Mike Lipper’s Monday Morning Musings
Excessive Security Risks
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
This last week may possibly have been part of a third correction. After 2017 where there was not a single trading day the market moved 3% either way, 2018 had fifteen such days and finished slightly down. The first correction experienced frequent and rapid sentiment change. The second started after the bottom reached on Christmas Eve and finished after the first full trading week in January, with equity gains in the middle single digits recovering a third to half of the 2018 losses. The third correction was a materially smaller gain last week. For the week ended Thursday, the average US Diversified Equity Fund gained 6.5% for the year to date period.
Investors and particularly investment managers, should always be learning from the present to aid in their thinking regarding their long-term responsibilities to their beneficiaries. (We are all temporary renters of our talents and other assets.) One way to look at the current level of the market is to assume a lower rate of return on risk, be it an investment in stocks, bonds, commodities, and real estate. This somewhat pessimistic view suggests that for retirement and other long-term future payments, the old assumption that equities will continue to appreciate at 9%-10%, as they have since 1926, may not continue. This belief has led to an institutional stock/bond ratio of 60% in stocks and 40% in fixed income. Actuaries in turn assumed a combined return of 7-8% for pension funds, led by the gains in stocks. During this lengthy period, we experienced several deep market declines, wars, and periods of high interest rates, all of which may have been necessary to set-up the subsequent gains that propelled the overall stock gains into the 9-10% range. Although I do not rule out these kinds of wide swings, I do not feel justified in including them into a planning norm. I am considering a different model that looks to the last five years as a better representation of the next five years. In the five years through last Thursday, the average US Diversified Equity (Mutual) Fund gained +6.16%. Future fixed income returns are expected to be lower because we have lower interest rates than in the historic past. Credit losses could drive rates materially higher, which would not be good for stocks.
A Bigger Risk: Seeking Security
For a professional investor, I have often felt that their stomach was a better guide to turning points than their brains! First, it is important to understand how the brain works. Based on conversations with the neuro-economics professors at Caltech, our memory system works on chains. We attach a single thought to an existing chain if it is important to be remembered. We need to find patterns, even in a pattern less world, in order to reduce anxiety. Most of the time, what we believe to be judgement is pattern recognition. Second, the mark of a professional is the willingness to doubt and make mistakes. After all, the experienced investor and hiker know that “no man steps into the same river twice”.
The messages from a professional’s stomach are involuntary. They come from self-experience or observation of others. They send a message of caution not to be greedy when prices are going well, contrary to the brain’s enjoyment of compounding winnings. The other life-long message is the disbelief in absolutes. After the emotional rollercoaster ride of the last eighteen months they instinctively don’t believe in absolute security. They have seen unfortunate surprise endings to securities, firms, jobs, marriages, and lives. Retreating to cash or cash equivalents can be subject to both regulatory changes and inflation. After eight years of gaining assets, an ETF closed due to redemptions (96 months of net sales vs. 1 month of net redemptions.)
What to Do?
Risk was one of the lessons I tried to impart to a board of a liberal arts college attempting to aid enrollment by adding business courses. The presenting professor said he was going to teach about risk avoidance. I suggested he got it all wrong and pointed out that we cannot avoid risk. He should instead focus on risk assumption, with a focus on unintended and unavoidable risks. For our clients we try to move from risk avoidance to recognizing the risks assumed. Taking appropriate measures to reduce the overall risks is an art form, not a science. The single most important risk management goal is to protect future payments on specific future dates.
The second tool in risk management is to understand the leverage that is already being applied to your investments, directly or indirectly. Stock, bond and commodity prices are leveraged by some investors with margin loans. These currently total $554 Billion according to FINRA. This does not include “non-purpose” loans used to support non-securities purchases, which are often used as a cheaper substitute for mortgages. Also not included are corporate loans to employees for the purchase of their own stock, or in some cases relocation benefits. Most of these could be called instantly, forcing the liquidation of all or part of the stock position. We have reason to believe that many Chinese CEOs have had their loans liquidated by selling out their position. In addition, there is operating leverage when operating earnings move more than operating revenues, due in part to corporate borrowing.
One new point of leverage is the delay of deliveries caused by bottlenecks both in the US and China, which stretch critical supply chains and lead to squeezed profit margins.
From a portfolio of funds viewpoint I am looking at some funds differently. We’ve always looked for funds which gained more than the market and average competition on the upside and lost less on the downside. Often that meant we wound up with more volatile funds than some of our clients would like. Recently, I have been paying more attention to funds that go up and down less than peers. What attracts me is higher capture of the up markets than down markets. In one case the fund’s upside capture rate was 72% and downside 62%. This could be a good lower risk addition to a pension type account that is looking at a minimum five-year time span for the portfolio. If the next five years is close to normal and has only one or two down years, this fund will meet their reasonable actuarial standard.
Question of the week:
Can you meet your obligations over the next five years with a 6% equity return?
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