An Awkward Moment with Frustration not Exhaustion - Weekly Blog # 591

Mike Lipper’s Monday Morning Musings

An Awkward Moment with Frustration not Exhaustion

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

Trying to develop a sound long-term investment strategy at any time is difficult, as most of the time we are clearly not at a top or bottom of a significant market move. We wander along an uncertain path to an eventual turning point, but each day, or in my case week, I must read the current sign posts to decide whether or not to change direction on the path I am traveling. Currently, there are three difficult choices to select from:

1. Stay reasonably fully invested in the upward sloping secular trend, accepting that there will be periodic cyclical movements.
2. As the opportunities and risks in today’s world are not the same as in the past. We should become increasingly defensive by building meaningful cash reserves.
3. Prepare for global policy mistakes that causes devastation.

I put the chances of being correct for each of these choices at 65%, 30% and 5%, respectively. On an overall basis I would improve my odds by sub-dividing the portfolio into timespan segments and periodically re-weight the commitments to the segments based on both perceived future conditions and the changing needs of the beneficiaries.

These three working conclusions are based on the following inputs:

Secular Continuation with Bouts of Cyclicality

• Most of the current volume is being generated by those that have a short-term time horizon. They are being whip-sawed by politically oriented news which is generating a lot of frustration. However, it is not generating the quantity of transactions representative of final exhaustion, or a complete retreat from participation.
• Nevertheless, traders are making decisions based on liquidity e.g. compare the ratios of advances to declines on the NASDAQ 211/314 vs. NYSE 411/229. (In general stocks on the NYSE trade in greater volume than on the NASDAQ) 
• Net flows into and out of ETFs shows short-term withdrawals this week. The two largest withdrawals totaled $4.6 Billion and the two largest net purchases totaled $1.2 Billion. The S&P 500 and MSCI Emerging Markets were sold and Consumer Staples and Gold were bought. 
• Even after Friday’s drop of 3% for the NASDAQ it is till up +16.63%, whereas the DJIA is up only +9.87%. Both gains will probably be larger than the total earnings gains for 2019, suggesting the market is looking for a good 2020.

Game Changers

• Lower interest rates and less binding loan covenants are likely to cause more bad loans.
• Only 42% of weekly prices are rising. Could we have deflation in goods and inflation in services and imported goods?
• Last week the interest rate offered to depositors went from 0.65% to 0.73%, suggesting that banks are increasing lending in face of slowing demand for products and services.

Global Mistakes

• The battle for dominance is essentially driven by defensive needs, not land or market dominance.
• The Chinese have been thinking in these terms for more than a thousand years. The earliest example of their well-developed thinking is in the writings of Sun Tzu entitled “The Art of War”. Jessica Hagy has produced a book that visualizes Sun Tzu’s thoughts. These should be understood by other world leaders and are shown below:
• Hold out baits to entice the enemy
• Feign disorder and crush them
• If your enemy is secure at all points, be prepared for him. If he is in superior strength, evade him.
• If your opponent is temperamental, seek to irritate him. Pretend to be weak, that he may grow arrogant.
• If he is taking his ease, give him no rest. If his forces are united, separate them.
• Attack him where he is unprepared, appear where you are not expected.
• These military devices, leading to victory, must not be divulged beforehand.
• The general who wins battles makes many calculations before a battle is fought.
• The general who loses a battle make but few calculations before-hand.

The Asia Times has an article entitled “China now has edge in Indio-Pacific”. It is based on a think tank report from an Australian group named United States Studies Centre. The study raises the question “Could the era of US military primacy in the Pacific be over? Their view is that internal conditions within the US suggests that it will not fully fund the needs of its National Defense Strategy. At the same time China is building a capability which in a surprise attack would destroy or cripple some or all of the US’s Western Pacific main installations in Guam and Japan. (Interesting that the report did not name our forces on Iwo Jima and in the Indian Ocean.)

My Point of View
As a former electronics, aerospace, broadcasting and conglomerates analyst, I have seen the power of small electronic components change massive companies and markets. The current “trade war” was designed to protect the primacy of our semiconductor technology, which is critical to both US and Chinese defense efforts. To paraphrase Admiral Alfred Thayer Mahan’s statement of Who controls the Seas, controls the world. I believe the two Emperors of China and the US are acting as Who controls (leads) semiconductors and related technology controls the defense of their countries.

An Important Question
Considering how long value focused managers have suffered, can we build portfolios that are able to survive a similar period, regardless of our investment strategy? Any thoughts?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/08/short-term-recognitions-plus-longer.html

https://mikelipper.blogspot.com/2019/08/sentiments-approaching-reversal-points.html

https://mikelipper.blogspot.com/2019/08/is-last-week-significant-weekly-blog-588.html



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A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

Short-Term Recognitions Plus Longer-Term Work - Weekly Blog # 590

Mike Lipper’s Monday Morning Musings

Short-Term Recognitions Plus Longer-Term Work

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

Short-Term Recognitions
We have reports of financial cycles since the beginning of recorded history and are always in some phase of a cycle. The keys to financial survival and future success are to recognize where we are in the present cycle, something which is almost always difficult to do emotionally. It is tough to label the current down draft. Is it a trading incident, a correction (normally about 10% from peak), the beginnings of a “bear market” (normally about 20% from peak), or a major crises that occurs once in a generation, with a decline of 50% or more? Only time will tell which of the alternatives describe our immediate future.

In the current US stock market most of the trading volume is from groups that are short-term oriented. With this orientation they tend to react to changes in sentiment rather than long-term trends. In the current market environment, I tend to focus on price changes for the NASDAQ Composite Index, which has risen the most of the three main stock market indices. The Composite includes a fair number of tech stocks and companies that provide services. Both of these have been growing their revenues faster than the industrial companies in the Dow Jones Industrial Average (DJIA) and the more broadly invested Standard & Poor’s 500 Index. (If it weren’t for the weak performance of the mid/small mixed financial services companies in the NASDAQ Composite, the lead would be even larger.)

Viewed in this light, the most recent weekly difference in the number of stock prices rising or falling may be instructive. The New York Stock Exchange (NYSE) had 373 gainers and 440 losers, whereas the NASDAQ had 203 gainers and 516 decliners. The NASDAQ is only off -5.21% from its peak, half-way toward being labeled a correction. Clearly one goes through each gradation until the ultimate bottom is reached. Whatever the appropriate level, some further fall is a reasonable expectation.

As I and others have stressed, the current market is led much more by sentiment than the investment fundamentals found in financial statements. Nevertheless, one should recognize that sentiment can impact prices for securities, currencies, and commodities. Each week The Wall Street Journal (WSJ) shows the weekly price movement of 72 items. Like many sentiment indicators, the rises and falls are normally bound in a 60/40 range. This week only 30% of the prices rose, with 70% declining. If attitudes toward prices remain outside of their normal range, it could be significant and could point to a larger decline than a mere correction.

One statistical series that may be misinterpreted is the constant sale of stocks by well-known value investors. These trimmings are being viewed as disenchantment with the holdings and while some disenchantment may be true, before reaching that conclusion it is necessary to review their record of inflows and outflows. When these previously successful investors are forced to make a partial liquidation they often choose among their most liquid positions, not necessarily their weakest. This has been the pattern for many quarters. If the downturn becomes more pronounced the time for trimming will likely end and favor totally selling out of selected names that may not have the same chance of price recovery. This typically happens near the end of market declines.

Time to Build Research Lists
In past market declines my fellow analyst friends would have lists of names and prices they wish to recommend to clients and/or purchase for themselves. All too often these lists are not executed due to the low-level of confidence in the new analytical work being done. It is with these thoughts in mind that I am now suggesting that this is the time to begin in-depth work on new names, not in portfolios or coverage patterns.

The first place I would look for candidates is the mutual fund investment objective averages. There are 19 fund averages that have risen less than 6% this year and 4 that have produced negative returns. These are:

Agricultural Commodities     -8.88%
India                        -5.58%
Natural Resources            -5.26%
Base Metals Commodities      -2.80%

Apart from the funds focused on India, the other three are classic supply/demand vehicles which are now suffering from insufficient demand for the current supply. We know from history that these conditions lead to future supply being curtailed by the withdrawal of some of the participants, although with both population and wealth growth there is little question that future demand will be higher than today’s level in the future.

India is a fascinating opportunity currently experiencing internal political issues. Nevertheless, it is the fastest growing major economy in the world. Faster than China and within twenty years it will have a bigger population too. Fourteen of the remaining investment objectives focus on international investing, many with an Asian mandate, highlighting two possible attractions. The first is summed up in a quote from the Chief investment Officer of Matthews Asia. “Growth that depends less on trade and more on continued savings, efficient investment, and institutional reform. All things to which Asia remains committed.” For a global investor, the largest risks is a decline in the value of the US dollar relative to other major currencies. (This may also reflect a relative decline in the standard of living for many US residents.)

The only domestic oriented investment objective with a low year-to-date average return of +4.25% is Small Company Value Funds. As with other value-oriented investment objectives, performance has lagged most other groups for the past several years. These funds must meet redemptions by liquidating and dealers might not be willing to take their discard into their limited inventory. The three commodity types mentioned above will rise when their markets are dealing with shortages.

There is another category that at some point may include some real bargains, internally driven turnarounds. Internally driven turnarounds most often result from new leadership and the restocking of operating management with new talent. Introducing new products and services with attractive pricing will also help. Unlike the swing from oversupply to shortage, internally driven turnarounds take time and may attract short sellers who are not patient.

Investment Conclusions

1. Review your portfolio for those positions you want to own for the next bull market and dispose of the rest.
2. Start the lonely job of researching new potential holdings which are likely to be winners in the next new market phases.

Questions of the Week:

1. Are you prepared for a down market?
2. Are you looking for the next Bull Market Winners?  

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

https://mikelipper.blogspot.com/2019/08/sentiments-approaching-reversal-points.html

https://mikelipper.blogspot.com/2019/08/is-last-week-significant-weekly-blog-588.html

https://mikelipper.blogspot.com/2019/07/chinese-emperors-learn-all-roads-lead.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 - 2019
A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

Sentiments Approaching Reversal Points - Weekly Blog # 589

Mike Lipper’s Monday Morning Musings

Sentiments Approaching Reversal Points

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

In the near future US stock market sentiment will approaching a reversal point.

Handicapping the US Stock Market
The art of picking winning bets at the racetrack is called handicapping. The betting goal is the same for long-term investors, to have more money at the end than when you started. Note, unlike baseball it is not the number of wins vs. loses. Both handicappers and investors recognize they will be wrong a percentage of the time, but in both cases success is measured by the number of dollars remaining at the end of the game, suggesting that in order to cover the losses gains will need to be larger. As the portion of the wins must be bigger than the average win, most successful investing involves a streak of contrarian thinking.  With that in mind I’ve laid out my view of the current level of the stock market.

As of August 9th, the three major stock market indices have declined modestly from their recent record levels. (S&P 500 -3.54%, DJIA -3.92% and NASDAQ -4.45%) None of these are even near a -10% correction, a -20% bear market, or a generational decline of -50%. Even including the worst week of the year, the three indices are up between +15.87% and +23.14% from the lows generated on January 3rd. However, the weekly survey of sample members of the American Association of Individual Investors (AAII) shows that only 22% are bullish for the next six months, with 48% being bearish. These percentages are historically extreme. A somewhat more nuanced view is expressed by bond and bond fund investors that also indicates caution. For the week ended Friday, yields on a Barron’s list of high-grade corporate bonds yields fell 11 basis points vs. only 4 bps for a similar list of intermediate credits. (Remember, a fall in yield means prices rose, indicating increasing demand.) During the trading week ended Thursday, General US Treasury Bond funds rose +2.25%, while the average High Yield fund declined -0.48%. It’s interesting that in a week where the Fed lowered interest rates by 25bps, the flight to safety pushed US Treasuries higher. 

Like Charlie Munger and Warren Buffett I am not a big fan of book value as a measure of operating success, although it is somewhat useful as a gross comparative measure. Comparing last week’s market to book value with those of a year ago, the DJIA declined very slightly, while the S&P 500 is the same as a year ago. Thus, the market is not grossly overpriced despite second quarter earnings being flat. According to analysts, the current quarter is expected to show a 1-2% decline that will be made up in the fourth quarter.

However, there is still reason to be concerned. On a year to date basis mutual funds have gained 2-3 times their average rate of gain for the last five years. Additionally, they are producing gains that are higher than their very long-term rates of return. Funds limited to the largest stocks, both within the US and abroad, have gained +14.47% year-to-date on average, compared to their five-year average return of +5.77%. Multi-cap Funds, a group of funds without a size limit which often has some large caps, were up +13.74% year-to-date and +5.32% for the past five years. Funds focused mostly on US holdings did somewhat better than those invested abroad due to having more tech holdings and the long-term rise in the dollar.

Short-Term Investment Thinking
Just as the betting results on the most favored racehorses is not great because they rarely produce enough betting winners to cover losses, I am betting against both the AAII crowd and the buyers of US Treasuries. I would also not be surprised if 2019 ends with high single-digit equity gains. In most of our managed accounts I would not disturb the highly selected funds in our portfolios.

Caution: Healthcare Could Look Like Financial Services in the Future
Over my professional investment life the Financial Services business has been quite good to me and my family. However,  the average rates of return have not been as good as they were in prior decades. Looking at the structure of these businesses today, while the numbers are larger the number of people and firms have shrunk. The number of publicly traded firms has been cut in half. The rates of return are also smaller than what they were years ago. Perhaps the single best measure of the decline is that fewer sons and daughters of successful professionals and successful investors want to enter these businesses. In sum, I believe the percentage returns are smaller than those of past decades for most investors. There is a very real risk that the same trend will govern the Healthcare Industry.

As with the Financial Services business, the Healthcare business is already highly regulated by the government and it is likely to become more so. In both cases the purpose of government regulation is to make care available, better, and cheaper for the public. I have twin fears that it won’t happen. The first is a story in Sunday’s New York Times about an individual who went to Mexico for a knee operation  paid for by a generous employer funded insurance plan. This is just another example of what is now called medical tourism, in this case to lower costs. Non-US citizens, both the very wealthy and the very poor, are entering the US for healthcare services they can’t get at home. For many years US residents have been traveling to other countries to get medical treatments not been approved here. These trips, along with the number of Canadians in our hospitals, demonstrate that patients will travel to get what they believe to be better or cheaper medical care. They may or may not get it.

What has likely caused the increase in medical tourism is the combination of increased regulation and the limiting of profit making of doctors, hospitals, insurance companies, pharmaceutical companies and all their suppliers and servicers. As an investor, as well as portfolio consultant to a hospital, I have looked at their financials. The good ones are reasonably profitable, but increasingly many are not and therefore  one needs to look beyond the dollars of profit. The first ratio to consider is profit relative to investment. Perhaps more important, is their perceived ability to pay dividends to their owners. For the most part these organizations feel compelled to reinvest their so-called profit into their activities. In many ways I do not consider retained earnings as current profits, because as an outside investor I can’t spend it.

As someone who has a large family dependent upon me to pay some or all their medical bills, including insurance, I would appreciate lower medical costs. It is important to understand that insurance is temporary risk shifting, favoring long periods of paying premiums directly or through the workspace. In the end my real desire is for others to have the lowest costs, but I want the best care for my family and the best often includes the new best drug or procedure. My fear is that as we restrict profitability in the healthcare system we won’t get the lifesaving or life betterment new drug or procedure quickly enough.

Just as we are well served in the financial services businesses by an appropriate level of profit, we need to ensure that the healthcare system can do its job of making our lives better.   


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

https://mikelipper.blogspot.com/2019/08/is-last-week-significant-weekly-blog-588.html

https://mikelipper.blogspot.com/2019/07/chinese-emperors-learn-all-roads-lead.html

https://mikelipper.blogspot.com/2019/07/us-stock-markets-new-highs-misleading.html



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

Copyright © 2008 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

IS LAST WEEK SIGNIFICANT? - Weekly Blog # 588

Mike Lipper’s Monday Morning Musings

IS LAST WEEK SIGNIFICANT?

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

There were some clues this week as to the possible future direction of the US stock market and the likely leadership for various future periods. Both the S&P 500 and the NASDAQ Composite had their single worst week of the year. I view the performance of the NASDAQ as a better predictor than either the S&P 500 or the Dow Jones Industrial Average (DJIA). The gains from the common low point of the year on January 3rd through this past Friday were: NASDAQ +23.83%, S&P 500 +19.78%, and the DJIA +16.74%. This order might be representative of the level of speculation, or at the very least the reverse order of dividend yields.

It may also be instructive to look at the number of new highs and lows for the week. The New York Stock Exchange registered 603 new highs and 250 new lows vs. the NASDAQ’s 322 new highs and 337 new lows. From this data one might conclude that this week’s decline was more a function of correcting from recent enthusiastic gains rather than representing a fundamental change in direction or future leadership.

Possible Causes for The Decline?
On July 31st the Fed’s announced that it was dropping interest rates by 25 basis points. The market was up after the announcement but turned lower during and after the news conference and then fell for the next two days. The NASDAQ had a ratio of losers to gainers of 1.91/0.73. Why? The following list might suggest some reasons:

1. Buy on the rumor and sell on the news is normal.
2. Disappointment that further interest rate declines were not identified as likely.
3. Because of the growing number of consumer and commercial credit extensions, rates should be rising to discipline the market.
4. China’s leadership is in no hurry to address trade tensions while increasing control over all elements of its society.
5. Disappointment with the two Democratic candidate television debates.

The first possible cause is a normal trading reaction. The second is mainly a concern for rate changes during the next 12 months. The third is a concern as to the depth of the next recession. The fourth and fifth causes might impact not only the next presidential election, but also the conditions during the next presidential term.

If only one of the five is important a single portfolio structure can be created. If more than one is important, it reinforces the need to subdivide one’s assets and liabilities into separate timespan portfolios, which we can help construct. For example, if one looks at various slices of the S&P 500 for the last month, the order of the four best performing slices were: S&P 500 Enhanced Value, Value, Growth and Quality. (We have maintained that value-oriented portfolios might perform relatively well coming out of the next recession. In anticipation of this, at least one manager we follow used the brutal decline in the fourth quarter of 2018 to buy some bargains and then used the first quarter of 2019 to lighten up on extended growth companies.) If one wishes to look for possible dramatic turnarounds, the worst mutual fund investment objectives this year through Thursday were the international value fund categories. They have generated average gains between 5% and 7% vs. gains between 23% and 28% for domestic growth oriented funds.

Not Market Timing
Market timing is a process that requires making three decision in a row. The first is to sell. The second is where to place the money in reserve, and the third is the new buy. The odds of making three correct decisions in a row is very difficult and only a few investors can achieve it. The biggest mistake is often made with the reserve element, as cash usually becomes too comfortable and delays re-engagement with risk. The third, which is the most difficult, is to choose something sufficiently different from the investment that was sold.

Further, market timers tend to move the whole portfolio all at once. I suggest a gradual approach, which allows for confirming that the basic view has not changed over time. One of the advantages of using mutual funds as your preferred vehicle is that it allows you to focus on changing investment characteristics, something the funds themselves are generally not set up to do. You are taking advantage of their selection skills in rapidly building a sound portfolio.

Is the Past Week Significant?
I suspect it is an appropriate time to start to move the portion of your portfolio designed to make payments over the next five years or so. For longer-term portfolios this may not be the time to make moves, particularly for those investors that have at least ten years before needing to make payments. One should definitely be judicious in making changes in legacy portfolios.

   
Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/07/chinese-emperors-learn-all-roads-lead.html

https://mikelipper.blogspot.com/2019/07/us-stock-markets-new-highs-misleading.html

https://mikelipper.blogspot.com/2019/07/twin-problems-not-enough-greed-and-too.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 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.