Are Investors Taking Too Much Investment Risk? - Weekly Blog # 713

 

Mike Lipper’s Monday Morning Musings

Are Investors Taking Too Much Investment Risk?

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

One can rarely earn investment gains without taking investment risks. Investors often believe they imperil too much for the risk assumed. This view has led Lee Cooperman to comment that he is a fully invested bear. (He is counting on his timing and trading skills to save his capital) I am in a somewhat similar position in my investment account, which excludes my “burn-rate” and personal future generation endowment accounts.

Focusing on my operating investment accounts I wonder if I am taking too much near-term investment risk, as I do not believe I have sufficient trading skills and expect to be premature. The best way for me to escape a major decline might be to reduce the premature gap from “the top”. The way to do that is to recognize the excessive investment performance achieved by others as a precursor to a massive decline. Prior road trips with a young family echo in my mind, “are we there yet?”.

Listed below are an increasing number of signs of excessive investment performance:

1. Most diversified equity mutual funds produced a 20% gain for 2021, with some professionally managed investment accounts producing returns of 30% or better. History suggests that this is unusual and characteristic of an approaching top.
2. The types of stocks generating above average momentum are like those we have seen in the mid to late stages of a bull market. While stock market cycles and economic cycles don’t have to be coincident, the major ones usually are.
3. The pandemic’s economic cycle impact is unknown. In a normal investment cycle, it would either be the equivalent of an investment “bear market”, or as they say at “the track”, an aberration that should be disregarded. There is reason to disregard the impact of the pandemic, but market leadership does not look like the beginning of a new “bull market”. If we are not in a new bull market, we are in an aging expansion approaching ten years. Bull markets are not closely tied to an economic cycle, but there is something of an echo effect.
4. For some time, the predictive power of reported earnings per share has deteriorated, due to changes in accounting and regulatory rules. From a long-term investment perspective, I prefer to focus on aggregate pretax operating net income, which is not marred by non-operating net interest earnings and changes in share counts. I further attempt to back out the impact of changes in accounting rules, including recognition of depreciation and amortization.
5. We have entered a period of accelerating inflation, which needs to be considered when attempting to predict earnings power generation. This is particularly important in companies reporting significantly larger rises in net income than sales. There are many reasons for this, including operating leverage, with most of the gains coming from the exercise of pricing power to offset inflation. Earnings so generated, are not usually the source of future earnings gains.
6. There are lots of good investment managers, but some with “hot performance numbers” appear to have unsound analytical backing and may be generating gains from skilled market analysis. This is difficult to maintain and is what we used to call “racing luck”.

I am not attempting to precisely predict the future. What I am attempting to do as a good pilot is avoid air pockets that can cause a sudden drop in altitude or permanent loss of capital. 

After The Fall

To the best of my knowledge there has never been an active market that did not have intermittent declines. I therefore have a high level of confidence that at some point there will be future declines in all markets I’m invested in. 

There are two causes for wars, underlying and immediate. Analysts are unlikely to identify immediate causes beforehand but should be able to spot many of the underlying causes. Most of the causes are essentially an ongoing change in the perceived level of competition. When enough power has shifts to one side, the situation is fraught with danger. The leader sees an opportunity to further increase its power and the loser fears further loss of power. Either side may choose to react to this growing disequilibrium. I suggest the growing gap in relative safety measures are such that it is reasonable to fear some unplanned explosions.

 Whatever happens, it is our responsibility as fiduciaries to invest before, during, and after the fall. This plays to our preferred method of investing in stocks, which is through portfolios of mutual funds, mostly somewhat diversified. In preparation for this task, I read the diverse views of successful fund managers. The goal is to build focused portfolio of funds that think differently. This holiday week I had more time than usual to read what managers were thinking about the longer-term future. Two long-term very successful managers produced reports that should earn their place in equity fund portfolios, as described below:

The Capital Group published a 2022 Outlook on the “Long-term perspective on markets and economies”, which had the following highlights:

1. Market leadership is currently the same as it was before the pandemic. (This is an indication of a continuing long bull market)
2. Global economic growth is slowing, particularly in China. (Valuations have expanded, particularly under the influence of buybacks and M&A activity.)
3. Inflation should persist longer than expected, due to broken supply chains, shortages of materials, and more importantly of competent employees, particularly at the trained supervisory level.) Nevertheless, Capital believes inflation will not rise to the double-digit levels of the 1970s. In most inflationary periods stock and bond prices rose.
4. A good time to focus on stock selection by looking for pricing power, sustainable growth, and rising dividends.
5. Expect increased volatility in this midterm election year. (Perhaps this view is best expressed in the firm’s Growth Fund of America, ranked 17th of top 25 mutual funds year to date and the single best for the week ended December 23rd, gaining +3.55% vs +1.25% for the Vanguard 500 index fund. (Compared to many other growth funds, this multimanager vehicle is more risk aware.)

The other fund management group that has produced thoughtful pieces is the London based Marathon Asset Management. They are a successful global investor with a sizable sub-advisor and separate account business in the US. What distinguishes their thinking is their focus on the supply side of the equation, whereas almost all the other investment managers first focus on the changing levels of demand for a company’s products and services. This tends to put them earlier in the timing of the investment cycle. Their portfolios tend to look like those of a value investor, making Marathon a good investment diversifier in an otherwise growth-oriented portfolio. The following are some of their investment ideas:

1. Moody’s and S&P Global are viewed as an oligopoly taking fees for assessing credit instruments. (This is not completely accurate as there are a number of smaller credit tracking agencies, both in the US and elsewhere. What makes them attractive businesses is their ability to access a small increase in prices each year, as well as a fluctuating demand level. (At least I hope so, as both are in accounts I manage, and in a somewhat similar position is Fair Isaac, which provides FICO credit ratings on 99% of US credit securitizations.)
2. With a limited number of new copper mines coming on stream and local governments pushing tax collections, the price of copper is rising. It will probably rise much further as auto production moves to battery electric vehicles (BEV) from internal combustion engines. BEVs, which use roughly 80 lbs. vs 20 lbs. of copper per vehicle.
3. “Private equity will face major headwinds in a governance play with little leverage as topping” (This is another set of headwinds as it is an overcrowded area, with entry prices expected to rise and provisions expected to decline.) “Growth valuations are based on visibility, the ability to push out time horizons ten or twenty years into the future with sufficient certainty to justify paying for that outcome, a very difficult call in a new world based on political whims.”
4. Japan has not adopted the US approach to corporate governance and has limited M&A activity and corporate raids. Stock options are evolving, with more shareholder friendly conditions. (A number of global investors, including Lazard, have a long-term favorable view of Japan, despite its recent economic record. Japan is becoming a more needed US ally, both militarily and economically.)

Next week I hope to devote the blog to some things I and other investors have learned (or relearned) in 2021. Please send me an email on what should be included in the list.    

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Questions Without Answers Indicate Uncertainty - Weekly Blog # 712

 

Mike Lipper’s Monday Morning Musings

Questions Without Answers Indicate Uncertainty

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

Searching for Direction

Investors gain confidence when they have a clear sense of direction, particularly regarding short-term market moves. They ask a lot of questions in the hope of finding concrete answers. This is increasingly true as markets move closer to the top of a major phase. Thus, extreme confidence, while generally reassuring, is a warning sign of a nearby top. 

Each week I examine lots of data and articles in the media looking for concrete answers, or at least a guide as to direction. This week I came up with some interesting questions, without any good answers. As many subscribers are professional or insightful individual investors, I will serve up the questions with elements of my indecisive views. I am hopeful some will provide answers as a Christmas present and communicate them to me, either for my personal use or to share.

Are Smarter Investors Calling a Turn?

For some time, I have suggested large investors in the NASDAQ stock market are on average brighter than those invested exclusively or mostly on the New York Stock Exchange (NYSE). This is based on the performance of various small-company mutual fund portfolios trading on the NASDAQ since the March 23, 2020 trough. On average this has been the best performing group based on market capitalization (The other groups are large-caps, multi-caps, and mid-caps.) However, year-to-date smaller caps are running in fourth place. There was possibly a change on Friday with its high volume? The NYSE volume was 5 million shares, split roughly 2 million on the upside and 3 million on the downside. On the NASDAQ, total volume was close to 8 million shares, split 4.6 million shares on the upside and 3.2 million on the downside. The NASDAQ Composite has declined 5.53% from its 2021 peak, the most of the three popular indices and roughly halfway through a classic 10% correction.

Does Friday's market action suggest savvy players picking up bargains at low prices?

Commodity Funds Rising Earlier than Expected

Numerous individual commodities are rising due to shortages. The median commodity fund is up +28.79%, while the weighted average fund is only up +3.92%. The reason for this difference is the extreme performance of Energy funds +71.98% and Precious Metals funds -10.41%. Commodity price cycles typically extend to one or more decades, for example from 1996 to 2016. Professional commodity investors did not expect a general commodity rise for at least another five years, after several new mines became operational. The switch to electric vehicles from internal combustion engine vehicles has accelerated demand for some metals, while the interest in currency coins has simultaneously impacted the demand for numerous commodities.

Are these speculative trends going to continue and cause actual mine and mill openings to accelerate? 

Investors Are Finding Other Markets Attractive 

While the US equity market has gained about 25% year-to-date, three other markets are also up over 20%:  India +22.3%, Taiwan +22.0%, and Canada +21.5%. Many investors now see international diversification as prudent, with political turmoil making US investing difficult for at least the next three years. As the economy recovers from various pandemics and tax/trade uncertainties, declining percentage gains in rising earnings will hurt. 

The Fed is Not Helping 

The Fed is basically defining its role as affirming the current situation by looking forward from its present position.

Critical Question: Do you think you will change your investment strategy materially before the next top?

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Two Contrarian Questions: Next Recession? and Is NASDAQ Leading? - Weekly Blog # 711

Mike Lipper’s Monday Morning Musings

Two Contrarian Questions:

1. Next Recession?

2. Is the NASDAQ Leading?

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

Position in Polite Society

In a global society searching for popularity, anyone posing the two blog questions would be labeled a contrarian. That person first needs standing to voice a view significantly different than the commonly believed view. To understand my occasional contrarian views and questions, one should understand their origin and basis.

The Origin of My Contrarian Questions

As with others, I tend to learn more quickly and deeply when my money is at risk. While in grade school and secondary school I was an indifferent student, particularly in precise subjects. Numbers only took on real meaning when I was introduced to the New York racetracks. Suddenly, the eight or nine races a day focused my adolescent attention on statistics and other factors that would lead to losses and gains. I started out behind, as I charged my expenses (going to the track and lunch) to my at-risk budget. After-all, I was going to the track to make money, not for a day in the country or entertainment.

Below, I briefly outline the aspects of what I learned at the track, which have carryover implications for investing:

1. There are too many variables in terms of the number of horses, races, and conditions to be reasonably expert on all. (Screen opportunities to find the best selections)
2. The most popular bets, if won, would at best pay off an equal sized losing bet. Favorites win less than half the time. (Thus, betting only on favorites is a losing proposition)
3. Most bettors have a narrow selection process heavily focused on the most current information, with a home track bias. (More complete analysis often suggests this race is different than the immediate past)
4. Because of the differences in odds, one can finish the day ahead by winning only one of three races. There are also times where one can win more on the second horse at the end than the first. (The correct handling of money can enhance the results, such as weighting the size of bets and paying attention to the probability of results.)

The Next Recession

As someone with a contrarian bent, I believe the next recession is closer than most expect. During the fourth quarter it is common to see projections for the coming year. Most of what I see suggests 2022 will struggle to produce essentially flat results, partially because of the significantly above trend in 2021. Many forecasts do not even mention a recession or suggest a very low chance of one. From the above discussion this prediction sounds like a bet on a favorite, which would be reasonable. But the absence of a discussion on the lengthy period since the 2013 recession is not prudent. Yes, we may be coming out of a downturn in the economy labeled with COVID headlines, but the downturn experienced was not a standard cyclical decline and is therefore outside the history books. Perhaps future historians will label it a recession and take some of the inevitability of recessions off the table for a while.

Throughout recorded history we have regularly had periods of expansion and contraction generated by external and internal causes. External causes usually result from increases in demand caused by new markets or resources. Contractions are mostly caused by over expansion, usually through excessive debt generation. Military and trade wars may start out as expansions but eventually lead to contractions because of the resources wasted in these battles.

Increasing exposure to non-bonded credit is the current flavor of the month in the institutional and high net worth portion of the markets. A decreasing minority of institutions have yet to increase their exposure to “privates” or alternatives. The initiators of these debts are probably raising entry prices while simultaneously lowering safety covenants. At the very same time the Chicago Federal Reserve Bank and the Bloomberg indices of financial conditions are deteriorating. Politicians around the world and around the corner, in governments of all sizes and shapes, are encouraging increased spending, meaning more debt issuance. 

I cannot predict the time when all these trends will create some combination of a recession and or financial crisis, but prudent investors are not currently being offered enough reward to offset the inflation and currency risks.

Is the NASDAQ Leading?

As there are “horses for courses”, there are market conditions favoring one kind of bettor or investor. Part of the problem we analysts face in determining what may happen, is not knowing the individual or institution motivation in buying or selling a security. At best we have “circumstantial evidence”, which can lead us in one direction or the other. 

One of the factors in understanding the strength of various bets at the track is how much they are influenced by hometown biases and similar tie-ins. To some degree I can play a similar game by looking at the differences in trading on the New York Stock Exchange (NYSE) and NASDAQ. Thus far in 2021, the stocks listed on the NASDAQ have produced a higher return than those on the NYSE and Dow Jones Industrial Average. The NASDAQ stocks also led the decline this autumn. 

This Friday was an up day for the market, which highlighted the following similarities and differences in the NYSE and NASDAQ:

                                                                                                   NYSE        NASDAQ

Up Volume                   2.07 mil    2.09 mil

Down Volume                 1.74 mil    2.26 mil

New Lows (% stocks traded)  6.7%        17.1%

Stocks on the NYSE are on average older, larger, and more cyclical than those on the more junior exchange. To my mind there is a meaningful difference in the mix of active traders on the two exchanges. The NYSE is almost completely the home of passive stock index investors, including institutions and investors taking advice from brokers, now styled as wealth managers. By contrast, much of the volume on the NASDAQ is generated by active professional traders. (One of the regular rumors at the racetrack is that the “smart money” is betting on a specific horse, causing the betting odds to drop due to unexpected inflows.) Since NASDAQ prices led on the way up and down, I am wondering whether it is the current home of the “smart money”.

The Value of a Contrarian

I believe the smartest thing I did as Chair of a non-profit investment committee was to mostly limit the membership of the committee to active professional investors. I searched for a bearish investor and was able to get one with a long record of shorting stocks. In most years he was quite successful. He was a great addition to the committee in two ways. First, he questioned many of the buy recommendations from other members of the committee, including its chairman. The questioning led to some recommendations being withdrawn. He also contributed one of our big winners, a company trafficking in a little followed area that was not held in high repute, defaulted residential mortgages. It worked out very well and was a very good diversifier.

A contrarian’s value is enhancing the investment discussion and process. Contrarians do not count their ratio of gains vs loses, but the aggregate sums of money earned vs loses.

Question of the week: Are you getting sufficient contrarian views to help with your decision process?    

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Selections - Weekly Blog # 710

 

Mike Lipper’s Monday Morning Musings

Selections

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

Premise

One might say we make lots of selections each day, consciously or otherwise. One of the reasons I rely on lessons from betting at the racetrack is that it forces selection based on known and unknown criteria. The same can be said of investing.  In both cases there are active and passive decisions, although passive passes the decision making onto others. 

In almost all activities, particularly completive activities that can be measured, I try to improve my results by shading the odds a little in my favor. Experience is the best teacher, but each experience should be analyzed. The easy part of the analysis is the number of active participants, locations, length of time, and rewards. What is not easy to determine is the motivation of each participant. A reasonable attempt to figure out motivation is to examine the history of similar activities by participants.

Goals

The strongest of all goals is survival. Survival first requires the preservation of capital by limiting losses and participating in gains. If one wants to grow capital, lost capital must first be made back up to the starting capital level. Actually, return to the original capital level is insufficient, as there are expenses and taxes which reduce initial capital. In today’s world, the appropriate measure of capital is current spending power vs spending power at the beginning. Thus, changes resulting from inflation and foreign exchange need to be calculated and incorporated.

From a Historical Perspective

All life is cyclical. We know our results probably contain ups and downs. Psychologists tell us we normally feel twice as bad about loses than the pleasure of gains. One smart family financial office measures losses, including purchasing power, vs gains achieved. Their goal, which they have achieved, searches for opportunities that will produce gains twice as large as their real adjusted losses. With those concepts as a guide, I first examine the outlook for losses.

Outlook for Three Levels of Losses

Currently, most global stock market indices are showing year-to-date gains. While down from the peak levels of early spring, the gains are greater than those earned in the last two, three, and five years. These gains have been derived from the even larger gains of a small minority of stocks. My guess is non-indexed accounts produced smaller gains. There have been a significant number of absolute losers. The Financial Times recently published an article with the following headline “Half of this year’s blockbuster IPOs are underwater, despite broad stock rally”. They further note, “Goldman has led on 13 deals that raised more than $1 billion this year, but nine of these are now in the red” … ”Six of the 14 deals led by Morgan Stanley were trading below their IPO prices”. I suspect an important portion of these underwritings were bought by hedge funds and other highly sensitive market players. My guess, to the extent possible, is that none of the underwritten shares are currently owned by today’s “fast money” players.

With the above as background, I believe it is wise to look at the three types of market declines:

1. Corrections - Normally a 10% decline from peak. Through Friday, we are about half-way through a standard correction. I always assume the very next day after I purchase a stock there will be a correction. I can therefore tolerate such a market move. 
2. Cyclical – Declines of around 25% occur within each decade, The problem for an investor who pays capital gains taxes out of this account, is the reduction in the size of the account resulting from taxes paid. This raid on capital must be made up to recover the original capital base and is particularly galling if the stock recovers.
3. Structural – Recession/depression with loses exceeding 50%. These are generally part of the economic realization that something is out of order. They often occur during periods of excess borrowing, where the lenders’ financial stability is threatened.

My View

A correction has already begun, and it is not worth repositioning long-term portfolios. We have not had a cyclical decline for a number of years, and it appears to be long overdue. There are increasing numbers of business and people having difficulty. Odds are, within a five-year period there will be a cyclical market decline. Portfolios should be pruned of weak holdings. Weak holdings are those that would cause irreparable pain if they fell by 25% or more before returning to their current level in five years.

Selections Process

This is the topic of a forthcoming speech to a group of financial institutions and their advisers regarding analytical approaches to selecting individual securities, advisers, and funds. Needless to say, my approach is not the standard pitch.

Selecting Individual Securities

Rarely does a person want to exactly copy another. After reviewing the standard Graham & Dodd financial statistics, I focus on what makes a company different. Unless the stock is very cheap compared to peers, it is usually the non-statistical differences which make a stock attractive. I am suggesting that after securities analysis there should be business analysis. The following is a brief business analysis of five stocks owned in accounts, or by me personally. (These are not recommendations for purchase, as that would only be wise if they fit the needs of each portfolio and were priced attractively.)

Apple is viewed as a growing “annuities producer”. Rarely after a single purchase of an Apple product does the customer switch to another brand. Currently, there is a more than usual risk of delayed new purchases due to supply chain issues, higher prices, and the draw of forthcoming new products. Years ago, many General Motors car brands were in a similar position as people in America replaced their cars in one to three years. As with Apple, GM’s strength was in its distribution system. Apple’s is better, having their own stores and departments within big box stores. The annuity like value of their sales helps with their planning and is an attractive attribute for long-term investors. At some point, when attractive new features stop coming, it is possible the annuity like trend will become similar to the overall growth of the market. However, they will continue to produce good sales in countries with faster growing populations.

Berkshire Hathaway is managed for the non-shareholder heirs of current holders. This fits the desires and needs of a large portion of Berkshire’s owners. At some point, I suspect pieces of the operating company will be hived off to shareholders or other operating companies. The book value of these companies starts with their acquisition price, plus earnings less dividends paid to the holding company, which in a number of cases is way below what these activities are worth in an open market. I can envision a day when my grandchildren will receive a growing cash dividend from a smaller, regularly managed company.

Moody’s is a toll collector of fees from most of the world’s fixed income issuing companies, including non-profits and various levels of government. Most of these organizations will grow in an increasingly complex world, where debt is required for progress.

Raymond James Financial has the fastest growing financial services retail distribution network on a per share basis. They aggressively create homes for investment salespeople who find their current employers unattractive.

Goldman Sachs has probably more bright and talented people on a per share basis than any other financial services company. What is intriguing about GS is that it is transitioning from its old model of utilizing borrowed capital to one using capital generated by its own customers. When there is a new profitable game in towns around the world, Goldman will probably be in it. 

Selection of Advisors and Funds

Our history of being an advisor to institutions is one of great length. (We have enjoyed a number of tenures of twenty years or more, which only expired with the change of key members of the investment committee or a desire to go in a different direction). It is disrupting to change critical advisors, so it is done less often. Turnover of a stock portfolio is a more tactical move. With that in mind, the factors to be considered are more about the advisor than the holdings in a portfolio. Portfolios of equity mutual funds change about every 10 years, halfway between the 3-year turnover of a stock manager and the 20 years of a manager of institutional accounts.

In developing approaches to manager selection, one cannot avoid biases. These are thought patterns which at one point had a reasonably good foundation in facts. The intellectually honest advisor consultant or manager should use the current picture to update their biases. The following are my current working biases: 

1. Both highly concentrated portfolios and wide universes can be used successfully.
2. Short investment periods should be examined to find patterns of success.
3. Periods of weaknesses should be discussed in detail to understand humility, blame shifting, and blind spots.
4. Multigenerational team building, by both copying others and new thinking.
5. The reasons for low and high turnover and the difference between turnover of dollars and names.
6. Multiple generations of management in key departments.
7. Business Management skills and controls, analyzing successes and failures.
8. Small vs large losses.
9. Size of boards and executive committees, the smaller the better.

Art Forms

If good investing is an art form, then investment management is a bigger art form. Still larger is the investment management business art form.

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Investors Be Alert to November’s Risk Lessons - Weekly Blog # 709

 

Mike Lipper’s Monday Morning Musings

Investors Be Alert to November’s Risk Lessons

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

In the US we have just celebrated Thanksgiving. Other countries also have typical harvest festivals where they are publicly thankful for personal good harvests. As a perpetual student of investing, I am thankful for the investment mistakes I and others have made, for they represent learning opportunities. We have an opportunity to not repeat mistakes by learning from them. Both George Washington in the American Revolution and Abraham Lincoln in the Civil War started off by losing battles. They came close to losing their wars, but learned well and changed their tactics/strategies. 

In my discussions with successful investors, I usually probe their mistakes, asking what they learned from them. They often mention that there was a factor in clear view that they did not fully appreciate. In general, these factors were not standard securities analysis issues, but some critical element that would have significantly changed the valuation of a security or market.

The month of November could be such a period where changes unfold that make a major difference. In most developed countries with active securities markets stocks sold at near or above normal valuations, with high-quality bonds selling at depressed prices. In most countries COVID-19 was highlighted as the major cause of supply chain shortages leading to rising rates of inflation, although they were usually the result of economies being stimulated with wide-spread grants. These excesses were tolerated, but they made owners of capital nervous. 

Political leaders recognized the best way to win the next election was to continue contributing to inflation, providing more money than the amount of goods and services available. In the US, the latest census will shift seats from urban centers to southern states in the 2022 election. Texas will get two additional house seats and Florida one. Both have strong Republican governors and legislatures, which probably means these three new seats will go to Republicans, with Democrats losing three seats at a minimum. Historically, the party that wins the prior Presidential election loses the next mid-term election in Congress, particularly in “The House”. Based on history, it is logical to expect Republicans to gain enough House seats to prevent the continuation of Democrat spending and taxation policies.

During early November it was rumored within political circles that President Biden wanted a second term, even while his approval rating was simultaneously dropping. At the same time anti-energy moves were pushed by the Administration, most impacting Texas the leading petroleum producing state. The attack on the energy industry continued this week with the tapping the Strategic Petroleum Reserve and the raising of the royalty rate for drilling on government land. (The Strategic Reserve was set up so the military would have a source of energy should foreign countries prohibit sales to the US). It is a bit ironic for this President to make these moves while seeing himself as FDR like. FDR prohibited US oil companies from selling their oil from Indonesia to Japan, giving Japan a reason to expand its drive further South in the Pacific.

In the second week in November portions of the US and European markets topped out, while China’s market was already in decline. This week a new COVID variant, Omnicron (B.1.1.529), from Africa emerged. It is growing very fast and has caused the suspension of an increasing number of international flights. While some may feel this is just bad luck (racing luck), the medical profession has expected new variants for some time.   

On Friday most of the World’s stock markets fell materially. In the US the popular stock indices declined between 2% and 3%. Some sectors were worse, with Health/Biotech falling 4%. A number of individual stocks also declined materially, with at least one falling by 20%. 

Does the abbreviated US stock market session on Friday give us a clue as to its future movement? Possibly, both the New York Stock Exchange and the NASDAQ traded 3.4 million shares on Friday. Ninety percent of the NYSE volume was in declining prices, with only 71% for the NASDAQ. However, the number of new lows on the NYSE was 9.5% vs. 17.2% for the NASDAQ. This suggests to me that further declines are needed for the NYSE to bring stock investors back into the market. It is possible buyers were purchasing options instead of stock and if that happens broker/dealers may buy additional underlying shares.

At this point I do not see anything that would turn sentiment for trading in the week ahead positive. Only skilled traders should try to ride the various bounces that could occur. Initially, US investors will likely follow the path of Asian and European investors, which appear to be muted. Patience may be rewarded.

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What do you think?

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https://mikelipper.blogspot.com/2021/11/best-bet-more-sweaters-and-parkas-vs.html

https://mikelipper.blogspot.com/2021/11/lessons-from-london-mistakes-repeated.html

https://mikelipper.blogspot.com/2021/11/do-you-believe-congratulations-are-in.html

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Best Bet: More Sweaters and Parkas vs Overcoats - Weekly Blog # 708

 

Mike Lipper’s Monday Morning Musings

Best Bet: More Sweaters and Parkas vs Overcoats

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

I don’t like to lose bets, especially investments bets. That being said, I am highly confident those in the northern hemisphere will suffer a colder winter than expected. The streams of cold weather from Asia which flow over North America and Europe are moving south this year and will bring a colder winter to the US. (This contradicts “global warming” or climate change predictions.) The second and preventable driver is the need for politicians to be re-elected.

The only game that counts in Washington DC is getting elected, which importantly is based on money deployed from all sources. Despite food prices reflecting rising transportation costs, the central government is determined to hurt the states supplying energy for heating. Three states in particular are being targeted: Wyoming, West Virginia, and Texas. The first two are the leading exporters of coal to the rest of the nation, with Texas being the leading exporter of oil and gas. (Natural Gas is a major source of heating for much of the northern portions of the country.) These three states have significant Republican majorities, both in terms of votes and more importantly political contributions.) 

The game of war often relies on misleading the enemy regarding your intensions. In Washington this is done by a friendly media focusing on stimulus, even though it is a major contributor to inflation. While inflation is the cruelest tax on the poor, those in power believe the loss of some votes in the city districts won’t endanger the city progressives.

There are already a lot of predictions regarding the sharp rise in the cost of heating this winter. Landlords, already having difficulty collecting rents, may cut the amount of heat. Non-profits, including government bodies without actual or equivalent “rainy-day” funds, may face similar problems. Schools in low-income areas may similarly have shortages of students, teachers, and administrators.

Many of the aggrieved or their representatives will appeal to the media for help in sweaters (inside) or parkas (outside). Those appearing in overcoats will be considered tone-deaf, no matter how well intentioned.

Faulty Responses

Many of the shivering responders shown on television will emphasize the spike in heating costs causing an increase in “common colds”. The number of non-workers will be blamed on “acts of God”, due to shifts in northern wind blasts. They will not likely admit that part of the problem was self-administered, either out of The White House or Capitol Hill. By curtailing the capital generation of energy producing industries the government has caused the US to be an energy importer. It is no longer the net energy producer and exporter it was two years ago. They did this by causing pipelines to close, or not be built at all. Furthermore, in a stretched global market for oil, bureaucrats are increasing the industry’s burden by holding price investigations.

Multiple Year Transitory

As is often the case, economists look at the top-down government numbers of goods produced or shipped for problems, not the services or labor required. In their calculation of supply chain shortages, they fail to recognize the nature of the labor shortage. Not only are entry level workers missing, skilled workers and competent/trustworthy supervisory employees in service functions are also in short supply. (A good bit of these absences can be attributed to "educational" sector unions from pre-nursery through PhD programs.) These issues will not be addressed in the coming cold winter.

Long-Term, the Federal Reserve is Trapped

The favorite tactic of those in Washington is to change the rules if they are losing. Members of Congress are trying to make various economic/government financial agencies into social arbiters, including the Fed. Neither the Fed nor their supervised banks are equipped or authorized to perform these functions.

To the extent central governments want to spend a lot of others’ capital on controlling climate conditions, they will sponsor increased spending. This will result in both the Fed and the debt market increasing global debt massively. One wonders whether present low interest rates will become generational lows. Will higher rates drastically change the allocation of credit to the detriment of consumers at the low end?

Causes of Inflation

Inflation is caused by having too much money and borrowing power relative to the level of goods and services on offer. By itself it would be self-correcting through changes in price, including foreign exchange. However, when central banks create more money than their economies can immediately use, it leads to inflation. This is exactly what has been happening, so much of the current inflation has been caused by stimulus (bribes) payments. Thus, governments are a source of inflation.

Investing Choices

Perhaps the only wise reason to own securities today is the belief that the managers of some companies will be able to grow dividends above average inflation after taxes. 

If you have other reasons let us know. 

Did you miss my blog last week? Click here to read.

https://mikelipper.blogspot.com/2021/11/lessons-from-london-mistakes-repeated.html

https://mikelipper.blogspot.com/2021/11/do-you-believe-congratulations-are-in.html

https://mikelipper.blogspot.com/2021/10/mike-lippers-monday-morning-musings.html

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All rights reserved.

Contact author for limited redistribution permission.

Lessons from London: Mistakes Repeated - Weekly Blog # 707

 

Mike Lipper’s Monday Morning Musings

Lessons from London: Mistakes Repeated

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

The Learning Process 

For thousands of years human bodies and emotions have not changed. One should therefore not be surprised we repeatedly make the same mistakes. Too bad because most of the time we only learn from our mistakes, and possibly those of others. One of the great advantages of visiting London and friends/colleagues of fifty years or more is the opportunity to ponder past mistakes. It is a particularly good time now, as the financial community is being forced to play a role in governing human behavior through directing corporate and market behaviors. My recent visit to London this week has brought me to this task. 

Humans often want more than they currently enjoy and search for things beyond their current condition e.g., defense. The search starts with the extended family, community, tribe, state, nation, alliances, supranational organizations, and corporations (particularly utilities and financial communities). Why is the list so long? 

The answer rests on the reliance of top-down thinking. A review of top-down mandate disappointments demonstrates that without well thought out bottom-up practical thinking, the desired grand idea fails to be carried out successfully. A couple of examples will illustrate the point. 

In the UK, wisdom is apparently equated with investment success and that is why most CEOs are replaced in their sixties. Independent directors also have limited terms. An extreme example is the likelihood that no chief investment officer or investment CEO has lived through a bond "bear market". It is now very popular for incoming CEOs/Chairs to be female or minority. Many are qualified, but one wonders whether they are the most qualified. Much of what is done today is done to obtain a high ESG numerical rating. In the future, as in the past, clients and shareholders could suffer from the single-minded thinking of graduates from elite universities, military regiments, or clubs. 

There are at least three Investment Trusts (Closed-End Funds) that are over 100 years old, and they can teach us two useful lessons. Each was a narrow sector fund investing in American Railroads, Texas Oilfields, Mortgages, and Rubber Plantations in Malaysia. Today we have many open end and closed end specialty funds. Some perform very well during a particular period of time but underperform more diversified portfolios over longer-term periods. The second lesson to be learned from these old sector funds is that when one invests in a narrow-based fund it may evolve into something quite different. The managers often recognize the need to invest in another type of business when the original one is no longer attractive. 

I am always looking for different ways to analyze investments and other activities. One successful multi-generation family uses an additional measure to gauge success, believing losing money is much worse than not optimizing the upside. In their relatively small number of losses, they measure the multiple that gross gains represent of gross losses. This approach appeals to me for endowment and multi-generational types of accounts. 

This week there is a dichotomy between a highly valued US stock market and the slightly negative performance of the generally lackluster major stock indices. A contrarian or good analyst might look at the US data for the week and notice the often inverse 6-month prediction reflecting the American Association of Individual Investors (AAII) sample forecast. The bullish forecast jumped to 48% from 42% the prior week. Additionally, 6.9% of the NASDAQ stocks traded hit new lows, while only 3.2% of the NYSE shares hit new lows.

In walking around the non-financial districts and shopping centers there were very few working ATMs to get cash. When commenting about this to veteran investors they commented that their children don’t use cash. Local bank branch sites are increasingly being used for restaurants or stores. (Similar trends are seen in the US.)

While traveling there is a risk of not reading financial news thoroughly. One article had the headline “Berkshire earnings tumble by two-thirds”. Only in reading the small print did one discover the comparison was versus the prior quarter, which had a very large investment gain. More importantly, third quarter operating earnings rose quarter to quarter.

Two observations that could have major long-term implications became known this week: 

1. Morningstar believes that a safe withdrawal rate of 3.3% from a 50/50 balanced retirement account would preserve capital through retirement. (I have my doubts considering government inflationary policies and demographic trends producing fewer productive laborers.)
2. Apparently, the Central Committee meeting of the Chinese Communist Party (CCP) did nothing to slow Chairman Xi’s goal of being in power to at least age 83.

Question of the Week: Any changes in your thinking?

Did you miss my blog last week? Click here to read.

https://mikelipper.blogspot.com/2021/11/do-you-believe-congratulations-are-in.html

https://mikelipper.blogspot.com/2021/10/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/10/are-we-listening-as-history-is.html

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Do You Believe Congratulations Are in Order? - Weekly Blog # 706

 

Mike Lipper’s Monday Morning Musings

Do You Believe Congratulations Are in Order?

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

Interpreting US Stock Market

Various US stock indices reached record levels last week. Does this indicate a new “bull market” or a new phase in an old one? Based on recorded history, the choice is not based largely on one’s political views, but on long-term earnings trends, dividends, and how they will be priced. While the precise answer for any future date is uncertain, the specific date is irreversible. Our job as risk managers is to guess the correct strategy today, although most long-term investors are somewhat reluctant to make major changes. 

Some investors weigh losing any significant money to the market or taxes as much more important than the write-down of inventory prices. Investors should adjust the importance of these factors in making tactical and strategic decisions. Absent these hurdles, investment decisions should be based on odds and penalties. 

Odds should be based on selected histories. For example, at the racetrack one tends to place more confidence in a horse that has developed a consistent pattern around the track. This is relatively easy to do with securities, as prices normally have a cyclical pattern. The more difficult decision is assessing the penalty for being wrong. This decision becomes easier if a specific portfolio structure is introduced, as discussed below:

Burn Rate Portfolio

In addition to anticipated future payments we should set aside a reserve for unexpected non-market related contingencies. The sum-total should be put in what insurance companies call, a “side pocket”. The critical question is how long a period of unfortunate markets the side pocket should cover before the main investment portfolio once again produces wealth for future needs. As mentioned last week, history does not exactly repeat, but rhymes. Apart from a grossly mismanaged recession in the early 1930s, most recessions end in three to five years. One might therefore want to use a five-year plan.

In today’s investment environment, one should not put the entire “burn rate portfolio” in cash. Inflation will erode the purchasing power of the dollar relative to the currencies of countries supplying our needed products and services. The most critical rule for the reserve account is being liquid. Some of the money may be needed in five working days, some within a month, and almost all within a quarter. 

Depending on the size of the account, I would be inclined to invest 50% in well-diversified, conservatively valued equities, or well-chosen mutual funds. The bulk of the remainder should be invested in high-quality corporate bonds, with maturities spread over the next five years. A relatively small amount should be invested in a retail US Treasury Money Market fund. The most important next step is to create a separate side pocket from your investments accounts.

Investment Accounts

In today’s environment the only portion of the account not invested in equities is a timed buying reserve. The key is to invest this cash out of the market, reconstructing a different buying reserve at least annually. Within the diversified investment account, one should have some market price sensitive stocks, usually selected from cyclicals. Another portion, depending upon the comfort level of the investor, should be invested in time sensitive investments, often secular and explosive growers. 

We cannot avoid being international consumers and investors today. Bear in mind that the general history of wealthy investors is to choose some investments less influenced by local governments. Within the investment account there is room to invest both aggressively and conservatively through individual equities and or mutual funds. (Because of my background of globally following fund and fund like vehicles, I rely more on funds.)

Brief Comments of Interest

• The Chinese government has proved it can mobilize the civilian portion of its economy for war, if needed.
• Judging by changing price/earnings ratios, stocks within the DJIA are more cyclical than those in the NASDAQ composite.
• Growth and value stocks within the S&P 500 have performed about the same year-to-date, 30.4% vs. 31.2%.
• A president of a long-term, low turnover fund stated that his fund’s performance of 20%+ was “not good enough”. Our analysis suggests 20% is difficult to repeat every year.

The following groups of stocks are up from their 2011 lows: S&P 500, Russell 2000, Russell Growth, Russell Value, MSCI World ex USA Small Caps, Consumer Discretionary, Consumer Staples, Financials, Health Care, and Materials.

The only three stock sector mutual fund indices generating performance over 30% in 2021 are: Lipper Financial Services +39.72%, Lipper Global Natural Resources +33.25%, and Lipper Real Estate +30.49%. Among the commodities funds the winners were: Energy Funds +84.16, Specialty Funds +44.27%, Base Metals Funds +32.22%, and General Funds +31.45%.

Four observations from T. Rowe Price:

• The Delta variant spread appears to have peaked
• Corporate and government debt levels are elevated
• Chinese regulatory actions have likely peaked
• The Baltic Dry Index recently dropped from its precipitous rise 

Of the 25 best performing funds for the week, there were 13 small caps. Additionally, 31 of the 32 S&P Dow Jones global indices were up for the week.

Question of the Week: Any changes in strategies contemplated? 

Did you miss my blog last week? Click here to read.

https://mikelipper.blogspot.com/2021/10/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/10/are-we-listening-as-history-is.html

https://mikelipper.blogspot.com/2021/10/guessing-what-too-quiet-stock-markets.html

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All rights reserved.

Contact author for limited redistribution permission.

Securities Analysis as Taught Leads to Volatility - Weekly Blog # 705

 

Mike Lipper’s Monday Morning Musings

Securities Analysis as Taught Leads to Volatility

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

The long-term history of making money in the market is not  following the majority  with their money. In simple terms, choosing not to conform with what others are doing. Winning in the market means converting some of the wealth of others, often the majority, to our own. This maneuver requires using different approaches and tools than others use.

 

Sector Bets Fail to Produce Top Results

The academic course on Securities Analysis is taught as a companion course to accounting, or worse, macro-economics. Both work on past history and have precious little to do with future movements of companies, stocks, or economies. More useful studies would instead focus on profits and securities. 

All too often securities selection processes screen for companies which appear to be in the same industry, as measured by misleading government data. As a junior analyst I was assigned the steel industry. I quickly discovered that although the number of steel companies was small, it was a mixed bag of companies. You could divide the group by the location of their headquarters and proximity to critical resources, usually coal, or to a growing customer base. In this case an investor did far better with Inland Steel, based in steel-short Chicago, rather than in Pittsburg and West Virginia coal country. 

Another worthwhile distinction was the cost and quality of labor. In the early days of the externalization of producing payrolls, commercial banks were prominent. However, overtime they lost market share and eventually lost the entire market to independent payroll service providers who provided better services. They provided more help filing payroll tax returns and offered lower prices, due to their labor not being paid bank-type overhead. Today the payroll market is dominated by service companies with extensive and modern computer systems, which are good at servicing. (Our accounts own ADP.)

A final example is computers. Many of the large industrial companies manufactured the early computers, the biggest and best being IBM, a stock my grandparents owned. The key to their success was not only adequate technology, but superior leasing prices and great sales engineers. IBM’s top salesman regularly presented to Wall Street and was a missionary sales person. However, the industry changed from massive main frames taking up large airconditioned rooms, to desktop personal computers whose parts could be produced in low-cost regions of the world and could be assembled elsewhere. 

Dell started out by taking customer orders for computers which could be customize and air shipped to customers. Today, many believe Apple (owned in our accounts) is the leading company. This is the result of the late Steve Jobs’ focus on style and ease of use. His most important achievement however was handpicking his successor, Tim Cook, an expert known for supply management and development. What relatively few investors appreciate is its global network of Apple Stores and a growing mail order business generating repeat business, essentially building its own annuity business. (Remember, US automakers had market level price/earnings ratios when customers replaced cars every three years with newer models.)

Less popular ways of analyzing securities included: 

• Paying more attention to insufficient supply than excess demand.
• Focusing on differences in manufacturing approaches and costs.
• Understanding the personalities of key operational people vs known leaders and their educational biases.

We Don’t Create Winners, Losers Do

No matter how prescient and bright we are, to have great results we need others to create attractive entry prices and unreasonably excessive exit prices. Utilizing these as working assumptions, I am getting nervous about the flow of institutional and individual money in private equity/debt (private capital). For many years there were more good private companies offering participation in their attractive futures than potential investors. They attracted investors with relatively low entry prices. 

Recently we have seen a reversal, with a huge flows of institutional and individual money seeking to exit the public markets and enter the private markets. By definition, entry prices either directly rose or the firms had to carry senior debt prior to generating private capital returns. There is so much reversal of traditional roles that one of the oldest buyout firms, with a great long-term record, is converting some of their US and European investments to a publicly traded fund. For some of its investments Sequoia is trading up in liquidity.

One of the disturbing concerns in the privates market is the number of new advisers that have entered the market. They have increased the number of funds and are spreading the investment talent more thinly. In response, T. Rowe Price, an experienced investor in privates, is buying an existing manager to get the necessary talent in an increasingly competitive market. (Owned in Financial Services Fund accounts)

A number of well-known university and institutional portfolios have announced performance in excess of 40% for the fiscal year ended June 30. Some are probably reporting private investments with at least a quarter’s lag. (My guess is performance for the year ended March was better than the year ended June 30.) Most investors did not do as well and consequently some are likely to pile into an overheated private market with scarce investment talent. The history of investment returns is that it is extremely rare to find a manager who can consistently return over 20%, which is roughly three times the growth of industrial profits. The organizations that reported 40%+ profits undoubtedly benefitted from lower entry prices and better terms than is currently on offer. 

I am a long-term member of the investment committee of Caltech, an internally managed investment account with a talented staff. They have put a cap on their exposure to buyouts and venture capital. I applaud this decision because of the history of hedge fund performance. It shows that even very good hedge funds suffer when a minority of hedge funds experience serious liquidity problems. This was in part because of debt, but some of their holdings were also owned by trading interests desperate to liquidate some of their excessively leveraged holdings created by falling prices. This is a classic example of others causing some investors to have poor results.

Moody’s is also concerned about the rapid growth of inexperienced managers offering private capital vehicles. The credit-rater was criticized for the exponential growth of CMOs. (Moody’s recovered, and just this week was selling at a record stock price. Moody’s is owned in our managed and personal accounts.)

Historical Odds of Equity Bear Market

There is wisdom in the saying that history does not repeat (exactly), but rhymes. The ebb and flow of markets are driven by emotional excesses, with investors reacting to various stimuluses. I previously mentioned a successful pension fund manager liquidating his equity portfolio after it gained 20% in a calendar year, reinvesting the proceeds at the beginning of the next year. He produced a record absent of large losses, with reasonably good gains on the upside.

We may be approaching a “rhyming event”. I feel more confident taking a contradictory view when it is supported by large scale numbers. The US Diversified Equity Funds (USDE) have combined total net assets of $12.4 Trillion, representing 2/3rds of the aggregate assets in equity funds. According to my old firm’s weekly report, the year-to-date average gain was +21.01%, vs a 3-year average gain of +19.21%, and a 5-year average of +16.76%. More concerning is only 4 of the 18 separate investment objectives within the USDE bucket produced over 20% 5-year annualized growth rates. Of the 14 Sector Equity funds, only 2 grew +20%, and only the World Sector Fund average gained 20%+. At the individual fund level, only 3 of the 25 largest funds produced 20% growth rates. During the same 5-year period, the average taxable fixed income fund gained 3.34%, and the average high yield bond fund grew 5.47%.

Recently, a number of endowments reported gains of over 40% for their June Fiscal years, driven by successful private equity/venture capital investments. Some of these private investments were reported on a logged basis. Remember, in many cases they had spectacular performance through March, and have been relatively flat since then.

The cyclical nature of human emotions suggests that when earnings growth does not support lofty valuations, we are likely to have a “rhyming event”.

What do you think? 

Did you miss my blog last week? Click here to read.

https://mikelipper.blogspot.com/2021/10/are-we-listening-as-history-is.html

https://mikelipper.blogspot.com/2021/10/guessing-what-too-quiet-stock-markets.html

https://mikelipper.blogspot.com/2021/10/what-is-problem-weekly-blog-702.html

Did someone forward you this blog? 

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

ARE WE LISTENING AS HISTORY RHYMES? - Weekly Blog # 704

 

Mike Lipper’s Monday Morning Musings

ARE WE LISTENING AS HISTORY RHYMES?

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

Pseudo Historians?

Whether we appreciate it or not, we are pseudo-historians because we store knowledge of our experiences, thoughts, or what we’ve learned from others directly or through the media. We call this “Memory”. Recall some important incident that happened to you ten years ago. If it is a pleasant memory, we delight in it and it takes up more space in our memory bank than unpleasant memories. Notice, as we get older and have more memories there is little recognition of mild events. Also notice that when discussing a specific memorial event with someone who experienced it with you, the details are somewhat different than yours. As you discuss the slightly different shared views of the past, it would not be unusual to see that you have sugar coated certain aspects. 

Welcome to the world of the historian and notice how two competent people observe the same thing differently. (My personal Queen, my wife, just reminded me that the Queen of England has said “recollections vary”.) Furthermore, most histories are written by the victors or their supporters. Typically, many are called victors for taking some small part in a victory. There are far fewer histories written from the losing side. Few want to be tagged as the reason for defeat. (I wish business schools had extensive courses on commercial failures, as they would be much more instructive than accolades not fully deserved.)

Why am I focusing on the way we learn from historical rhymes in this investment blog? Typical investors believe they have past knowledge they can use to make future decisions. I believe they are not paying sufficient attention to the past, as most investment disappointments are regularly repeated. 

Why Now in October?

One of the curses of history is tied to the seasons and sporadic rotation. Without the same cyclicality of the earth’s rotation, we humans evaluate history to understand why we are in our current condition. This coming week on October 28th & 29th, 92 years ago, became known as Black Monday and Black Tuesday. Over those two days the Dow Jones Industrial Average fell 24%, with volume reaching the unheard number of 16 million shares on Black Tuesday. As early as March 25th that year the Federal Reserve warned of excessive speculation. The stock market had been rising for 9 years and had gained 10 times its starting level. Various pundits proclaimed the stock market had reached a permanently higher plateau. (My grandfathers’ brokerage firm was preparing to retire and was closing client margin accounts.) In addition to investment speculation, the farm community was carrying excess debt due to unexpected crop price declines. (There is a debate as to whether the stock market break was the cause of the Great Depression. It potentially resulted from the loss of confidence that swept the nation, as only16% of the US population was invested in the stock market.)

What About Today?

I have little confidence in my or anyone else’s ability to regularly predict the future of markets consistently. What I attempt to do is gather relevant information that may provide clues as to the future. The following list of inputs is not an attempt to persuade, as in a “Ben Franklin sales pitch” which always has more favorable elements. The data points should be noted, but not weighed, as the unknown future is not as much a mathematical game as a psychological one. The following is my list of items that can lead to an investment decision:

Positives in favor of continued US stock Market Gains

1. For the markets to move higher, the old Dow Jones Theory requires the Dow Jones Transportation Average (DJTA) to confirm the gains of the Dow Jones Industrial Average (DJIA). In the latest week the DJIA gained 108 points and is close to a new record high. The DJTA simultaneously rose 383 points from a lower base. Railroad and trucking companies are transporting more freight out of burdened ports. Airlines are benefiting from increased domestic/international business travel and are additionally profiting from freight business diverted from ships to meet seasonal supply demand.
2. This week, investors using the New York Stock Exchange (NYSE) showed their bullishness by pushing 401 stocks to new highs vs 108 to new lows.
3. In their sample weekly survey, the American Association of Individual Investors (AAII) raised their bullish prediction to 46.9% from 37.9% the week before.
4. The market has been in a constrained trading range for more than six months. The loss of political confidence has led to a loss of investor confidence, resulting in a massive amount of uninvested cash waiting for a signal to invest.

Negatives Against Investing Now

1. Twenty-two out of 88 mutual fund investment objective averages have risen over 60% since March 23rd, 2020, most being the more popular fund categories. Historically, performance exceeding 20% per annum is unsustainable. There are two ways to correct this condition, lengthen the flat period or endure negative performance.
2. For the week, the number of new lows on the NASDAQ was 340, more than three times the number of new lows on the NYSE. Due to the relative absence of passive investors on the NASDAQ, I believe their investors are savvier than those on the NYSE, whose investors are more sensitive to volatile cash flows from passive funds and public investors.
3. The discussion of Black Monday and Tuesday, plus the length of time since the bottom in 2009, reminds me that excess speculation often leads to a market correction. The big difference between now and 1929 is the big debt bulge not covered by flows is in the government sector (federal, state, and local). Current corporate debt in unprofitable companies is also a problem. 
4. While public participation in the stock market is much higher than the 16% in 1929, it is comprised mostly of retirement accounts. In the past they have not been particularly sensitive to market moves, but growth in the lack of confidence could see dramatic changes.

Please share with me which you see first, a 50% rise or fall?  

 

Did you miss my blog last week? Click here to read.

https://mikelipper.blogspot.com/2021/10/guessing-what-too-quiet-stock-markets.html

https://mikelipper.blogspot.com/2021/10/what-is-problem-weekly-blog-702.html

https://mikelipper.blogspot.com/2021/10/the-confidence-game-weekly-blog-701.html

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A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Guessing What Too Quiet Stock Markets Signify? - Weekly Blog # 703

 

Mike Lipper’s Monday Morning Musings

Guessing What Too Quiet Stock Markets Signify?

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

“The Dog Didn’t Bark” This Week

In one of the Sherlock Holmes detective stories, he solved the mystery when he observed that the dog didn’t bark. I am wondering whether the global stock markets are sending us a message we are not hearing. There was nothing that happened this week to restore confidence in global political leadership. However, markets meant to discount future prices, never-the-less drifted up on below average transaction volume. Market analysts view relatively low volume as a sign of lack of conviction. Perhaps another view, at least temporarily, is a growing lack of conviction in our own ability to manage our way through uncharted waters. We seem to lack the conviction of a Christopher Columbus who set out on a journey into unknown waters with heavily leveraged vehicles, searching for a faster route to the theoretical riches of Asia. (Even after three attempts, all he accomplished was a failed experiment. At the time it was not recognized that his so-called failure led to the richest discovery of all - The Americas. Spain benefited from Latin American gold for the next 200 years.) 

Are the Financial Stocks Showing the Way?

This week several leading US financial stocks reported their third quarter earnings, including JP Morgan Chase, Goldman Sachs, and Morgan Stanley. (All three are owned in accounts I manage/own). All three reported significantly larger than expected earnings gains using GAAP (Generally Accepted Accounting Principles). While their stock prices rose, gains were modest relative to predictions. Thus, the small price gains relative to announced earnings had the immediate impact of lowering their price/earnings ratios. Why? 

The market saw through the GAAP numbers and instead focused on the recurring earnings power of the three firms. Participants in the market were not willing to pay for released loan credit reserves and tax settlements. For example, JP Morgan’s GAAP earnings per share in the third quarter was $3.74. Later in the press release it was revealed that the combination of credit releases and more favorable tax settlements amounted to $0.71 per share. This meant the per share earnings that should be used for valuation purposes was $3.03 vs. $3.00 per share in the second quarter. Hardly an encouraging sign of growth and unsurprisingly the share price did not rise. I believe the reasons to own JP Morgan are their “fortress sized” balance sheet, their dominance in various financial sectors, and a growing commitment to increasingly use financial technology likely to change the nature of banking.

Goldman Sachs announced that their nine months earnings were higher than any of their full record earnings years. This result was achieved during a period of significant restructuring to impact the future earnings power of the leading investment bank. No other firm so perfectly captures the favorable elements of the period, which included a record of assisting clients with Mergers & Acquisitions and record financial advisory revenues. Underwriting earnings were also strong, due to private placements, convertibles, and IPOs. Third quarter earnings in Asset Management were good, but less than the second quarter’s large “harvesting” of private equity. During the quarter, GS continued to invest in broadening its capital raising in Consumer and Wealth activities, as well as increasing its technology spending.

Morgan Stanley had similar results, but because of its business line mix, did not have as big a price increase as Goldman Sachs. MS has a larger and more retail oriented wealth management group. It also benefitted from popular IPOs. 

None of the three stock prices gained as much as third quarter earnings. Mathematically, this means their current p/e ratios contracted a bit and could be an unrecognized warning that future earnings gains may be more difficult to achieve. When one analyzes the sources of the gains they appear to be historically more speculative and cyclical than the firms’ other businesses. {Warning #1}

Are Universities Leading the Wrong Way?

This week, the investment performance of various university endowments was published for the June 30 year. The leading gains were in an astonishing 40% to 60%+ range. This is a group of investors that historically had difficulty beating the S&P 500. (Few followed the strategy of going to cash for the rest of the year when their equity performance produced a 20% rate of return. Additionally, they held bonds in an inflationary environment.) This year’s juice was a substantial investment in alternatives. Most of the dollars in this category were invested in private capital, mostly equity and less in hedge funds. 

As a student of investing, I have noticed that market peaks result from many more buyers than sellers trying to participate in the latest capital appreciation trend. Today it is rare for a financial institution or financial distribution system to not offer participation in private equities, which have multiple transaction and other fees compared to publicly traded products. The private equity culture offers participation in size limited, private fund vehicles. Once the vehicle is fully funded the sponsor, believing there is still more money wanting the privilege of investing with them, offers additional funds. The very success of fund raising encourages new entrants from existing fund groups, often built around mid to lower-level people. This has many economic impacts:

1. A valued employee resigning from a manager wants a significant compensation increase compared to their present employer. 
2. The old employer may in time find compensation for new talent, but also wants to earn more. 
3. The private equity industry grows rapidly, and thus with higher expenses and a need to perform quickly, they bring out the next fund. 
4. The bargaining power of attractive investment owners recognizes that there are more buyers than sellers for the opportunities to invest in their companies/ideas. This produces higher entry prices. 
5. Lower returns for private equity funds will come from increased acquisition prices. 
6. To corral investors for future new funds sponsors attempt to discipline their investors into investing in future offerings, promoting the fear of not being eligible for new investments if they fail to do so. 

This head long growth of investing in popular alternatives appears to be a race to the top without a useable parachute. {Warning #2]

Timing ?

If I could regularly time price movements, I would be able to buy a big yacht and invite you to regularly come with me. Don’t pack your bags because I can’t deliver. What I can offer are two different tools. 

The fist is a partial examination of the current picture, including the two warnings already labeled. As many of you know, I feel the actions by savvy investors in the NASDAQ are more useful than those on the NYSE. The latter are clouded by passive funds driven by some users to hedge their long positions. Furthermore, since many former brokerage commission salespeople have converted to being “wealth managers”, they feel they must do things to continue to earn their fees. Their clients look at the market through the Dow Jones Industrial Average (DJIA) lens. Consequently, these managers make their moves on the NYSE. There are also numerous institutions with large asset bases and small investment staffs who find comfort in big names and liquid markets. The following table illustrates the difference between the investors in the two markets:

Market  New Highs  New Lows  Issues Traded

NYSE       345        134        3,570

NASDAQ     305        336        4,990

NYSE investors don’t seem to be worried, NASDAQ investors are!!

The other insight I can offer are the periods immediately preceding WWI and WWII. For the aware investor it was increasingly clear that hostilities would not be avoided, but the exact timing was difficult:

WWI - It was about six months after the assassination of the Archduke and his wife that War was declared. During this period there were considerable troop movements. Both alliances discussed their likely actions and considered the industrial power of the US being under the control of an isolationist, pacifist, ex-college president. Economic conditions were worsening in central and eastern Europe. Frequent political and military moves were in the direction of armed conflict, only the timing and specifics were not clear.

WWII - From the American point of view, Europe was already at war. It had little impact, but generated some sympathies in the US. A US president was running for the first third term election, as an isolationist. Once elected he cut off US oil to Japan, which was involved in a land war with China. The US economy was also deteriorating due in part to federal government actions and policies. (A war would bring the US out of a long recession.) This was the first time in US naval history when they moved all the Navy Aircraft Carriers out to sea from their Pearl Harbor port, leaving the old Battleships behind. The week before there was smoke coming from the Japanese embassy in Washington as they destroyed their critical papers. (The US later provided temporary living quarters for the members of the Japanese embassy at a luxury hotel with a golf course, while they awaited their exchanged Tokyo personnel.) There was not much reaction from my mother’s guests that Sunday afternoon on December 7th when I burst into the living room, announcing the attack on Pearl Harbor. Not many people quickly grasped the meaning of the raid. I sensed something bad had just happened and worse would come.

What Does it Matter?

All too often people don’t grasp the significance of events. What would happen if some large private equity firm or a major private equity fund financially disappeared, leaving lots of debt outstanding?  I don’t know, but I do have a bad model.

On August 17th, 1997 Russia announced a restructuring of their debt, in effect defaulting. The so-called Smartest Hedge Fund in America, with Nobel Prize partners on board, was heavily invested in leveraged Russian paper. Initially, most people were not particularly disturbed. They were as nonplused as those on that Sunday evening in1941, who had not contemplated how interconnected the global financial world was. The first thing that happened the following morning was Latin American investments being dumped at any available prices. Long-Term Capital Management (LTCM) and other hedge funds and traders were desperate to fill their reduced liquidity. The situation got worse as it became clear that major trading firms on Wall Street had similar positions to LTCM or had loaned them money. The potential size of the problem got so big that the Federal Reserve Bank of New York convened a meeting of the major capital players at the offices of Bear Stearns. Resurrecting what Mr. Morgan did in 1907 to force the community to bailout a Trust company borrower whose unpaid debts could trigger other defaults and bring the system down. The Fed, with the help of the US Treasury, was able to assemble both the capital and liquidation procedures to prevent more of the “street” and numerous banks from failing. These saving functions had an interesting aftermath. Years later, the Treasury found it could bailout Bear Stearns but could not do the same for Lehman Brothers, the only firm that did not participate in the bailout.

I don’t know when any of the histories I have outlined will be repeated, but they should be studied because of the odds similar situations will appear.

I appreciate any views from any of our valued subscribers.  

Did you miss my blog last week? Click here to read.

https://mikelipper.blogspot.com/2021/10/what-is-problem-weekly-blog-702.html

https://mikelipper.blogspot.com/2021/10/the-confidence-game-weekly-blog-701.html

https://mikelipper.blogspot.com/2021/09/two-confessions-weekly-blog-700.html

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What Is The Problem? - Weekly Blog # 702

 

Mike Lipper’s Monday Morning Musings

What Is The Problem?

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

Where are we?

As we enter the third quarter, often a good performing quarter, US stock market volume is underwhelming. Apparently, declining confidence in global political leadership has led to a fall in investor confidence. In the latest week, each of the six best performing funds had a different investment objective. In fund performance order they are: Managed Futures, Flexible, Tech, Financial Services, Natural Resources, and Precious Metals. This suggests no common theme or the likelihood of similar stock positions. Thus, success is likely the result of critical skill in stock selection, not sector or market selection. A similar focus is seen in fixed income, where corporates are outperforming governments.

The American Association of Individual Investors (AAII) weekly sample survey of members is showing no enthusiasm for either a bullish or bearish future for markets. This survey is often a reliable contrary indicator for the next six month’s performance. Of all the indicators reviewed, the only one that’s relatively strong is the Barron’s Confidence Index, which favors stocks over bonds.

In general, I believe actions speak louder than words, particularly from members of the investment/financial community. This week I am seeing an increasing number of respected firms uprooting their employees and moving to Texas or Florida, not just for lower state taxes but for a better lifestyle. In addition, within the fixed income world there has been a considerable shift of investment people from one well known large employer to another. I am also noticing various product lines being transferred from one insurance company to another in the insurance sector. There are undoubtedly specific reasons for each of these shifts, but underlying each shift there appears to be a view that the future will be better for employees and their clients at their new firm. 

Should we be looking at longer periods and seeking different clues? There are brief lessons from Rome, Netherlands (vs Spain), England, and the USA. If we apply these and other lessons, we can handle our competition with China long-term.

Rome

For hundreds of years Rome was the dominant power in Europe, North Africa, and the Middle East. It was the technological leader of the world based on its mastery of building roads for military chariots and commerce. Rome was also the builder of aqueducts bringing water to Mediterranean cities. 

Rome was brought down by its own invention of “Bread and Circuses”. The political powers in Rome provided bread and free entertainment to its supporters in their arenas (circuses). In effect these were bribes. These “gifts” to the population of Rome, the tributes from conquered lands, allowed many Romans to not work. The history of great empires like Rome is that they fell due to internal pressures and the unwillingness to properly defend themselves. Thus, the great Roman Empire was defeated by bribes that weakened their will to survive.

Netherlands

The country fought a series of wars to free itself from the threat of occupation by the much larger and richer Spain. It was essentially a war between Spain, with its import of Latin American gold wealth, and the aggressive Dutch merchants who worked together. (One of the classic paintings of this era shows a group of merchants serving as night watchmen to alert their community to the danger of fire in their midst.) These merchants were inventive, creating the first stock exchange. They were also early in developing funding vehicles such as trading companies servicing their established colonies in South America, Asia, and Africa. Robeco also successfully built the first self-managed and owned mutual fund, way before the late Jack Bogle’s Vanguard. 

When I was a junior security analyst at Burnham, there was great respect paid to the firm’s Dutch clients who were believed to be very savvy judging risk. (I remember commenting on one occasion that the Dutch were selling shares in a Dutch international company to the Americans. It seemed to me that the locals were right, and they proved to be.) 

From a small geographic base and only a merchant fleet, they established a number of large international companies and colonies, without the benefit of a strong military. This proves that under the right circumstances merchant power and expertise is equal to or better than a strong military base. Even today, Dutch financial companies “punch” way above their geographic weight.

England

England, or more precisely the United Kingdom, is another former global empire from a small country with limited natural resources. Like the Dutch, they were early in building a savings industry, which is now a world financial power. The country has also produced more legal principles than any other in the world. While The Magna Carta was only between the King and Nobles, it proved to be the foundation of the concept of limited government. 

The English did something few countries have done, passing the crown three times to leaders born outside the country, and it worked well. The political establishment has also yielded to a popular view other than the sitting government. (While we celebrate the US victory at Yorktown as the end of the American Revolutionary War, a peace treaty was signed in London before the battle even began. Without electronic communication, America had to wait for a ship to arrive with the news.) The change in London was led by prime minister William Pitt, the Younger, who deemed the war too expensive relative to the value of US trade. The long war was difficult to win, so the finest military and navy conceded. Only great leadership of a country has the strength to recognize changes have taken place that require a change in policy.

USA and Prohibition

Almost as soon as elections were held in the cities of this country, it was common for some political groups to offer alcoholic drinks to would be voters. A small-scale throwback to the “bread and circuses” of Rome, but still a type of bribe. When the temperance movement gathered steam I suspect it received some support from those who felt gifted alcohol on election day may have changed some votes, particularly in big cities with lots of new voters. 

Much like with William Pitt, the Younger, popular opinion turned against prohibition when policies needed to be changed in the 1930s. It probably cemented the “wet” politician relationship with bootleggers, speakeasy proprietors, their suppliers and customers. Even after Prohibition, the only places in New York state to get a drink on election and primary days were locations independent of New York law, the Indian reservations and the dining room at the United Nations. This demonstrates the US can change policies when the perceived facts change.

China

I believe the current leadership in China is largely consistent with its history, demographics, and its financial structure. Approximately 90% of the people living in China today are descendants of the Han Chinese, the remaining 10% comprised of approximately 55 other national groups. While many of these groups have lived peacefully in China for hundreds if not thousands of years, they are viewed as potentially disruptive by the central government. Based on these concerns I believe the government does not want to add new nationalities into China. Because the Nationalist government fled China, they view Taiwan as largely Han Chinese. If I am close to correct, I do not believe Xi wants to occupy other countries. However, it is afraid of being trapped by unfriendly neighbors. That is why they want them to be friendly and not be controlled by other world powers.

Xi has other problems, including incipient competition funded by some successful businesspeople. He is very conscious he’s in a race against time, with the population aging and not replenishing itself.  The Chinese are prodigious savers who’ve had little to spend their money on and a heritage of living rurally with weather/crop cycles. Within family groups and some small communities there is a combination lottery lending mechanism, allowing the winners to jump to a higher economic level. In aggregate Chinese savings are enormous, funding both business and various levels of government.

The best way for the US to become more competitive with China is in some respects to copy them. Currently, our political leaders measure our success by the amount we are spending on goods and services. Although this provides current value, some consumption has no value long-term, causing this country to fall further behind as a saving society. The US government should switch its emphasis to saving for the future, where we are very much underfunding retirement. Additional savings would push up savings income and attract Chinese investors anxious to diversify their investments.  They are all conscious of the risks in their own over leveraged society. 

If we are able to do this, we would accomplish what my wife describes as a double win, benefiting both the Chinese and the Western investor. Such an occurrence would generate a lot of confidence.

Why Now?

While many people talk longer-term, most of their psychic and financial income is relatively short-term, impacted by their own expected tax rates. The future is almost never crystal clear and for many it has become either less clear, less attractive, or both.

Near-term elections over the next three years may provide some answers, or they may not. It will depend on leadership characteristics changing from the standard politician’s focus on the next election and those of statesmen or women focusing on future generations.  

   

What do you think?    

 

Did you miss my blog last week? Click here to read.

https://mikelipper.blogspot.com/2021/10/the-confidence-game-weekly-blog-701.html

https://mikelipper.blogspot.com/2021/09/two-confessions-weekly-blog-700.html

https://mikelipper.blogspot.com/2021/09/observations-prior-to-excitement-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 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.