A Good Week for Long-Term Stock Investors - Weekly Blog # 516

Introduction

“Six months ago everything was good you couldn’t find a reason to sell stocks. Now you can’t find a reason to hold them.”  I was delighted to read this quote in The Wall Street Journal. I only hope there are more expressed sentiments of discouragement. As our subscribers have learned, such views and increased volume of transactions are necessary to have a successful test of a bottom. The actual index close can be higher, lower, or equal to the questioned low point, but without a change in sentiment it is just statistics.

Parsing out the quote I found the singular buy and sell driver encapsulated in one word, “a”. Perhaps it is my long training as an analyst and portfolio manager, as well as a racetrack handicapper, or just living through these times. However, I have never not had conflicting reasons to buy or sell or take any other actions. One of the training techniques for salespeople when trying to make a sale is called “The Ben Franklin Close”. Perhaps the wisest of the Founding Fathers, who was essentially a successful businessman, used the approach of listing the plusses and minuses of a proposal in two columns on a single page. As long as the potential buyer accepted the validity of the list and the positives out-numbered the negatives, Ben Franklin closed the deal. To make a final decision, I require the weighting of each listed item not just the number of items. My experience has made me a contrarian. I always have doubts.

Investors make the most money in periods of doubt. These periods of doubt are often ones where the bulk of the “experts” are on one side or the other. For example, the vast group of experts who were against the British leaving the European Union predicted dire results if the foolish people voted for Brexit. They predicted unemployment would rise significantly, the value of the currency would drop, and London would be deserted by the financial community. In a front page article in the weekend WSJ Review section, a British editor indicated that the Brits are doing just fine. Unemployment is the lowest it has been in years and the pound is higher than it has been in some time. Additionally, the number of the financial people being transferred to the Continent appears to be in the hundreds not the thousands predicted.

Recognizing that I can and have been wrong, or at least premature, periods of doubt represent opportunities that “experts” can be wrong. After all, the Western Hemisphere was discovered during a period where many “experts” believed the earth to be flat, because they could not see beyond the horizon. By definition, long term investors must look beyond their current horizons.

An Explanation via Fund Data

Investment Performance

One of the main differences between growth and value fund investors is the time horizon expected to bring gains.

The growth investor is looking to a brighter future for the companies in which they invest. Value investors are betting that there will come a time when the values they perceive become more appreciated. Over time both have produced good results, but at different times. (This is why in many of our fund portfolios there is a sample of each discipline. Due to the long underperformance of value-driven funds, a contrarian might start to nibble. It is quite possible in the next wave of acquisition activity that smart acquirers will recognize the value properties before the market does.)

Currently, while the “popular” media is full of headlines as to problems, successful investors are evidently favoring growth. In the year to March 22nd, most equity funds are down a bit, but there are only eight fund peer group averages that are up 3% or more. Of the US Diversified Equity funds, only the four growth fund categories produced 3% or more. In the Sector fund group, just the Global Science and Technology funds make the grade, and they were higher than the Growth funds. Just two other investment objective categories: Latin American funds and China Region funds made the 3% gainers leaders.

Flows

While exchange traded products are governed by many of the same regulations as conventional mutual funds, the reasons their owners use them are different, therefore they should not all be lumped together in deciding market implications. The vast bulk of the money in ETFs and ETNs is invested in broad Index funds, which are primarily used by trading entities like hedge funds and discretionary advisors. In numerous cases these have replaced more expensive derivatives.

Mutual funds, a much older investment vehicle, were primarily designed for retirement, estate building, and other long-term needs. They are found in individual accounts, defined contribution plans [401k], and individual retirement accounts [IRA]. As the participants fulfill their needs they redeem their existing funds and use the money, or change to more conservative investment options. For many years growth funds were among the most popular funds, performing quite well and above most retirement measures. Because of the lack of growth of new investors, redemptions are not being offset by new sales. To my mind these are “completions” of earlier promises.

To respond to the lack of growth in sales of funds at the retail level, brokers in the US and elsewhere have been reducing the number of funds being offered and reducing the number of fund houses with which they are dealing. Funds are not the most profitable products for brokers and some managers. At some point this may change.

On the Horizon

Committees in the US Congress and the Administration are working on a second tax bill. Some of the possible provisions address the need to create more retirement capital in the US. Other countries are also addressing the lack of sufficient retirement capital in an era of extending life spans, expensive health care, and slower to no worker growth. Seniors vote, while often young people don’t.

Conclusions

Despite perceived and perhaps more importantly unperceived problems, equity risk investing is needed by the world and will happen.

The more people sell the more opportunities exist for the patient buyers and their advisors.

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Investors Need to be Wrong to be Right – Weekly Blog # 515

Introduction

Investing is an art not a science. In science the search is for a repeatable answer under every identified condition. As strong as it may seem to many, the search is not in the end the largest performance number. The search is the delivery of the required funds to meet the accepted needs of the beneficiaries; be they institutions or individuals investing within the realms of prudence. Thus, the investment manager’s primary function is to aid in the feeling of the well-being of the beneficiary. According to a recent report on happiness as applied to nations, well-being is based on income, healthy life expectancy, social support, freedom, trust, and generosity. It is far easier to contribute to well-being through sound investing. I believe our clients hire us to provide sound investments for them in order to accomplish their well-being. Thus far I have been able to deliver. But much of this is not based on the certainty of math and science that I learned in school and university, but as a handicapper at the New York racetracks. From an investment standpoint what I learned at the track that is useful can be summarized as follows:

1.  The objective is not to win every race but to finish the day as a winner (including expenses).

2.  Don’t bet on every race, there could even be days when no bets are made as the payoff odds are not appropriate to the probabilities foreseen.

3.  Occasionally the most popular bet is logical in terms of expected results, but the payoffs are too low because it doesn’t take into consideration what can be called “racing luck.” At these times it could make sense to invest in the second or third most logical horse if they are being offered at reasonable odds for second or third place and turn into larger money makers if racing luck overcomes the favorite. This is a good bet as favorites rarely win, even half the time.

4.  After concluding the most logical result, the real analysis begins, which is how much should be bet on this horse in this race? Weighting one’s bets can make the difference of a nice win vs loss record and walking away as a winner for the day.

5.  Accepting that I was wrong an uncomfortable number of times, but learning from the experience by re-examining both my analysis and how I handled my money and to a lesser degree my expenses.

Thus, I believe that, like other investors, I will be wrong in terms of market direction, sectors, “factors” and selections. To defend our beneficiaries’ interests I have adopted a policy of having a number of different bets at the same time, but with the recognition that unlike at the track where races end, the investment process continues through many cyclical periods.

“Goldilocks” May Be Leaving

Liz Ann Sonders of Charles Schwab among others is raising concerns about the future. After all, for at least nine years it has been somewhat easy to ride the secular rise in the US stock market. (Shorter periods for other stock markets.) This issue brings up a number of questions: evidence of impending change and what should be the correct investment policy going forward. In terms of evidence of impending change there are two important elements:  flows into stocks are from traders not investors and credits may be mispriced leading to fixed income not providing stable values. This week some in the press for the first time are heralding significant flows into the equity market from “funds”, which shows the Public is buying the current conditions. The truth, according to Thomson Reuters’ Lipper Inc., is that $20.4 Billion came in net, but $18.7 Billion went into domestic oriented ETFs with $8.2 Billion going into the SPDR S&P 500 and $3.1 Billion into PowerShares (Invesco*) QQQ. Both of these are favorites of hedge funds and other traders. In numerous cases ETFs and ETNs are being used by these players as substitutes for futures which are more expensive. I am noting that a number of investors have sold short some ETFs that represent over 10% of their assets and in at least one case over 100%. What may be more disturbing is that a number of independent investment advisors and a number of advisors working through brokerage firms are managing discretionary accounts exclusively in ETFs/ETNs. Some of these are probably good, but I suspect many do not have any successful background in market trends, sectors, “factors” and the selection of individual securities. They may be, along with others, contributing to a much higher turnover rate in ETF/ETN portfolios than conventional mutual funds.

*Invesco is held in a private Financial services fund and personal accounts that I manage.

Credit Concerns

Remember that most significant stock market declines begin after a period of fixed income market declines. Through March 15th most bond funds are showing a slightly negative total return, which includes both their income and their market movement. The only domestic groups that are not negative are loan participation funds, some specialized credit vehicles, and ultra short maturity funds. I don’t know when the next recession will commence, but I expect it will be within this first term of the President. I do know that during a recession bankruptcies and other financial difficulties occur and they are not being priced into the market. Institutional term loans are being priced at only 3.2% above prime corporates, compared with 3.1 % before the crisis that began in 2007-8. Further, while banks have much more capital than they did before the last crisis, their book of derivatives is somewhat higher.

In a talk at a Futures conference last week, my old friend Tom Russo, formerly General Counsel to Lehman Brothers, mentioned that when a counter-party believes it was duped, the entire class may be considered illegal as an auditor will have difficulty claiming the asset is worth 100 cents on the dollar. He said, according to the Financial Times, that “when you owe a little bit you call your bank - when you owe a lot you call your lawyer. “A good bit of derivatives are directly or indirectly financed through the credit market.

What Should Investors Be Doing Now?

There is no special reason for long-term investment policy to be changed as long as it contemplates that there will be periodic market declines. This is similar to money that is invested in what we label Legacy and Endowment Timespan L Portfolios®. For those with a shorter focus of at least five years, they should be making two lists of equities and equity managers.

The first list should be of items that at higher prices would become risky if the general stock market rises at a rapid rate. (There is some chance of this happening as new money rushes in on the basis of buy-the-dip or FOMO fear of missing out.) The risk is that such a surge most often leads to a major fall, which could lead to structural changes. The second list should be labeled “Hopefully not to be used, but probably will be.” It is a list of sound companies and managers who may be slightly damaged in a decline but will survive and prosper. Both of these lists should have names and prices scaled to avoid emotional price reactions. Five or ten price points could be prudent.
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Danger Ahead, New High Stock Market: Is Capital Preservation with Appreciation the Answer? Weekly Blog # 514

Introduction

At the end of February I was about to suggest that both the high and low for the year 2018 were in place. If either price was violated it would be troublesome. After the first nine days in March I am getting much more concerned about a breakout above the January highs.

Why are Higher Prices Dangerous?

Perhaps I am jumping to the wrong conclusions, but for many the 400 point rise of the Dow Jones Industrial Average on Friday can be chalked up to volatility, but others may see it as a successful test of the February lows. (I would have preferred a lower test with more volume of trading and statements of discouragements.) But the realist needs to accept reality, not wait for the perfect. There is a good chance that others will see it as a successful test, encouraging buyers with significant power to return and drive the next upward move. Using the very volatile sample by the AAII, 45.2% of their surveyed members are now neutral, which is higher than both their bullish and bearish members. This is a rapid change from just three weeks ago where the neutral tally was 32.6%. In the recent week the top 25 performing mutual funds had gains between +7.77% and +6.07%. All but one of these were growth oriented and or specifically science & tech oriented. 

Thomson Reuters tallies analysts’ earnings estimates and in their latest report the analysts expect the S&P600 Small Caps to have earnings growth for this year of +24.1%  compared with +19.45% for the S&P 500 and +37.67% for the Russell 2000. Both the fund performance leaders and earnings estimates are based on a belief that the future is going to be good, led by positive future developments in terms of technology, politics, and economics. (Perhaps they will be correct.)

After nine years of rising markets, I have been on the lookout for signs of an inevitable market decline. In terms of magnitude of decline a normal cyclical decline is in the range of 25%. These happen normally once within a decade. Not too many people are psychologically wiped out in these declines and usually return to the stock market within a few years after the decline.

A much more serious fall, that is often labeled a collapse, happens infrequently, normally once a generation and is generally in the range of 50% from the peak and has investors leaving the marketplace never to return, This type of fall is in the passing on their distrust of the market to the next generation. The individual and societal losses from these collapses are relatively small compared to the forgone profits from the recoveries, which impacts the rest of their lives and often also the next generation’s. As both a fiduciary and an investor I would like to avoid these results. I attempt to do this with an eye on a number of different market histories.

The major traumatic collapses start with apparently successful investing, that not only turns a small amount of money into a larger amount of money but inflates the investor’s belief in their own investment skills. Often this confidence leads to the use of borrowed money in the forms of margin or derivatives. A speculative fever takes over the crowd, while they recognize there is some risk their confidence is such that they can get out without large losses.

The driver of these “animal instincts” is based on an unshakeable view of the future. These speculative markets are driven by sentiment, not researched fundamental investing. This is why I am paying more attention to measures of sentiment, along with attention to internal financial calculations.  One of the fuels of a major top is the sucking into the market of all or most of the available cash.

Assuming the US and perhaps other markets pierce their former highs, the various pundits, including non-professionals, will proclaim that those not participating are stupid. They have never studied handicapping at the racetrack where in each race there is likely to be at least one horse with a good, very current record receiving a disproportionate amount of the betting money. This is the favorite of the crowd, no different than the current market where leading funds are heavily invested in a select group of multinational tech companies. At the track, while the favorites do win at short odds, they don’t win enough money to cover the losing bets the majority of the time.

I am concerned that over the next year or so too many investors, including those institutions that are de-risking, will get sucked into the market. My fear is not for them alone after their disappointment of losses from the next peak, but for the opportunity losses in a future recovery. Unfortunately in our society these are the losses that are socialized for the rest of us to pay.

What are the Signs to Watch?

Currently, the most visible largely speculative source of flows into and out of the market are the Exchange Traded Funds (ETFs). Much of the current activity in these securities is by traders, often at hedge funds, who are using ETFs rather than more expensive derivatives. In the last week, while the larger mutual fund industry had a small net inflow due to net purchases of non-domestic funds ($2Billion), ETFs had a net outflow of $12.6 Billion with $10.3 Billion in one ETF invested in the S&P 500. This is a sign of a trading market that has lots of speculation occurring.

The second item to watch for soon is mutual fund advertisements heralding their ten-year performance results, which had been trailing more current periods. It is easy to look good from a bottom in March of 2009.  These market efforts could bring a lot of unsophisticated money into the stock market, which will entice the so called sophisticated players to trade the market on the way up convinced that they can get out in time.

What can a Wise Investor Do?

In an over simplification, portfolio strategies can be divided into two buckets: Capital Preservation and Capital Appreciation. For some of our clients, particularly those who have worked hard for their money, their primary concern is capital preservation. This is particularly difficult today if one is concerned about after inflation and after tax earnings. Around the world, governments in theory are sponsoring inflation as a way to create jobs, by ballooning the income of businesses and individuals. What they are actually doing but not discussing is lowering the purchasing power of the loans that they are repaying. This is a continuation of a trend, as governments since their beginnings have debased their currency as a way to payback less value than what they received. 

To the capital owner and the individual, inflation is another form of taxation. In the current environment income taxes are not the only source of pain. Because of the recent changes in the US tax code, I believe we will see an aggregate increase in fees, tariffs, sales and use taxes, as well as various forms of value added taxes. If the job of capital preservation is to maintain the purchasing power of capital, it must earn more than inflation, all taxes, and other distributions. I suggest that in the current market, high quality bonds can’t produce the necessary income. (That is why in our TIMESPAN L Portfolios® we should only have fixed income in the Operational Portfolio.)

At this juncture, until we see much higher real interest rates, the best suggestion is high quality stocks whose yields are in the range of the ten year treasury and have a history of periodically raising dividends roughly in line with inflation. One would like to find dividend payout ratios below 50% of earnings, if possible. In truth that is going to be difficult to do with appropriate diversification.

As a practical matter many accounts are going to have to dip into the capital appreciation bucket. In selecting funds or stocks I would array them based on a guess of how many years into the future the particular issuer will pay a dividend that would qualify for inclusion in the capital preservation bucket. In some cases this may be in only a few years. In others, like with Berkshire Hathaway* and Amazon, the indefinite future may be too short. In these cases the willingness to periodically sell off some of the appreciation to fund the preservation bucket could allow the position to be in the portfolio.

* Owned in both a financial sector fund and personal accounts that I manage

<b>Questions of the week:

What portions of your portfolio do you consider Capital Preservation and Capital Appreciation? Do you expect to change these based on market cycles?  

Investors Should Use Microscopes – Weekly Blog # 513

Introduction

Learning experiences occur everyday for investors with an active, searching mindset. We can see their importance more clearly if we utilize a number of tools. At this point in the market’s evolution from a combination of volatility and no forward progress for many stocks, we should be searching for some guides for both our investment emotions and our considered actions. I am suggesting there may be some valuable insights being offered by looking through a microscope as to very recent investment performance for equities and fixed income.

 Current Views through a Microscope – Equities

One of the basic beliefs supporting market analysis is that from time to time the ownership of stocks rotates from “strong” sound, long- term holders to short-term oriented momentum trading “weak” players. Strong and weak are applied loyally to their current holdings. In theory the market’s purpose for periodic meaningful declines is to shake out the weak holders selling at indiscriminate prices; e.g., offering bargain prices to strong buyers who foresee longer term value at these depressed prices. Historically, after a low price is followed by a rally, the question comes up whether the low price is actually the bottom of the move. Often a second or even a third down move “test” is required to convince some strong investors to be buyers. These tests can be at or somewhat near the prior low price. For me it is not only the price move that is critical in declaring a bottom. What I look for is a dramatic change in attitude on the part of the sellers who are exhausted from the emotions of the decline and proclaim they are leaving the game, often calling it “fixed.” At the moment I am not hearing this lament from the sellers. Thus, I believe the February bottom to be a weak bottom. Most of the time weak bottoms are not when the base for subsequent, substantially new highs are generated.

With the above thoughts in mind I wonder whether the stock market, not individual stocks has seen its high in January, which would fit the pattern of post performance from a prior good year.

For Those Committed to Equities for the Long-Term

Many of us have responsibilities to be largely invested in stocks or stock funds because the history of successful large macro bets is poor for many that have tried. Getting three successive correct decisions (Buy-Sell-Buy) in a row has proved to be difficult for most who try. Thus for the rest of us professionals we try to produce the best returns that we can within our prescribed market.

One of the reasons that all institutional investors should pay attention to the results of mutual funds is in aggregate they are the best contemporaneous record of institutional money. (Bear in mind many of the mutual fund management shops manage a great deal of money in non-mutual fund accounts, but use many of the same securities and strategies.) By using a microscope on the very small number of average mutual fund performance through March 1st, one can see some useful patterns. The average US oriented diversified fund declined only -0.31% where the average sector fund fell -3.13 % and the average world equity fund gained +0.11%. What these numbers suggest to me is that during periods of volatility liquidity is important. Further, that an important part of short-term global investing are the inputs from currencies.

There are some other lessons from this study. The best diversified US oriented fund category was the Large-cap Growth funds, which gained +4.02%. (Part of the gain is probably due to investments in a small number of globally oriented tech companies; the average Global Science & Tech fund rose +6.36%) What is significant about the leading performance of the Large Cap Growth funds is that in most weeks it has the largest redemptions. Contrary to the popular view that redemptions are a sign of disappointment in returns, (as these are often the oldest funds many investors own) the redemptions are the completion of particular phases in an investor’s life cycle; e.g., retirement.

Fixed Income through the Microscope

Utilizing the mutual fund data through March 1st, the average domestic fixed income fund was down -0.91%. Not particularly helpful to balanced accounts that were looking to fixed income gains for stability to offset equity losses. Institutional investors and some retail investors did find better investments than the general bond market in Loan Participation funds (Bank Loans) +0.97% and Emerging Market Debt funds in local currencies +2.65%. To emphasize, the importance of currency in Emerging Market Debt fund investing, bonds traded in dollars were down -0.63%.

In reading the annual reports of fixed income funds that our clients own, I found the following statement, “Credit sector is less compelling.” This particular fund has a long history of providing slightly above average income with less downside than most of its peers. Currently, they are sitting with shorter duration bonds or higher quality.

I have written in the past of my unease with the growth of credit funds, both in the US and globally. The leading bank distributing syndicated loans is Bank of America, not one of the leaders that I know of in credit research. The search for yield has been a trap in the past.
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Copyright ©  2008 - 2018
A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.