2018 Lessons Should Be Learned - Weekly Blog # 557

Mike Lipper’s Monday Morning Musings

2018 Lessons Should Be Learned

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

                        

            

The biggest benefit from living are the lessons that could have made us healthy, wealthy, and wise. To ourselves and our loved ones the biggest losses are those lessons we could have learned and didn’t. 2018 has been a tumultuous year, but it gave us numerous opportunities to learn to improve the way we think and thus shift the odds of future results favorably.

We should have learned to reduce the use of labeling as a part of decision making, particularly in terms of labeling people with a single identity. This was brought home in 2018 in cheap polling to make political and investment decisions. Think of yourself, how many words would be appropriate to describe you as a person, as a family member, as a voter, or as an investor? We use easily descriptive labels as a short-cut to building the ultimate equation for decision making, without allowing room for contrary modifications imbedded within each level, e.g. child of, native language, health condition, source and quantity of debts and composition of assets, etc. This is not a new phenomenon, William Shakespeare’s plays often spent the first act describing or labeling the main characters and their current condition, only to change readers views by adding humor, pathos, and most of all surprises in later acts. He delivered an unexpected conclusion and a great opportunity to learn about the human condition.

Investment Lessons - Trillion Dollar Mislabel

In 2018 the media crowned Amazon, Apple, and Microsoft as candidates to reach a stock market valuation of $1 Trillion. They all used technology, operated globally, were leaders in sales for some important aspect of their business, and compared with the older industrial leaders were relatively young companies. Marketers quickly branded the three stocks along with a few others as a new investment asset class and produced highly focused investment strategies using them as a single investment. Yet they are very different, particularly in terms of their 2017 annual numbers, as shown below:

         Range of Reported 2017 Results

                                High Middle Low
Return on Equity                 49%   21%  13%
Return on Assets                 16%    7%   3%
Operating Margin                 32%   27%   2%
Revenue per employee($000)    $2,013  $841 $314
Net Income per employee($000)   $451  $126   $5
Sales Growth                     31%   23%  16%
Price/Sales                       7x    4x   3x
Price/Earnings                  218x   44x  13x

Clearly there is very little similarity among the three trillion-dollar candidates. One is the leader in four measures and the other two are both leaders in two different measures.  Each stock can be appropriate depending upon both time horizon and tolerance for volatility. Amazon is the fastest growing and its valuation assumes the rate of growth will continue indefinitely and does not discount for single man risk. It could be a worthwhile stock for very long-term time horizon investors who can take advantage of periodic volatility. A great investment for grandchildren with doting grandparents.

Apple is evolving into a quasi-annuity producer based on its store and mail order ecosystem. (While people did not realize it, the main auto companies thought they were doing the same with their annual introduction of new/improved cars and a predictable scrappage rate, which worked if the new cars were attractively priced and life-styles did not change). Apple is the only one of the three that I directly own and I’m happy to own it because its numbers and prospects are what a private company would want. Thus, I am comfortable with it today as a value-oriented holding. Microsoft is fundamentally a software manufacturer for its own devices and products of other manufactures. Because of the cyclicality of demand, it requires higher margins to carry it through changes in cycles. In recent years it has been more successful with its newer products and services. All three will benefit from “the cloud”, but there will be a shakeout in the path to the cloud and this could produce disproportionate surprises.

Market and Economic Statistical Mislabels

Even before Biblical times there were records of seasons and agricultural cycles. While there was some periodicity in their occurrence, it was chalked up to weather patterns which were in the hands of the gods and did not occur with mathematical predictability. Today we label these cycles mathematically if they drop by 10% - 20% from their prior highs. We use two continuous quarters of economic declines as a measure of recession. These mathematical measures are not connected to the cause, frequency, and duration of the poor results. In an ever-changing world I question if these measures have anything but media value. Thus, I do not believe that the stocks traded in NASDAQ are in a bear market and those listed elsewhere are not.

To me the causes of both bear markets and economic declines are man-made. Bear markets are caused by excess speculation that dries up investor reserves, either through direct commitment or through borrowings that provide the large amount of leverage used by speculators. Recent reports show that margin debt, free credit balances and short interests have been declining instead of expanding as in most speculative surges. (We can still experience stock market declines, but they are unlikely to be severe). I do not hold out the same relaxed attitude for the credit markets, as they are showing signs of speculation as new participants buy covenant-lite provisions at interest rates that are too low for the possible increases in defaults.

Economic and financial declines are the results of political and business leaders attempting to keep an aging expansion going beyond its normal life. Most US CEOs of public companies are in place for five years and most politicians are focused on their next election, typically in two to four years. In each case their rewards are very time sensitive. Their choices of action favor current stimulus rather than long-term solutions to fundamental problems, which include the integrity of education, enforcement of laws and regulations, immigration controls, health care, defense, and the development of new generations of leadership.

Thus, it is clear to me and others that there will always be bear markets, recessions, and depressions. Louis XIV recognized this with his statement “after me, the deluge”, as he weakened both the power structure by centralization and the economy by spending on continuous wars. Having written that, I echo St. Paul’s plea to avoid retribution “not now”, I believe we need to experience more unwise speculation, higher capital expenditures by business and even larger deficits before we suffer our deluge.

Two Warnings

This somewhat comforting view can be disturbed by two potential problems:

• Firstly, China’s leaders clearly see the challenge in their race to become relatively rich per capita before they become too old to work productively. Their cities need to continue to absorb those leaving rural areas of the country, which is straining under the weight of excess capacity as it transitions to more service and consumer-based jobs. This pivot must avoid reduced debt payments, particularly to government sponsored banks and to some shadow banking groups. The authorities are willing to sacrifice the underlying equity if both the banks and employment can be saved. These actions are not just of academic interest to the rest of the world. Just as countries can and do export inflation and deflation, they can export credit problems too. The way they do it is by passing risk onto external owners of credit and equity. This is already happening as China opens up to foreign investment. Some of the foreigners may be sufficiently skilled in working through Chinese bankruptcies, while others may experience serious losses that show up on their own books. This risk and the decline in the purchase of imports, or foreign branded merchandise made or assembled locally, can make China a different risk for the rest of the world, particularly the US and its multinationals.
• The second problem is that there is a significant chance that the next major economic cycle we experience after a likely recession is going to be quite different than those of the past thirty years. Consumers and businesses will accelerate their dependence on global trade. Countries can no longer afford the expense of national champions. Any place in the world where there is a perceived high margin business will be under attack. Many will be disrupted. Political leaders will eventually shift their alliances from local employment centers to national, if not international consumption bases. Some future political leader will say “We are all Consumers”. Technology and education, not schooling, will penetrate former protected positions. We will be surprised and suffer some pain as we work through these experiences. Hopefully our descendants will benefit.

December 30 Conclusion 

Monday will be the last trading day of a year and is one we would not like to re-live. But there is a slight chance we could have an explosive day in the markets on Monday. If it were to happen, a few lucky managers could claim a wining year, where most of us will have to admit that we lost some money for clients on paper in 2018. More importantly, 2018 investment performance should be looked at in comparison to the double-digit gains of 2017 and the good gains of the last ten years. More importantly, our clients should understand that occasionally we collectively can suffer losses and not lose position for better results in the future.

We wish 2019 will find our readers healthier, wealthier and wiser.

Question of the week:

How much of your portfolio is managed for a bear market, recession, and recovery?

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2018/12/cash-is-four-letter-word-weekly-blog-556.html

https://mikelipper.blogspot.com/2018/12/news-focus-may-drive-investment-success.html

https://mikelipper.blogspot.com/2018/12/investment-memory-friend-or-foe-answer.html

Did someone forward you this blog?

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

Cash is a Four-Letter Word - Weekly Blog # 556

Mike Lipper’s Monday Morning Musings

Cash is a Four-Letter Word

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

                                   

We have been instructed not to use foul language in polite communication, (think of another four-letter word beginning with “F”). The time to recognize the biggest danger of a word and the concept behind it is when the word is most useful. That is exactly why I am calling to our subscribers’ attention the word “cash”. It looks like cash will be the only positive major investment class in 2018. Stocks, bonds and commodities, as well as some real estate and most currencies, except the US dollar, will all have a minus sign in front of their performance.

Major brokerage firms and various wealth management groups are heralding cash as the preferred asset class. Yes, it is better to make small positive returns than losing money. I have been studying this question for more than sixty years. Recognizing my historic bias based on my experience of using mutual funds, I use mutual funds as my primary filter. Utilizing the latest available data from the Investment Company Institute (ICI), with numbers as of September 30th, 2018, the aggregate weighted average cash commitment for all long-term funds (equity, hybrid, and bond funds) was 3.2% of assets. Most investment objectives have 5% cash or less as a percent of their total assets. This roughly represents under one year’s regular income production. Those reserves would only allow for a few additional names to be added to their portfolios and therefore would not normally be enough to make an enormous difference in performance. Unfortunately, many funds today are having net redemptions, which can only be handled by judicious selling. Many fund managers are concerned about a sudden surge in redemptions at the very same time of weak prices and limited available liquidity and do not want to commit all their cash to the market. There are two exceptions to the relatively low cash commitments, Asset Allocation Funds (18.25%) and Flexible Portfolio Funds (14.14%). While these funds often appear near the top of the performance parade in a declining market, over a full market cycle they are not even close to performance leaders.

Not only do I pound performance data concerning this issue, but I spend time with senior portfolio managers and presidents of fund management companies. There are all kinds of managers perceptive to future market declines and they often tend to be premature in terms of timing. Rarely do they commit the bulk of their reserves anywhere near the bottom. Matter of fact, when the eventual full recovery happens, they often have not fully committed to the markets moving toward new highs. Why does this occur?  Usually the recovery is based on anticipation of favorable changes not currently reported to be in place. Another reason is that emotionally the cash position is providing too much comfort. Buying after a meaningful decline requires some extra intestinal fortitude. Perhaps we should search for fund groups that replace the savior of funds relative assets with a rigorous long-term committed runner.

Recently we were able to restore appropriate equity fund levels to a cash flow account. This is an example of the advantage that some institutional accounts have over a fully committed personal account. Further, I suggested to a younger subscriber that he commit half of his cash reserves over the next six months to meet his retirement capital needs.

This post focuses on cash allocation as an input to a performance focused portfolio, which could be a semi-permanent element of portfolio management. There are other cash buckets such as planned external cash expenditures and purely opportunistic cash awaiting near term deployment. I do not know which cash bucket was used on Friday. Some of the financial sector stocks I follow showed transaction volume being 50% to 100% greater than Thursday’s volume. Friday’s combined NYSE and NASDAQ share volume was the highest since August of 2011. To me, it is more interesting to guess the motivation of buyers who are making commitments than sellers who are giving up. Traditionally, market analysts view this type of transaction volume as stock moving into stronger hands capable of tolerating currently perceived concerns.

For several long-term accounts that have periodic external payment needs, I have suggested that once a cash commitment is made it should be separated from performance analysis. This anticipates the actual expenditure but does not factor it into the asset allocation analysis. 

What to do Now!!

• Determine whether the resignations of General Mattis and the chief envoy to the anti-ISIS coalition are signs of continued political disruption which are of greater concern than trade issues. 
• Recognize that some of the signs of short-term capitulation appear to be evident, including Friday’s spike in trading volume led by stock price declines of former large “tech- leaders”. These stocks fell about 5% on Friday compared to 3% for most other stocks. The greater declines of NASDAQ stocks relative to NYSE stocks were probably the result of less liquid OTC trading books. 
• In a measure of price movements for the week, a chart in The Wall Street Journal showed that only 19 out of 72 price indicators rose, eight of them being currencies. 
• One measure of market sentiment is the often-mentioned American Association of Individual Investors (AAII) weekly sample poll of responses to the question of market direction for the next six months. The current reading showed that most of the sample were bearish or bullish, with a decreasing number being neutral. This is essentially a prediction of continued high volatility. Supporting this view are the 25 best performing funds for the week, six of which were invested in Futures, a leveraged way to bet on fast movements during a short period of time. 

We will only know later if we are at a bottom or not. What we should be doing is following the words of the famous Wall Street trader and a friend of my Grandfather, Bernie Baruch. Explaining his actions before a post-crash investigation committee of the US House of Representatives he referred to himself as a Speculator, which he defined as someone who looks to future time horizons.

Looking to the Future
Long-term value-oriented investors should change their focus away from expected current earnings reports. The great John Neff of the Windsor Fund developed his thinking as to the ultimate earnings power of companies during “normal” times. This allowed him to buy good companies at remarkably low price/future earnings ratios compared to high P/Es on declining earnings. This strategy worked for many years, both for the Windsor and Gemini funds.

Growth oriented investors would be wise to review the current issue of Barrons, which had a long article on a Venture Capital Round Table. I found two items of great interest. The three participants were investing in their expectation of future disruptions to various economic sectors: Financial Services, Supply chain Management, and Farming. To show how far out into the future their thinking extended, there was a discussion on manufacturing products in space, which they saw as a new commercial frontier. As a student of the market, the second thing I found of interest was that one of the three was a successful portfolio manager of an open-end mutual fund, T Rowe Price New Horizons (*). To some degree he and other open-end funds are investing in private companies because of the reduction in the number of attractive publicly traded small and mid-cap companies. Many of entrepreneurial companies are now waiting longer to go public.


(*) A long position is held in client and personal accounts.   



Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2018/12/news-focus-may-drive-investment-success.html

https://mikelipper.blogspot.com/2018/12/investment-memory-friend-or-foe-answer.html

https://mikelipper.blogspot.com/2018/12/worries-2nd-derivative-3rd-degree-and.html

Did someone forward you this blog?

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

News Focus May Drive Investment Success - Weekly Blog # 555

Mike Lipper’s Monday Morning Musings

News Focus May Drive Investment Success 

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

                                   

We are bombarded with hundreds if not thousands of bits of “news” and observations each day. Separating those that are important enough to impact our investment actions is one of the keys to long-term investment success. One useful filter is to separate the incoming into time buckets. The first is a cause for immediate action, before too many others do. The second are those significantly impactful inputs that are likely to change extended periods of investment results. Of course, the biggest bucket is for discards due to lack of value and/or integrity.

The sorting mechanism that I use can be described mathematically. The first can be described as the prime derivative. It contains factors that are slow to change most of the time and are likely to shape the results at the end of the investment period.  Demographics is an example which encompasses all those alive today and their inter-relationships. Other examples include the number of consumer units vs. the number of producing units, the interactions between productivity and income, the interactions of health and wealth, the size of the agricultural community to the quantity and quality of food produced, etc. These factors tend to move slowly.

The second bucket deals with the rate of change in the factors impacting the items in the first bucket. These factors are more driven by psychographics or how people feel at a moment. They are volatile and can change rapidly, as well as reverse direction. The content of the second bucket can be described as the second derivative of the first. Apparently, we have entered a period where the track of the second derivative is getting much more attention than the first. Liz Ann Sonders of Charles Schwab (*) is quoted in Barrons as saying “better or worse matters more than good or bad”. Someone else has said “after driving 70 miles per hour, no one likes driving at 55 mph”.

Second Derivative Hot Spots
For portfolio managers who are generating much worse returns in 2018 than 2017 and are thus dealing with career risks, the following are some of the hot spots currently causing concerns:

• Cash is likely to perform better than stocks or bonds in 2018.
• This week there was a record net inflow into money market funds.
• Small business optimism has become weaker.
• Growth is declining in both China and Europe.

A contrarian might focus on the following items:

• The very volatile and often wrong American Association of Individual Investors sample survey which showed 21% to be bullish and 49% bearish.
• The size of the short positions in the SPDR S&P 500 and iShares China Large-Cap both represented 17% of their assets. These shorts will be covered eventually and often at losses, as these ETFs move up in price.
• Stock valuations using forward P/E estimates are the lowest in five years.
• More hedge funds closed in the third quarter than started, implying less competition.
• The most recent survey of US bridges showed that 9.1 % were deficient 2 years ago.

LONG-TERM INVESTORS USE A TELESCOPE NOT A MICROSCOPE
Looking through the current malaise and all but certain recession, followed by a certain recovery, I focus on fulfilling the reasonable needs of future beneficiaries. The list of items from the first bucket or first derivative are as follows:

• While most of the developed world’s population is stagnant, with an aging population that will need to find some retirement support, the developing world is producing both workers and consumers.
• In the developing world the levels of schooling and healthcare is improving.
• Technological developments will produce more value and at lower prices.
• There will be a shift of savings from the developing world to the developed world to help meet retirement purchases.
• Because interest rates have been constrained, valuations are acceptable for long-term investing.  

Question of the week: 
Which of the three lists most represent your thinking and why?


(*) A long position is held in a financial services fund that I manage or in a personal account or both.


Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2018/12/investment-memory-friend-or-foe-answer.html

https://mikelipper.blogspot.com/2018/12/worries-2nd-derivative-3rd-degree-and.html

https://mikelipper.blogspot.com/2018/11/on-road-to-capitulation-and-recoveries.html


Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

Investment Memory Friend or Foe? Answer: Supply/Demand Changes - Weekly Blog # 554

                                   

Mike Lipper’s Monday Morning Musings

Investment Memory Friend or Foe?

Answer: Supply/Demand Changes

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

           
The professors at Caltech tell me that the portion of the brain associated with decision making is allied to our memory bank. Very recently the investing world has been besieged by erudite papers and comments predicting the forthcoming recession. (Not the more important issue, the recovery to rejoin the secular growth trends.) The doctrine being passed out essentially compares current indicators, e.g. short rates rising with long interest rates declining, etc. This seems like a trip down memory lane. In turn, memory dictates their judgement and thus their actions. It is as if they have surrendered to algorithms.

It is reported that the great philosopher who learned by several financial reversals, Mark Twain (Samuel Clements), said that history does not repeat itself, but it rhymes. Most major surprise victories won on the battle or sports fields, as well as those in business and in the financial markets, are not extrapolations of the recent past. Why then are so many surprised by the failure to repeat? I suggest that there are two main reasons: faulty memory and changes in supply and demand.

Part of the faulty memory comes from forgetting some details over time. Perhaps more importantly, there are important contributors to the results that were not generally known at the time. Some of these unknowns resulted from the motivations of the various participants and some actions had little to do with the main thrusts of the large events of the day. These contemporaneous happenings and motivations were not triggered by the main event, but by their transaction volume which was included in the total volume of the “big event”. This makes me suspicious of most of the reporting of the event. (Remember, every day investors buy and sell to meet specific needs, which is not tied to what many others are doing.)

CHANGES IN SUPPLY AND DEMAND-Critical for 2019-2091
Most of the time when we look at economic and financial history we don’t tie the actions to supply and demand imbalances. It goes without saying that if supply and demand are in perfect balance there will be little if any price or other disruptive moves. Usually it is easier to assign numbers to the supply side of the equation. Often the only thing we know about the demand side is the quantity of the transactions; not the size of the unmet demand at various prices and specifications.

Most tradeable quantities are in sufficient supply at current prices; however, I am conscious of shifts in the demand side of the equation. For example, the recent bankruptcy of David’s Bridal was in part due to changes in American bridal practices - later marriages, less highly decorated formal religious ceremonies, and destination weddings over local situs. I suspect we may be seeing the last US manufactured sedans replaced by SUV and pick-up trucks. I was struck by the reported concerns of the leaders of OPEC, who are not concerned about the supply side of the price equation, but the demand side. They are probably seeing some of the changes in the usage and mileage driven by cars, the growth of Uber and Lyft, the growth of the use of LNG by utilities, and perhaps the overall consumption shift from manufactured items to services. Guessing the level and nature of demand is an extreme skill. Few have the ability of the late Steve Jobs of Apple (*). He successfully predicted the demand for products and services that didn’t already exist. His view was that only when potential customers saw his new inventions would they know that they wanted it. Some may feel that this is the quickest way to go broke, as there is a long and painful history of others producing new products that no one wanted at the time.

Investment Demand
Being a fiduciary investment manager as well as an investor for our family, I am concerned about two elements of demand that impact historic ratios, short selling and retirement capital. Because it has been very difficult to find individual winning short positions over the past ten years, the number of individual security shorts have been declining relative to the size of the market. With extremely rare exception, I am not a short seller directly or use funds that short individual securities. So why am I concerned about the drying up of individual short selling? I believe that intelligent successful short sellers are an important policeman operating in the market. They police financial statements and corporate actions in search of large mismatches between current perceptions and a more precise reality. Like a beat-cop, they are an influence to keep the game honest.

There is still a reasonable amount of short selling going on, but it doesn’t have the same curative value individual security short sellers used to have. These more modern short sellers are shorting various stock, bond, and commodity indices. They are doing this through the futures market or more cheaply through ETF/ETPs. Thus, one does not know in looking at the net daily flows made thru various Authorized Participants (AP), whether it’s market maker hedging or primary investment demand. Both the APs and the Exchange Traded Fund or Exchange Traded Product portfolio manager may be shorting daily to keep their book balanced.  In addition, there is a practice which invests in pairs of stocks, with one long and one short position. They make or lose money by the difference in the price spread between the long and short contracts. To avoid unrelated moves both issues need to be largely similar, with a price difference that mirrors a single essential difference.

Retirement Capital-The Second Element
In some respects, medical science is much more a curse on humanity than a benefit. Around the world people are living longer than their meager retirement capital and their medical and social needs are becoming even more expensive. Most politicians recognize that the various governmental healthcare plans do not have enough money to support them or pay for the increased expenses that are coming. “The yellow-vest” riots in France suggest that in most countries raising taxes materially won’t be feasible. The only sources available to meet these obligations are from the private sector. In the US it appears that the politics are not right to even get the miniscule retirement capital changes being sought in the current moribund second tax bill of the current administration. Actually, there is something likely to happen over the next several years that could be a major help to a significant, but not major portion of the population. After more than a decade, instead of robbing the purchasing power of savers through inflation and taxes, we have experienced a meaningful tax savings and higher interest rates. Cash has for the first time in quite a while become an acceptable investment asset class and we could see growth in cash savings if the banks and money market funds find credit worthy investments. This is a global problem and it is important to recognize that just as we saw in the Brexit referendum, the senior population will vote if their children and grandchildren don’t. After the turmoil of the oncoming recession, let’s hope that the subsequent recovery will attract long term investment capital for retirement.

Markets Pivots on China’s Supply and Demand
A very recent contradictory trend is occurring in Chinese stock prices. Since the beginning of November Chinese stock prices are performing better than those in the US and many other markets. This makes sense to me in light of my call in September and October for US investors to hedge their US positions by purchasing Chinese securities or funds holding those positions. The hope was that the Chinese stocks would continue their decline and the US stock prices would rise. This is a classic example that in a good hedge at least one side of the hedge should make money. All of this is happening when many observers are betting that the Chinese economy will grow at slower rates in 2019 and perhaps beyond. (If you will, review the second derivative from last week’s blog.)

The current leadership of both countries, while discussing tactical issues, are very focused on strategic issues. There are two examples of this. The first is that China is very dependent on imported resources and is the world’s leading importer, and for at least a while is the leading exporter. Most of these goods traverse the South China Sea with its man-made new island forts. To my mind, this is one of the reasons behind the tariff issues, not the relatively small number of manufacturing jobs in key states. On the surface it is the free navigation of these waters by naval ships and planes that is being fought over. Now there has been no discussion regarding commercial passage, but without appropriate protection commercial shipping is at risk if only one navy can protect it.

The second example was mentioned in a small article in the NY Times. The Chinese sent up the first known rocket to probe the dark side of the moon. This is important, for it demonstrates the capability of Chinese rockets and instruments. One can see that these capabilities could be a potential threat to other nations. One can see the US’s interest in a sixth military force in the Space Corps. This probably won’t happen until the Pentagon and Congressional powers can be brought on board. Nevertheless, the long-term threat is there.

What is Missing?
While “the world is too much with us” we need to think beyond the oncoming recession and even the 2020 election. Though there are some heralded overnight successes, most major change agents take at least twenty or more years from the spark of genius to widespread use. As investors, hopefully for ourselves, but more importantly for future generations, we should be paying attention to these changes in demand that will fund the supply side and set new parameters for growth.

(*) A long position is held in personal accounts.     


Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2018/12/worries-2nd-derivative-3rd-degree-and.html

https://mikelipper.blogspot.com/2018/11/on-road-to-capitulation-and-recoveries.html

https://mikelipper.blogspot.com/2018/11/selectivity-over-factors-weekly-blog-551.html


Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

Worries: 2nd Derivative, 3rd Degree and Surprises - Weekly Blog # 553

Mike Lipper’s Monday Morning Musings

Worries: 2nd Derivative, 3rd Degree and Surprises

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

                                         

The job of the analyst and leader is to worry about the things that most others don’t worry about. The worries that most are concerned about won’t happen as imagined, but others will. As is often the case with jargon, those in the know want to protect their position by defining a situation in terms that only they understand. The concept of the second derivative is known by sports people, hunters, and drivers. In plain language, the first derivative is the speed of something moving and the second is the rate of change in that speed. When driving, we note the speed of one car overtaking another. What is of significance to avoid accidents is whether the overtaking vehicle is accelerating or decelerating. The risks of an accident happening is much greater if the overtaking vehicle slows upon passing, creating an unsafe gap between the moving vehicles.

Applying the 2nd Derivative
Quite foolishly, far too many investors believe that reported earnings will dictate future values. Foolish because in today’s world the validity of reported earnings is as accurate as the former Chinese Premier’s distrust in reported GDP numbers, thinking of them as man-made and not reflective of reality. One of the better consulting firms, the Boston Consulting Group (BGC), has published its “Value Creation Insights” on corporate activity. BGC noted that current prices include current expectations. This suggests that their clients can only raise stock prices by accelerating expectations, or for numbers-oriented people, by driving the second derivative higher than the first.

The problem facing investors today is that the current and expected 2nd derivative is negative. Through the third quarter most American companies were reporting record results driven by high profit margins. These expanding margins were the result of sales growing way above trend and by utilizing underused human and plant capacity. Part of the driving power of these results was supplied by overseas workers, customers, and facilities. Most non-US markets have recently declined. The media and others have attributed this to the current trade conflict. While this is somewhat true, I believe an equal if not greater impact is due to consumer demand slowing and higher wages being paid.

Will the Saturday Night Truce work?  
Clearly the Saturday night truce could dramatically change some of the trade issues, while creating others. While markets are likely to move this coming week, my guess is that the earliest we’ll clearly see the impact will be the following week. Although that is likely to be a knee-jerk reaction, as the details will not be forthcoming until next year. Nevertheless, as much as I would like to be wrong, I do not think that trade itself will be enough to get the first and second derivatives moving in the right direction for investors. This is the logical view.

The Absurd View
Part of the training at my two educational institutions, the racetrack and the US Marine Corps, is to always be on the alert for surprises. Some of them may be so surprising as to be considered absurd or unbelievable. In that light I suggested in last week’s blog that the US stock market could go to a new high this year. My reason for suggesting it was that in the light of the declines of the past few weeks, no one would have such foolish thoughts. Foolish me, I discounted radical swings in sentiment. Global stock markets rose last week, probably in anticipation of a favorable result. Of the 30 top movers among the 72 market price indicators, 26 were stock market indices and only four were commodity indices. Thus, one can see that changes in sentiment drove stock buyers more than they did commodity or currency players. With the Dow Jones Industrial Average gaining +5.59%, S&P 500 +4.46% and the NASDAQ composite +6.19% in the week, new highs are only +4.81%, +5.81%, and + 9.04% respectively away from their former peaks.  The absurd goes from impossible to possible and some may even say probable.

Whether or not the numbers play out as suggested, the key takeaway for investors is to expect surprises, some good. In the long run markets move on supply and demand, which may or may not be seen. However, in the short-term, changes in sentiment can make for dramatic moves.

The 3rd Degree
People need to find others to blame for their misfortunes. If they can find the culprits who did this to them the culprits can be severely punished and possibly get restitution, ensuring this problem won’t happen again. To accomplish this corrective goal requires some hearing in the court of law, or more quickly in the court of public opinion via the media. This need has been present in societies throughout history. Because the guilty can be deceptive, they need to be questioned sharply, with or without appropriate protections. If headlines are generated, the prosecuting attorney or media can go on to bigger and better things, but this will not necessarily be better for the victims.

Despite repeated trials in court or the media these offending problems continue to reappear. Why? I suggest there are two fundamental generators of these problems. The first is the so-called victim, who in these circumstances possesses bad judgment. Bad judgment is often sourced from a school or the media trying to educate quickly, but not thoroughly. A similar source may be the staffs supporting various politicians, as well as the politicians themselves.

Since the main culprits won’t acknowledge their culpability, there is a search for other perpetrators. Thus, all that serve as fiduciaries for others, as members of boards and advisers, are at risk of entering a 3rd degree chamber. Prosecutors are not interested in the number of years where things were done right, or the elements of sound judgment that didn’t work at times,  suggesting a failure to process rather than the quality of judgement. Did you know, if not, why not? Type of questions. This is exactly why when sitting on a board or working for them I ask a lot of questions, with the hope that at least the questions, if not the answers, will hopefully be remembered in the minutes.

The reason for bringing this up now is that it has been a long time since we have had a bunch of scandals. (Because of human nature I suspect malicious things happen all the time and only occasionally bubble to the surface.) Often when the economy is not performing well there is a public need to find culprits. We know that some things will surprise people and therefore there will be a need to shift blame. These issues may not come out in force until there is a recession, which will come at some point.


Question of the week: 
What do you think and are you planning to do anything about it? 


Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2018/11/on-road-to-capitulation-and-recoveries.html

https://mikelipper.blogspot.com/2018/11/selectivity-over-factors-weekly-blog-551.html

https://mikelipper.blogspot.com/2018/11/history-guide-not-map-or-trap-weekly.html


Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

ON the ROAD to CAPITULATION and RECOVERIES - Weekly Blog # 552

Mike Lipper’s Monday Morning Musings

ON the ROAD to CAPITULATION and RECOVERIES

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

                                         

Every connection to life has its own ups and downs. One of the major translation errors from the singular precision of mathematics to the real world in which we live and invest is the implication that the shortest distance between two points is a straight line. Not that it is incorrect, but in the real world of dealing with people and their money, straight lines are a fantasy. As sure as days follow nights, we deal with changing observations based on changing conditions. Thus, we should educate ourselves and others about cycles. In the two-dimensional world these are linked in time by plotting ups and downs, or if you prefer the mathematical term, their representation is sinusoidal. Actually, even that picture of reality is incorrect, cycles travel in multiple dimensions. Meaning that we cannot totally rely on past cycles being repeated exactly in the future. Thus, in planning for our investments we cannot rely solely on history. We need to be aware of the differences between past cycles and current conditions. Even more difficult is guessing the differences in future cycles.

As an investment manager for long-term institutional and individual investment accounts I am now focusing on identifying the coming bottom for stock prices and more importantly the nature of the recovery from the bottom. The answers to the second question are to an important degree a function of whether we will be hitting a cyclical or structural low point. There will be elements of both types of declines in the bottom, but one usually is more predominant.

CYCLICAL BOTTOM 
Most cyclical bottoms are created by dramatic change in sentiments based on very current stock price changes. One example is the (AAII) weekly sample survey. Three weeks ago the American Association of Individual Investors reported the percentage of respondents that were bullish was 41% and bearish 31%. This week AAII reported 25% being bullish and 47% being bearish. Barron’s produces a confidence index based on the difference between high quality and intermediate quality bond yields. Unlike the AAII statics this index usually moves less than one percent from week to week and has only moved 2% over the last year. It moved 2% this week compared to the prior week, in a direction that demonstrates there is concern in the bond market. (While the AAII numbers are highly volatile and are often negative indicators for future stock price moves, history suggests concerns in the bond market precede those in the stock market) Another indication of concern is that 14 of the 25 best-performing mutual funds for the week were Precious Metals Funds, a rarity. A sudden surge in gold mining stocks and funds after a long period of poor relative performance indicates worry rather than hedging.

Most of the time recommendations from transaction focused brokers and fee paid investment advisers are similar. However, brokers are currently recommending the building of cash positions (To build future buying power), whereas advisers are continuing to recommend holding on to stock positions. This dichotomy may reflect the “growth/value” dilemma. “Value” stocks, which are often significant dividend payers, usually fall less in down markets and underperform in up markets. “Growth” stocks tend do better in up markets and did quite well into the third quarter, led by the FAANG + BAT stocks, although they have given a lot of that back in the less than two months since then. Investors traditionally feel that the loss of a dollar is twice as painful as the pleasure of a dollar of gain. Thus, while some more mature investors are concerned about the size of their money pile, those that have cash flow needs are more focused on the expected terminal value of their accounts. (As an investment manager it is our job to work with accounts to achieve the proper balance.)

As Yogi Berra said, you can see a lot by observing. My wife Ruth and I did our usual “Black Friday” investment research visit to the glitzy Mall at Short Hills. Our overall observations were:

• Mostly women shoppers, often in groups consisting of three generations
• Good but unobtrusive security
• Shoppers very selective, with some quite empty stores. Specifically:
• Apple(*) - Quite full, but no outside lines
• Verizon - Better than normal, but not crowded
• AT&T - Actually had a few people there
• T Mobile - Some traffic, possibly due to being opposite Apple
• Starbucks - Jammed
• William Sonoma - Very busy
• Canada Goose - Lines outside, with limit access
• Tiffany - OK
• Hermes, Gucci, and Chanel - All busy

Relative to prior years I would give it a solid B, perhaps a B+. (I wonder whether the strength of the women’s’ shopping can be tied to changing demographics, economics, and shifting voting patterns and are these cyclical or structural?)

Market analysts might consider that this week the DJIA, S&P 500, and NASDAQ composite reached prior lows. This could represent a double bottom from which a price recovery could take place. If it were to happen, we would have experienced a cyclical decline with the relatively gentle capitulation that occurred this week.

STRUCTURAL DECLINE
While most of the time the stock market anticipates a recession, it doesn’t happen every time. The 22% one day decline in 1987 was unrelated to an economic recession, whereas The Great Depression of the 1930s combined an overpriced stock market with an out of balance economy and government errors. Historically, investors without trading skills are better off within a year or two after a cyclical fall, if they stay invested in their reasonably diverse stock portfolio or funds. On the other hand, a structural decline can take much longer to recover from and some companies and sectors won’t come back. Thus, out of prudence, I look for signs of a future structural decline and there are a few that need to be watched.

1. The Bank for International Settlements (BIS), the bank for central banks, is pointing to the rise of “Zombie” companies. These are companies whose return on invested capital is below their cost of capital. If these conditions continue the companies will not be able to generate the money to grow and will eventually consume their own capital and commit suicide. BIS sees the number of these types of companies growing. An expected rise in interest rates without an increase in return on invested capital will have them trapped.
2. Several young people entering the financial services business have asked me where they should start. I have suggested that if they can get exposure to past mistakes in workout situations and/or bankruptcies, it is much better than focusing on the successes of the firm. Thus, I try to learn what I can when one of these surfaces. David’s Bridal, a chain of stores selling wedding gowns and related materials announced it was going bankrupt. The press chalked up the problem to a change in young people getting married and wanting less flamboyant weddings, which may be true. However, I think there were other problems that an outsider could see. For example, too much inventory, slow cash conversion, sloppy credit extensions, and their second set of private equity owners over-leveraging their relatively high purchase price. (I cannot comment on the critical issue of management)  The over-leveraging of a high acquisition price is far from unique in today’s world. Years of interest rates not high enough to absorb credit loses combined with a sharp increase in relatively inexperienced people at non-bank credit institutions making loans is a prescription for trouble, although it does not parallel the sub-prime credit expansion that contributed to the last financial crisis. Interestingly, we are seeing some non-bank mortgage companies withdrawing from their market.
3. I believe the financial services sector is critical to the workings of the global economy. As an investor in this segment I know that at times one can make money in these stocks, but not always. Nevertheless, I study it because of their centrality to the system. I am seeing activities that suggest some career investors in this segment are concerned about growing concentration. Merger and Acquisition activity is increasing to improve revenues and reduce overhead (people). Suggesting that this is a drive is to maintain or improve profit margins and returns on invested capital, rather than growing the business. 
4. Two of the sharpest minds in our business see this as both an opportunity and a challenge. The first is the very well known, often contrarian, chairman of Berkshire Hathaway*), who was working down an excessive amount of the $120 Billion in cash by buying and additional $13 Billion in financial services stocks, including $4 Billion in JP Morgan Chase* stock.  He and Charlie Munger are still maintaining $100 billion for big opportunity investments at attractive prices. Less well known in the US is Paul Myners from the UK. Paul has had success in the investment management business in UK, US, and Hong Kong. Besides his investment management work he has also led the financial industry both in the UK Government and import industry bodies. His latest role is chair at Autonomous Research, a very good in-depth research firm covering Europe, the UK, and US companies. He is selling the firm to Alliance Bernstein which is partially owned by Axa (*), in part due to the shrinkage of research commissions, particularly in Europe.

(*) A long position is held in these securities either in a financial-services fund I manage or in personal accounts, if not both.

I always look for changes in the structure of the market that can disrupt how investors react. There are two aspects worth watching. The first is the large and still growing amount of money being invested away from publicly traded markets. Pensions & Investments magazine has published an article on foundations. It tabulated how the fifty largest foundations allocated their assets between stocks, bonds, and other investments. Other investments, which included private equity, hedge and venture capital funds, real estate, and direct investments, represented 60% of their total of $230 billion. Fourteen of the fifty largest foundations have more money invested out of the market than in it. I have seen the pull of these investments in endowments and foundations whose investment committees I sit or sat on. For a number of years as a group they have underperformed, even before fees are deducted and certainly afterward. This is in spite of a limited number of quite spectacular results from individual funds or properties. If the flows away from the market slow down or reverse there will be less leverage available to private and public companies, which could lead to structurally lower returns.

All too many investment results are phrased in terms of risk-free returns, which is translated as superiority relative to US Treasuries. One of the more successful fixed income mutual fund managers, Michael Hasenstab of Franklin Resources, has a view that US treasuries are due for a perfect storm. His three reasons are:

1. The US fiscal deficit will rise (This may be particularly true with the House Ways & Means committee in the hands of spenders who will want to match defense spending increases.)
2. A decline in bond buying by the Fed.
3. Inflation will rise.

If “risk-free” rates of return decline, it may materially impact asset allocation and overall rates of return.

Conclusion:
As of the moment, because of a lack of enormous enthusiasm at the prior peak, my current guess is that we are dealing with a cyclical decline and good holdings should not be disturbed. However, I will keep looking for increases in the list of structural issues that need to be addressed before we have a structure driven fall.

What do you think?


Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2018/11/selectivity-over-factors-weekly-blog-551.html

https://mikelipper.blogspot.com/2018/11/history-guide-not-map-or-trap-weekly.html

https://mikelipper.blogspot.com/2018/11/things-are-seldom-what-they-seem-weekly.html


Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

Selectivity over Factors - Weekly Blog # 551

Mike Lipper’s Monday Morning Musings

Selectivity over Factors

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

We are entering a new phase where successful investing will be different than successful litigation and gatekeeper buying. The classic way to judge the strength of a civil law case is to follow past precedents. The same reliance on history carries the day with most institutional gate keepers and investment advisers. Their standard phrase is “Past Performance does Not Guaranty Future Results”. Nevertheless, soon after delivering this dictum they mouth such and such factor or manager has the following good record compared to other records, except when things change.

I believe that underneath the volatility we have seen in 2018 we are seeing greater dispersion in the returns of factors and mutual fund classifications. This ranges from pseudo mathematical certainty to the art form of selectivity. Increasingly the differences in performance are more important than the similarities. Another way to look at it is that instead of looking at any giving picture two dimensionally, we search for a third or perhaps other dimensions. This leads to different views being developed by different observers. The more successful observers will be much more valued than those who are just model makers until the next changes in the investment picture.

POSIBLY BIGGEST CHANGE IN 100 YEARS
Practically all of those who have been schooled in Liberal Arts courses believe that it is the government’s function to stimulate the economy out of a recession. From this requirement it follows that it is the government’s responsibility to control the economy. Modern governments, whether elected or command controlled, translate that into job creation. Increasingly, leaders are becoming frustrated with their inability to get their economies (people) to comply with their desires. Part of their problem is that their favorite handmaiden, the central bank, has not been as effective as desired. The institution that studies the central banks with the most detail is perhaps The Bank for International Settlements (BIS). The head of the BIS’s Economics-Research Department is quoted as saying “politicians have come to rely on central banks to stimulate growth since the (financial) crisis.” Yet, with very rare exception, constituent economies have produced below normal historic results. Central banks/governments have kept short-term interest rates below the levels needed to cover  non-paying loans, whose interest rates are too low. A still greater penalty has been levied on economies by the misallocation of resources during recessions. Far too many people continued to be employed by failing organizations kept alive during the recession, instead of transferring that human capital to sustainable activities. In the face of these challenges some governments have reduced administrative burdens and tax levels, but this will probably only have a modest impact. The more people and businesses recognize that central powers are attempting to manipulate them, the lower their confidence in their own ability to build their own futures.

As is often the case, I am fulfilling the function of the prudent analyst gazing at the various futures ahead. Clearly I am ahead of the current thinking of those in power and most of their opposition. Nevertheless, I am beginning to ponder the impact of an appropriate investment strategy in response to the relative ineffectiveness of the top/down thinking of the central powers. The following topics should be explored by those charged with the responsibility to make payments to multi-generational beneficiaries:

1. Will the coming recession be largely caused by cyclical or structural causes? If largely cyclical, we have been there before. We know how to play that game, which is mostly based on sell/hold/buy decisions in the same securities. If structural problems are the main cause of the recession, the decision process centers around which areas and instruments should be employed and which should be abandoned.
2. What is the probable length of the recession? Typically, a cyclical recession is quicker because prices can adapt quickly. A structural recession involves the transfer of productive resources from one sector and location to another. This raises the question as to how quickly critical employees can be found and trained, not only in manufacturing but also in sales and service roles.
3. What will be the new measure of success in the post-recession recovery period?
4. How much of our economic and personal lives will be disrupted by technology applications? There are some that have concerns about the world of Big Data and its impact on individuals. Due to internal security concerns China will be the leader in that world, even more so than Saudi Arabia was in a world run on oil.
5. In a recession, particularly one caused by structural factors, corporate and personal defaults will likely be higher for credit instruments than for underwritten bonds. However, with the shrinkage of the number of brokerage firms and commercial banks, who will do the underwriting? It may be easier to distribute credit instruments directly to pockets of wealth rather than through a syndicated underwriting of bonds. (In the latest week, focusing only on financial organizations, two  yields tightened and six widened.)

SHORT-TERM POSITIVE
As mentioned in past blogs, market analysts believe that significant price moves are unlikely if there are price gaps between trades, particularly when comparing price ranges day to day. Gaps in price charts need to be filled before a sustained move is likely. Of the three main stock market indices, two had price gaps filled by declining prices this week. There are only six weeks left in this calendar year to avoid breaking a fifty-year rule, that bonds and the S&P 500 do not decline in the same year. Bonds are off this year. The only fixed income funds positive on the taxable side are Ultra Short Obligations, Short Investment Grade Bonds, High Yields, Short US Governments and Money Market Funds. With only the US Diversified Equity Funds macro group being positive, the only way to avoid breaking the fifty-year rule is for there to be a pretty broad stock price increase in the next six weeks. Because no one expects it, there is a chance that we could even reach record levels by year-end.

A MAJOR WORRY FOR GRANDCHILDREN
In the weekend edition of the Financial Times there is a three-page article about the opening-up of some of the secrecy surrounding the long-term outlook for the US military. What becomes very clear in the article is that the current administration is worried about the growing technological skill of the Chinese. It is quite conceivable that at some point in the future the Chinese military establishment could surpass the US capability to an extent that could be extremely upsetting to the US. (I firmly believe that this is a more important concern for this administration than the loss of manufacturing jobs in the US.)


Question of the week: 
What actions are you contemplating based on the changes you foresee?


Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2018/11/history-guide-not-map-or-trap-weekly.html

https://mikelipper.blogspot.com/2018/11/things-are-seldom-what-they-seem-weekly.html

https://mikelipper.blogspot.com/2018/10/we-are-in-training-exercise-weekly-blog.html


Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

History a Guide, Not a Map, or a Trap - Weekly Blog # 550

Mike Lipper’s Monday Morning Musings

History a Guide, Not a Map, or a Trap

(a long read)

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

         

I have often said that when an analyst is scratched a historian bleeds. While this is true, it should not be a trap that automatically leads to a set of decisions. Beginning to prepare this blog on the early morning of the 243rd birthday of the US Marine Corps I am struck at how much is different from our Corps tactics, strategies, and missions. To fund the military, General Washington ordered the marines,  to guard the transport of silver from New York to Philadelphia so that the troops and suppliers could be paid. This particular mission is no longer required, but the movement of critical assets for future use has become endemic to me as a long-term investor for clients, family members, and beneficiaries of non-profit groups.

Just as the specific tasks assigned to the USMC has changed, so have those who we work for as investment advisors and members of investment committees. One axis of our work is generational, the consideration of essential needs of families for their senior members through contemporaries, children, grandchildren, great-grandchildren, and the unborn. In a somewhat similar way, members of a university investment committee focus on the different needs of the present and future donors, students, faculty and staff. I also focus on delivering the capital necessary to fund the attraction of the best future students and faculty.

With this multi-generational self-imposed mission, I have concluded that there are a number of different attitudes that have to be identified and placed within the range of possible extremes. History is useful in identifying past extremes but is far less useful in drawing up a map of necessary future actions. (There were numerous roads from New York to Philadelphia, but only some were considered relatively safe and suitable for moving heavy, wealth-laden vehicles and consequently only one was used.) In developing investment policies for delivering wealth, answers to the following questions will have an important impact on the choice of the best road to travel.

1. The primacy of spenders vs. savers, or phrased differently, focusing on today vs. tomorrow. Spending addresses the identified immediate need, whereas saving addresses future known and unknown needs through the power of uncertain compound annual growth rates (CAGR). The selection of the appropriate mix is dictated by emotional management and political skills. 
2. Dependency on self, internal forces, or third-party forces. Since the American Revolution we have seen a number of other social revolutions. Two of which have enormous investment implications. At the time of our Independence, individuals and close family members functioned as the primary deliverers of health solutions and capital for growth and retirement. Today, the bulk of the population is dependent upon third-parties to provide these services, at a cost of less freedom of choice. 
3. Coping with the past as the primary model for the present. The cook book model borrows from science, by repeating past experiments in order to produce known results. What passes for judgement is essentially a memory of the real or imagined past, extrapolated to the future. The problem with this very popular model is that it does not include a risk quotient. What are the risks of fundamental changes from the past? Ignoring the potentials of changes is dangerous, as one can lose the purchasing power of capital and/or the loss of opportunity. While surviving change is good, waiting for it can be expensive. Having meaningful reserves can be performance limiting and for managers is a career risk.

Questions Shape Portfolio Construction
Each of the three questions raised, if answered, should have some impact on how both individual and institutional portfolios are constructed and will be addressed separately.

1. Some people and organizations plan to spend their last dollar while taking their last breadth. The critical question for them is the shape of the glide path of expected payouts. The account should be measured on a total (reinvested) return basis. Other accounts hope to be perpetual or have an expected maturity so far into the future that mathematically it is the same. A critical political question is how to balance the current spenders vs. capital accumulators and postpone spending for future generations. Historically, income beneficiaries believe they have the first right to the income produced. Often this is expressed in terms of dividends and interest payments and does not include realized and unrealized capital gains. Unless there are rights of invasion. Capital belongs to the “remainderman”. With these dual responsibilities, most of these accounts are managed similarly to balanced mutual funds. These accounts typically own bonds and high-quality credit instruments, along with various forms of equity. In most market cycles the balanced nature of the account produces a less volatile price pattern than a full equity or bond account. In the current market cycle, the unspoken difficulty is dealing with inflation. (I suspect for individuals or high-quality institutions, the inflation rate for the "best products and services" are higher than published inflation rates.) High-quality bonds and credit instruments have yields pretty close to published inflation rates. Many dividend paying companies attempt to keep their dividends growing at the rate of inflation, but often fall behind in a rising stock market. It takes the combined skill of a politician and investment manager to keep all of the beneficiaries happy all the time.
2. Relatively few investors have the same attitudes of a pioneer entrepreneur, or a misanthrope wanting to be independent of other parties' control. Most people cede various accident risks to insurance companies or governments and most employees in the US and elsewhere are coaxed into retirement accounts or pensions. In the past, individuals provided for their own needs, but unfortunately most people today are not endowed with the discipline and appropriate skills. One of the dangers to long-term general investment returns is this tendency to cede control, particularly by younger generations. This is a global trend. The savings from the massive buying power of a central force, be it a private health insurance plan and/or a government agency, is dissipated by the large bureaucracies which follow rigid regulations. This causes general expenses to rise and they will be also borne by those who can escape these services, even though they are paying for them directly or indirectly. From a long-term standpoint, despite some current disruptions, we expect after-tax and after mandated expenses to rise on a secular basis. From an investor's point of view there may be an increased desire to buy into disruptive companies, away from high-quality fixed income which will have difficulty producing returns after inflation and taxes.
3. Part of investors and politicians "physics envy" is developing a set of immutable laws that are always right. Far too many investors look to statistical histories for physics like certainty of future developments. They have forgotten their sports days. Whether it be baseball, football, golf, tennis, or horse racing, the real purpose of winning or losing streaks is to see when and by whom the streak is broken. The following is a list of time series that have generally been predictive, as well as the direction of their predictive power:
1. For the last 50 years there has been no single year that bonds and the S&P 500 have both fallen. (As of last Thursday, only 7 out of 27 fixed income mutual funds are positive year-to-date. Only 9 out of approximately 100 equity fund investment objective performance averages are up. Few if any, are predicting a double hit to accounts.)
2. Sentiment changes – The American Association of Individual Investors' weekly sample survey in the past three weeks has gone from being 28% bullish to 41.3% bullish, an almost 50%turnaround. (This is a highly volatile indicator and I often view it as a negative or reverse measure.)
3. Much of chart analysis follows principles similar to those of architecture. Foundations for large buildings should not have gaps in their underpinnings, likewise the three major US stock market indices shouldn’t either, although they currently have  two each. (Thus, on average it is unlikely they will go to new highs until there is a down market to fill in the gaps.)
4. The Wall Street Journal publishes 72 price changes each week   for stock index, currency, commodity and ETF prices. During the latest week there were 20 that gained over 1% for the week; one was a commodity, 1 a currency, and 1 an ETF, with 17 being stock indices. (This suggests that this week 's movement was trading related, perhaps a relief rally with little economic support, not a good sign.)

All that I know is that each week we move closer to a significant stock market decline, perhaps with a recession. While there are few bears in the market place, in general there is little capital in visible reserves.

A Possible New Portfolio Structure
Perhaps it would be wise to structure a portfolio so that it is comprised of three unequal buckets.

1. The first bucket for American investors is an opportunity bucket to hold securities and other assets that are expected to appreciate over an investment cycle. 
2. The second recognizes that from time to time bargains show up, often briefly. The use of these resources requires courage of conviction to avoid "falling knives" that will plunge the stock out of existence. 
3. The third bucket would rarely be used, but is intended to take advantage of fundamental changes which arise when various statistical streaks are broken and things that shouldn’t happen do. 

To put this new structure into place, using only someone's age as a rough measure of maturity and responsibility, the following table could be a good point of departure for an individual investor. The Institutional investors could require a different structure:

Initial Age Opportunity Bargain Purse Changes
    20           100%            0%         0%
    30            90            10          0
    40            80            15          5
    50            70            20         10
    60            60            20         20
    70            50            20         30
    80            50            20         30

Questions for the Week

1. What do you think of the questions that shape portfolios and do you have any others?/
2. Am I am being too pessimistic as to the reliance of third parties impacting investment returns?
3. What do you think of the two "new" reserve elements of bargains and changes?

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2018/11/things-are-seldom-what-they-seem-weekly.html

https://mikelipper.blogspot.com/2018/10/we-are-in-training-exercise-weekly-blog.html

https://mikelipper.blogspot.com/2018/10/committing-reserves.html


Did someone forward you this blog?

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com


Copyright © 2008 - 2018
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

Things are Seldom what they Seem - Weekly Blog # 549

Mike Lipper’s Monday Morning Musings

Things are Seldom what they Seem

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

         


Stock Prices Don’t Follow Headlines (It’s the other way around)

This is being written the Sunday before a much-heralded mid-term election in the United States. As a consequence of being exposed to the so-called professional and social media, one would think the outcome of Tuesday’s election will dictate future stock prices. Not only is this excessively simplistic, it is not historically accurate. The impact will only change the scope and content of the limited number of bills that can pass through both houses and be served up to the White House to approve or veto. Further, no matter which party wins there will be a number of new committee chairpeople, with meaningful changes in staff. As Louis XIV found out, it is difficult to control the empowered nobles. The new chairs will begin to negotiate with members of both parties, an army of lobbyists, and people in the White House. (I am on record with a group of seasoned and senior investment people suggesting that whomever wins the mid-terms is likely to lose the next presidential election, primarily due to their inability to deliver on their campaign promises.

With most participants in a battle for “control” of Capitol Hill focusing on their role in the 2020 campaign, investors should look to history as a guide for the importance of a political party moving stock prices. This weekend I saw a study of the last 12 presidential elections and which party controlled the White House, Senate, and House of Representatives. Of the 12 contests for dominance, there were only two times when one party controlled all three branches of government. Ranking the 12 in terms of the performance of the S&P 500, control of all three branches of government only produced rankings of 6th and 9th. (The intramural score card showed that Republicans and the Democrats evenly split the remaining 10 contests.) I suggest that is exactly what the American voters want, a relatively weak government except during periods of great national stress. Further, in looking at the critical issues decided during the President’s first term, almost none of them were major campaign issues before the President took the Oath of Office.

Despite this somewhat controversial view point, notice the media pronunciations on Sunday through Tuesday trying to tie the stock market moves to various political motives. Instead, wise investors should look at the following elements:

1. On Friday the Dow Jones Industrial Average declined -109.91 points. Some estimate that the decline in the price of Apple (*)  represented about 100 of those points, which doesn’t have a political message. Actually, if one measured from the opening price on the exchange to the last price on the exchange, Apple didn’t move. The decline all occurred in the after-hours trading Thursday night. Because there is a legion of Apple haters, I suspect that in the after-hours dealer markets it was easy to short the stock.
2. The rallies on Thursday and Friday morning look to me to be largely shorts buying to cover their positions.
3. Due to the sudden volatility exhibited last week, all three of the major stock indices have developed price gaps below current prices. Many market analysts believe that most sustainable price trends need to fill any price gaps before they can make a sustainable move.
4. It is reported that asset managers have reduced their positions in US equity futures.
5. Looking at the Weekend WSJ edition’s chart of the week, in evaluating the performance of 72 measures of stock indices, commodities, ETFs, and currencies, 48 were higher and 24 were lower. 
6. Based on market history we have just entered the most favored six months of the year, November through April.
7. Perhaps the most long-lasting element is that governments are slowly addressing the global retirement capital deficit. The US government is increasing the limits that individuals can put into their 401k for company matching.

What May Be the Most Dangerous Four Letter Word

Could a four letter word be the most dangerous word in the financial community? And the word is bond, not James, but the contract that used to be called the certificate of confiscation.
           
There has been a net outflow from bond mutual funds for the last six weeks. Are investors waking up to five factors?

1. In the last five years the average taxable bond fund has produced a total reinvested pretax return of +1.79%. Many bond investors use the income from bonds to meet their current spending needs. This implies that they are not getting the highest return element in bond investing, which is the compounding of interest on interest. Further, inflation has probably reduced the purchasing power of both their interest and their capital at maturity.
2. Bonds are meant to be safe and secure without risk. While we know we can lose money in stocks, that is not supposed to happen to bond holders. This can and does happen if the price of a bond drops due to a rise in interest rates, inflation, or the issuance of more attractively priced newer bonds. Relatively few bond investors can avoid the need to sell their holdings before maturity and thus get the current market price rather than the maturity value.
3. There are some that believe that interest rates will rise. Martin Feldstein, the President Emeritus of the National Bureau of Economic Research, is one. He has said “It would not be surprising if the rate on ten-year Treasury bonds rises to 5% or more over the next few years with an inflation rate of 3%.” 
4. There is an expression that came out of German Hyper Inflation, which is “Watch out when the Banks start building”. For many years, on the way to the New York Stock Exchange I walked past One Wall Street, which was the headquarters for a bank that lost a proxy fight. The cornerstone had the date of 1930. Today we are greeted by the announcement that JP Morgan Chase has selected an architect to design its new Park Ave. headquarters tower.
5. Maybe bond fund investors are sensing their risk. For the last six weeks they have been net redeemers of their mutual funds.

Bottom Line
Recognize that things are seldom what they seem. Perhaps now is the time to review your holdings and update your investment process. We may be able to help. 



Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2018/10/we-are-in-training-exercise-weekly-blog.html

https://mikelipper.blogspot.com/2018/10/committing-reserves.html

https://mikelipper.blogspot.com/2018/10/learn-from-blame-game-weekly-blog-546.html



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We Are in a Training Exercise - Weekly Blog # 548

Mike Lipper’s Monday Morning Musings

We Are in a Training Exercise

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

         

We are Never too Old or too Rich Not to Learn
After almost ten years of a one-way domestic stock market we are experiencing some discomfort. Fixed income markets have been falling for some time and most commodities and currencies, ex the US dollar, are in bear markets. One might say that many investors in the US stock market over the last ten years have learned little and forgotten much.

Some of the realities we have forgotten:

1. Change is always present, but it becomes noticeable at different rates and times. From a portfolio standpoint, the time of maximum risk is often when each position is profitable.  The current prices of many positions are two to one hundred times their original cost. The danger herein lies in the belief that the size of these gains is permanent. Any detailed study of wealth over the years will show that it fluctuates and the only way to lose a lot money is to make a lot before one loses some or all.

One way to see the power of change is to examine the ten largest market capitalization companies in a series of ten-year intervals,1998-2008-2018. (See the footnote as to why the three periods were selected.) Only Microsoft and Exxon made the list in all three periods. Thus, there was an 80% failure to maintain relative market capitalization. One might say that any long-term investor who does not own these two for the next ten or twenty years is betting that they don’t survive at the top of the relative peak in market cap.

2. Perhaps, the most creative part of human nature is the ability to circumnavigate around an accepted standard. At one point in financial history the most important measure was yield, which was replaced with book value, which gave way to size and then to earnings per share. Now it is non-GAAP earnings. Usually, sellers of securities favor the old popular measure, where buyers prefer a newer version. Because of changes in accounting standards, tax rates, and regulations, private equity participants often use EBITDA (Earnings Before Interest, Depreciation, and Amortization). I prefer operating earnings adjusted for debt service. The one thing I am confident of is that in ten years the transaction price battle between buyers and sellers will utilize other analytical measures. The art of selling well and buying wisely demands nothing less.

3. One of the most valuable lessons that Charlie Munger taught Warren Buffett was that it was better to buy a good company than a good business. With the cycle of disrupting the old and replacing it with the new, there is a risk of buying into a copycat model based on the financial ratios of some currently successful company or venture. At one point there were some 300 US automotive companies, semiconductor manufacturers, restaurants, banks, insurance companies, and universities. According to Mr. Buffett, a good business is one that any fool could run and often does.

Defining a good company is not a mathematical or a historic exercise. The focus of the search is not on the “C” suite exclusively, it’s on the bulk of the people. Can they do the next important job? Do they have the trust of their clients and suppliers? Will they generate many of the new ideas and procedures that make both large and small differences. While too many annual reports state that their employees are their best asset, some do make that condition happen.

4. Market price liquidity is not important until it becomes critical. Most of the time price sensitive buyers and sellers keep prices and the spreads between them in check. During periods of stress the urgent price insensitive buyer or seller dominates the market and is a heavy user of the liquidity pool. As their insistent need to trade uses up much of the present liquidity, it frightens away some potential liquidity providers, leading to both greater than normal dispersion of prices and spreads between bid and offer levels. Often the price insensitive player is motivated by a need to meet an obligation. This could be an Authorized Participant or a Market-Maker keeping his book in balance. The biggest destabilizer is an owner meeting an immediate margin call.

There are some that say the unusually severe drop in the Chinese “A” share market was caused by the government’s concern about the quantity of  debt in China. They put pressure on the four major government-controlled banks to reduce the size of their loans. They in-turn called part or all of the loans to various entrepreneurs who pledged shares in their company. To meet the call they liquidated enough of their holdings to meet the banks’ demands.

Maybe one of the reasons  many NASDAQ stocks with good earnings and prospects fell more than other stocks is that large portions of their shares were owned by hedge funds, private equity funds, and senior employees who were meeting margin calls. This is the kind of market action that has been periodically happening ever since there have been collateralized loans.

At times, the size of the liquidity pool is more sensitive to sudden changes in sentiment than financial and economic numbers. Periodically, changes in political trends can cause driven investors and speculators to become price insensitive, causing liquidity providers to reduce their commitments or retire from the game.

Perhaps investors have learned enough from last week’s training exercise. Enough to know that when the real market reversal comes they will recognize what to do, before, during, and after a future “big one”. I hope so.

Footnote
2018 is ten years from the last major market decline and 31 years from the biggest single day decline, which was much more a market phenomenon than an economic one.

2008 was the first year of the great financial crises. This was the result of excess leverage by the private sector in response to a series of governments attempts to postpone a crisis in the economy, although they made future crises worse.

1998 was the year I sold the operating assets of Lipper Analytical to Reuters Group Ltd. It was a good company because we had good people who were dedicated to helping both our direct and indirect clients. 


Did you miss my blog last week? Click here to read.

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Copyright © 2008 - 2018

A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.