it may mean that it is not spending enough on plant and equipment and/or research and development. These considerations are important in an increasingly competing world of relatively slow growth.

In history, when the ancient people felt that the Golden Calf  did not answer their needs, not only did they destroy the statue, there was a period of turmoil and violence until new, and in some cases, better beliefs were established.

The Dangers of Buying the Next Dip

This past week there was an extremely sharp jump in the portion of the American Association of Individual Investors views on the market. In one week 41% are bullish, a gain of 12 percentage point from the week before with a concomitant decline in bearish beliefs and neutral holding about even. Both the Dow Jones Industrial Average and the S&P 500 went to new highs, not immediately echoed by the NASDAQ Composite. It is quite possible that the two senior averages need to catch up with the NASDAQ. The year to date performance shows the performance gaps, DJIA +12.68%, S&P500 +16.88% and NASDAQ + 22.96%.

Could this be the key missing element to a race to the top? While a number of highly respected market analysts expect a minor pull back, as there are a few price gaps that should be filled in before a major new top is reached. This could be accomplished by a 5 to10% correction. The Goldman Sachs* view is that there won’t be a dip as too many people are expecting it. (Remember the humility production function of the market.) This focus on sentiment over financials is a concern of Professor Robert Shiller as expressed in The Sunday New York Times when he refers to John Maynard Keynes’ belief that market participants were not making their own investment decisions, but were guessing what others were doing, in other words, trying to follow “smart money.”
*Held in the private financial services fund I manage

My concern is that this trading attitude may actually succeed. The risk is that the successful traders and later their acolytes will have faith that it is a repeatable result, and they are truly skilled. My concern is that when the next “Big One” occurs it will be quite different than managing through normal drops and even minor corrections. The difference is the size of the trading capital in the marketplace having to provide liquidity to non-price sensitive ETFs and margin-called players. There is little to no capital on the floor of the exchanges. Dealers have capital constraints and banks are limited by various regulations in a global marketplace connected in less than nano-seconds.

I don’t worry about trading losses, they come within the territory of investing. What I do worry about is the potential of future revulsions to investing and a generation that will decide “never again.” This will be tragic for themselves and their families. But also the rest of us taxpayers who are likely going to have to pick up some of their missing retirement capital.

More Evidence Indexing is Faulting

You have to excuse me for looking at the world with lenses that start with mutual funds which I have been following for more than fifty years.
Each week I look at the funds’ performance for varying time periods. For the week ending last Thursday I saw an interesting pattern evolving. My old firm, now part of Thomson Reuters, tracks close to 100 different fund peer groups. The largest equity group is the $ 1.2 Trillion S&P 500 Index funds. I compared its results for three periods and counted the number of peer groups that beat the large Index funds as shown below:

Type of Fund
# of Fund Types Surpassing Index Funds

52 Weeks
5 Years
US Diversified funds
Sector funds

There were four fund types that beat the index in all three periods, 2 diversified and two sector fund types. The key point is more active managers are beating the Index. It is not because they switched from dumb pills to smart pills. It is due to greater variability of performance within the 500. Mathematically this splitting is called less correlation and greater dispersion. Within the Index there are some big winners and a few big losers which is meat to active managers, and in theory to long/short managers (hedge funds and the like).
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Sunday, September 10, 2017

7 Steps to the “Big One” - Weekly Blog # 488


One of the signs of a truly expert professional is the recognition that he/she could be wrong. This question should come up to those of us that have to develop a view on a series of futures. We should recognize that the only consistent product of following the swings in the market is humility. Actually I learned this first at the New York racetracks where it became obvious one could not pick the winner of every race and it was rare to be right even half the time. I learned that the real object of betting is to come away a net winner. Thus by proper picking, which we call analysis, and prudent handling of money, one could accomplish the goal by cashing winning tickets one-third of the time. Actually there are much bigger winnings to be had. The bigger winnings in the future come from examining one’s losing bets. Over time it becomes clear that there are a limited number of patterns to the losses which drive the analytical imperative to see whether repeated losses stem from a faulty system of analysis.

With that series of doubts in mind I am now rethinking my assurance in last week’s blog that any forthcoming market decline will be one of normal proportions and not the “Big One.” Because we think in numerical terms, a normal decline is between 10% and 25% and the “Big One” is more likely to be 50% or more and come around once within a generation.

Modeling “The Big One”

In last week’s blog I listed seven characteristics that described the lead up to one of the most famous market collapses, “The South Sea Bubble.” Summarizing the seven steps as follows:

  • Displacement
  • Credit and Monetary Expansion
  • Overtrading
  • Financial Distress
  • Fraud/ Malfeasance
  • Widespread Mistrust and Revulsion
  • Panic Selling
Looking at the current stock markets around the world with particular emphasis on the US, I only saw elements of the first two steps to a South Sea kind of collapse. This is particularly true with the lack of enthusiasm for most US stocks and equity funds. Even with Byron Wien and Bill McNabb, the retiring CEO of Vanguard lengthening the earnings forecast period to pull down the market price/earnings ratio to more attractive levels, most investors are using shorter time periods. (When I came into the professionals’ markets in the 1960s and early 1970s it was not unusual to be quoted five forward year P/Es.) Without this stimulus there is no need to fear a major decline and periodic declines will be of normal size. During normal declines, most high-quality long-term portfolios should be maintained in place. 

However harking back to my education at the track, maybe I am missing some other patterns which could lead to different conclusions. Perhaps I should be looking at what is happening in the bond market. This won’t be easy for me. In a study of single portfolio manager Balance funds it became clear to me that, with rare exceptions, the managers that performed well did so with only a portion of their portfolios. They were either good at stocks or bonds. This finding suggests that stock and bond mavens speak in different languages and don’t communicate well to the other side. (I am experienced as a stock fund and individual stock picker and rarely voluntarily use individual bonds.)

Are Bond Prices Peaking?

For more than a year the most favored type of mutual funds have been bond funds, with Intermediate Maturity Corporate Bond funds alone receiving $ 93 Billion on a year to date basis. This flow could well be the missing level of enthusiasm on the road to the South Sea list. This could also be moderating this past week. According to my old firm, this last week was the first week in thirty seven when there were net outflows in High Grade Corporate Bond funds. Corporate treasurers and investment bankers are counting on this demand, as 2017 expectations is for issuance to top $ 1 Trillion. If accomplished it would fulfill the second item on the list of expansion of credit. With a reasonable outlook that the US and other national governments will be running deficits this year, there will be an additional monetary expansion.

Perhaps the most intriguing element on the march to the South Sea is displacement. On the equity side I counted on the internet filling that role. With my eyes now focused on the debt markets I see a much more structural set of changes which are not obvious to most investors, individual or professionals. The first and biggest change is the role of collateral for speculative loans.

Years ago the brokerage industry could make a reasonable profit through simply charging commissions. It has been many years since equity agency brokerage business was profitable. A number of different financial products replaced traditional stock brokerage business by the larger firms. By far the biggest was the margin loan business where a brokerage house extended credit to an investor at a relatively attractive interest rate. In turn the brokerage firm borrowed money from a bank against the collateral that the borrower put up. With the decline in retail interest in trading stocks this source of revenues shrank. However, it has been replaced by supplying credit to various trading entities; e.g., Hedge funds. The most favored collateral for these loans is US Treasuries. The demand for treasuries is so high that the current yields average 1.77% and according to Eaton Vance their average performance on a year to date basis is 3.15%, which is materially better than similar performance for US agencies (a gain of 2.56%). In theory, the full faith and credit of the US Treasury is a bit better than those of US Agencies therefore the yields should be lower for the treasuries and generate slightly better performance. Thus one can believe that the treasury market is experiencing some displacement.

I suspect globally one form of displacement is in the nature of the collateral that is borrowed against. Moody’s* has noted that its Base Metals Price Index has gained 29% this year. It suggests that these gains may be due to an increased level of speculation rather than surge in user demand. Copper has risen 50% in this period. I believe that one has seen the top of the use of futures on iron ore and copper as collateral by various merchants around the world and particularly in the Far East. By the way there is a slight negative correlation over the last five years between a large basket of commodities and US stocks.
*Held in the private financial services fund I manage

There is still one other displacement element and that is Emerging Market Local Currency bonds and funds. This is the best single type of fixed income fund for the last three years and doing very well this year in part because a number of commodity producers are located in emerging markets. The number one ranking for three years may need to have a warning label attached to it. The single worst performance period to extrapolate into the future for investment purposes is three years. In a period as short as three years often the market is going in one direction. Going back to my race track experience the odds of continuing winning after three years is remote.

Two Possible Signs of a Bond Top

This week the iShares 20+ Years Treasury Bond ETF had a year-to-date gain of 10%, that is unlikely to continue. The 10 year US Treasury yield hit a low of 2.02% closing at 2.06%.  To me these represent unsustainable levels.

My Concerns

I believe a good bit the high quality fixed income trading is on borrowed money from the banks. This is akin to the period immediately before the Lehman crisis. The abrupt liquidation of fixed income collateral spread to credit concerns in the equity market, leading to a stock price decline. While the overall level of leverage in the system is probably less, so is the flexibility of both the majors and the regulators to act.

Please Help

Communicate with me and assure me that I don’t have to worry now.
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A. Michael Lipper, CFA
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Contact author for limited redistribution permission.