Are Markets Getting Too Far Ahead? - Weekly Blog # 738

                                    

Mike Lipper’s Monday Morning Musings

Are Markets Getting Too Far Ahead?

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

Caution

The function of trading markets is to discount future results. As with any predictive exercise, one should recognize judgement mistakes will happen. One major predictive mistake is to get too far ahead of future results, often caused by not recognizing the ebb and flow of future events prior to conclusion.

Connecting many current predictions, we are absolutely going to go thru the following stages, all in predictable time periods.

Bear Market  >  Recession  >  Political Change  >  Bottoms  > 

Recovery  >  Buying Opportunities  >  Bull Markets

Note: there was no mention of mistakes and inconsistences.

Incomplete evidence is popping up suggesting the stock market will return to form and force us to be humble. My best guess is that before we get a formal call that we have entered a recession, we may go through a somewhat violent trading surge first. It will cause some to question the inevitability of a meaningful recession, although the result will not preclude a major decline from causing a restructuring.

Current Evidence 

1. For the last 2 days of the week, major US stock indices explored lower prices but closed above their lows.
2. While the Dow Jones Industrial Average (DJIA) had only one rising session, the Dow Jones Transportation Index had two. (I believe the transportation index is a better judge of current conditions than the DJIA, which has more of a future orientation)
3. Last week, there was only one stock price index which rose out of all the S&P 500 indices. (This is unlikely to be repeated regularly.)
4. The number of shares traded on the NYSE had more volume for the week than the NASDAQ, with 17 million shares declining and 14 million rising. The volume of trading on the NASDAQ was essentially even, with 14.58 million advancing and declining. (As expressed in the past, the NASDAQ has more active traders than the NYSE and consequently is more useful for predictions.)
5. The JOC-ECRI industrial price index declined -3.4% this week.
6. Market analysts often believe the results of the American Association of Individual Investors (AAII) survey should be viewed as a contrarian indicator. This week, the AAII bearish indicator was an extreme 58.3%, up from 46.9% the prior week.

I believe the odds favor more upside than downside well into July.  The Atlanta Fed’s current GDP reading may soon indicate a flat or contraction estimate, with a possible confirmation by the Federal Reserve on July 28th.  (The 35th anniversary of “Black Monday”)

Fixed Income Signals

Stock investors have learned to pay attention to price movements in the fixed income markets, which tend to be more sensitive to price risks than stock jockeys are.

While the yield curve has been rising sharply for short to five-year maturities, it is essentially flat for five to thirty year maturities.

The collective bet is that inflation will not rise beyond five years. (What does this say about the Presidential election of 2028?)

One sign a bottom has been reached is when an important group of investors capitulates to the current trend, selling out of their positions quickly.

Some believe investors in credit instruments have capitulated and sold off their credit instruments, a move not echoed in the high-quality bond market. This week, the largest net redemptions in the Exchange Traded Fund (ETF) market were high current yield funds (pejoratively called “junk bonds”). The redeemers were reacting to a perceived increase in credit risk.

The concern bridging the fixed income market and the stock market is the belief in book value on corporate balance sheets. Book value is based on historic cost less depreciation of fixed assets, which can only be written down, not up. One popular “value investing” approach is to buy shares of a company whose price is below book value. However, if current stock prices do not adequately price book value due to changing conditions, the current book value discount may not be accurate.

Thus, some of the fears expressed in the fixed income world can travel into the equity world, making some stocks risky.

Political Warning

General George Washington warned us about political parties, which is as true today as it was at the founding of the USA.  He said the following:

“However political parties may now and then answer popular ends, they are likely in the course of time and things, to become potent engines, by which cunning, ambitious and unprincipled men will be enabled to subvert the power of the people and to usurp for themselves the reins of government, destroying afterwards the very engines which have lifted them to unjust dominion.”

(This quote was part of The American Rhapsody performance delivered at the final concert of the season of the New Jersey Symphony. The US has been blessed by the wisdom of its founders.)    

Please Share Your Thoughts

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https://mikelipper.blogspot.com/2022/05/bear-markets-recessions-not-inevitable.html

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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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3 Potential Risks - Weekly Blog # 495

Introduction

Contrarians are useful even when they prove to be wrong. In forming an investment committee for a non-profit institution of professional investors, I felt it was incumbent on me to somewhat balance the committee, largely populated by generic optimistic money managers with at least one contrarian that was well skilled in finding good shorts. While it would have been inappropriate for this institution to sell short betting on falling prices, the answering of some bearish views were useful in appropriately constructing our long portfolio which did well. We were better prepared to be long-term investors on the long side for reviewing and appreciating contrarian views.

Current Thinking Process

Stock markets around the world are rising well ahead of current sales and earnings, even adjusted for modest growth projections. The buyers are enjoying what could be called a “melt up.” Economic sentiments are moving higher.

While I do not know how long these trends will last - be it a day or multiple years - I believe it is critical to consider the potential risks that are currently apparent to this long investor and manager.

First Risk: Simplistic Decisions

On October 26th The Wall Street Journal published a multi-page critique entitled “Morningstar Mirage” which purported to show that the firm’s various ratings were not helpful in making decisions as to what mutual funds to buy. The article decried the marketing power of Morningstar’s ratings, not recognizing that at least since the 1930s funds that performed well attracted the most sales if they were known. In the same light there was no real discussion of the questionable mathematical processes used to reach its conclusions.

The biggest risk to investors is not the Morningstar Mirage. The biggest risk is that the financial community believes that investors want simple answers to complex questions. Sales people who can get very limited time with both their prospects and their accounts are trained to use the KISS principle, (Keep It Simple Stupid)” in their communications. It has never been clear to me whether the communicator or the investor was stupid.

Often people spend more time at a sporting event or preparing a special meal then they do making investing decisions which can have significant impact on their lives and those of the beneficiaries. At the game each play, each course or each critical ingredient is thought about deeply. As the readers may be aware I learned the basis of securities analysis at the racetracks, spending hours on each race. I am told that one of the most successful racehorse owners in the last 30 years in the UK spends a great deal of time on the races and the breeding of her horses. We should do no less than Her Majesty.

When Hylton Phillips-Page, my VP of Fund Selection and I analyze a mutual fund we spend a long time getting to understand how the fund, its managers, and supporting organizations impact the past results. A much more difficult task is guessing how we think the past will not be simply extrapolated into the indefinite futures. The term futures is a recognition that there will be interruptions of past trends as conditions change.

The risk of simplistic decisions is much broader than choosing mutual funds.  Not only investment decisions, but all types of other decisions, including political, career, and other personal decisions are put at risk when given only cursory attention. The past is useful as to what happened and more importantly what didn’t.  Most studies of human decision-making involve a number of biological organs. The brain and our senses are very complex and they interact differently when conditions change, and they are always changing.

Second Risk: Credit Withdrawals

In each of the general write-ups of major stock market reversals almost all the attention is devoted to stock prices. In truth almost every major stock market decline was slightly preceded by the withdrawal of credit support. Since we are not out of October, we should first start with October 28, 1929, the biggest single day drop in the Dow Jones Industrial Average up to that point. On that day, the index dropped 12%. Most recounts do not include the fact that the market had been dropping since August and a good bit of the buying was done with borrowed money called margin. The borrowed money came from the major banks who issued it to the brokers, who in turn offered it to their clients on the basis of their portfolios. The banks used call loans to the brokers using their clients’ collateral. As the market declined in the late summer and early fall of 1929, the value of the collateral fell, reducing the safety for the banks that were starting to call their loans. The brokers called their margin accounts to put up more collateral which most didn’t (or were not able to) and were rapidly sold out of their holdings. This is an example of a non-price sensitive insistent seller.

A similar thing happened in 1987 where in one day, October 19, 1987, the DJIA fell 22.6%. European stocks were down about 10%. Portfolio insurance used futures to hedge long institutional positions. Many of the futures contracts were margined against the long positions owned by financial institutions. In Chicago there was no requirement to be able to short on a price uptick as there was in New York. When New York opened there was a wall of sell orders.

A somewhat similar occurrence happened with the collapse of Lehman Brothers when the “repo market” to finance its fixed income inventory was closed to Lehman due to a different set of rules and expectations in London.

Trying to avoid a future similar event, the Dodd Frank Act focused on what banks and others owned, not the risk in their loans. I suspect that most of the inventory owned by the Authorized Participants, (the market-makers for Exchange Traded Funds and similar products) are highly margined. At some point the providers of these loans may get nervous as to their collateral cushion and may want instant repayment which could create a problem.

There may be similar potential problems in both the US Treasury and Foreign Exchange markets where high leverage is available.

Third Risk : Career Risk

If investors are guilty of simplistic investment decisions, professionals live in fear of being fired either by clients or employers, This is a particular risk if someone needs to publicly report performance or work for publicly traded companies. Thus, despite reasonable long-term results, near-term absolute and even more importantly - relative results - drive terminations. This is normally a mistake on the part of the terminator for two reasons. First, most of the time there is a partial or complete recovery. Second, and much more dangerous to the investor is the choice of the replacement, often a manager that has good long-term results which are appropriate for a decline, but poor results in expansions.

Bottom Line

Risk is always with us and it is the highest when least expected. Drive on two-way streets, they are safer.

__________

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