Four Letter Words to Sounder Investing - Weekly Blog # 678

 

Mike Lipper’s Monday Morning Musings

Four Letter Words to Sounder Investing

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

When I was growing up I was admonished not to blurt out various four-letter emotionally driven words, which had the effect of me not using four-letter words at all.  I rarely focused on words such as love or nice. When I now think about communicating sound useful concepts to long-term investing, it strikes me that there are at least five four-letter words that shine a light on critical concepts. These are briefly discussed below in alphabetical order.

Debt

Debt is the temporary transfer of capital from lender to borrower in exchange for periodic interest payments. Both sides benefit from the exchange, the lender receives payment for delaying current spending and the borrower from using someone else’s capital. In a world where debt is growing faster than the growth of the economy, the question arises, is this a wise temporary transfer of capital?

From the borrowers’ viewpoint it should be about the amount of benefit received, be they individuals, businesses, or governments acting as an intermediary for taxpayers. Such as borrowing to invest in long term assets that will produce a stream of income larger than the interest and related costs. A mortgage on a business building is a good example.

Unfortunately, we are seeing more borrowing by both governments and individuals for consumption. One can look at much of the stimulus spending, which politicians hope will benefit them at the next election. Some may call these bribes, like the “bread and circuses” of ancient Rome, which at least built roads and bridges that produced a stream of increased traffic. 

When viewing any transaction one can often identify at least one winner, although this is not the case for high-grade debt today. The lender is receiving interest payments that will not fully compensate for the future decline in purchasing power, both in the national and international markets. (The JOC Industrial Price Index is up +108.81% and producer prices are up 12% year over year.) This may be why large commercial bank loans fell in the first quarter, even as deposits grew.

There is currently another problem with debt, the fastest debt growth is being financed outside of regulated banking institutions. The source being brokerage/investment banking firms and other financial companies. Margin loans to support securities transactions have grown 70% year over year. In well-managed brokerage firms, utilizing listed stocks and bonds as collateral is reasonably safe for the lender, who can recover from some of their clients going broke. However, there has recently been a surge of borrowing to leverage non-listed derivatives tied to relatively illiquid stocks listed globally. The question facing the market is, are we approaching a crisis like the Morgan Library Panic of 1907 where the banking community was forced through locked doors to contribute to endangered competitors? The problem would likely be socialized with government bailouts today, adding to the growing deficit by partially financing it with more debt. Bottom-line for most institutions and individuals, debt is not currently priced for the long-term inherent risks.

Risk

Sir Isaac Newton came up with a critical rule, “There is an opposite and equal reaction to every action”. Too bad he did not offer an investment rule for his own considerable fortune, suggesting every investment caries both rewards and risks throughout its existence. There is no such things as a riskless investment. The key to assessing the size of a risk is what a knowledgeable, disinterested, investor would pay for an asset producing an acceptable rate of return relative to all other investments. This may be the reason that on the more actively traded NASDAQ the number of stocks rising was 8.5% vs 5.8% falling, compared to 18.4% rising and 3.2% falling for the NYSE. 

Rate

Rates tie streams of numbers together, like miles per hour. Most of the time in the investment world the two streams relate to interest rates, earnings growth, sales, and book values compared to prices. The wise investor adjusts the first stream for the probability of it continuing the current movement. The price may also need to be adjusted for the likely size of the investment. (Remember, quoted prices are for small purchases, take-over prices are normally higher than pre-bid prices.) 

Rank

Rank is an orderly display of participants based on criteria such as length of period, size, volatility, etc. One should remember there is nothing that promises the sustainability of completed periods. The winner may have been slowing down or speeding up immediately before the end of a period. Also, first place gives no indication of any negative event impacting one of the participants, which may not reoccur. While repetitive high rankings are assuring, it is not a guarantee of future results. In picking funds or stocks, you need to adjust for the change in skill of each participant. Because conditions change, one should not place too much emphasis on repeated success. Remember, winning streaks almost always end.

Time

By far the single most important variable in choosing an investment is the period to be measured. Unless an investor believes they have superior trading skills, they should focus on one or more time periods. The longer the period, the more likely the return will be smaller. The number of full participants will also decline through acquisition or failure. 

The following set of observations may be relevant in applying attention to today’s details:

For the current calendar year through last Thursday, the best mutual fund macro peer group was US Diversified Equity Funds +12.02%, followed by Sector Equity Funds +11.96%, Commodity Funds +11.59%, World Equity Funds +6.82 %, and Alternative Equity Funds +1.84%.

Keep in mind that this data is for almost one-third of a year. The 12% return for US Diversified Equity Funds and the +9.53% return for All-Equity Funds is close to the long-term stock average of +9-10% per year, which excludes fund expenses. This raises the question of whether an investor should stick around for the rest of 2021. If you were to stay invested this year, a contrarian might invest in the average World Equity fund, which has generated roughly half the gain achieved by US focused funds. Of the 25 best performing mutual funds this week, 10 invested in the China Region. A leading broker noted that investors were buying European Equities, inflation-oriented investments, and “value” stocks. They were selling high yield and emerging market securities. (Note that the five largest tech stocks have a combined market value larger than all the emerging market stocks.) 

Most large gains by investors result from holding stocks and equity funds for a long time. An example of the effect of compounding is the US Diversified Equity Funds return of 12% doubling in 6 years. (Which assumes an annual return of 12%). If the compounding rate were 9% it would take 8 years and at 6% the doubling would take 12 years. 

We rarely live in an average year. Based on history, roughly two-thirds of the years rise and one-third decline. Because of the compounding effect investors have more money in their accounts than simply multiplying decades of average performance. Results can be very satisfactory. Hopefully we will recover from increased “rates, regulation, and redistribution” in the future.

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

https://mikelipper.blogspot.com/2021/04/the-other-side-weekly-blog-677.html

https://mikelipper.blogspot.com/2021/04/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/04/respecting-opposition-market-weekly-bog.html

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A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

The Other Side - Weekly Blog # 677

 

Mike Lipper’s Monday Morning Musings

The Other Side

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

Approaching a Trade

Both buyers and sellers are essential ingredients in making a market. While I am an advocate for buying and owning securities to produce desired returns in a particular timeframe, most participants don’t consciously follow that approach. Many buyers and sellers ignore probable returns for a period, other than in the current trading environment. Consequently, many transactors deal with similar sets of information but have different views.

How to Develop an Investment Position

When I was the chairman of a non-profit investment committee, I wanted an investment committee similar to a Mid-Western Pension fund’s external investment committee, composed of outside investment professionals guiding a competent internal investment staff. However, I went a step further and included an experienced bear as a member of my committee. The questioning our bullish views forced us to consider the alternative and do better research. In one case, because it looked washed out to him, he recommended investing in a sector that had produced very large losses. Because of his normal bearish attitude, we paid attention to a rare bullish suggestion which turned out to be one of our best investments. This experience taught me to look at the “other side” of the argument in executing each investment.

The Purpose of This Particular Blog

Almost all commentators on the market and the US economy are bullish. Readers don’t need me to add my voice to the commentary on pent-up demand, the supply of savings, and the use of government money. You can get lots of “happy talk” elsewhere. What may be helpful are some brief points from the “other-side”. This is particularly true in the study of market cycles, where a characteristic of reaching a turning point is the almost total rejection of thoughts contrary to the dominant trend. 

Points to Consider (Not Necessarily to Accept)

1. Quarterly earnings growth rates will decline. Many companies will experience the largest percentage increase in the forthcoming cycle. The habit of comparing the current quarter to the same period in a prior year is meaningful but can be misleading. For many companies, the second quarter of 2020 was impacted by the biggest lockdown ever. Starting with the third quarter of 2020, the recovery began and accelerated in the following two quarters. For some, current earnings are a function of addressing pandemic generated shortages, which will not continue. This may be particularly true for so-called value stocks, which are often cyclical performers. A more useful comparison for many companies would be the same quarter in 2019. To claim a specific company as a growth company might require double-digit growth from the prior best seasonally appropriate quarter.
2. Recognize some of the probable drivers of inflation now and in the future. The JOC-ECRI Industrial Price Index is up +101.01 % compared to a year ago and up +2.85% in the latest week. The increased reliance on corporate tax collection drives up inflation. There are two main forms of tax collection, sales/use taxes/fees and income taxes. In many “blue governed” states and municipalities, we will likely see increases in fees for services where deficits are common. A bigger source of future inflation will likely come from an increase in income tax rates, both at the corporate and individual level. When a company is faced with a tax rate threatening after-tax income, they take steps to lesson its impact. These include raising prices and reducing expenses, the largest of which is probably labor. They might also move earnings to more favorable locations and reduce quality.
3. Understand the implications of the current size of the Majority in the House, which is 6 members. The senior vote counters are worried about the 2022 Congressional election and their solution is to pass HR1, their first bill of the year. This bill would federalize the election process and remove the states regulatory power over elections. HR1 supporters have already attacked, without reading, the latest election law in Georgia.  They now plan to bring a proposed expansion of the number of Supreme Court Judges to the floor. 
4. This weekend, the deep political division in “the chattering class” was very evident in two half page articles in The Wall Street Journal and The New York Times. The headlines for the two articles are instructive: “How a Physicist Became a Climate Truth Teller” (WSJ) and “Learning From a Family’s Investment Mistakes” (NYT). The second article fails to mention it is a repeat of a Biblical question to Jesus, asking if it is proper to pay taxes to a government not seen as carrying out God’s work. Looking at a coin and seeing the image of Caesar, He intoned “Render Unto Caesar the things that are Caesar’s; and to God the things that are God’s”. The Ford Foundation saw it differently, much to the disappointment of Ford’s heirs. (As an analyst, I believe you can make an investment portfolio grow in numerical value over time, with difficulty and some mistakes. One of the hurdles in reaching that goal is learning what and whom to believe. It is relatively easy to make judgements in terms of dollars, expenses, and reputation. The sources of verifiable truth in the “good deeds” arena are much more difficult, as truth and beauty are in the eyes of the beholder). Because of this need to find “the truth”, The Wall Street Journal interview with Steven Koonin is so valuable. (Before briefly mentioning his views, I need to identify my biases. Steven Koonin was a Provost at Caltech, where I am a senior trustee. Additionally, two members of my family are past and current students at NYU, where he started and ran their Center for Urban Science and Progress.)  His base case seriously questions man being the main cause of climate change. From my days as a geology student, I was taught how the geology of the earth apparently evolved as measured by the different levels of sediment making up the earth’s crust. At one point our midwestern region was underwater and the Sahara Desert was rich with plant life, all before man walked upright. I agree with him that we should instead be focusing on the dangers and causes of pollution impacting our health. One of the policy problems that needs to be addressed is the bailing out shore communities after repeated flooding. We need a more truthful analysis of the problems we face and how to voluntarily modify human behavior.
5. Do large commercial banks know something about credit? The leading banks made two moves this week, JP Morgan Chase (*) sold $13 billion in bonds and Bank of America (*) sold $15 billion. These sales were easily absorbed, as net flows into mutual funds and ETFs were increasing. Along with other mega banks, they also reported meaningful increases in deposits, even though interest rates on demand deposits fell to 8 basis points from 10. At the same time, they reported a decline in the amount of loans. Thus, banks are not making loans after being flooded with deposits and the proceeds from the sale of bonds. Is it possible that under the flood of stimulus cash they are seeing a smaller number of credit worthy borrowers? (*) Shares owned in personal accounts.
6. Charles Schwab Corporation (**) reported a record number of new account openings, excluding those that came in from acquisitions. Many of these accounts were young, first-time investors buying into more speculative securities, in many cases on margin. One leading market analysis group commented on the extended historically high bullish sentiment in the American Association of Individual Investors sentiment survey, saying the “lack of AAII fear is a fear itself”. (**) owned in private financial services fund and personal accounts.
7. For some time I have maintained that on balance the investors in the NASDAQ stock market are more investment savvy than those investing in the New York Stock Exchange, in which I was a former member. This is due to the NYSE attracting more non-price sensitive passive buying. This past week, 20.8% of the stocks listed on the NYSE recorded a high, vs only 11.4 % of the shares on the NASDAQ.
8. The two best performing fund peer groups for the week were commodity funds focusing on Energy +5.03% and Agriculture +3.14%. There were another 11 peer groups that gained between 2% and 3%.

In order to remain comfortable with their holdings, fully invested subscribers likely believe the somewhat negative indicators mentioned are sufficiently wrong. Please let me know privately what you believe.           

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

https://mikelipper.blogspot.com/2021/04/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/04/respecting-opposition-market-weekly-bog.html

https://mikelipper.blogspot.com/2021/03/the-biggest-risk-we-all-face-weekly.html

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Historical Alerts for Current Investors - Weekly Blog # 676

 

Mike Lipper’s Monday Morning Musings

Historical Alerts for Current Investors

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

From the Ancient Past to Present

The problem with history is that there is too much of it. One can easily pick out any number of events and suggest they foretell the future. Thus, any selection is fraught with biases, incomplete information, and are insufficiently like the present to be worthwhile.  Recognizing these drawbacks and the SEC dictum that past performance is not a guaranty of future performance, there are several historical events that may be useful in thinking about the future.

Ancient Rome

By the 1st Century AD, Rome had transitioned from being a so-called Republic to an empire, although it still needed the support of the bulk of its citizens. To stay in power, the leaders fed the population what was called “bread and circuses”, of cheap food and entertainment. The population accepted these bribes instead of serving in the military and taking on societal responsibilities. Studies of the rise and fall of numerous empires suggest almost all fell from internal deterioration, causing eventual military defeat. 

Subscribers can decide for themselves whether the excess funding for COVID-19 and roads and bridges etc. is like the Roman bread and circuses. Or is enlarged deficit spending perhaps the excuse to raise income and estate taxes to reduce political power bases and enlarge union dues political contributions?

Discoveries of Gold

The discovery and exporting of gold from Latin America and hundreds of years later from California, was interpreted as a sign of internally generated moral superiority. Not only was this wealth delivered with relatively low apparent cost, but it was assumed it would last forever. Little thought was given to the destabilizing impact of the new wealth and the reaction from those who weren’t so lucky.

Vladimir Illich Lenin

He was supposedly quoted as saying “The Capitalists will sell us the ropes with which we will hang them”. Others may have said the same or similar things. (I wonder if a similar comment could be made of Silicon Valley, Wall Street, and other CEOs today. Could they be “selling rope” by supporting excess stimulus spending?)

FDR’s First Term

FDR arrived in the White House with a “Brain Trust”, which led to an enlarged cabinet and new departments. He quickly attempted to pack the Supreme Court with more judges and reduced military spending. The reason for the big rush was that he was not convinced he would maintain political control of Congress after the next congressional election. Consequently, there was a need to push as much legislation as possible through in his first year. (Does this seem similar to today?)

Short-Term vs. Long-Term

Now Focus

While a single week only captures the “hot breath” of the moment, it can be insightful regarding the thinking of the transactors. Of the over 100 mutual fund peer groups I briefly review each week, only five gained on average more than 2.5% for the week: 

Five Best Performing Weekly Mutual Fund Averages 

Precious Metals             +3.54% 

Latin American              +3.51% 

Agricultural Commodities    +3.06% 

Large-Cap Growth            +2.92% 

Base Metal Commodities      +2.82% 

 Precious Metals - Gold mining stocks up, but not gold

 Latin American - Recovery in Brazil

 Agricultural Commodities - China buying more than expected 

 Large-Cap Growth - Politics Driven

 Base Metal Commodities - Reflation in Asia

There were 8 Precious Metal funds in the top 25 and 8 Natural Resource funds in the bottom 10 for the week. The 8 Natural Resource funds probably reacted to very current price trends. The performance of Energy funds and Precious Metals funds are often more parallel than divergent.

Markets See Things Differently

The New York Stock Exchange (NYSE) is the senior market in terms of size, history and perhaps prestige, but the NASDAQ may be the savior due to the relative absence of large, passive investor pools. The junior market has more stocks listed and proportionately more “tech” companies. While the image of the NASDAQ is that it is more speculative, the table below suggests it does not appear to be so this week. 

 

Exchange    Number of Highs    Number of Lows

  NYSE            669                54

 NASDAQ           518               128

I believe the NYSE gets more passive and individual investor transactions than the NASDAQ. NYSE prices move more in line with the weekly sample survey of the American Association of Individual Investors (AAII). In their latest survey, 56.9% were bullish on the outlook for the next six months. This is one of the more extreme readings and is often viewed by market analysts as contrary to future results.

Longer-Term

While it appears we are in an up-market for the moment, long-term investors are focused on the next major move. Unless there is a dramatic change in how people think, the current expansion will be followed by a measurable contraction, followed by another expansion. There is no guaranty however, many of us lived through a relatively flat period from 1968-1982 as the country was adjusted to the ending of the Vietnam war, severe inflation, and its correction. Today there is too much debt being financed outside the banking system. It will take a long time to be liquidated and could lead to a longer than normal recovery.

From 1900 to Present

The following instructive tables of the S&P Historical Composite show the Inflation-Adjusted Secular Highs and Lows.

         High from               Low from

Year     Prior Low     Year     Prior High

1906       +334%       1921        -69%

1929       +396%       1932        -81%

1937       +266%       1949        -54%

1968       +413%       1982        -63%

2000       +666%       2009        -59%

Current    +315%

According to Steve Blumenthal of CMG, the above chart shows:

• Secular bull gains totaled 2075%, for an average gain of 415%
• Secular bear losses totaled -329%, for an average loss of -65%
• Secular bull years totaled 80 vs 52 for bears, or a 60/40 ratio.

While the ratio of years is correct, to me the more significant fact is that since 1877 only the 1932 low was below the prior low, suggesting a portfolio with a buy and hold approach, using diversified mutual funds, probably works under most conditions.

Question of the week:

What of all the elements in this blog makes sense to you?

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

https://mikelipper.blogspot.com/2021/04/respecting-opposition-market-weekly-bog.html

https://mikelipper.blogspot.com/2021/03/the-biggest-risk-we-all-face-weekly.html

https://mikelipper.blogspot.com/2021/03/2-presidential-lessons-to-be.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.

Respecting the Opposition & Market - Weekly Bog # 675

 

Mike Lipper’s Monday Morning Musings

Respecting the Opposition & Market

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

Competition Lessons

As a competitive fencer, I regularly fenced men who were better than me. For the most part they had longer arms and were probably better athletes, a real advantage in fencing. I was determined to score as many touches as possible to win matches. The first thing I had to learn was to respect my opponents’ skills and physical advantages. I thus developed what boxers call counterpunching moves. These mental attitudes followed me into the world of investing, where they are called contrarian.

Applications

I believe it would be extremely foolish as an American who served in the US Marine Corps to not identify China as a strong and growing opponent, one whose moves should be respected. Despite having fund investments in China for clients and myself, I am forced to acknowledge China currently having the most prudent central banker. Despite apparently coming out of COVID-19 first, it is retarding its growth by squeezing the non-bank financial providers, who are major providers of loans to the tertiary sectors of their slowing economy. The service sector and light manufacturers have recently grown faster than the rest of their economy but have little in the way of collateral available to be pledged. (Over the centuries there have been numerous Chinese commercial collapses.) As China’s economy has been a major importer of goods and services from the US and the rest of the world, a slowdown in China can create problems here and elsewhere. Unlike other countries attempting to fuel their recoveries, they are delaying going after credit growth outside the banking system. The authoritarian power structure is attempting to get ahead of a problem that has caused disruptions in the past.

A second application of the respect principle is to acknowledge the lessons of the stock market. The most consistent market lesson being the teaching of humility. Below are three historic examples of what may be its future progress:

1. A new bull market riding an economic expansion fueled by government spending.
2. A third term of Obama’s lack of progress.
3. A second coming of FDR’s elongation of an economic recession into a depression. 

I don’t know which path or combination of paths we will take, but I am prepared to be uncomfortable. Contrarian investing is uncomfortable and human beings take comfort in conformity. Contrarian investors must exercise patience, but as Saint Augustine said, “Patience is the companion of wisdom”, hopefully we have enough.

Current Confused Pictures

Hopefully, Positives

• A new generation of investors providing quick liquidity to the less liquid.
• Exchange Traded Products readily available to make directional bets.
• Equity Mutual Fund Holders redeem on average at 4.2 years.
• VIX readings dropping to 17.32 from 46.8 last March.

Perhaps, Negatives

• JOC-ECRI change in a year +88.47%
• Current performance of S&P 500 too high historically. Since 1926 it has averaged +10.3%. Do yearly returns need to decline below normal?

        % Change        Years

        72              1     

        20              2

        15              5

        12             10  

• Over the last year, 12 major currencies rose vs the US$ and 2 declined. Below are the top 2 currencies increasing vs the US$ and the two that declined.

     Australia   +24.4%      Korea       -2.3%

     Singapore   +23.0%      Hong Kong   -0.3% 

Interesting 12-month numbers for Standard Poor’s 500

             13.34%  Average S&P 500 Fund

             13.61%  Average of 30 largest S&P Funds

             13.91%  Gross performance of the stocks

The average large-cap core fund gained +12.53% and probably had 1-2% in cash, suggesting the superiority of passive investing comes from being fully invested, low turnover, and low fees. This could be a good model for all investors in funds or their own accounts.

Two Post-Mortems

While there were some typos in last week’s blog, it had two observations that proved to be germane. The first being Archegos, the family office that had their equity total return swaps liquidated to meet margin calls. We mentioned both Nomura and Credit Suisse had announced expected losses from margin transactions over the weekend. What I didn’t know, was that on Friday, if not before, Goldman Sachs (*) was aggressively liquidating the collateral supporting the Archegos account, where the market action in a number of  “thin” stocks was bothersome. Early trades in Asia were also quite heavy. Sometimes instincts moves faster than knowledge. 

(*) Goldman Sachs is a position in our private financial services fund.

Focusing on instinct, my smart wife Ruth commented to me that not only was the price of food going up at the Supermarket, but also the price of paper goods. This was borne out Monday when it was announced that the price of cardboard boxes went up. These two instances prove that investing is not only an art form but also an active-duty sport.

What do you think?  

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

https://mikelipper.blogspot.com/2021/03/the-biggest-risk-we-all-face-weekly.html

https://mikelipper.blogspot.com/2021/03/2-presidential-lessons-to-be.html

https://mikelipper.blogspot.com/2021/03/mike-lippers-monday-morning-musings.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.