Faulty Decision Processes at Change Points - Weekly Blog # 607

Mike Lipper’s Monday Morning Musings

Faulty Decision Processes at Change Points

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

On the surface stock owners are expecting seasonal presents----unless they have already received them. By Friday morning media headlines were mostly good and had set up a favorable 2020, unless one looks deeper. Frequently, I reference a chart in the Weekend Wall Street Journal that measures the change in the current prices of stocks, commodities, currencies and other investments. This week 65 of 72 prices rose, suggesting some form of inflation is mounting. The numbers hawk in me saw a possible problem, as we normally see positive category price changes in the 31-42 range. (The seven falling prices were: S&P 500 Real Estate, Natural Gas, Lean Hogs, Yen, S&P 500 Telecom, US Dollar, and corn). The out of normal price behavior made me think about the benchmarks that investors use to guide their decisions.

The most prevalent sales pitch in moving investors into or out of securities is a short comparison of two alternatives. If “A” is larger than “B”, “A” is a buy. This assumes the measure is relevant to the needs of the investor and most importantly, the relationship between A and B is reasonably constant and meaningful. Currently, the price of gold mining stocks is going up, yet the price of gold is flat. One could say that this is compensation for the plentiful risks in mining. Alternatively, some stock buyers expect gold to become more valuable due to the fall in the dollar. Regardless of the reason, the market for physical gold is not sharing the same enthusiasm. Perhaps the comparison is faulty, as one alternative represents a view of future attractiveness and the other a measure of current value. This dichotomy suggests that simple statistical comparisons need to be understood more fully.

As someone who’s developed a large number of open and closed-end fund indices, I question whether many benchmarks are relevant in making decisions as to the future value of investments. This week my old firm noticed that two mutual fund categories, equity income and utilities, were getting net inflows, while other equity categories were not. Some buyers, perhaps spurred on by their wealth managers or other investment advisers, were attracted to these two investment categories because of their comparatively high dividend yields and/or lower volatility. In our investment management practice we rarely use funds from either category. If some of our accounts need current income we use higher yielding funds, but not the highest. Furthermore, we prefer to use funds growing earnings and cash flows that pay higher dividends. A few growth and income funds have delivered both rising dividends and capital appreciation for years, which over time has given investors a better return than either Equity Income funds or Utility funds.

There were two recent articles in The Financial Times that I believed should have been tied together. The first, based on Morgan Stanley research, was titled “Investors Braced for Low-return Decade after years of Robust Growth”. The article compares the last ten years to the last thirty years and estimates that current investment performance is below both. Initially, I felt they’d failed to adjust for inflation and currency depreciation.

A few pages later there was a news article about the rapid movement in the location of magnetic north. It has been moving for 500 years, causing navigators on land, sea, and in space to adjust their navigational instruments. To me, the second article reflects the reality of change and should also be required before we apply benchmarks. The world of medicine adjusts for changes in height, weight, and other characteristics when it compares modern people to those in the past. Popular stock and bond market indices should also be adjusted and consider both the world we live in and what the future might hold. “Political scientists” that use pooling data to predict attitudes and voting preferences also need to adjust their slicing and dicing of the population and the way they collect data, which will be between expensive and very expensive.

A Barron’s panel of experts have concluded that the S&P 500 will rise 4.1% in 2020. The precision is breathtaking, but if you actually believe the number wouldn’t it be prudent to sell now and wait for a better re-entry point, likely to occur in most years? (This applies to tax-exempt and not tax-deferred investors).

Alternatively, a contrarian indicator is the number of puts vs. calls traded on the S&P 100. Last week the ratio was close to three times normal. While buy and hold investors in aggregate have a better record than traders, those in derivative markets and on NASDAQ are better short term. I believe we will remain in a sentiment driven trading market for a while longer, which could be emotionally trying for investors. However, those who are steadfast will likely accomplish most of their realistic long-term goals.

Please privately share what you think with me, as my crystal bowl is unusually cloudy.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/12/investors-are-worrying-about-wrong.html

https://mikelipper.blogspot.com/2019/11/contrarian-stock-and-bond-fund-choices.html

https://mikelipper.blogspot.com/2019/11/mike-lippers-monday-morning-musings-all.html



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Value Can Lead – Weekly Blog # 531

A Possible Turning Point

July of 2016 to June of 2018 may have been a turning point. Interest rates started rising to meet commercial demand for loans, even before the political conventions. Three weeks ago we began seeing that tech-led Growth funds were no longer the weekly mutual fund leaders, value is now leading. In a gross oversimplification some people divide equities between growth and value. According to a table in the weekend edition of The Wall Street Journal, looking only at the sectors within the S&P 500, note the following weekly performance:

Utilities               +2.25%

Telecom Serv      +1.18%

Real Estate          +1.06%

Energy                 +1.03%

vs.

Information Tech         -2.19%

Financials                     -1.93%

Consumer Discretion  -1.87%

Health Care                  -1.79%

One could choose to ignore very short-term performance results, which is normally wise. However, a glance at the charts of the three major stock indices might well suggest that there is a potential warning in the near-term data. Both the Dow Jones Industrial Average (DJIA) and the Standard & Poor's 500 (S&P500) are showing reversal patterns and the NASDAQ Composite (NASDAQ) could be as well. Clearly something has changed and this could be labeled sentiment. The American Association of Individual Investors (AAII) conducts a sample survey of its members which can be quite volatile and the sample may not be representative enough. Nevertheless, it is worth noting that in a three week period, bullish responses dropped 37% to 28.4% of the sample and bearish responses rose 88% to a reading of 40.8% of the responses. (The causes for the sentiment shift will be discussed below.)

A Positive for Value

While some may disagree with me, I believe from a low level the increase in interest rates is a positive for those who are looking for value. The search for value is much more difficult than the search for growth in rising revenues and earnings. While many value advocates speak of intrinsic value, what they really mean is what price a knowledgeable buyer for the company would pay. Therefore, value is a derivative of the price of a transaction. Value-oriented investors attempt to arbitrage the difference between the current price and a future expected transaction price. If one believes in the commonality of assets, a similar transaction price for some could establish value or at least be indicative of it.

Rarely have I found complete commonality of individual assets and thus an adjusted price becomes the theoretical price, with the buyer really determining the value. Most buyers want to earn a premium over their cost of capital and therefore higher interest rates drive acquisition prices. Commercial interest rates imply that they have imbedded within them a credit cushion for bad debts particularly for commercial loans as distinct from borrowings by governments. Thus, in late June and early July of 2016, after the end of an undeclared recession started to raise commercial interest rates, buyers could foresee the profitable use of loans. Thus the beginnings of a new expansion started.

Cash Flows

One of the first tasks we learned from Professor David Dodd was to reconstruct financial statements so that they could be used by investors instead of creditors. To me the single most valuable statement for determining value was the Cash Flow statement, which is rarely commented upon by the pundits. Recently, when I looked at one of these documents it became clear to me that the proper reconstruction is dependent very much on the intended use by a potential acquirer of a company. Acquirers could be quick liquidators, passive investors, a buyer of talent, customers, patent seekers, or others desiring excess capacity and unique assets. In some cases the acquirer may want to remove capacity from the market. The following is a brief list of items found on the cash flow statement that should be handled differently depending on the user: depreciation/depletion policies, property, plant and equipment, acquisition or disposals, repurchase of company stock, repayment of debt, and dividends.

As a practical matter value is not only dependent on interest rates, but on the willingness of others to extend credit to businesses and individuals. Currently, we are seeing a surge in the willingness to offer credit, which is a counter-force to the central banks wanting to raise the price of money. I am concerned that the pressure to offer credit may lead to narrower profit margins, resulting in lower than appropriate reserves.

Stability Leads to Instability

At some point this over-extension of credit creates a vulnerability which could create a major distortion of risk and lead to a recession. Right now credit reserves look to be stable; however, please remember a quote from Hyman Minsky, “Stability leads to instability. The more stable things become and the longer they are stable, the more unstable they will be when the crisis hits.” Instability could mark the end of the current phase, making investing for value problematic.

Shifting Sentiments

I have already noted the somewhat dramatic shift in market sentiment. Many will attribute it to the troubled trade discussions. I personally believe the shift away from the tech-driven growth favorites was overdue. At least on a temporary basis, some retrenchment was to be expected in terms of excessively large positions.

In dealing with short–term trade movements it may be worthwhile to focus on July 3^rd and July 6^th.  The first date is another example of the media-political-academic complex wrapping history to their own needs and ignoring the real motivations of the principals. On July 3^rd, 1863 the final day of the Battle of Gettysburg was fought. Robert E. Lee, probably the smartest American general, sacrificed some of his best troops in charges up a hill to breakthrough the Union lines. Most history books state that if he had won the day he would have pivoted and attacked Washington DC, likely resulting in the desired end of the war.

Looking at a map and understanding where the Union’s economic strength lay, as well as what was happening in Vicksburg on the very same date, shows me a different set of plans. If the Confederate forces had broken through in southern Pennsylvania they would not have pivoted, but instead headed north to disrupt the rail and other east-west train traffic. This would have isolated economic parts of the North and could have taken some pressure off the battle of Vicksburg, which was about to fall to Sherman, leading to the destruction of the South’s war making capability on Sherman’s march to the sea.

Bearing in mind another example of the general public being misinformed, we may be seeing a similar mistake in terms of perceptions of the trade/security issues we are now facing. On July 6 the scheduled implementation of the Trump tariffs is meant to happen. To my mind the trade issues are not the real focus of the current US Administration, security is.   

For whatever it is worth I do not expect anything of significance to happen on July 6.

What do you think on the switch to value and the trade and security issues?

__________

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.