Where We Are Depends on Where We Have Been? - Weekly Blog # 622

Mike Lipper’s Monday Morning Musings

Where We Are Depends on Where We Have Been?

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

3 Useful Quotes

“Things Are Seldom What They Seem”

“Et Tu, Brute”

“3 Strikes, You’re Out”

Most investors are now asking “where are we going?” I don’t know, but I believe that it is the wrong question to ask. Such as asking about the roof of to be built before understanding the foundation necessary for the structure. The best answer may come from application of the thee three quotes. “Things are seldom what they seem” was used in an operetta by Gilbert & Sullivan.

“Et Tu, Brute” was a critical line from the play entitled Julius Caesar by William Shakespeare. They were written for English audiences, about 400 years apart. These audiences were aware of the internal politics beneath the surface during the reigns of the two powerful queens, Elizabeth and Victoria. English history is replete with attempts to replace the then current leadership and/or succession. Some were successful.

As a practicing security analyst with a contrarian leaning, I always try to be conscious of the wisdom of the quote from Gilbert & Sullivan. In a recent blog I suggested that both main US political parties are deeply split, making it difficult for either of the two leading candidates to get much through the next congress. (One might say that the 2020 election is much more critical to the “down the tickets” than to who sits in the White House.)

“Things Are Seldom What They Seem” 
From internal sources it appears that the reaction to the discovery of the Coronavirus was similarly impacted by political fragmentation, as is expected in the US post the 2020 election. The leadership in China is decided by the senior political leaders and the current Leader was viewed as a compromise between former members of the Communist Youth League (CYL) and the Shanghai faction. The CYL are centralists and the Shanghai faction are more commercially driven.

Wuhan was the capital of the country under the nationalist Chiang Kai-shek, considered problematic by the central government. The mayor of Wuhan was from the Shanghai faction. Thus, for three weeks the central government hid the exponential growth of the number infected. (Both China and the rest of the world paid the price for this internal battle.)

“Et Tu Brute”
For those that may not remember, or never knew about the politics of ancient Rome, there are a series of political lessons. The lessons are about the surprise and disappointment of Julius Caesar when his supposed close friend and supporter became his final assassin. Rome was traditionally ruled by its elected Senate. Because of competing senate factions a triumvirate was formed with Pompey of the army, which included: the army, Cassius, the richest senator, and Julius Caesar (the favorite of the crowds). Caesar claimed to have successfully led an army to capture what is today France and England, earning the loyalty of his army by giving land to his troops. On bringing his army back to Rome he proclaimed that he would be their sole leader, inciting the displaced Senators and causing them to unite and kill him. Shortly after the assassination Rome was ruled by an Emperor, which lasted for centuries. The key lessons applicable today are:

1. Political alliances of supposed equals don’t last, giving way to individual leadership.
2. The power of the masses can install a leader but can’t maintain him/her unless all rivals are neutralized or destroyed.

What do these lessons have to do with today’s investments? That all leaders are in control, be they political, corporate, or sports. Families are temporary. The successors that succeed will often go in a different direction and execute strategies that their predecessors wouldn’t, suggesting that long-term investment strategies are temporary.

Three Strikes, You’re Out 
The nature of economies, market prices, and volumes, is to expand and contract. This undulating pattern is based on human behavior. We want to believe in Sir Isaac’s rule that a body in motion will remain in motion and when it is stable, it will remain stable. Instead of extrapolating the present into the future, we should expect changes that won’t come evenly, as people change over time.

For some time I have expected a reversal, due to the length of our economic and market expansion. Luckily for our clients and family I did not immediately react by selling our long held positions. While I expect periodic ups and downs, like Warren Buffett, I don’t want to bet against this country. My view permits hedging the global market in an attempt to “flatten  the curve”, using a current popular phrase. Nevertheless, I have been expecting a bear market.

Below are the three signs of economic and market problems, ordered by their severity:

1. Demand is falling. China has been the single biggest contributor to global growth, although that rate was dropping even before the COVID-19 and tariff issues. It has become less export oriented and more consumption focused. Europe is also effectively at “stall speed”. Longer term, this suggests their talented people will move to other parts of the world. These are structural issues.
2. Due to insufficient income growth at households, businesses, and governments, borrowers are attempting to buy growth through debt. In far too many cases the growth is utilized for immediate consumption rather than investment, creating the inability to earn enough to repay the debt. Due to the growing pile of debt, inflation and interest rates will rise in time. This is a cyclical problem that can be solved, but it is likely to lead to a rise in defaults, or repayment at a depreciated value.
3. A basic economic rule is that if a commodity is in short supply the price will rise until there is a surplus. This happens not only for commodities but for people too, including lawyers, performers, and certain types of engineers. Today the most prominent over supply is oil. Normally, if the commodity is controlled by commercial interests, periods of oversupply will be handled by agreements or the debt market. Today’s problem is that swing production is in the hands of national governments who need the revenues to meet consumption requirements. These requirements are beyond their current ability to raise taxes without suffering political consequences. If prices remain low many companies will go into default on their obligations, hurting some financial institutions and other investors. The quickest way to solve this problem is through a combination of agreements, strategic reserves, and limitation on new production. Longer term, energy needs per capita are likely to be reduced through technology.

Thus, for some time I have been hearing the umpire calling “3 Strikes, You’re Out” in terms of a recession. These are the underlying causes, but there was also an immediate excuse that ignited the problem, much like the assassination of Archduke being the excuse for WWI.

COVID-19
The media, either through ignorance or political malice, has worked the global population into a frenzy, fanning fears of a truly massive number of deaths from the novel Coronavirus. I am very conscious of the number of victims attached to two universities, whose Boards I sit on. Surprisingly, a number of their victims are students or younger staff, contrary to expectations the virus would hit those of us in the senior category. (To address this risk, my wife and I are completing a self-imposed quarantine.)

Recently I reviewed a published list of the history of plagues, which we now call viruses. There have been eleven in which one million or more people died, three of which were listed as one million perished. This is the level that numerous knowledgeable data scientists are predicting without any intervention from new drugs, including re-purposed drugs, therapies, or vaccines. That seems like a reasonable expectation to me. Perhaps it is high considering the lockdowns and some progress on discovery and delivery procedures. I believe it is important to scale the number of deaths compared to the size of the population. We have many more people in the world than in the years 541-542 where 30-50 million died, or the Bubonic Plague in 1347-1351 where 200 million died, or even 1981 to present where 25-30 million died from HIV/AIDS. From a long-term investment viewpoint, this should not be a large factor in future investing.

Have We Exited the Bear Market?
As regular readers of these blogs are aware, I have been calling what we have seen as a bottom. This is a record short time to be in a bear market, thus it may be just the first phase of a longer bear market that pays some attention to the “3 strikes, you’re out” elements mentioned above.

Are We in a New Bull Market?
Possibly, but market analysts believe we must spend time on building a new base from which we will drive past the old peaks. Perhaps the most bullish indicator is the sample survey of the members of the American Association of Individual Investors (AAII). For the last three weeks the AAII survey has 50%+ viewing the next six months as bears. Not only has this survey proven to be a contrary indicator, it is also rare that any of the expectations exceeds 40%.

On the bullish side, this week we saw many stocks gain more in a week than you’d expect in one or more years. One of the reasons that some stocks were up more than 10% while others rose less than 5%, was the reaction of some in Congress to buybacks. The view is that it would be unwise for a company to buy back its own stock right now. Many corporate executives felt they were no longer prohibited from making personal purchases. Following their leaders, employees not labeled as corporate insiders but believers in the company, bought stock. I believe performance differences between stocks in the same industry may be a type of loyalty index. The bullish attitude also extended to prices on stock indices, ETFs, Currencies, and Commodities shown in The Wall Street Journal each Saturday, where an unusually high percentage of 86% rose.

Bottom line
I would use any rise to liquidate disappointing company stocks, then divide purchases into as many as ten weekly lots for investment on down days, often Fridays. We need to see many of our problems addressed in order to get a full-throated roar from me now.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/03/stealth-bottom-and-other-considerations.html

https://mikelipper.blogspot.com/2020/03/searching-for-bottom-understanding-and.html

https://mikelipper.blogspot.com/2020/03/searching-for-bottom-and-plan-weekly.html



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

Copyright © 2008 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

STEALTH BOTTOM? and Other Considerations - Weekly Blog # 621

Mike Lipper’s Monday Morning Musings

STEALTH BOTTOM? and Other Considerations

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

         

Sector Selections?
Better Yields 
Market Structure Changes Implications?
Early 2021 Patterns
         

DID WE HAVE A STEALTH BOTTOM ON WEDNESDAY 3/18?
Is it possible the pundits did not recognize that we achieved the low for this “correction” cycle? Somewhat usual, I am asking the question that others don’t. First, to me “correction” is a term that should be applied to a down market attempting to correct a former structural weak up market. The US stock market likely would have gone down regardless of the surprise of the novel Coronavirus. Briefly, the causes were:

• China changing from being export led to domestic demand focused.
• The US market over valuing earnings per share, rather than focusing on operating earnings or GAAP net income.
• Excessive commercial and individual lending that was outside of the established banking and credit institution channels.

It was only a matter of time before a market that assumed its long expansion would continue unabated. The virus and its policy reactions showed collectively that the emperors of the world were all lacking the advertised “new clothes”

Two weeks ago, I prematurely thought that the market’s search for a bottom had been reached, although I warned it would be tested and the test could come at lower or higher prices. On Wednesday March 18th we had a substantial jump in NYSE volume. The VIX  index  jumped to 84, compared to 12 the year before. The daily low wiped out all gains achieved since the day the current administration was elected.

For the 3/18 low to be recognized as the low for this phase, it is likely that at least one more attempt to set a new low will occur and it didn’t happen on Thursday or Friday. Both the volume and VIX retreated. News chatter has also improved from both China and the District of Columbia.

At this point in time I am of the working view that we have probably reached a bottom, addressing the excessive elements mentioned. What the bottom does not contemplate is the structural changes to investment policies going forward. At least they are not currently clear to me. Consequently, I am beginning a very wide scan of the future, looking to the 2021-2025 period. The rest of this blog will hopefully generate responses from our very perceptive subscribers, with their contributions either for or against attribution.

SECTOR SELECTIONS
I have maintained that looking through the lens of more than 200 different fund categories, both registered with the SEC and other domiciles, I can see the daily work of some of the brightest investment people in the world. As many of them do not publish their views on a timely basis, I let the performance of their portfolios speak for them, supplemented by periodic publication of their portfolios and occasional conversations with a limited number of them. As a contrarian, the first place to look are the fund classifications that are doing poorly. Are they providing essential products and services, but are priced or delivered incorrectly?

The first two fund categories are globally priced but delivered locally. They are doing particularly poorly now, both in terms of fund performance and in their markets globally. The first is real estate, where all of their international, global and domestic fund categories are performing near or at the bottom. Their buildings do not seem appropriate for the increasing number of people that have or will have limited mobility. Furthermore, their pricing may have to change from being an estate asset, to being used for life or health use instead.

The second major global fund classification suffering are the energy producers and deliverers. In the future we will need more, not less energy as a key replacement for human labor and comfort in a climate challenged world. While consumers of energy will eventually pay for the whole chain of services through direct charges and taxes, they leave others to finance the system and thus have little optionality.

With the expected changes in both the automobile and real estate sectors, they should gain more influence and share the risks of what is delivered. That means they should become equity owners as well as consumers. Some movement in this direction will let the marketplace become more efficient in terms of pricing, including an investment in long-term delivery. This will become obvious when more people recognize that in our lifetimes, we are renters of assets, both short and long-term, and our control ownership dies with us.

For those who want to participate in future development, nothing is better than air. I am not focusing on the hot air produced by politicians and other sales types, or passenger travel. The current requirement to work from home emphasizes the importance of communication and package delivery. The physical and financial limitations of pipes and wires are likely to reduce their importance in the new world. Telecommunications will become our way to make our work, safety, and entertainment more efficient. The management of telecommunications has been tied in the past to the financing and rate setting of the public utility model. Ultimately, consumers pay for telecommunication services through a number of different prices and taxes. To the point consumers do not recognize the all-in cost of what they are getting, that should change. (This may lead to smaller governments at all levels.)

The second and largely unexplored investment opportunity of the future is drone package delivery by air. We are already using drones for both package delivery and crowd identification/control, particularly since the virus crisis. (Loudspeaker equipped drones are being used in an attempt to disperse crowds and direct them. They are also being used to patrol various locations.) We need to establish a grid system for drones that allows them to travel safely and efficiently, as well as instituting other regulations. One should expect weightier deliveries with appropriate policing. I wonder when drones will  carry robots to finish the delivery, or perhaps do some of the on-sight work. There should ways for us equity types to participate in this innovation.

The advocates at Matthews Asia have put forth an interesting view. Can China, now that it no longer has any new cases of the Coronavirus being reported from Wuhan, a city of 11 million, be a good place to invest for a globally diversified portfolio? There is evidence as to the power of a command economy. Large companies are loaning money to their smaller suppliers. Apple has all its Chinese retail stores open, distinct from their stores in the rest of the world. An interesting headline from the Financial Times shows that Apple is not alone, “Volvo’s China plants almost back to pre-shutdown levels.”

BETTER YIELDS
Over the last couple of years, few if any individuals or institutions could pay their increasing bills from the interest or dividends available in the US market. This may be changing. We may be returning to an old model where equity dividends were larger than those of high-grade bonds.

Each week Barron’s produces a Best Grade Bond yields index and this week the index read 4.01%. (That is the highest I remember in a number of years.) In the same issue there was an article that highlighted the following yields from large financial institutions: J.P. Morgan Chase 4.2%, Morgan Stanley 4.5%, M&T 4.2%, and US Bank 5.1%. I believe all of these are owned by Berkshire Hathaway, which I also own along with J.P. Morgan and Morgan Stanley. More importantly, these yields are below the Barron’s index of intermediate grade bonds (5.37%), which have a higher yield due to their perception of having less safety. In that article they also show the banks, with what they calculate as their stressed price/earnings ratios: J.P. Morgan at 22.2x, down to 10.1% and Morgan Stanley with an earnings power calculation assuming large credit defaults. I do not suggest these companies for your investment, but to show that there are corporate yields higher than high grade bonds.

If any of our subscribers own or are contemplating municipal bonds, I would be happy to discuss the risks that have led to their sharp price declines.

MARKET STRUCTURE IMPLICATIONS
A perpetual warning that should be given to all investors in publicly traded stocks and bonds, is that companies and holders share the same name, but not necessarily the same path of progress and value. The day-to-day price of securities is a function of its owners, particularly those who are selling. The sellers are transacting to meet their own needs and desire for liquidity, as well as to partake in other opportunities that may or may not be competitive with the stock’s name. In the past, most cities and towns had street level walk in brokerage offices and registered representatives to handle customer originated ideas. Their somewhat safer house recommendations have been replaced by packaged products like pensions, 401-k or similar products, and mutual funds.

The upstairs broker or website producer is now a registered investment adviser, or perhaps should be. They wish to have the customers either legally or actually become a discretionary account. Some of these advisors are really quite talented, but others are not. Many of these accounts perceive that they invest as major institutions do, but do not really understand the needs of the institutions. One way or another, they and others have been heavily invested in the Dow Jones Industrial Average (DJIA). Interesting because the DJIA was the worst performer of the three popular US stock indices on the way up to the peak, as well as the worst of the three on the way down. This is interesting because the junior in terms of age and repute, the NASDAQ Composite, was the best in both directions. The NASDAQ voluntary market makers provide the least liquidity of the three markets. In the latest week, 88% of the stocks listed on the NYSE fell, while only 74% of those on NASDAQ declined. More aggressive institutions and individuals are prominent investors in the outgrowth of the OTC market. This suggests that the herd instinct of the public and their less than market sophisticated advisers were panicking last week, which is one of the characteristics of a turnaround.

EARLY PLANS FOR 2021-2025
I have for sometime taken the view that the sales and earnings reported for the current year have little value in making investment judgments for 2021-2025, the shortest period I normally focus on. As this blog is already quite long, I will outline briefly the initial part of my thinking in building an investment plan for the future. For this purpose, I will just focus on the political input.

I believe in a fan approach to the unknown of taking two extreme positions. In this case I assume one party takes total control of the White House and both houses of Congress and list their priorities. Next take the other side. If you have more difficulty with the second, you haven’t been paying attention and are letting your political leanings influence your analysis at a cost to the performance of your investments. Beneath the surface, both parties are now badly fragmented and being held together for the sake of the election, primarily in the House and somewhat less in the Senate. The day after the 2020 election is over the campaign for 2024 begins in earnest, with a high probability that there will be two different candidates for president. As a practical matter, whomever wins the various elections will probably need to give ground to the “special interests”, often represented by their former colleagues. Furthermore, the challenges that will dictate the record of the office holders will be surprises like Covid-19 and changes in governments and other powers around the world.

I will pay attention to the political competition which is a “parlor game” for the media, but I am more interested in the likely changes in supply and demand for products and services. I would appreciate any thoughts from subscribers, as far too few people are thinking about the future constructively. 



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/03/searching-for-bottom-understanding-and.html

https://mikelipper.blogspot.com/2020/03/searching-for-bottom-and-plan-weekly.html

https://mikelipper.blogspot.com/2020/03/should-changes-in-markets-change-your.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.

Searching for Bottom, Understanding, and Select Futures - Weekly Blog # 620

Mike Lipper’s Monday Morning Musings

Searching for Bottom, Understanding, and Select Futures

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

“The Bottom”
Even before the end of hostilities, survivors begin to determine how bad is bad when someone is attacked. Is this the bottom? For those in and around the stock market there is lots of history to provide clues. At 9:26 AM on the 13th, Larry Goldstein, a very successful micro-cap fund manager and a junior analyst in the same shop with me years ago, wrote the following:

The factors that make a bottom in the US stock market include a combination of climatic selling with an intraday reversal, combined with a breakthrough announcement on testing and treatment for the Coronavirus...This will turn, it always does.

On Monday he was generally right. There was a sizable price gap opening in the DJIA compared to the previous day’s close. The low for the day (21,159 vs 21,200 Thursday close). The close on Friday, which may be close enough to fill the gap, was 9% higher than Thursday’s close.

A Largely Predictable US Stock Market Fall
What was not predictable is the size of the decline in one month’s time. A student of history could have predicted two out of the three causes for the decline. I know of no way to predict the rapid spread of Covid-19, although it’s clearly possible that some in the medical sphere had knowledge of Chinese conditions. The rapid spread of the Coronavirus was a convenient time for Russia to attempt to grab a much larger share of the oil market from US shale frackers and “swing” producer, Saudi Arabia. A student of 19th century world trade history would not have been surprised.

In the 19th century a great German military strategist proclaimed that war was just another way to execute national policy. In the 21st century one could easily substitute trade wars for military wars. Some may even suggest that Germany provided the muscle for WWI due to that country’s late economic development. Germany needed more global markets but found themselves blocked by the trading strengths of the US, Great Britain and others. One could also point to the Japanese attempt to build a “Co-Prosperity Sphere” as being a contributor to the Pearl Harbor attack.

In the current era, China’s contribution of at least one quarter of the growth in world trade was dramatically changing. Under their command economy they needed to create both employment and a rising standard of living. They were evolving from being an export driven economy to having greater reliance on internal market development. Thus, the growth rate of their exports declined, so too would the rate of import growth. The trade issues with the US added to these contractions, Europe lost some exports to China and they received lower price imports diverted from the US.

Europe’s general economy had slowed and in some cases was approaching stall speed, while Russia and Saudi Arabia attempted to catch up with the more developed world through massive capital projects. Both are critically dependent on oil exports to generate the capital needed to hold off the global drive of popularism. Thus, the Russian move to capture greater market share makes sense, it came with much lower prices, contrary to the Saudi’s own needs.

Remember, most large expansions by industry and government are debt financed. The equity market is often slower to react to economic trends than the fixed income market. That is exactly why the following quote from BlackRock’s CIO of Global Fixed Income was so unnerving.

“If you don’t know where the safest asset in the world is, it becomes impossible to figure out (where) everything else is.” 

This uncertainty for the week ended Wednesday led to net redemptions in corporate investment grade bond funds of $7.3 Billion and $5.1 Billion from high yield bond funds. (More on the threat of the bond bomb later.)

Going Forward
The odds are favorite that we have seen the bottom of the major US stock market indices for some time. (I am guessing there is a 60%-75% chance that this is a correct assumption.) I assume any top or bottom will be tested before investors accept a major turn in the cycle. The test can be above or below the bottom, but it will have less sustained force behind it. I have reasonable confidence in the turnaround as a result of measuring the price differences of our closely followed roster of financial services stocks, between Wednesday and Friday closing prices were within 0.3% of being equal.

The reliance on reported earnings per share is a worry for equities. It is a much-manipulated figure due to changes in accounting standards, federal/state tax rates and rules, plus buy backs. Utilizing I/B/E/S data from REFINITIV, analysts estimated that fourth quarter reported S&P 500 earnings would be +10.2%, but net income only +8.2%. That spread widened from 2% in their first quarter 2020 estimate to 2.4 % (+14.3% earnings and +11.9% net income). Since mid-February, or even earlier, no one is holding to 2020 earnings estimates.

The reason for showing the spread is that analyst and perhaps corporate management believe others will accept the reported per share numbers. I always look at any equity in terms of what a knowledgeable person in that or an affiliated business would pay for the entire company. I believe most acquirers would start with net income in building their price bid, or 20% lower before adding premiums and discounts. Thus, many stocks were priced too high, historically they normally are priced at a discount to what an occasional acquirer would pay.

The problem of valuing fixed income paper is more fundamental. There is far too much reliance on debt in our society. Starting with most governments running a deficit, businesses issuing debt to meet current needs, and individuals use debt through credit cards and other devices to cover living needs.

Too many in the population are not using debt to leverage their equity in the purchase of investment producing assets. Those that properly use debt, their underlying equity assures the lender is not taking the first or possibly the largest long-term risk. These days, most debt issues are largely for refinancing existing debts, not increasing earnings generation. (Most of the time, long-term gold owners use their gold positions to hedge against the valuation of other assets. However, after an extended price rise, such as now, they use some of their gold to meet current cash needs or payoff their debt.)

Opportunities 
In many respects we have involuntarily entered a new era. Because Coronavirus it is now critically important that most families be connected electronically. Instead of traditional European style food shopping where one goes to the food market daily, we will attempt to regularly store essential food needs for two weeks or more. We may change our entertainment mix so that more is delivered electronically and less in theaters and stadiums. Universities and other schools may have to learn how to educate differently, rather than putting on classes and giving exams on paper. Perhaps we will need to reconfigure the structure and size of campuses and student housing.

To me, as both an analyst and entrepreneur, I believe we have this year a unique opportunity to build soundly without paying too much attention to the impact on the record. We have involuntarily entered a “gap year” and the track handicapper can throw out one or more races as long as the horse, jockey and trainer are building skills.

As an investor and portfolio manager for others, I am going to be searching for what will be different after these crises are over. Covid-19 and similar problems will be addressed with increasing success throughout the year. Near-term energy prices will settle as market forces find equilibrium points. The “debt bomb” will take much longer, perhaps a generation of both write offs and long-lasting penalties.


Discussion for the week: I am happy to chat with subscribers and explore the opportunities they did not see as we finished 2019.         



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/03/searching-for-bottom-and-plan-weekly.html

https://mikelipper.blogspot.com/2020/03/should-changes-in-markets-change-your.html

https://mikelipper.blogspot.com/2020/02/hate-doesnt-work-for-investors-weekly.html



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

Copyright © 2008 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

SEARCHING FOR A BOTTOM AND A PLAN - Weekly Blog # 619

Mike Lipper’s Monday Morning Musings

SEARCHING FOR A BOTTOM AND A PLAN

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

Where Are We?
It has been about ten trading days since a large gap developed in the popular US stock market indices. Market analysts believe two things about gaps.

• First, most of the time gaps must be filled before the trend can continue. Less often, there is a belief and sudden realization that something important has happened, contrary to what had previously been believed. 
• Second, and perhaps more significantly, China managed to shift gears and become less trade oriented just as the earnings outlook for 2020 turned more modest, with much of Europe approaching “stall” speed in the first quarter. 

In late February, largely non-coastal investors with drivers licenses for ten years or more, had what could be called a “red scare”. They feared there could be a radical change in government that would put into question both their taxes and the long-term health of the economy, including their investments. At the same time an increasing number of investors became conscious that the “workshop to the world” and a big customer was dealing with a new fear labeled COVID-19. After substantial stock market gains in 2019, it appeared wise to take a foot off the investment peddle and wait for future developments.

What Happens on a Gap Day?
These are the Friday, March 6th stock price changes, a Gap day for the Dow Jones Industrial Average (DJIA) and a single high grade financial services stock we follow:

                                          Financial 
Occurrence                        DJIA  Services Stock
Friday Opening vs Thursday Close -2.54%     -4.29%
High for Day vs Thursday Close   -0.48%     -2.98%
Low for Day vs Thursday Close    -3.43%     -6.58%
Close for Day vs Thursday Close  -0.98%     -4.31%
Close for Day vs Friday Open     +1.60%     -0.03%

If you just compared the closing prices of the two days, one might conclude a continuation of the prior down days. However, if you compare the close with the opening, you might think the downward pressure on the stock was spent. Turnaround days are frequently challenged by another down day, which either holds at current prices or finishes higher or lower and is then followed by a price rise. This is in effect the first day of the end of lower lows, at least for a while. Let’s hope so.

Any Evidence of a Fundamental Turn?
Remember, almost any study of past market cycles indicates that the market senses change before new events happen. Both periods before World War I and II showed that markets sensed forthcoming problems. At other times markets have started to rise before the news events that followed.  There are at least two current observations that point to an upward market.

While stocks can get favorable surprises, bonds and other credits rarely do. Interest rates are a driver of fixed income markets and are therefore tracked carefully. As a stock analyst I pay attention to the bond market as a forecasting tool. As with many tools, you need to carefully separate those becoming popular vs. those the smart practitioners are using. While an increasing amount of money is being poured into fixed income markets and funds, it has the feel of the Children’s crusade in the Middle Ages, which resulted in them being slaughtered. The current shrinking level of interest rates will clearly not fully pay for the increasing needs of the future.

Looking at the current interest rate table, while the front end is dropping, yields for maturities of five years and longer are going up (fixed income prices are falling). Each week Barron’s tracks an index of what it labels “Best Grade Bonds”, as well as another index made up of intermediate grade bonds. This week the yields of the best grade bonds declined by 30 basis points compared to the intermediate credits, which declined by only 13 basis points. Translated into non-market talk, high quality bond prices went up more than twice as much as the yield hogging intermediate crowd. This suggests that the big money feels the need for better quality. With common stocks yielding more than bonds, one would think that money would come back into the stock market at some point in the future.

Addressing the fears being generated by COVID-19. I find it encouraging that funds invested in India were the worst performing group this week, while three funds invested in China were among the top twenty five performers, indicating a brightening picture in China. Apple expects its factories in China will be operating at their prior levels by the end of the month.

The Plan
During each bull market a group of mid-level Wall Street executives, either formally or informally, created a Planning Group which disappears during the next recession as members find new and better income producing jobs. This demonstrates that during the bull market there was a group thinking beyond the next accounting period. I participated in some of the discussions, as it was useful to increase my knowledge of how “The Street” thought about the present always being difficult and the future always being better. I saw the benefit of organizing one’s thinking about the future and the futility of planning. With those thoughts in mind I suggest we are in some form of interregnum, where it could be useful to ponder the future. The next section is therefore an exercise in thinking about the future, providing a platform to disagree and aid your thinking.

Coaches and Racetrack Handicappers Deal with the Future Now
All winning or losing streaks are relatively rare. Normally, life rotates between wins and losses. Every professional coach needs to both assure his/her players that the immediate past does not dictate the next event, and more importantly the lessons that should have been learned.

As you can’t speak to the horses and can only communicate with jockeys and trainers, bettors often throw the past race or races out. I therefore suggest we throw out not only the first quarter of ’20, but be prepared to extend the discard pile to at least the first half and possibly all of the year. The recovery from the virus and a difficult election cycle will only distract us. It will not be particularly significant to our investing in ’21 and beyond. Here are the following lessons:

1. We live in a world of interconnected surprises. One needs to be alert and see them both as an opportunity and a threat.
2. Periods of expansion almost always lead to an over extension, which stretches resources beyond their capacity.
3. Crisis Management all too often starts after the crisis is already well on its way.
4. Physical, mental, and emotional health are critical assets that are potentially at risk at all times.
5. The ability to recover and correct is the sign of a champion in sports, business, and relationships.

Planning Elements
The following are considerations in building a sound plan:

1. Assess the need for money within calendar year periods, e.g. 2021-2025, 2026-2035, Beyond 2035.
2. Within each of the years, one should list the needs in terms of importance.
3. Assume a minimum of a two year down market that could stretch to four years.
4. Review your current portfolio and separate out those investments that are fulfilling their desired or at least expected results. Reduce by at least half those investments that are not working.  As we are going into a recession no later than 2022, the limit in aggregate “turnarounds” should be 10% of the portfolio or better (10% of the risk portfolio.)
5. Begin building your shopping list for future investments and slowly buy a minimum position to get the reports and begin to understand how they trade.
6. As many around you become more pessimistic and follow the market’s fall, begin building the foundation for the next investment cycle.
7. Attempt to spot strong elements of excessive ego in both yourself and the senior management of your investments. Reduce their position levels to recycle money for the next expansion. Allow for some mistakes, as we all make them and must recover and move on.

Question of the week: Are you thinking about the next investment cycle? 



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/03/should-changes-in-markets-change-your.html

https://mikelipper.blogspot.com/2020/02/hate-doesnt-work-for-investors-weekly.html

https://mikelipper.blogspot.com/2020/02/investment-losses-can-be-prots-weekly.html



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Copyright © 2008 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

Should Changes in Markets Change Your Investment Structure? - Weekly Blog # 618

Mike Lipper’s Monday Morning Musings

Should Changes in Markets Change Your Investment Structure?

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

Warning
Traditionally, investors use comparisons as a tool for making critical judgments and grow comfortable with current events that are within the envelope of past experiences. Momentum driven investors prefer data in the mid-range of past experiences, whereas contrarians look for a reversal of “normal” trends. Both sets of investors may find the current marketplace unsettling. Some may be considering changes to either the structure of their investment thinking and/or their specific selections. Possibly turning off the autopilot based on past security price action, or viewing corporate results through the lens of political or economic pronouncements.

What has Changed?
If we have entered a period of fundamental change, it has not been going on long enough to catalog all that is changing. The following is a partial list of observations different than past experiences:

1. US stock market indices have dropped more than 10% from record levels in six trading days. (Historically, a drop of 10% is labeled a correction, suggesting record price levels were not appropriately valuing current conditions.) In the latest week, our list of client owned funds or those of possible interest showed only 9% in the best performing quintile, compared to 35% for the trailing twelve months. (Obviously, the funds’ managers were not positioned for the correction.) Within the S&P 500, they would have needed substantial holdings in Communication Services, Real Estate, or Healthcare, down -6.34%, -6.34% and -6.66% respectively. For the week, the best performing equity category within the index was Growth, which fell -7.15%. The ten best performing funds on the list fell under 1% and the ten worst declined -12.11% to -13.31%
2. One of the base beliefs of many investors and particularly large investors, is that large market capitalization reduces risk. That was not the case this week, with the Dow Jones Industrial Average falling -12.36% vs. -10.54% for the NASDAQ Composite.
3. During the week ended Wednesday, ETFs had net equity redemptions of domestic investments of $14.5 billion, compared to $4.3 billion of domestic equity redemptions for the larger conventional mutual fund universe. I believe most of the trading in ETFs is done by investment advised retail accounts and institutional trading accounts, whereas most mutual fund redemptions come from retirement oriented accounts seeking to reduce perceived risks by cutting back on their equity exposure.
4. Each of the four largest private equity fund groups has over $1 trillion in assets under management. In total they are believed to hold over $2 trillion in “dry powder”. Private equity and private capital (Fixed Income) used to be funded exclusively by institutional investors. Increasingly they are receiving money flows from retail investors, directly or indirectly. (This has led to a situation where the prices paid by private vehicles are higher than those paid by the public, which could drive deal prices higher and possibly result in more leverage.)
5. In fixed income there are risks from a slowing global economy due to a normal economic cycle. There are also temporary payment problems caused by Covid-19 and credit terms are growing loser in response to increased competition from higher flows. Simultaneously, some investment advised money is fleeing equity markets and rushing into fixed income markets, where interest rates are declining.
6. A change is likely in future weekly blogs regarding the alerts of news items with a contrary perspective. In the past, I have highlighted the negatives along with some positives. Going forward, I will redouble my effort to find positives.

New Alerts
China has experienced three long-term positives that have not gotten a lot of attention:

1. The Chinese government has ordered its mines and refineries to open for business.
2. Apple stated that all its manufacturing plants are now open.
3. While the Apple store may not be open, I suspect customers are ordering merchandise and services on their Apple and other devices from their homes. Recent checks with companies reveal that much of their “intellectual” and service works are being conducted from employee’s homes. (I have not been able to determine when this will be recorded in their financial records)

The spread between the 30-year US Treasury bond yield and the 3-month yield has gone negative. In the past this was a reasonable predictor of a recession. I suspect some small and mid-sized companies will fall behind in paying their bills, due directly or indirectly to the Coronavirus (Covid-19). In many cases, I believe their creditors will try to avoid starting the bankruptcy procedure, but some will be forthcoming. (The US Treasury should have sold all the 30-year paper they could, as demand exceeded supply. The average maturity on US government paper is about half the UK’s maturity.

What to do Now?

1. Recognize that the structure of the economy and markets are changing. Compartmentalize a single portfolio into sub portfolios based on payment responsibilities, separating risk appetites.
2. Most patient investors don’t need liquidity to get out of declining positions in the majority of their portfolio. From a risk standpoint, market capitalization is only critical in rare circumstances and can be expensive. More critical in the long run are the time and effort to follow what one owns, as well as any new opportunities. I personally address this issue by using both investment companies and individual stocks. For example, I believe a good investor should be exposed to healthcare, although I don’t own a single stock in that category. What I do own is some specialized healthcare funds and more generalized funds that have good healthcare analysts and/or portfolio managers.

Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/02/hate-doesnt-work-for-investors-weekly.html

https://mikelipper.blogspot.com/2020/02/investment-losses-can-be-prots-weekly.html

https://mikelipper.blogspot.com/2020/02/the-art-of-portfolio-construction.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.