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

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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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Copyright © 2008 - 2020

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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All rights reserved.

Contact author for limited redistribution permission.

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?    

 

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The Confidence Game - Weekly Blog # 701

 

Mike Lipper’s Monday Morning Musings

The Confidence Game

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

The Rules of Life

Whether voluntary or not, by taking our next breadth we display confidence in knowing it is beneficial for us. Consciously investing relies on a series of confidences:

• That we can make a difference having a favorable impact.
• That we have the skills needed to achieve the desired goal. 

When we apply these hurdles to investing we are applying the following articles of faith. 

• That on balance the positive trends we see can be extrapolated into the future.
• That perceived negative threats will be moderated, or at the least don’t represent insurmountable hurdles.
• That we have enough skill or luck to execute. 

The range of executions vary from radical active changes to passive acceptance that we are in an acceptable condition for the moment. Regardless of our decisions, we are making choices that affect us and others.

Our level of confidence impacts where on the spectrum of actions we are likely to reside. I sense a number of people investing as fiduciaries or for themselves losing confidence, causing them to contemplate making contrary investment decisions. In addressing these signs of change I rely on history as a guide. This is a blog about investing for the long-term and is not an instrument of political criticism.

What’s Changed

The ways policy decisions are made and communicated has changed dramatically since the mid1930s. Both Hitler and FDR were expert on the use of Radio speeches or “fireside chats” to move their populations into accepting war as the only answer for their ultimate protection. Other political leaders did not fully grasp this change. (Wendell Willkie counted heavily on his positive relations with the major newspaper publishers and editorial boards. Unfortunately, his support was lacking in a couple of midwestern states, costing him delegate votes at the 1940 Republican convention. My ever-vigilant brother noted that I misspelled his name in the last blog.)

JFK’s telegenic personality vs.. the dour faced Richard Nixon cost him many young voters. LBJ, President Kennedy’s successor, had little choice in running his own election campaign due to constant negative television coverage of the Vietnam war.

Donald Trump had the benefit of a more intense polling, harkening back to the packed and enthusiastic crowds attending Revivalist meetings 100 years earlier. He generated these crowds in many states and communities where network television was not a believable presence. 

Throughout history, the one constant has been the increased speed of communication. Currently, most people get their political news through their computers. This was particularly true during the “lockdowns”. Two critical differences from the television network reporting of earlier years are:

1. The absence of the FCC’s mandated “fairness doctrine”, giving some acknowledgement to the opposition’s point of view, has filled the news hole with paying commercials.
2. Today, social media appeals to their perceived audience and rarely takes time to give a balanced view. The commercial art of visuals has also greatly improved. With a global platform of news and uncensored opinion the world is constantly being “informed”. 

Confidence in the US is Changing

As is often the case, the US bond market is directionally ahead of the US stock market. Many investors outside the US are very conscious of our economic/financial problems. As is customary for good investors, they hedge their bets. If they are high quality fixed income investors the standard way to hedge their currency risk is to buy US Treasuries. On a secular basis the foreign exchange value has been regularly declining vs other “strong” currencies, in part due to our expanding deficit. Markets adjust to perceived risks and in order to offset the currency risk the yield demanded for US paper in the global markets has been higher. However, in the last couple of years the perceived risks in other currencies seemed lower and their yields were consequently lower than those in the US.  

A couple weeks ago this attitude changed, with the yield on US paper rising and prices declining. This “shook-up” the equity markets which were selling at record levels. As almost all traded markets are priced off other markets, if Treasury yields rise the future return in other markets will also have to rise to remain competitive. Consequently, other fixed income rates will rise and if fixed income yields go up equity prices will go down. Market analysts are very conscious as to the inverse price trends of high-quality bonds vs high price/earnings ratios stocks e.g., FAANG and other tech stocks.

Causes of Declining Confidence 

 There is no mathematical formula for confidence. Psychologically, investors consider many different factors important to them. The reason for the long review of political communication is that government is one of the major contributors to individual and institutional investor confidence. In a simplistic model, governments have two broad buckets of policies and executions. Using this approach I will briefly list some of the critical elements in each bucket.

Policies addressing the following challenges:

Belief in US promises

Big Central Government

Borders

Business Relations

COVID

Inflation

Military Leadership

Political Leadership

Taxes

Executions

Afghanistan – For 20 years we have hired both US contractors and local people, including military and police forces, to keep our commitment relatively small. We made actual and implied promises of the eventual relocation of these people to the US and broke these promises with the way the US pulled out. (Many other countries may be questioning the steadfastness of the protection we are providing them. Are they at risk of high social spending in the US leading to financial constraints which might result in a hasty and poorly planned/executed retreat?)

Big Central Government - The main reason it took 12 years between The Declaration of Independence and the issuance of the US Constitution/Bill of Rights was the fear of tyranny by a strong central government. The result was a Constitution limiting the power of the central government, with most power left to the states. In two clever ways the Founding Fathers deemed that the Capital should be built in a swamp, having high humidity in the summer and cold during the winter. Furthermore, under President Washington the original cabinet had only four members: the secretaries of State, Treasury, War, and the Attorney General. Currently, there are 24 members plus 9 Principal officers. The current attempt to have a national law governing how elections are handled, considering individual states have that responsibility, is just what our founders were afraid might happen.

Borders protect and enhance all states. With most of the developed world facing shrinking populations, the US needs more workers and future students to continue our growth. However, they should be people who will contribute to our society, as most legal immigrants have in the past. We must control all our borders to make this happen.

The government’s role concerning businesses should be kept as small as possible. Businesses are not licensed or set up to serve the social needs of a community. They should choose to be good citizens, as it is good for their business and their people. Misapplying the anti-trust statues will reduce employment and send more jobs overseas. Practical companies, including professional practices, have already established foreign production capabilities to supply both US and international clients. I often see new CEOs of global companies coming from beyond our borders. They have the experience of running smaller versions of their US companies, whereas domestic candidates have not experienced managing a complete unit. We need these executives working with us rather than for international competitors.

The COVID pandemic was amazingly well handled in the production of vaccines. Compared to other countries, the deployment of the vaccines and related regulations and services was not as good. (It may or may not be important that the deployment was under a different administration than the initial production.) My real concern is whether most children, particularly those with special educational needs, will ever catch up with students educated beyond our borders. Longer-term, this will have an enormous impact on our long-term wealth production.

Increasing inflation has many causes, some caused by the present administration. I Increases in living costs are most painful for lower wage people, including the current rise in the cost of gas, with more expected for this winter’s heating. The increases are due to the US government restricting the growth of the petroleum production and pipelines. In addition, the cost of increased regulations is forcing businesses to add expensive people, which customers will eventually pay for through higher prices or lower wage increases and job numbers.

For some time, Military Leadership has been heavily influenced by relatively junior generals or admirals being promoted because of a perceived relationship with critical members of Congress or the White House. This may be why the President “didn’t hear” any objections to the way the pull out of Afghanistan was planned. The Chairman of the Joint Chief of Staffs, by calling his opposite number to assure him that our senior most military officer would alert the target’s command structure if President Trump ordered an attack on China, might also be a symptom of this problem. I will let others decide if this was close to being a Benedict Arnold act. What concerns me even more is that we are meant to have the military subservient to civilian control. We would like to see other countries follow the same practice so that the world not be governed by an international group of military officers.

The current day-to-day political leadership of the country is centered in two places, the senior, unelected, staff in The White House and the aged leadership in the two houses of Congress. We have never seen a less impactful political gang in control of the Presidency, the Senate, the House of Representatives, most lower court judges, most permanent government workers, and the media. The “circular firing squad” they have created suggests they are not ready to govern effectively. For those responsible for planning future investments, this chaos introduces more questions than answers.

The Founding Fathers knew, and many political leaders know that tax legislation is the power to destroy. The current administration’s tax motivation is to deploy tax revenue from the “rich” to pay those with lower wages. One might call these “bribes”, under the theory that these people will show their “gratitude” by voting for the source of their grants. As bad as this is for democracy, it may not be the real motivation. The real motivation might be income tax regulation to destroy or curtail a major source of contributions to the Republican Party. (During our history we have only had income taxes during wartime. Through close to half of our peace time existence, tariffs collected on imports were the main source of running our small national government.) As a matter of financial history, any large-scale deployment of money creates leakage from both sides of the transaction. Some of the leakage will result from inefficiencies created by not having appropriate procedures and some will be easy to plunder. More impactful will be the legal diversion to put elements of income and wealth beyond the scope of the regulations. (The lawyers and accountants will earn their high fees.)

Reactions

This is a continuing movie. While we may think we know the end, we don’t know the timing. Based on history we should now be in the midst of a meaningful correction, although in evaluating the indices it hasn’t really started yet. Only a small minority of stocks in small industries rose this week. 74% of the Wall Street Journal’s list of market changes declined.

One of my worries is that on the Monday the trading markets dropped, I assume a higher than usual portion of the transactions were not reported on the relevant exchanges. One possible indicator is the after-hours price drops. In a list of stocks I am following because my accounts own them or are considering them for future purchase, 31% had further declines of 2.3% to 4.9% below their last sale on their formal markets. I am worried there is not sufficient capital available for the trading desks to absorb a major decline.

Tactics & Strategy

 In terms of trading tactics. After almost every decline there is some sort of price recovery of market averages that takes many stocks near the levels they were selling at immediately before the decline. (Some issues won’t get that bounce.) Certainly, by the second day I would be a seller of any position that I would not choose to own for years into the future.

Strategically, as a long-term investor I would hold positions that should be held for competent heirs until new information questions the long-term, after recognizing the need to pay capital gains. I would also use down markets to look beyond one’s normal comfort zone to broaden the opportunity set.

What do you think?     

   

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

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

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

https://mikelipper.blogspot.com/2021/09/3-thoughts-to-ponder-weekly-blog-698.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.