Normal or Abnormal Decline Approaching?Weekly Blog # 499

Introduction

Future stock market declines are inevitable unless we modify human behavior. Also, as days follow nights, after the declines there will be future rises. None of these statements are new or profound. The critical questions are, what to do in anticipation and during a decline?

John Vincent messaging through Seeking Alpha, regularly reviews the 13F reports filed by investment management organizations as to their stock holdings. In reviewing a number of independent investment managers with over $1 Billion in their portfolios for the third quarter, I have observed some trends.

First, many managers who have sold recently acquired positions did not report significant profits. Secondly, sales of shares acquired years ago are producing large returns, some on the order of two, three, or four times original cost. Since my investment clients and I are long-term investors, it is the second observation that becomes something of a guide to our management philosophy.

Since few or any managers consistently buy at the bottom (or sell at the top), there will be periods of time that they will likely hold positions at a loss before they eventually sell at a profit. Thus, the critical question is how big a loss is acceptable as a price to earning large profits? A further and more difficult question is, how long does one have to wait to get into a profit condition?

Accurately predicting the future without incorporating a mistake is a fool’s errand. However one can apply both logic and past history as a guide. Stock prices regularly decline for periods of one year or longer, “normally” two to three times over a decade. These corrections may be 10% or more up to so-called “bear markets of 20%+.  Few investors have experienced getting out at or near the top of a “normal” decline and getting back in before prior peaks have been achieved. Thus one is probably better off holding through a cyclical downturn and subsequent recovery.

On the other hand once a generation stock prices decline in the range of 50% or more. We have had bouts of these types of declines in 1973, 1987, and 2007-9. In the last two cases we held through the declines in part because we recognized the potential market risks after the decline had begun. There is a greater risk that the recovery period could be extended. The recovery from the “Great Depression” of the 1930s lasted until the mid 1950s for the average stock and in the case of one of the popular growth stocks, RCA, until the mid 1960s. Thus, there is a real advantage to attempt to sidestep an “abnormal” market decline.

Even if we can determine the odds of a forthcoming decline, particular diligence is required to separate a future “normal” decline when the odds favor holding through the decline and an “abnormal” decline when side stepping would be advantageous. I am considering to attempt the last task. I do this with the hope that my heritage will give me an advantage. The family folklore is that in the late 1920’s my Grandfather persuaded  his clients to pay off their margin loans and go to cash. The family legend is that they did.

Next I am examining the current conditions to separate which of the current trends point to a future “normal” decline and which could be indicating a larger problem. 

Trends that Presage a Decline

No single present trend guarantees a future event and even the aggregate weight of trends do not guarantee a particular result. One of the useful concepts learned at the race track and as an analyst is to assign odds to various factors that could influence the result. Always leave room for “racing luck” or “unknown unknowns” as well as unintended consequences. Nevertheless, reasoned analysis is better than relying exclusively on hope.

Sentiment Overriding Numbers

Utilizing the distinction that S&P* is making between Growth and Value components of the S&P 500, one can see two different stock markets being created. Value stocks are being evaluated on both the basis of their financial statements and the near-term price and volume trends in their business. Using many measures these stocks are being valued within the range of fair value. Their stock price trend is moving up in tandem with an economy that is somewhat errantly expanded. However, the value stocks are moving slowly compared to the growth component.

Led by a little more than a handful of stocks labeled as the FAANG group, Growth stocks are significantly outperforming the aforementioned Value stocks. This is happening globally and particularly in terms of Asian security prices.

One of the reasons that up to the present I felt that the next market decline would be of a “normal” type that we would hold our good stocks through the cycle, is the general lack of enthusiasm for stocks. I have not seen the kinds of enthusiasm I saw in the run up for the Dot Com bubble. Nor did it reach the levels of enthusiasm seen many years earlier in the South Sea Bubble or the Tulip Bulb craze. But the level of enthusiasm for certain stocks and for the market in general is worth watching. Two of the lenses that I look through are the research that Liz Ann Sonders puts out for Charles Schwab & Co.*  and the weekly survey by the American Association of Individual Investors (AAII). This is a very volatile time series. In the latest week only 29.4% of those surveyed are bullish as compared with the prior week when the reading was 45.1%. If, over time, the bullish contingent numbered consistently over 40% and the bearish group is below 30%, I would be nervous short-term, as I view this particular indicator as a contemporaneous measure.

Fixed Income Signals

As has been often pointed out that most of the modern declines in stock prices were preceded by some disruptions in the fixed income markets. We have already seen some price nervousness directed at the High Yield bond  market in spite of no generally expected increase in defaults by the major credit rating agencies. This nervousness has not yet been felt in the intermediate credit market. Barron’s has two bond indices, one labeled Best Grade Bonds which saw its yield rise 5 basis points this last week. The other  measure, for the Intermediate Grade bonds, saw its yield drop by a single basis point. This suggests to me that there is wide scale disenchantment with the credit market this week.

My main worry after the collapse of Lehman Brothers and Bear Stearns is not the price/yield of credit instruments but their availability in a stressed market. Recently I have mentioned that the market for US Treasuries is considered to be the most crowded and is under investigation for price manipulation in the related foreign exchange currency markets. There are some professional press articles raising concerns about liquidity. A liquid market is one where trades can be executed without moving prices. Most high grade markets are extremely liquid almost all the time. The meaning of the last sentence pivots on “almost.” At the final point of their crunch both Bear Stearns and Lehman could not access the repo market to satisfy their desperate need to refinance short-term debt.

I don’t have any independently derived measures of liquidity.  However, I may something of a mirror image of available liquidity looking at major Money Market funds. (Remember when Lehman went down it caused one large Money Market fund to “break the buck” or to be slightly valued below the level of its deposits including interest earnings? They had to suspend redemptions which could have created a “run” on Money Market funds if the government did not step in. Thus, liquidity is very important to Money Market funds.  JP Morgan has four large multi billion dollar funds in the US. These four range in size between $21 Billion and $140 billion. What is perhaps of interest in this matter is that three of the four have between 50% and 64% of their investments maturing in eight days or under. Only their 100% US Treasury Securities Money Market Fund is much more exposed to longer maturities, with only 21% maturing in eight days or less. This difference could be due to a belief that the owners of this fund are less likely to need cash as quickly as the owners of the other funds.

Two of the four funds have more than 50% of their holdings in repurchase agreements, largely with other capital markets providers. (What we do not know is whether JPMorgan is on the other side with the same organizations so their net exposure may well be much less.) The real key to the questions as to the size and nature of short-term liquidity is that it is a matter that is currently being worked on by the major participants - not because they want to for the tiny current interest rates - but because they must to keep the global financial system working.

The Thanksgiving Weekend Visit to the Mall

As many of our long term subscribers to these blogs may know, my wife Ruth and I visit the glitzy Short Hills Mall in New Jersey to frequently do our market/economic research. Due to family commitments, we could not get over to the Mall until Sunday afternoon. The Mall was crowded but not jammed. The high end stores were generally attracting a good crowd, but this was not universally true. While a number of jewelry stores were busy, Tiffany looked sparse as some of the others were almost vacant. Both Verizon and Apple* were doing good to great business, we think. While some couples had a handful of bags, they did not seem to be burdened down. There were a few empty store spaces and ads for sales help were generally lacking. I had the feeling that most merchants were not over-inventoried, as some were in the past. All in all a good but not a great beginning to the shopping season. We don’t yet have a view on the online business and whether shopping habits have shifted.

     

 From an investment viewpoint retail will do okay but won’t be a leader.

*Held personally or in the private financial services fund I manage.

Conclusion

We should be careful with our investing. There are too many moving parts to this puzzle to be dogmatic, but risk levels are probably rising.

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A. Michael Lipper, CFA

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Be Thankful for Risk - Weekly Blog # 498

Introduction

In the northern Hemisphere, this is the season of festivals to celebrate the gathering of a good harvest. In the US, we recognize this tradition as Thanksgiving. World Stock Markets have been quite kind to investors so far this year as seen through the eyes of mutual fund holders using category averages and highlighting some exceptional performance:

US Diversified Equity Funds	+14.34 %
Sector Funds.	+9.76 %
World Equity Funds	+16.73 %
Mixed Assets Funds.	+11.25 %
Domestic Long Term Debt	+3.51 %
World Equity Funds	+7.65 %
LeaderGlobal: Science&Tech	+46.84 %
LeaderPacific: Ex Japan	+38.22 %

Source: Lipper Inc., a Thomson Reuters Company.

If the calendar year ended last Thursday night these results would be above average on a historical basis but shows that investing in Asia and in global science & technology issues has produced extraordinary results.

Performance Always Comes With Risks

Investment history is a tale of gains and loses with hopefully some lessons that can be used in the current time frame. This last week we had an example of very long-term rewards from investing in the auction of Leonardo da Vinci’s painting of Salvator Mundi for $450 million. In the Wall Street Journal, our friend and columnist, Jason Zweig made a good attempt to quantify the painting’s return, from presumably its first sale to this week. By his calculations after an attempt to adjust for inflation using gold as a very rough measure, the annual return since the sixteenth century was an outstanding 1.35%. But even this, by today’s standard low return, was better than cash, gold, and bonds, but not stocks. Another author has calculated the gain after inflation in the equivalent of the S&P500 since 1871 to be 6.9%.

There are two important lessons from this data: 

• First, accepting risk can produce better returns than perceived safer investments. 

• The second that the $450 million price compared to an auction house estimate of $100 million did not appropriately consider that this may be one of only 20 finished works by  the talented artist. Scarcity has a value

This is one of the reasons we favor individual stock selection over sector bets. This has implications for our fund selection process of favoring funds with less than 100 positions and even a few under twenty positions over broad index funds or passive sector funds. To us differences do  matter.

Recently we have been reviewing reports on the 13F filings of a number of well-known investment managers. In an over generalization most seem not to have owned a lot of winners in the third quarter, but continue to own and enjoy good results from positions bought years ago. ⁺

+Email me at Mikelipper@gmail.com  for more info on our Timespan L Portfolios®

Whether we like it or not we are all risk takers anytime we get out of bed or cross a street, let alone make a long-term investment decision. In an over-simplified model any portfolio’s strategy can be summed up as capital preservation or capital appreciation or for most, a ratio of the two. In the above model of comparative returns to the value of Salvator Mundi’s portrait, it is important to note the better performance of the painting over cash, gold, and bonds. To me there is a quotient of risk in all three of the under-performers that has been viewed as “safe.” For example, cash is not protected against inflation, particularly the virulent type that has been seen periodically through history. In addition while most of the time the costs of holding cash on account is small, and with minor custodian risks, both have been known to create anxiety for cash owners. Perhaps the biggest risk in holding cash is a dramatic change in the needed use of the cash to meet needs. If these are true for cash, similar risks may be present in other “safe assets.”

At this time holding US Treasuries could be more risky than generally perceived - based on two bits of news not generally appreciated. The first is analysis by Merrill Lynch echoed by others, that Treasuries are the most crowded trade in the market. This suggests that there is a supply/demand imbalance with some of the participants not exercising price discipline which may explain why the yields on US treasuries are higher than agencies UK, German, and Japanese issues of similar maturity and perceived quality.

The second and perhaps related bit of news is an article headlined from the Financial Times which said “US Treasury dealers accused of collusion.” There are similar, other cases pending. The results of these cases one way or an another could cause disruption to not only the market for US Treasuries, but also to many markets that use treasury prices as benchmarks in setting the prices for other instruments and markets.

Accepting Intelligent Risks Can have Its Rewards

Obviously not every single risk works out for long-term investors, but many do.  The key, particularly for our longer term investment accounts is in careful selection of mutual funds. Two of the matrices that we study are prices and related valuations plus the underlying selectivity as evidenced in the portfolios of mutual funds. Currently we appear to be in a two-tier market with a couple handful of good performers becoming price performance leaders. This not true for a second tier.

One study points out unlike in 2000 the fifty largest companies in the S&P500 were selling at 31 times earnings. Today the fifty largest is selling at 17.9% which is generally in line with historic records. One explanation for the high valuations of some stocks is the Charlie Munger belief adopted by Warren Buffet that it is better to “buy a wonderful company at a fair price than a fair company at a wonderful price.” This philosophy depends on the ability to find wonderful companies at fair prices. In my mind, this is dependent on sound and smart investment analysis. A good investment analysis course could be taught exclusively on the wins and losses in Berkshire Hathaway’s^* history. Recently they have been reducing a large position in IBM which perhaps has not yet developed into a wonderful company and have been buying Apple*, still evolving as a wonderful company. While Berkshire is a very long-term investor in a number of securities, it is price sensitive, currently sitting on $110 Billion in cash and $180 Billion in investments.

*Held either personally or in the private financial services fund I manage.

Conclusion

Accepting the risks of disappointing results from time to time does not diminish the odds in favor of long-term gains. One needs to balance the goals of capital preservation and capital appreciation. The ratio should

probably shift inverse to near-term market performance.

Question of the Week:

If you were forced in terms of your own account how would you divide your portfolio into only two buckets between capital preservation and capital appreciation and is the mix different in your professionally managed accounts?

On To Stock Peak; Mild Danger - Weekly Blog # 497

Introduction

Gift buying is strong selectively in US and China this week. While political leaders emote, speculations in stocks are increasing and fixed income vehicles are displaying fault lines. Current concerns produce hurdles, not walls that can’t be breached. One of the benefits of segmenting portfolios into sub portfolios based on time horizons is to be able to focus on the impacts of various influences. This is the rationale for developing the TIMESPAN L Portfolios^® and how we look at the current picture.

Next Two Years

While most investors swear allegiance to being long-term investors, almost all that they consume in the way of views is what to do right now and that will be judged on the basis of the next month, quarter, current year and next year. They over emphasize whatever near-term payment concerns they have and ignore the impacts on longer term needs. If that is the tune that investors are currently dancing to, I will display what I believe to be relevant to this period’s dance.

In a consumer driven economy one should look at shoppers. At the local high end mall Saturday night it was crowded with people carrying a small number of shopping bags. We got the sense beyond buying, that  shoppers were examining prices, styles, quality, and inventory. At the crowded Apple^* store there were lines of buyers that began in the morning and were still present in the evening. What is on sale for shoppers are items that they could buy either at many stores, or they came to buy in one particular store, online or both - but they came to spend money. There were so many of them at three of the restaurants within the mall that the wait for tables stretched to an hour or beyond. 

In China the wonderfully manufactured Singles Day apparently once again produced record orders for merchandise and services. The purchases broadened out from buying for someone special to the buyer to the buyer herself or himself.

These controlled shopping frenzies were also present in the stock and bond markets. In the US, S&P^* has developed a quality ranking array which is different from its credit ratings. In the credit ranking array the objective is to gauge the odds on timely payment of future payments of principal and interest. Balance sheets and their future projections drive the credit ratings. On the other hand, the quality rankings are based on the income statements and the ability to grow them. In the last month particularly (and also for the latest twelve months) the companies with the low to lowest quality rankings had the stocks that appreciated the most. Obviously these stocks were perceived to have prices that deeply discounted their futures.

* I personally own shares in these stocks

Individual stock investors as measured by surveys of the American Association of Individual Investors (AAII) have a similar view as to the shoppers. In the last two weeks the percentage of those surveyed has dropped their bearish views from 33% to 23%. While this is a very volatile time series on the basis of casual conversations, it seems to be reflective of current thinking.

Equity Fund Leaders

In the week that ended Thursday, the weekly 14 of the top performing 25 performance leaders for the week were the Natural Resource and Energy Commodity funds. Six out of 10 losers for the week were with bank-heavy financial services funds. 

The enforced hotel “guests” in Saudi Arabia are probably a stimuli for the leaders. UBS points out that 70% of the world’s growth in GNP this year was caused by rising commodity prices both in energy and industrial metals. The decline in bank oriented funds could be an over-reaction from a view that materially lower US corporate taxes will be delayed and may be smaller than expected. On both the up and down sides of the week one can see the influence of news/rumor on near-term prices. I maintain the long-term trend of future energy prices were not changed by the Saudi arrests nor have the tax rates for banks changed the long-term generation of earnings and dividends of banks beyond perhaps a one time bump in 2018 or 2019. 

Fixed Income Markets Display Longer Term Concerns

Most often stock market declines are preceded by weakening fixed income markets. We are seeing some concerns being expressed in fixed income prices/yields. High Yield bond prices fell this week. Normally these, in effect, stocks with coupons which is what one wag called junk bonds, fall with the increase in the expected default rate or an actual unexpected default. Moody’s^** who typically has the best, but not a perfect record on expected defaults, is now expecting the stock market to rise because of low and declining expected default rates.

** Owned in a private financial services fund that I manage.

The fall in junk bond prices could be a reaction to the discussed restrictions on the tax deductability of interest charges to 70% of EBITDA, Earnings before interest, depreciation, and amortization.  A large amount of refinancing is expected over the next two years -  particularly by the mid to smaller energy companies that could be placed in jeopardy and possibly bring on defaults. 

Each week I look at the fixed income fund performance data from my old firm, now a part of Thomson Reuters. I have noticed for some time that US Treasury funds have consistently done better than US Government funds that often pay more interest than Treasuries. This has been true for at least five years for longer maturity funds and at least three years for the shorter ones. This must indicate that for some reason Treasuries are more valuable than higher earning agencies. I suggest one reason for this is that US Treasuries are being used as collateral for loans where agency paper is not as readily acceptable. Further I suspect that this collateral is backing loans for dealer and hedge fund securities which include positions in Exchange Traded Funds and Exchange Traded Portfolios. It is significant to point out as to the level of speculation in these markets that Deborah Fuhr  of ETFGI reports that globally this year, listed  funds that leverage have seen their assets grow 14% to $77 billion.

One of my market structure concerns is that financing inventory positions for market makers, authorized participants, hedge funds and brokerage firms is normally done with call-loans. A call-loan can be called with very little, if any, notice. Often when the loans are called the only way to pay it off is to sell some of the easily traded holdings. These are not price sensitive sales but are persistent. As in the past this can be a cause of an internal market panic. I do not rule out a recurrence of such an activity.

Endowment Period Concern

The focus has been first on low productivity of human labor. Next it has turned to capital productivity which is being addressed increasingly by additional leverage. I am now becoming more aware of research and development productivity. In each of the three productivity challenges part of the answer is better selectivity of people, projects, and research targets. All of these are being addressed, but with limited near term success.

Part of the problem is that there are shortages of attractive alternatives. Hiring more, poorly prepared laborers; committing more financial resources to low return ventures; not achieving technological breakthroughs in research; and utilizing the wrong scale for development won’t solve the problem. We need to both make smarter decisions and examine the structural impediments holding back productivity including education, appropriate returns for risk capital, and avoiding unwise intellectual property constraints. Some progress is likely in the very long-term. I just hope it arrives quickly enough to meet the retirement needs for today’s workers and students.

Misallocation of Capital

One of the advantages of focusing on Mutual Funds and ETFs is while they are large contributors of capital to our global society, they are also part of the institutional and individual mind set. For the latest twelve months looking at positive net flows of money coming into mutual funds with aggregate flows into investment categories, there are six each bringing in over $20 Billion. Five out of the six were bond funds which may do relatively little to address the productivity issues raised above. The more additive value to longer term corporate investment are equity funds. Unfortunately in spite of very good investment performance recently they are in heavy net redemptions with Large Cap Growth funds shedding $76 Billion and Large Cap Value funds $49 Billion. These net redemptions are almost actuarial in that they were purchased years ago to meet future needs which are now apparent. In the past redemptions were met by new sales. Currently it is more profitable for the financial community to redirect flows to other products. While some at the retail level is being directed into ETFs the bulk of their flows are from trading establishments that have short-term holding periods and rarely buy new IPOs. Nevertheless ETFs on many days have more net flows than the much larger mutual funds. Over the same twelve months previously mentioned, there were six ETF categories that generated over $20 Billion each. Five went into equities and one into bonds. Their flows are not likely to provide the long term risk capital that is needed for increased productivity of labor, capital and R&D.

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Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.