A Terrible Week - Weekly Blog # 772

 

Mike Lipper’s Monday Morning Musings

A Terrible Week

 

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

 

 

 

A Blogger’s Point of View

Everyone reacts to stimuli based on their physical, financial, and emotional perspective. Considering these filters, I had a rough week. While I almost always have views, I try to base them on facts. I found little in the way of published facts supporting or completely opposing my views. Therefore, to quote my arts photographer, I opened up my aperture to give more credence to a widened field of inputs. Some may refer to these as collateral notions, but in the absence of convincing evidence they will have to do.

 

Quality of Information

In the US Marine Corps, we were instructed to value our inputs in terms of accuracy and creditability when planning to engage the enemy. I find this type of information missing from most publicly available statements about the future, although there are occasionally some pre or post warnings to be found. This week there were two such notices concerning topics about future budgets and pandemics.

 

The Congressional Budget Office (CBO) regularly publishes estimates about future budgets related to Gross Domestic Product (GDP) and the Demographic outlook. (One problem with both studies is that accuracy in the past has been wide of the mark. In spite of that, they presented a single number answer in their projections. I question the precision and credibility of the single number. For example, their stated deficit for 2023 is $1.4 Trillion and between ‘24 and ’33 it will average $2 Trillion. As this is perhaps the single most important number for those who pay their salaries, I would be more impressed with a range and a description of what might cause the difference. Personally, I would doubt an estimate in the exact center of the range.)

 

Furthermore, while the demographic study shows a decline in population, it is my guess that a good psychographic study would show an even worse outlook concerning the number of hirable people and their willingness to work.

 

Perhaps the biggest blow to the creditability of government estimates and actions are summed up in the following headline “Fauci Changes His Public Tune on Covid Vaccines”. In an article in “Cell Host & Microbe Journal, Dr Fauci wrote that vaccines against respiratory viruses provided “decidedly suboptimal” protection against infection and rarely produced durable, protective immunity. (I am not qualified to have a medical opinion. I certainly don’t know whether they hurt and probably will continue to get shots if my doctor recommends them.)

The key lesson from these inputs going back to my USMC training is to evaluate inputs based on the sources of the input. In these particular cases both were paid for by a government apparently in need of political help, meaning they should be viewed with skepticism while searching for other “facts” or properly labeled opinions.

 

Application Analysis

Investors love numbers, but often don’t apply carefully with constraints in making investment decisions. The following is both a summary of the data and my applications of the input.

1. The longer the period measured, the smaller the downside. (It is best to invest for the long term, there are very few periods of 20 years or longer where it hasn’t paid to invest in a portfolio of stocks. - Losers are not around for the full period.)
2. Historically, when an inverted 2-year US Treasury yield is higher than the ten-year yield for more than 100 trading days, 10-year yields peak. The current inversion has existed for over 160 days. (Either the old formula doesn’t work anymore, or the drop is going to be large.)
3. In the minds of investors, most stocks traded on the NASDAQ are more growth oriented than those on the NYSE and many are considered to be speculative. NASDAQ investors are not normally more patient than investors favoring NYSE issues. Additionally, there are fewer passive investors owning NASDAQ stocks. Last week 61.8 % of the shares traded on the NASDAQ fell, vs. 53.7% on the NYSE. (Speculators tend to sell more quickly than investors, as they sense price problems more quickly. – Hint, the stock market sold off later in the week because participants finally believed the Fed was probably not going to lower interest rates this year. Even though many growth stocks are not highly indebted, the larger the number of years used to value earnings growth, the higher the valuation.)
4. There are 20.8 million employees in goods producing firms and 129.6 million in service providers. (In an attempt to reduce inflation, the political establishment is focusing on the sales of goods producers instead of service providers. However, these politicians probably are more likely to be Democrats.)
5. One of the most interesting aspects of the week was the rise in John Deere’s stock price. They announced rising earnings, declining supply chain problems, lower industrial costs, and an increase in their own prices. (The timing of their price increase is curious. While I do not follow the company, a number of my old analyst friends had great respect for it. This made me think that this savvy management team might be afraid of political pressure to lower prices in the not-too-distant future and wanted to start out from a higher level.)
6. The weekend WSJ ran the following headline “Brace for the Richcession”. The article highlighted wages going up more than inflation for the poorest quintile of workers.  The other quintiles could be losing ground, not only in terms of relative wage hikes, but because their home prices and portfolios have peaked. Thus, the Richcession in the title. (I am not certain of the nature of the problems the editors were considering, but they may also sense an attempt to restructure society and therefor the economy.)
7. The biggest immediate problem facing America and other economies is China’s economy slowing down. Exports to China are critical to world trade growth.
8. I do not know how to measure it statistically, but I sense there is declining trust throughout our ecosystem. All relationships are based on trust, be they personal, political, or economic relationships. (While I and my accounts have been purposeful global investors for a long-time, as an odds-playing investor I get nervous when I see what occurred last week. One of our most speculative sectors, equity exchange traded funds (ETFs), had negative outflows of $783 million, while international ETFs had inflows of $1.9 billion. This makes sense tactically and is appropriate for hedging purposes, but it is not encouraging for our children, grandchildren, and great grandchildren.

 

Readers, please share your thoughts as to my views.     

 

 

 

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Mike Lipper's Blog: Primer on Starts of Cyclical & Stagflation - Weekly Blog # 771

 

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Mike Lipper's Blog: What will the Future Bring? - Weekly Blog # 769

 

 

 

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“Things are Seldom What They Seem” - Weekly Blog # 718

 

Mike Lipper’s Monday Morning Musings

“Things are Seldom What They Seem”

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

This is the title of a song by WS Gilbert of Gilbert & Sullivan in the operetta H.M.S. Pinafore. The title seems appropriate to thinking about investing today. In gathering research to reach my conclusion, I excluded positives that led to a bullish conclusion, but not because it’s unlikely. To the contrary, most investors tend to be optimistic, their views are documented by investment and political pundits. Consequently, another similar voice is hardly additive. Seeing potential negatives is not a popular exercise, although it’s useful in bringing balance to one’s views. To be perfectly clear, the vast bulk of my investments are invested in stocks and equity funds for the long-term, even beyond my life. I hope the majority will pay off in total return, comprised of price appreciation and growing dividends. The biggest problem today is that very few investments generate income sufficient to meet reasonable future expenses after inflation and taxes. The inability to meet current and future expenses from dividend and interest payments is a sign of a highly priced market.

Critical International Competition

Our geopolitical discussions are often based on Ukraine or China, with these conflicts placing the Western world at a disadvantage, regardless of our greater wealth. The current administration is playing checkers, where one needs to get up close to the opponent to eliminate one of the opponent’s pieces. The Russian leader appears to be an excellent chess player. The goal in chess is to capture the opposing king, using players that have different capabilities and proximity. Our Chinese competitor believes time is on their side and is building a greater level of self-sufficiency. Both appear to be capable executors of tactics and strategies based on a lifetime of work and success. By comparison, many members of our cabinet and senior staff were chosen based on their identity and political views.

Earlier this week at an investment committee meeting I mentioned that Russia had already accomplished its real mission, sponsoring disunity among European NATO members. Both German and to a lesser extent Italian business leaders wanted to maintain close relations with Russia and China. While I still believe this is the way they play global chess, there is a contrary action on the horizon. One of the main political parties in Sweden, concerned about the fluidity of Russian troop movements, wants to join NATO. With Sweden’s technological strength and good military, it could more than make up for the potential loss of Ukraine. Whether this happens or not, the mere fact that it could, is an example of “things are seldom what they seem”.

Guessing the Future is Difficult

As securities analysts, we used to say the one saving grace of weather forecasters is that they made us look good by comparison. (In terms of weather, I should point out, the less than optimum choice of the date for the Allied landings in France was a correct judgement by Ike, which differed from the German Army’s conclusion.)

Each year, the accuracy of the Congressional Budget Office’s (CBO) budget revenue projections is compared to its past record. In fiscal year 2021 the projection was too low by 15%, three times the normal error rate of 5%. Outlays were too high by 4%, twice their normal miss rate. These projections were calculated after some midcourse corrections in March. The purpose of showing these misses is another example of skilled statisticians falling to Mr. Gilbert’s song title. 

I don’t have similar numbers for analyst misses in terms of sales and earnings for the same period. My guess is the private sector error rate was equal or more than the CBO’s. My concern, particularly for high P/E stocks with double digit earnings multiples, is that errors can start “to be real numbers” This may be particularly true if one wants to invest for periods of ten years or more.

Two Different Voices

This is the season where politicians and corporate managements tell us how good things are and will be with their fourth quarter and annual earnings announcements. Actions by consumers and investors are saying something different, with consumer spending in December slightly below November. It is possible consumers shifted to earlier holiday buying due to fear of shortages, although a recent walk through The Mall at Short Hills, a ritzy shopping center, did not reveal ebullient shoppers. This suggests very little business capital was used to expand capacity vs filling out the supply chain, although there was probably some inventory building on the industrial side. 

In terms of net buying of mutual and ETF fund shares, it was dominated by the buying international funds and the redemption of domestic equity funds.

Views on a Recession

Merrill Lynch market analysts believe the quickest way to a recession is a Wall Street Crash. Jeremy Grantham, a manager that has been early but correct, put out a very dire point of view in a piece titled “LET THE WILD RUMPUS BEGIN”. He portrayed a bursting of the US Extravaganza, taking stocks, bonds, commodities, and housing down to at least their base price levels. Barron’s headlined an article “The Countdown to The Next Recession Already Has Begun”. This article pointed to rising fed rates bringing on a recession in 2024.

We May Not Be Hedged Against What We Thought 

Suppose we have a $1,000,000 portfolio invested 90% in stocks and 10% in long bonds. If any of the thoughts expressed above materialize and stocks and bonds both drop at least 10%, you now have $900,000 portfolio. While you continue to be hedged against a relative decline of one of two asset classes, you are not hedged against the loss of $100,000. If you look at the purchasing power of your money, both inflation and foreign exchange could reduce the purchasing power of your investments.

Working Conclusion

Be prepared for a difficult market that will reset values, possibly for a few years. At the same time, maintain long-term positions for future generations. They will need it, because it is possible the world will restructure in an unfavorable way, but at least they will have a start.    

  

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

https://mikelipper.blogspot.com/2022/01/two-critical-questions-weekly-blog-717.html

https://mikelipper.blogspot.com/2022/01/current-causes-of-concern-weekly-blog.html

https://mikelipper.blogspot.com/2022/01/deeper-thoughts-weekly-blog-715.html

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Are We Going to Get “Ds”? - Weekly Blog # 694

 

Mike Lipper’s Monday Morning Musings

Are We Going to Get “Ds”?

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

School Communications

In the dark ages when I went to schools that used letter grades, the letter D was dreaded because it indicated you took the class, got credit for it, but did not get credit toward graduation. Today we live in a world where changes in sentiment are often a precursor for changing results.

With that in mind, I read the Barron’s Review & Preview column at 3:30 Saturday morning. The column was based on the latest University of Michigan Consumer Sentiment Survey, which called the reading a “stunning loss of confidence”. Sentiment in the first half of August dropped 13.5% from July’s reading. The University of Michigan survey noted that over the last half century there were only six deeper cuts. Clearly this was an emotional response. 

My job as an investment manager requires balancing potential risk and reward. In most periods both range between 40%-60%, although these normal bounds of expectations are exceeded every now and then. As this could be one of those periods, I believe it is now analytically appropriate to look at more dramatic expectations on the downside. 

Investment Implications of Declining Ds

Investors are unhappy for the following reasons:

Disappointment 

• The potential loss of US and Afghan lives
• Acceptance of being a smaller global military power
• Government generated inflation through excessive money supply growth
• Rising energy prices
• The personalities of political leaders at various levels
• While not pleased, investors are not sufficiently worried to generate taxes on extra taxable gains

Discouragement

• After the very large gains achieved from the March 2020 bottom, some give back is expected 
• Concerns over the increase in speculative activity in the public and private markets 
• The unknown impact of the Delta variant potentially lengthening the forthcoming correction 
• Normal pruning of portfolios makes sense to eliminate investments with weak prospects or questionable sponsorships 

Disappear

• Growing cracks in society, the economy, and politics are not being addressed with enough attention. Their impacts will reduce the comforts of capital long-term. 
• Well-guarded, dispersed reserves and controlled expenses become more important.

Depression

• While highly unlikely, a depression is possible due to mistakes like the March 13, 1930 passage of the Smoot Hawley Tariff. Up to that time many people felt Herbert Hoover was a great humanitarian and good President. Herbert Hoover lost re-election in a landside because he agreed with the political forces supporting the farm block. They had suffered a few years of bad weather leading to a substantial rise in farm indebtedness and low-price agricultural imports. Some US manufacturers were also hurt by imports. What was not evidently considered by US politicians was their raised tariffs being reciprocated by most other countries. This led to world trade and the value of our currency declining. One could argue that it also accelerated the rise of totalitarian governments in Germany and Japan. Hopefully, we won’t make a similar mistake in the future. However, if we experience a depression, survivors should be able to invest in good assets managed by talented people.

Lessons from Bob Farrell

Bob Farrell was the head of research at Merrill Lynch for decades. From his perch he saw both the markets and the actions of Merrill’s customers. Because his firm had the largest number of retail customers, he saw much more than the rest of us did. Thus, his “10 Market Rules to Remember” is well worth bearing in mind, particularly in a low volume rather trendless US stock market.

1. Markets return to the Mean
2. Excesses usually lead to opposite excesses
3. Excesses are never permanent
4. Rapidly rising or falling markets usually go further than expected and don’t correct sideways
5. The public buys mostly at the top and least at the bottom
6. Fear and greed are stronger than long-term resolve
7. Markets are stronger when broad and weak when narrow
8. Bear markets have three stages: sharp down (-20% or more), reflexive rebound (“suckers’ rally”), and a long-drawn-out fundamental downtrend.
9. When all “experts” agree, something else will happen
10. Bull markets are more fun than bear markets

Applying Farrell’s Lessons

Rule 9 warns of unanimity of expert opinion. I suggest that rule be applied to the latest report by the UN experts on Global Warming stating “It’s just guaranteed that it is going to get worse”. They further state that it is “unequivocal” and an “established fact”. 

While I don’t know what the future will bring, there is a large body of contrary opinion based on current and prehistoric geological history. I have been privileged to listen to Caltech professors and students who have a range of views, although they have never expressed the degree of certainty the UN scientists proclaim. 

Two other predictions of certainty from US government sources raise questions as to the accuracy of their expressed opinions. Next month will be the fiftieth anniversary of President Nixon closing the “gold window”, where foreign governments could buy gold at $35 an ounce. This was meant to protect the US against imported inflation and protect the value of the US dollar. In the last fifty years we have had both inflation and a decline in the purchasing power of the dollar.

More recently, the Congressional Budget Office (CBO) issued its analysis of expected labor productivity. For the period 2021-2031, they expect the potential labor force to grow 0.4% per annum, compared to 0.5% in the 2008-2020 period. They suggest it will produce labor productivity of 1.5% in the next decade compared with 1.2 % in the prior period. I question the conclusion, although it is possible if there is large scale automation and qualified labor to operate the machines and computers.

When I was in school taking “true and false” tests, we were urged to doubt any statement that carried the words “always and never”. This fits well with my real source of education, the racetrack, where there never was a sure thing other than the track and government taking a piece of the action before I got paid.

 

Application of this blog’s lessons

1. A change in sentiment can lead to a change in market direction, possibly soon.
2. Wherever and whenever possible we should be adopting the thinking expressed by Bob Farrell.
3. Be wary of predictions with an extreme view of certainty.
4. Learn from mistakes and teach those lessons.  

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

https://mikelipper.blogspot.com/2021/08/mike-lippers-monday-morning-musings_8.html

https://mikelipper.blogspot.com/2021/08/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/07/mike-lippers-monday-morning-musings_25.html

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The Biggest Risk We All Face - Weekly Blog # 674

 

Mike Lipper’s Monday Morning Musings

The Biggest Risk We All Face

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

Self- Inflicted Risk

While many try, nobody commands how we make decisions. That is why each of us are ingenious in building our own strict prisons. Our jailers are what we choose to believe or not believe. It is that process which leads to our single biggest investment risk: Conformation Bias. While we are very conscious of the endless sources of facts and opinions in this modern era, the way we deal with too much information is to ignore much and accept some of the inputs. 

I cannot improve on your own selection process but will attempt to aid you in assessing the strength of your convictions. In this way I hope to improve the consequences of deeply held beliefs. For centuries, most people held firm to the belief that we lived on a flat earth. The consequence of that firm belief led to the economic disadvantage of not finding other parts of the world and not understanding weather patterns.

With apologies to subscribers for another example of learning from my most important educational source, the racetrack. The ranking of other bettors’ beliefs before each race are the winning odds on each participant, measured by the number of bettors favoring a particular horse multiplied by the amount of money bet. The generally known percentage history of the most favored horses winning is way below half and closer to one-third. Few pay attention to the percent return on each successful horse, which tends to be much bigger. For example, in a race where the most favored horse pays off at even money, a bettor would cash a winning $2.00 ticket for $4.00. If a 10 to 1 shot is the winner, the winning $2 ticket receives $22, or 5.5 times the cash payoff of the even money winner. (The payoffs are after track fees and local taxes.) The job of a good portfolio manager, using this example, is to pick at least one of three races vs. the even money bettor.

In the long run it is more profitable to somewhat invest in greatly unpopular securities and funds rather than those that are popular, which is why understanding Confirmation Bias is so important.

A Self-Administered Test of Your Confirmation Bias

The following is a list of controversial statements, not necessarily my beliefs. There are six alternative buckets for your beliefs: Believe (80%-100%/40%-60%/10%-20%) and Disbelieve (80%-100%/40%-60%/10%-20%). Where appropriate, place the strength of your belief or disbelief in each of the columns, as shown in the italicized example below:

                                                                                                

                                                                                                                  10%-20%/40%-60%/80%-100%

Statement                                   Beliefs       Disbeliefs 

“Money is the Mothers’ Milk Of Politics (1) 80%-100%        10%-20%                                           

1. “Money is the Mothers’ Milk Of Politics   

2. Redistribute Capital to Redistribute Votes 

3. Need More Union Dues Contributions

4. Higher Taxes, Lower Growth

5. “Value” Better than “Growth” for 10 Years

6. Drawdowns 34%-49% (2)

Complete the table below by placing a check under one of the belief columns and one of the disbelief columns, answering for each of these six questions above. 

               Beliefs                        Disbeliefs 

      80%-100%  40%-60%  10%-20%      80%-100%  40%-60%  10%-20%

1.

2. 

3.

4.

5.

6.

1. A statement by Jesse Unruh, speaker of the California House and supporter of each of the three Kennedy Brothers.
2. In the last 23 years, the annual decline of the S&P 500 was -49% in 2008 and -34% in 1987, 2002 and 2020. 

If your beliefs or disbeliefs are dominant in either column, you are at risk of Conformity Bias and should examine the opposite point of view. This will enable you to set up an early warning signaling the pendulum is swinging in the opposite direction to your basic beliefs.

What to Do?

The most difficult job of a good portfolio manager is to periodically balance different points of view and quickly recognize early warning signs of a change. (At the track, a sudden shift in odds indicates new money has a different view, which should be re-examined to see if it contains new information which merits a change of opinion.) 

It is rare for our fiduciary portfolios to not have elements of growth and value. This is particularly true when the portfolio is broken down into sub-portfolios based on different payment and volatility needs. Currently, another major focus is domestic versus international, with China being under a controlled slowing and the US possibly being under a dangerous induced expansion.

Brief Updates 

Each of the following could be developed into its own blog, but I will spare you, although I’m happy to discuss these items with subscribers offline.

1. There are rumors of the administration thinking about instituting a tax on miles driven. Also, there is talk of an excess profits tax on those individuals and companies that appeared to have made money due to the pandemic and lockdowns.
2. Union membership has been cut in half since 1975, when it was 20% of the workforce, but it has risen a bit very recently.
3. The NASDAQ vs NYSE, which is the leader? In terms of year over year volume, NYSE -34.69% vs NASDAQ +30.50%. New lows in terms of the percentage of issues traded, NYSE 7.6% vs NASDAQ 11.9%. The relative absence of passive investors in the NASDAQ may be causing the difference.
4. The JOC-ECRI Industrial Price Index year over year is +83.7%. (Closer to home, Ruth mentioned that not only are food prices going up at the supermarket, but also paper products. It would be reasonable to assume packaging costs are increasing too. Paper, and energy for trucks, are part of the JOC index.)
5. The AAII bullish/bearish reading is 50.9%/20.6%
6. The largest free cash flow sector is Financials.
7. Large commodity speculators are increasing their short positions over their growing long positions in copper, crude oil, gold, live cattle, silver, T Bonds, wheat, and the Yen.
8. Small-Cap Value mutual funds are the leading diversified mutual fund peer group +20.46%. Mutual Funds should be important to other investors as 47.4% of US households own mutual funds.
9. James Mackintosh mentioned in the WSJ that the three stages of debt expansion are: speed, stimulus, and inflation, as evolved by Hyman Minsky.
10. The Congressional Budget Office (CBO) believes it would be too difficult to cut the existing budget to cover all the new administration’s planned expenditures.

Special Announcement to my fellow Analysts

Over the weekend the New York Times (NYT) published an article on the death of Bernadette Bartels Murphy. She was a former President of the New York Society of Security Analysts, as was I. Bernadette re-popularized chart reading and helped put the Market Technicians on their feet. When I talk with portfolio managers who have survived the cyclicality of the marketplace, they rarely couch their thinking about market analysis, as many benefitted from her efforts. We and the market have lost a major contributor to our progress.

 

PS

Early Asian trades are reacting to rumors of substantial forced margin account liquidations, probably from hedge funds. This could be a problem for the US Monday morning.

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

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

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

https://mikelipper.blogspot.com/2021/03/next-race-winner-weekly-blog-671.html

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Contrarian Bets and other Risks - Weekly Blog # 597

Mike Lipper’s Monday Morning Musings

Contrarian Bets and other Risks

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

A good bit of the reported sentiment suggests we are entering a significant market decline, followed shortly by a recession. To the extent that these opinions represent the popular view, my training at the New York racetracks suggests a contrarian view. The popular view is driven by a two day, eight-hundred-point decline in the DJIA, or an approximately 3% change compared to a frequent daily movement of about 1%.

There are two statistical measures that are also pointing down. These have often been wrong in terms of the direction of the US stock market for the ensuing six months, as indicated below:

• American Association of Individual Investors (AAII) surveys a sample of its membership each week to determine if they are bullish, neutral, or bearish on the US stock market. Extreme views are those values above 40% or under 20%. This latest week, Bullish sentiment was 21% and Bearish 39%. Three weeks ago, showing how volatile these views can be, the Bulls represented 35% and the Bears 28%.
• The buyers of Put and Call options are very focused on the near-term and when the Puts (bets on stock prices declining) reach historically extreme levels, they become contrarian indicators. Last week the ratio of puts to calls on the S&P 100 Index was 236 to 100. Similarly, the overall ratio of puts to calls was an above normal 73 to 100, normal is 60/100.

Longer-Term Risks
I previously noted that one of the most successful corporate pension funds moved out of equities years ago after they produced a 20% annual gain. They thought the result was unusual because it was between 2 and 3 times their actuarial assumption, suggesting they should withdraw from equities until the following year.

There are hardly any two-year periods with two back-to-back +20% gaining years. As of the end of the first nine months of 2019 there were 14 mutual fund investment objective averages producing +20% or more returns. Of these, the two biggest gainers in the last ten years on an annualized compound growth basis were  Large Cap Growth +13.37% and Multi-Cap Growth +13.21%. I suspect that the average fund in those two categories was loaded with what we used to label FAANG stocks (These averages with the leading performers are clearly doing a lot better than +20%).

Perhaps even more instructive is that the leading investment objective average for the last ten years was Health/Biotech Funds, which rose +15.41% but gained only +6.2% in the first nine months of this year. (For those who are going to be judged by their performance over the next five years it may be prudent to reduce exposure to managers that have produced +20% gains this year, with the understanding that these reserves will be recommitted to equities near the end of the next recession.)

There are other risks beyond staying too long with oversized winners. The biggest one has two names, prediction risk and execution risk. Most future projections are linear in nature and tend to be top-down, starting with aggregate demand or top-line revenues. Sports gives us two examples where this doesn’t work.

While I used to manage the National Football League-NFL Players Association Defined Contribution Plan, I do not claim to be a football analyst. However, I suspect more touchdowns are earned by broken plays than those illustrated on chalk boards in training camps. One of the great heavyweight boxers used to say that plans evaporate the moment your opponent hits you in the face. Far too many analysts and investors take future guidance from a company as a somewhat guaranteed plan. To me, I try to focus on the execution risks of any plan. I try to get some understanding as to what could go wrong and most importantly who will fix it. What I learned in the US Marines was that officers issue the orders of a plan, but enlisted men (particularly the corporals and sergeants) accomplished the missions, regardless of what is on paper. That is why in looking at operating companies I like to have an idea of who the supervisors, directors, and department heads are. With funds, while the portfolio managers are important, the key decisions are in effect often made by the analysts, traders, marketers, salespeople, administrators and occasionally the chief investment officer. These are the people who will execute the reality and are critical in our decision-making process.

One final set of risks bearing down on the current investment process comes with the initials ESG (Environment, Social, and Governance). This is not the appropriate vehicle to discuss the validity of the arguments for and against these tenants. My concern is that beneficiaries will suffer because insufficient attention is paid to prediction and execution risks. Below is a list of past predictions in terms of climate change which have already proven to be wrong:

          Year   Prediction

• 1966 - Oil gone in ten years
• 1970 - Ice age by 2000
• 1976 - Scientific consensus of planet cooling, famines imminent
• 1977 - Department of Energy says oil will peak in the 1990s
• 1988 - Maldives islands will be underwater by 2018
• 1988 - World’s leading climate expert predicts lower Manhattan underwater by 2018
• 1989 - Rising sea levels will obliterate nations if nothing is done by 2000
• 2005 - Fifty million climate refugees by 2020

Source: Calafia Beach Pundit quoting Mark Perry’s blog

While most of us are occasionally wrong in our own predictions, we need to understand the basis for forming the prediction.

The Biggest Risk to Fixed Income Investors
Having just questioned the process of predicting, I call to your attention a presentation made by Theresa Gullo, Assistant Director for Budget Analysis of the Congressional Budget Office to the National Association of State Budget Officers on “The Long-Term Budget Outlook”. The bottom line is that the CBO estimates that there is a two-thirds chance that federal debt will be between 71% and 175% of GDP in 2039. The two biggest culprits are major health care programs and net interest. Of the major developed countries, the only two running a surplus are South Korea and Russia. It seems likely to me that that many governments will increase their efforts to overcome the drawdown from innovation by materially increasing the global rate of inflation. This raises the potential of insufficient funding to satisfy fixed income beneficiary needs. 



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/09/mixed-near-term-after-recession.html

https://mikelipper.blogspot.com/2019/09/capital-cycles-changing-weekly-blog-595.html

https://mikelipper.blogspot.com/2019/09/concentrate-or-diversify-2-questions.html



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A. Michael Lipper, CFA

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The Top Before the “Big” Top - Weekly Blog # 567

Mike Lipper’s Monday Morning Musings

The Top Before the “Big” Top

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

                 

                

The one certainty about markets is their rise to tops and fall to bottoms. With this knowledge market analysts have developed many techniques to identify extreme movements, hoping to spot the appropriate time to reverse course and increase the chance of avoiding large losses or improve the chance of capturing large gains. Market analysts have probably used price charts since the beginning of organized markets in the ancient world. One of the charts that has a good record of predicting future movements is called a Head & Shoulders pattern. (No statistical or other measure is 100% successful over time. Being correct roughly 2/3rds of the time produces satisfactory results and the Head & Shoulders pattern generally does that.)

A price chart is produced for stocks each trading day in The Wall Street Journal, covering each of the three major stock indices: Dow Jones Industrial Average, Standard & Poor’s 500, and the NASDAQ Composite. The three generally move in the same direction, but at different speeds. For the past couple of weeks, the three have produced the same rounding top chart pattern seen during past tops. The critical task is weather to take action based on these patterns or ignore them. I wonder if this is a sign of an important reversal, as the reversal pattern shows three distinct top formations. 

Since the current market is down a bit from the former 2018 highs, a head is in place. Combine this with the relatively brief rounding tops mentioned and this pattern is predicting the end of the ten-year bull market that we have enjoyed for so long. A normal reversal is to approximately give up between 1/3 to 1/2 of the prior gain. (If I knew for sure, each of you would be invited on my personal Boeing 747 on the way to a voyage on my battleship sized yacht. But I don’t know.)

There is a second possibility, that the pattern of the last couple weeks is a possible first shoulder to a new high above the 2018 level, with a more distant final shoulder before a major decline. The current absence of “irrational exuberance” for stocks gives me some hope for the second possibility.

Cautionary Signs for Short-Term Investors

In general, commodity prices have been falling for more than a year since they completed their own bull market. While governments and central banks have attempted drive up growth and the rate of inflation. The continuing abnormal flows into fixed income and credit funds by both individual and institutional investors, at a time when the long-term outlook calls for rising interest rates, suggests that the new buyers are either naive or believe that they have superior trading skills in an increasingly illiquid market. Finally, there is the performance of mutual fund averages through last Thursday night, showing those with year to date gains in excess of 15%: 

China Region Funds       +17.75%

Energy MLP Funds         +16.22%

Energy Funds             +15.98%

Small-Cap Growth Funds   +15.23%

Mid-Cap Growth Funds     +15.05% 

I suggest that those funds currently showing year-to-date gains of +15% are speculative and should be traded out quickly in a decline. However, if investors believe they have these trading skills, the fund categories may be appropriate for short-term focused portfolios.

Thoughts for Long-Term Investors

While short-term investors dominate trading, long-term investors own the bulk of equities around the world. For the US taxable investor, the last ten-years has fattened their prior gains. This raises a question for those seeking to leave a legacy based on a stepped-up basis, without paying capital gains tax, is it better to take the valuation now and pay capital gains tax or the alternative valuation as of the date of death? Even with a major market decline, beneficiaries will inherit more than they would have previously. Institutional Investors concerned with the use of capital for multiple generations could stay invested as some of the present holdings may serve them very well.

MOHAMED A. EL-ERIAN, chief economic advisor at Allianz, and formerly with PIMCO, Harvard Management and the IMF, has published a piece criticizing economists, particularly those within governments, for their reliance on mathematical models without using behavioral science and game theory. Markets often seem to be better equipped than economists in predicting future trends. 

There appears to be some help on the way, the Bank of England is publishing a fan chart of possible future directions in their studies. The Congressional Budget Office (CBO) is already shows a fan chart where 2/3rds of the possible outlooks lie. The CBO study predicts that the US government deficit will rise by about 50% as a percent of GDP in 2019. This could be a low estimate, as both political parties are big spenders. I suspect the next Democrat administration will easily outspend the current occupant in the White House. (This is one of the reasons to bet that inflation will rise.)

History Suggests A Brighter Future

After long periods of stagnation, beyond the world of numbers, forces have saved various societies from their foolish management. The Dark Ages in Europe effectively ended with the discovery and importation of Latin American gold. After years of war spending in 19th century Europe the harnessing of steam power brought greater prosperity, as did the use of electricity. There is a chance that our world will be both disrupted and advanced through the spread of 5G networks, which will practically reach every person, vehicle, and activity. Within this century the rising education, productivity, and savings coming from South East Asia could be another spur. Finally, the evolution of African resources and its people would produce major benefits to the world economy.

Bottom Line

We are likely to experience reversals and volatility, but also pulsating progress. While a few may have the appropriate insights and trading skills to trade various markets successfully, most won’t be able to do it. Therefore, the best position is to stay in the game at various levels with sound and occasionally good investment managers.     

 

  

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/03/2-speed-vs-2-directions-old-better-than.html

https://mikelipper.blogspot.com/2019/02/lessons-from-warren-buffett-and-italian.html

https://mikelipper.blogspot.com/2019/02/could-biggest-risk-be-confirmation-bias.html

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

Learning is the Key to My Investing

Introduction

You are probably a recipient of lots of uncorrelated information and impressions. I am as well, but because of my obsession of always thinking about investing for clients I try to find investment inputs to almost everything that comes my way.  Most often I attempt to see available information, in other words inputs that others don't see.

My sense of this past week is that we are transitioning into more dynamic markets and there are growing forces that will stampede equity markets. Thus I am maintaining my market prediction that some time within 2015 we will see a + 20% to -20% or both movement in equity markets.

Lessons from weather

As beauty is in the eye of the beholder, the impact of weather is very much influenced by location and preparation. When I finished last week's blog, in the greater New York area we were dealing with excited announcements of a forthcoming blizzard. (Quite possibly the loudness of the warnings of an incoming multi-foot blizzard was due to the underreporting in 2012 of the oncoming storm "Sandy" when we lost electrical power for two weeks and New York had a particular subway inoperative for a year after the storm hit.)

When last week’s “storm” deposited only a smattering of inches of snow, many within NYC were upset with the closing of schools, offices, and subway lines. For some, if there was not the severe impact predicted, it was like it didn't happen. For those at the eastern-end of Long Island and much of New England the multiple feet of snow was a very different story. Even Nantucket, a summer home for the rich and famous lost all boat and plane connections to the mainland along with loss of electric and communications.

Because the airlines were fearful of a blizzard, they cancelled many flights (including our own) for what would have been the second major day of the storm as they were repositioning their planes to safer spots. Luckily for us our travel agent was able to secure two seats on one of the last flights out of Newark Airport.  Afterward, East Coast to West Coast travel was suspended for a considerable time.

I believe that there are numerous investment lessons one could learn from this and many major storms:

1. Location of persons and assets is critical to risk exposure.

2. Uncertainty is normal and we mislead ourselves believing in a high degree of certainty, particularly when expressed in finite numbers.

3. While the "official' forecasts displayed a range of possible outcomes, the media and their brothers/sisters in the political structure focused only on the most draconian possibilities.

4. In the right environment,  people panic.

5.  Recovery is normal after severity.

We will see whether the storm predicted for today and tomorrow in New York, New Jersey and New England will be real.

Misreading economic forecasts and data

During the last week, the Director of the Congressional Budget Office testified to Congress on the Budget and Economic Outlook: 2015 to 2025. There was little commentary within the investment sandbox because he did not see rising deficits until 2018. However, to those considering our TimeSpan L Portfolios ^TM approach, the forecast is relevant to the third segment, the Endowment Portfolio, which is designed for investing from five to fifteen years. I have less confidence in the Director’s numbers than I do in his projections as to what will cause the deficit to rise. His four key factors were:

 
1. Retirement of the Baby-Boom generation (most however, won't be able to leave economic production)

2. Expansion of federal subsidies for health insurance

3. Increasing health care cost per beneficiary. (means greater longevity)

4. Rising interest rates on federal debt

My US Marine Corps heritage and concerns about worldwide threats make me wonder how we can avoid a major increase in military and related spending.

Further we live in a dynamic global society where change is accelerating. One example can testify to some of these changes. According to the Financial Times, in 1960 GM was the most profitable US company with earnings of $7.6 Billion. In 2013 Apple^* was the leader with $37 Billion. (If one annualizes Apple’s current quarter's rate the profits would double for its current fiscal year.)  To me if one works the numbers, the profit per employee is staggeringly different; $12,666 for GM in 1960 and $399,568 for Apple in 2013. Part of the profit growth is that while both companies are global, Apple is getting much higher profit production than GM. Thus, I am seriously questioning the CBO's future estimates. I would be much more comfortable with a wide range of estimates, with some recognition of the level of uncertainty.  (I hope I learned from the blizzard last week, that the same storm, or passage of time, could give me the different snow fall results from Boston to New York.)

^*Owned personally or by the private financial services fund I manage

Fund investors and traders are not waiting for clarity in 2015

The following data points show different attitudes:

1.  In the week ending January 29^th, US fund investors added $8.9 Billion to Fixed-Income and $3.1 Billion to non-Domestic Equity funds while withdrawing a little from Domestic Stock funds. On a performance basis, the average International fund on a year-to-date was up 1.75% as the only General Equity fund to rise. (A number of Specialized or Sector funds also rose.) Bond funds are continuing to show good performance this year led by General US Treasury funds and Corporate Bond funds.

2.  One of the ways to measure bearishness is to calculate the ratio of the size of short sales to the average daily trading volume. I pay particular attention to this ratio for the more speculatively priced NASDAQ traded stocks. In the last reported period, the ratio was 6.54 days, up +27.9% from the prior reporting period. While this indicator is expressing a bearish point of view, it also identifies the level of potential buying that must come into the market to collect or cover bets. If the short ratio gets to be large, one could see a sudden spike rally.

The Super Bowl is different in 2015

While I have watched and attended  numerous Super Bowls, this one is going to be very different for me. In the past I hoped the officials made good calls on contentious plays and I hoped that the television commercials would produce added volumes for the advertisers and earnings for their shareholders. Like a professional sports game with poor officiating, in the investment arena a sound game plan can lose. The single most important contributor to the sport's revenue is the various television contracts, each collectively bargained contract determines how much will go to the players and their retirement needs.

This year I can concentrate on the playing skills of the two superb teams with quite different tactics and strategies.  The reason for the change is that after 20 years of good performance and service I resigned as investor advisor for the defined contribution plans of the National Football League and the NFL Players Association.

Question of the Week: I appreciate what you have shared with me in the past. Are there particular current items that you follow that determine your long-term strategy?

__________    

Comment or email me a question to MikeLipper@Gmail.com .

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.