Price Trends, Clues and Concerns - Weekly Blog # 506

Introduction

Bonds, stocks, and commodity prices are sending different clues while the pundits proclaim synthesized global economic growth. After thirty-six years of rising returns for fixed income, almost a decade of stock market gains, and commodity prices entering a new cycle, thoughtful market participants are confused. The one common impetus is growing confidence in decision-making. With more confidence investors are consciously or not accepting more risk because they are getting a somewhat clearer view of the future. As a contrarian, and often allergic to popular views, I have my doubts. I am not totally alone. Ian Bremmer of the Eurasia Group has said, “2018 feels ripe for a big unexpected crisis." My concern is that the growing confidence is crowding out a reserve for surprises, good or bad.

Inverted Yield Curve Fear

While it is true that the last seven fixed income prices declines came after the 2-10 year US Treasury yield curve inverted, I do not believe it is an immutable law of investment science. Nevertheless, it is a proper place for study. There is a similar pattern in the futures market when near-term investments are more expensive (higher yield) than long-term ones. What is important is that the market view is that the near-term future has more risk than the longer-term. Often this is right, but not always. Remember the surprise factor. In my opinion an inverted yield curve if and when it happens is more descriptive of current fears than predictive of long-term prices. Fixed income prices are set by supply and demand and are similar to the odds posted by book makers which are not the result of careful analysis but prices that will bring new bets into balance to keep the bookmakers’ capital risk into reasonable balance. The bookies and the bond market will lose out only if there are too many surprises.

The fears that there are oncoming inverted yield curves or other causes for bond prices to decline have been operating for the last few years. The biggest concern is not credit losses, but inflation. To service those who are concerned that inflation will rise above current levels, the US Treasury and others have created TIPS (Treasury Inflation Protected Securities) funds which are issued in roughly the same maturities as the other treasury paper. For more than the last three years the total return investment performance of the average TIPS fund is slightly better than the average intermediate US Government Securities fund. For longer periods the reverse is true. One wonders what the relative performance results would be when the reported inflation rate finally reaches or exceeds the Fed desired 2% level. It is possible that our and others are from time to time paying premiums to buy inflation protection and this is why the TIPS funds perform better rather than their pricing mechanism?

If one is managing retirement capital accounts for those that are currently working, I would substitute 30 year treasury yield for the 10 year. (More on this later.) 

Individuals investing in fixed income securities or funds should separate the total return numbers between income (interest) payments and market prices. Inflation will not nominally impact the income stream, but may have significant impacts on both the prices of the bonds and the purchasing power of the proceeds.

At Caltech and other places studying how the brain makes decisions, they have found that most humans make decisions on finding past memories that coincide with current conditions. Every now and then, the occasional winner will see the current situations as sufficiently different than the past that they opt for a new strategy. In other words the preferred algorithms will give way to new thinking and actions.

Stocks Are a Confidence Game

Almost every prognostication from brokers, advisors, and commentators in terms of the stock market were expansive. Two recent examples display the enthusiasm for the stock market are as follows:

Extrapolating the first full trading week suggests that the S&P500 will triple this year.

Goldman Sachs believes that the Bull market should run for another 3 years.

“Investors Intelligence” tracks letter writers in its latest report in Barron’s; 64.4% are bullish and only 13.5% are bearish. In approximately the same period the AAII weekly survey showed a significant reversal in their volatile report with the bulls declining to 48.7% from the prior week’s 59.8% and more significantly the bears gained to 25.1% from 15.8% the prior week. The AAII sample shifts each week which could have caused the changes and this week some were more worried about the impact of the bond market or were reaching to political news.

Commodities are Active

Based on perceived increasing demand from China and rising demand from US manufacturers, industrial metal prices are rising. In a classic example of a surprise, the price of oil touched $70 a barrel this week and there is a press story that some expect the price to reach $80 this year. In response, over the last four weeks the best performing mutual fund investment average is the Natural Resources funds, up 12.66%. As a contrarian and a long-term investor I am wondering when the increasing population and shrinking farming land will be seen in rising prices for grains. This hasn’t happened in a long time.

Very Long-Term Outlook

The latest available estimate of the global retirement savings gap in 2015 was $70 trillion and by 2050 it is estimated to be $400 trillion. Thus, in only 35 years there is a need for over five times more capital to be invested for retirement. (This is why I suggested using the 30 year yield for the spread calculation.) How should one invest to meet this long-term need? I do not believe that today one can evolve a consistent investment policy to meet these needs. My contrarian nature suggests that it may be easier to identify what not to do. The average S&P500 mutual fund beat 90 out 96 mutual fund investment averages for the last five years and 84 for the last ten years. I don’t think that will continue. The best performing hedge funds in 2017 were invested in large caps and securities driven by momentum (FAANG + 2 from China).  Different strategies at different times will be needed to avoid losses and achieve gains. This is why I believe that a portfolio of different funds or managers is the most prudent for the long-term.

Question of the week: What are the most prudent strategies for the long term?

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Reluctant Excuses: TINA to FOMO; Good News: Historical Trends to Apple Store; Accelerating Momentum: Incomplete - Weekly Blog # 505

Introduction to FOMO

Changing sentiment appears to be a much stronger force than earnings taking the stock market higher. A couple of years ago, investors reluctantly were buying equities in the face of expected rising interest rates, relatively slow earnings growth, and expected political turmoil. Their excuse for this questionable decision was TINA, There Is No Alternative. Over the last fourteen months this excuse has given way to another symbolic abbreviation FOMO, Fear Of Missing Out. During these last fourteen months and the first week of January, 2018, the S&P 500 has not had a single month decline. Momentum has become the mantra for the buyers as well as the larger audience of holders. In the last calendar year the leading investment performance factor within the S&P 500 universe has been the momentum stocks that gained 28.27%.

Will it Continue?

This week we had two very insightful experts publish their views of the year ahead with clues beyond. Byron Wien published his annual ten surprises that he believes have at least a 50% chance of happening and that his wide circle of global contacts believe have less than a 33% of happening. One of his surprises is that the market will take a 10% correction during the year. He thinks that a recession will not surprise us until at least 2019.  Further he recognizes that there may well be other surprises during the year that none are expecting. Nevertheless, one could interpret his views that stocks markets in general will be well behaved.

The second very worthwhile piece published this week was by Jeremy Grantham of GMO. Jeremy by nature tends to be on the bearish side. Thus it is a bit surprising that he entitles his piece “Bracing Yourself for a Possible Near-Term Melt-Up.” While he does acknowledge that we could have a 20% decline that he believes would be helpful, he also does not see a near-term recession. Like Byron he sees the S&P 500 as going well into the 3000 territory. B/t/w, his firm has an equity fund that is among the leaders in the institutional league.

The odds are that these two gentlemen will prove to be correct and I hope so. However, when I mention odds I am force to think of the lessons that my experience bought at the major New York racetracks which can be briefly summarized as follows:

1.  Past performance is good to organize one’s memory, but can be less useful in predicting the future.

2.  Each race (Market) is different with different horses and conditions.

3.  Different odds lead to different earnings.

4.  It is not the number of wins that counts, but the size of winnings taken away.

 5.  As a contrarian one can win more money by occasionally betting against the crowd.

Good News: Historical Trends to Apple Store

One of the reasons to own rather than loan is that over long periods of time human life is generally getting better. Most of the time we don’t get this message from our political leaders and their supporting pundits. If there weren’t problems to be addressed we might not tolerate governments and their expenses. Thus, we do not see a lot of publicity about the long-term progress we have made some of which from an article by Max Roser can be shown below:

·       Since 1990 there have been 130,000 people fewer in extreme poverty every day.

·       Globally in 1800 there were fewer than 100 million that could read. Today 4.6 Billion can read.

·       In 1800, 43% of the newborns didn’t see their fifth birthday. In 2015 child mortality was down to 4.3%. Improved health and nutrition has made us taller and smarter.

·       These and other positive trends are continuing and accelerating.

Part of the reasons for this progress is due to technology which marches to its own drummer. Technology itself is driven by the desire for increased profit. I refer to profit not in an accounting or monetary sense, but a desire to improve one’s own life, often to improve the lives of ones for which the individual cares.

This thought occurred to me this weekend when I accompanied my wife to the Apple Store at The Mall at Short Hills. It was by far the busiest store in the mall with both customers, salespeople, support staff, and in effect, trainers. It only took a little more than an hour to exchange her watch for a different model and synchronized it with her iPhone. During that time I had a chance to look at a very diversified group of customers waiting patiently to be served and an equally diverse sales and service group on a packed sales floor. 

What occurred to me is that we were experiencing an ecosystem which is building loyalty and a knowledge base both for customers and a helpful, well-trained sales force. In many ways each person in the store was looking for ways to improve his or her condition in a personally profitable way. (The visit made me happy that I have been a very long-term shareholder in Apple and reinforced my faith in their eco-system in spite of periodic hardware and software glitches.) 

The potential of Apple and its good competitors to deliver very useful products and services addressing many of our unmet needs suggests to me the rate of human progress will accelerate in the years ahead and will probably benefit my grandchildren, great grandchildren and their children.

  

Accelerating Momentum: Incomplete

In a market that relies on sentiment to drive its momentum, one can not wait on published financial and economic results. One should be paying attention to what consumers at all levels and investors are doing as well as saying. Recently I have been commenting on the AAII weekly survey of a sample of its members. As I have said previously, a normal distribution of the individuals' opinion is roughly 40% bullish and 30% each for neutral and bearish. This week the bullish reading exceeded 59% and the bearish number was about 15%.Two weeks ago the numbers were 50% and 25% respectively. Clearly a symptom of accelerating momentum

The siren of the rising stock market has not sucked in all the available money that is fearful of missing out. The banks (particularly the small and regional banks) have not lost cash deposits to the stock market. As a matter of fact, this week the average money market account dropped its rate to 0.30% from 0.33% the week before. The drop may be caused by less demand for loans or possibly that some banks were bulking up their cash items for year-end statement purposes.

Some market observers and I are carefully watching the yields on treasuries. Each major stock market decline had rising yields as money sought safety away from actual or perceived credit risks. Some feel a ten year yield above 2.50% could be alarming.

What to Do?

If economist Jeremy Grantham is correct that we are in a “melt-up” and there will be a 20% decline before the eventual recession which could trigger a bigger decline one may want to shift some of one’s equity positions into highest available quality. That would not have hurt you too badly in 2017 when the quality component in the S&P 500 gained 19.51%.

At this time large market caps with reasonable balance sheets yield above the ten year treasury. Not a great deal of actively managed investors and high market liquidity can be used as bond substitutes. Because we can always be surprised I would own a bunch of these. They may include AT&T, GM and GE plus a few others. If one becomes addicted to investing in quality stocks for the long run, there are more in the small cap arena than elsewhere, but these are for investing not cyclical trading.

Question of the Week: Do you agree or disagree with my analysis?     

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Copyright ©  2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission