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


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