We Are in a Training Exercise - Weekly Blog # 548

Mike Lipper’s Monday Morning Musings

We Are in a Training Exercise

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

         

We are Never too Old or too Rich Not to Learn
After almost ten years of a one-way domestic stock market we are experiencing some discomfort. Fixed income markets have been falling for some time and most commodities and currencies, ex the US dollar, are in bear markets. One might say that many investors in the US stock market over the last ten years have learned little and forgotten much.

Some of the realities we have forgotten:

1. Change is always present, but it becomes noticeable at different rates and times. From a portfolio standpoint, the time of maximum risk is often when each position is profitable.  The current prices of many positions are two to one hundred times their original cost. The danger herein lies in the belief that the size of these gains is permanent. Any detailed study of wealth over the years will show that it fluctuates and the only way to lose a lot money is to make a lot before one loses some or all.

One way to see the power of change is to examine the ten largest market capitalization companies in a series of ten-year intervals,1998-2008-2018. (See the footnote as to why the three periods were selected.) Only Microsoft and Exxon made the list in all three periods. Thus, there was an 80% failure to maintain relative market capitalization. One might say that any long-term investor who does not own these two for the next ten or twenty years is betting that they don’t survive at the top of the relative peak in market cap.

2. Perhaps, the most creative part of human nature is the ability to circumnavigate around an accepted standard. At one point in financial history the most important measure was yield, which was replaced with book value, which gave way to size and then to earnings per share. Now it is non-GAAP earnings. Usually, sellers of securities favor the old popular measure, where buyers prefer a newer version. Because of changes in accounting standards, tax rates, and regulations, private equity participants often use EBITDA (Earnings Before Interest, Depreciation, and Amortization). I prefer operating earnings adjusted for debt service. The one thing I am confident of is that in ten years the transaction price battle between buyers and sellers will utilize other analytical measures. The art of selling well and buying wisely demands nothing less.

3. One of the most valuable lessons that Charlie Munger taught Warren Buffett was that it was better to buy a good company than a good business. With the cycle of disrupting the old and replacing it with the new, there is a risk of buying into a copycat model based on the financial ratios of some currently successful company or venture. At one point there were some 300 US automotive companies, semiconductor manufacturers, restaurants, banks, insurance companies, and universities. According to Mr. Buffett, a good business is one that any fool could run and often does.

Defining a good company is not a mathematical or a historic exercise. The focus of the search is not on the “C” suite exclusively, it’s on the bulk of the people. Can they do the next important job? Do they have the trust of their clients and suppliers? Will they generate many of the new ideas and procedures that make both large and small differences. While too many annual reports state that their employees are their best asset, some do make that condition happen.

4. Market price liquidity is not important until it becomes critical. Most of the time price sensitive buyers and sellers keep prices and the spreads between them in check. During periods of stress the urgent price insensitive buyer or seller dominates the market and is a heavy user of the liquidity pool. As their insistent need to trade uses up much of the present liquidity, it frightens away some potential liquidity providers, leading to both greater than normal dispersion of prices and spreads between bid and offer levels. Often the price insensitive player is motivated by a need to meet an obligation. This could be an Authorized Participant or a Market-Maker keeping his book in balance. The biggest destabilizer is an owner meeting an immediate margin call.

There are some that say the unusually severe drop in the Chinese “A” share market was caused by the government’s concern about the quantity of  debt in China. They put pressure on the four major government-controlled banks to reduce the size of their loans. They in-turn called part or all of the loans to various entrepreneurs who pledged shares in their company. To meet the call they liquidated enough of their holdings to meet the banks’ demands.

Maybe one of the reasons  many NASDAQ stocks with good earnings and prospects fell more than other stocks is that large portions of their shares were owned by hedge funds, private equity funds, and senior employees who were meeting margin calls. This is the kind of market action that has been periodically happening ever since there have been collateralized loans.

At times, the size of the liquidity pool is more sensitive to sudden changes in sentiment than financial and economic numbers. Periodically, changes in political trends can cause driven investors and speculators to become price insensitive, causing liquidity providers to reduce their commitments or retire from the game.

Perhaps investors have learned enough from last week’s training exercise. Enough to know that when the real market reversal comes they will recognize what to do, before, during, and after a future “big one”. I hope so.

Footnote
2018 is ten years from the last major market decline and 31 years from the biggest single day decline, which was much more a market phenomenon than an economic one.

2008 was the first year of the great financial crises. This was the result of excess leverage by the private sector in response to a series of governments attempts to postpone a crisis in the economy, although they made future crises worse.

1998 was the year I sold the operating assets of Lipper Analytical to Reuters Group Ltd. It was a good company because we had good people who were dedicated to helping both our direct and indirect clients. 


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Music May Help in Diversifying Your Portfolio

Introduction

I try to learn from everything that happens to me every day. Most of the time the learning comes from linking one occurrence to some on the surface, unrelated activity. I have been worrying about appropriate levels of diversification of fund portfolios that I manage. Three events that happened to me last Thursday afternoon and evening were:

1.  A non-profit investment committee meeting

2.  A wonderful private violin and piano concert

3.  Picking up the wrong black brief case

A non-profit investment committee meeting
 

To be asked to join this small group one needs a successful career of investing for others as well as for their own money. This group meets periodically to discuss the individual investments in the portfolio and to consider new investments. Members  are used to commanding their own organization as well as responding to demanding clients.  All including the chair (me), have strong opinions. What has evolved in summing up a point of view by an advocate or a doubter is that the investment future for a particular investment is focused on the answer to a single question. For example the critical question for gold is the current level of inflation. Similar questions and answers were brought out for each investment considered. The other people in the meeting most often did not accept the single question and related answer. Not surprising that no major decisions were made at Thursday’s meeting.

Private concert

Mr. Norton Hall was the host in his lovely home for a wonderful preview of a concert to be presented over the weekend at Bard College featuring the very talented Elizabeth Pitcairn on violin and the equally talented Cynthia Elise Tobey on piano. I expect that the concert will be well reviewed. They played four pieces including one specifically commissioned for the concert. I was seated next to a well-known Professor of Mathematics as well as a refined music lover. I asked him if could he estimate the number of notes that were played. Later after consulting with the violinist who is a music professor, he estimated that perhaps 75,000 notes were played on the violin and since the pianist was actively using both hands she probably played twice that number.

What struck me in comparing the investment committee meeting which lasted for more than an hour was that we intensely focused on under a dozen possible decisions as distinct from the very pleasant concert which was produced by approximately 200,000 notes or specific finger actions of the talented ladies. In the first case we were being directed to make decisions on a single focus whereas in the second we were being asked to enjoy all of the work. My ear is not sufficiently sophisticated to pick up a mistaken note as written or played. 

Getting back to my concern for the proper diversification balance, the thought occurred to me that for the owners of investment accounts the overall result was more important the individual component’s performance. One of the reasons that I enjoy the music of a large symphony orchestra is the blending of many different instruments’ sounds. I find this much more pleasing than listening for the same length of time to a single instrument, for example a tuba. With those thoughts in mind, I believe that many accounts would be better off with a full complement of instruments rather than an equally talented duet. Thus I believe, particularly now that we appear to be entering a period of increased volatility and excessive emotional trading,  many portfolios would be better off with an intelligently wide diversification of instruments. I have thus far been totally unsuccessful in convincing professional committees to begin to add some form of commodity investing, specifically because they have done so badly. As distinct from my learned professional investor friends I resist single question and answer approaches that are so common with sales people. This may be because I lack the willingness to put my faith and clients’ money on a single decision. Hopefully I can find clients who have similar views.

The black briefcase caper

Due to inclement weather, we were among the first to leave the Thursday night concert in Manhattan. By mistake I picked up what I thought was my briefcase and put it quickly in the backseat of our car. As we were in the middle of the Lincoln Tunnel leaving New York I received a call that I had mistakenly picked up the wrong black briefcase. Luckily for the distressed owner, one of my sons was able to return the prominent lawyer’s satchel and pick up mine.

There is an investment lesson from this mishap. To a hurried casual observer, two items or two funds that look to be identical can be quite different when one looks into their interior. This may be a particularly important lesson when comparing ETFs with actively managed funds; while the components might be the same, the result is different. For a musical example, we have experienced two different conductors playing the same piece of music at various times at the New Jersey Performing Arts Center and noticed one considerably more pleasing to hear.

Short bits

1.  Is there a message from the following year-to-date performances?

Apple^* +42.5%, 

Microsoft +32.5%,

Berkshire Hathaway^* “B” +22.7%,

Exxon -6.0%,

Vanguard S&P500 +16.2%,

 Vanguard Total Stock Market +15.0%.

2.  Moody’s stock^* (as mentioned in last week’s post) gets a $100 handle.

^* Securities owned personally or in our private financial services fund.

3.  Elliot Management among others, including ourselves, suggesting the inflation data that the central banks are using is “fake.” They and others are referring to high-end real estate prices in places like New York, London, Aspen and East Hampton. My concerns are about the collection procedures and calculations.

4.  In the last 41 years the low on the unemployment rate was 5.25% with the current rate 5.8% which leaves some room to become better, but it is also a possible sign that the cash on the sidelines needs to rush into the market.

5.  Writers and numbers types don’t agree. The Thomas Piketty book earning a best business book prize when at the same time former senator Phil Gramm and Michael Solon in the November 11^th Wall Street Journal are the latest to address the author’s faulty analysis as being far too simplistic.

Bottom line

We have entered an important period of cross trends where trading abilities are likely to triumph for awhile over long-term investment skills. A well diversified portfolio can handle both. But the use of the four model Time-Span Portfolios (Operational, Replenishment, Endowment, and Legacy) should make it easier to meet the funding needs for each type of beneficiary.

Question of the Week:

Have you divided your holdings between trading and investment pieces?  

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Next Rise Needed for Peak

Introduction

Last week's post hinted that this week I would discuss where are we on the track to a major peak, an issue that I have been concerned about for some time. History suggests that those who use a crystal ball to predict the future are often forced to eat crushed glass. I certainly doubt most people's ability to predict the future with any accuracy. I do not claim any special powers or intelligence. What I do believe is useful is to cogitate about what can happen in the future that is not a mere extrapolation of a current trend.

Fear of loss of opportunity

The way people write about the large losses suffered from major declines is wrong or at best incomplete. There are two missing pieces. The first is what families talk about in terms of foreclosed leveraged loans which transfers property; i.e., the family farm or business. For me the second loss (which is both more difficult to measure and much more important in the end) is the loss of opportunity to make very cheap purchases of property, businesses, and securities. Based on the past, purchases made in distressed periods have yielded capital appreciation of three to one hundred times original capital. Throughout recorded history, burnt investors, often hurt by intellectual or legal frauds swear “never again.” They won't believe in any positive view of the future. We are already seeing investors, particularly younger investors, pulling back.  With this so-called risk revulsion as a prospect, I am focused on a track to be wary of the next market peak.


Watch for these signs

A sharp, narrowly focused big rally that will dramatically change the individual participation in the market is almost a requirement for a generational peak. Peaks need to suck in all or almost all available capital. They do this on the basis that despite an immediate strong upsurge, that further large price gains are a certainty. We have not yet had this precursor, but we could be setting it up starting with this week.

After 205 trading days without as much as a 5% general correction, we did get one by early February. This last week saw a  relatively low volume rally that regained almost all of the decline. The gain in the week was impressive. Perhaps impressive enough for people to extrapolate that 2014 could produce the kinds of remarkable gains that 2013 did. (Our own private financial services fund, as did some others approximately, produced a 40% gross gain. We have warned our holders that this type of gain is not expected to be repeated again in the near future.)

Volatility and dispersion

How could we put up some spectacular numbers that would excite people to override their natural caution? The answer is in two technical market words, volatility and dispersion. The mathematical definition of volatility deals with the amount of price movement that is different than some trend line. The popular press tends to only refer to volatility on the downside. The kind of exciting upside market price movement that will need to occur to suck lots of money into the market will not be called volatility, but genius. What will cause this kind of movement? That will be dispersion. The market is moving away from the high correlation market that took almost all stock prices down five years ago. What is happening now is that the relatively little volume being transacted today is away from the large secure stocks even though one could make the case that large caps and their supposedly large liquidity is the safest place for institutional investors today who are conscious of the age of the current bull market run. We are seeing most of the volume being done in social media-related securities widely defined. (In some cases these are the re-birthed "TMT" names, technology, media and telecommunications.) Just contemplate that Apple^* has a market capitalization exceeding Exxon. Listen up at your next cocktail party when the conversation moves from "Bridgegate" to the stock market, count the number of times Apple, Google^*, Twitter, and Facebook  are brought up relative to Exxon. Then judge by looking  at the outer ring  around the conversation and guess what they will be buying and selling soon. One of the reasons individual stocks can skyrocket is an increasing number of insistent buyers are overwhelming the market with buy market orders not terribly concerned about their going-in price because the rewards will be so large.

This kind of action can, and to some degree is, happening in selected currency, commodity, and bond markets which are deemed to be professional arenas. These can be reinforcing a bullish stock market. Much has been written about the smaller than normal interest rate spread between high quality and high interest paying paper. One of the reasons Moody's^* went to a new high this week was the increase in high yield offerings expected in both the US and Europe, which will require credit ratings. And this is where the reinforcement to the equity market comes into the picture. Moody's recognizes that historically low expected default rates will make high yield (low quality) bonds more attractive for purchase. Whether these new bonds are part of a refinancing scheme that lowers interest rates and extends maturities or are totally new to the bond market, the mere successful offerings in the bond market tend to make the issuers’ stock price rise. (This kind of reaction has penalized high quality stock funds compared to those which invest in lower quality or marginal companies.)

^*Stocks owned by me personally, by the private financial services fund I manage, or both.

Haywire

Markets collapse not because of immediate economic conditions, but from rumors or news of unexpected occurrences; e.g., the assassination of the Archduke Franz Ferdinand that was the proximate cause of the beginning of World War I. Clearly I do not know what event will stampede the market decline after a meteoric rise. But I have a possible one to think about. The present Chinese dynasty is very conscious of collapses of prior dynasties; they also think in longer terms than most of the world's political leaders and even some far-sighted military leaders. China is building for periods way beyond  the current expected terms of office. They want to restore China's place in the world to be number one. Along the route a lot can go wrong unexpectedly. Some problem dealing with China in rumor or reality could be the equivalent of that relatively minor shot in the decaying days of the Austro-Hungarian Empire.

What are the sorts of unexpected things you think could cause some future collapse or you don't think there will ever again be a major collapse? Please let me know.

_____________________     

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All Rights Reserved.
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Too Much Gloom and Too Many Opportunities

There are two relatively standard question clichés about travel experience, “Are we there yet?” And, “are we rearranging the deck chairs on the Titanic?” As this post is being composed on Sunday afternoon, the 30^th of December, we don’t know whether we are ‘there’ (a solution to the fiscal cliff) yet. We don’t know whether the political leaders in the US Senate can come to an agreement that the President and the majority of the members of both Houses of Congress can agree on prior to Tuesday. There is little reason not to be gloomy as to the result.  The gloom is not on the chances of an agreement, but rather on the probability that whatever agreement is made will not address the problem.

The problem is that the solution did not begin with the originator and popularizer of the term “fiscal cliff.” The Chairman of the Federal Reserve, a professor of economics from Princeton, was warning that monetary policy as controlled by him could not solve the shortage of domestic demand and that fiscal policies had to address the problem. His plea to the politicians was correct according to Stephen Roach’s latest letter, in the sense that experimental monetary policy has not worked in the US, Europe, or Japan. As I discussed in last week’s post, our economic problem is that we are suffering from a cyclical binge of too much debt combined with a multi-generational deficit.

The second question as to the rearrangement of the deck chairs on the Titanic actually may well be focused on a much bigger fundamental question. Often the deck chairs on the open decks of a cruise ship are assigned to various price classes for the voyage; the higher price tickets get the better seats, etc. In earlier days, epitomized by the Titanic, the crew and the management of the cruise line were more concerned about proper deck chair configurations than the absent life boat drills; actually there were too few life boats for the passengers and crew.

The current Presidents of the US and France want to redistribute the wealth among the passengers, akin to moving the chairs on the Titanic rather than paying attention to the life-saving needs for life boats and safety drills. Also like the Captain of the Titanic, the Presidents are not focusing on where they are going and having the best available communication equipment and personnel on board. History will determine whether the parallel is appropriate.

Staying with the ill-fated travel of the Titanic, one should point out that other ships made the crossing that night without running into an iceberg. Cruise ships have provided safe and pleasant travel to many thousands since then. The telling point is that with the correct management one can avoid some major, predictable crises. The key to that belief is the word predictable. One of my favorite Wall Street Journal columnists is Carl Bialik who writes interestingly and perceptively about statistics. In his latest column he writes about some of the pet peeves of professional statisticians. The first of Bialik's two pet peeves is that in too many cases, in the popular press and mindset, a single number is predicted without an accompanying statement as to the margin of error. The principal owner of the Titanic, his navigator, and single radio operator did not recognize a margin for error in their actions. Perhaps even more perceptively, Mr. Bialik mentions his second peeve, that the absence of evidence is not the same as the evidence of absence. (Those of us who live in New Jersey were victims of this misunderstanding when NJ Transit did not move its rolling stock to higher ground when the super-storm Sandy was approaching, for their preferred locations had never flooded. Because something hasn’t happened, doesn’t mean it can’t. The damage to the railcars will take hundreds of millions of dollars to repair and will interfere with commuter travel for many months.)

Many opportunities

I get out of bed in the morning, therefore I am an optimist. I believe that there are many opportunities offered to us every single day. Because of our own preoccupations, particularly about today’s problems, we don’t see the opportunities. In preparing for this blog, I saw information on three such opportunities.

Opportunity #1:  The growing middle class

The President of the US and his political cohorts are focusing on protecting middle class Americans from paying their share of the accumulated deficit. What he should be focused on is that there are already 500 million middle class Asians and it is expected by some to be over one billion middle class Asians in the foreseeable future, as mentioned by Kishore Mahbubani in the Financial Times. This is a  market that is currently crying out for the perceived quality of western brands. The US middle class can earn its way out of its share of the deep fiscal hole it is in by focusing on products/services marketed to this growing segment. Most of our investment portfolios recognize this opportunity by investing in multinationals and indigenous companies through selected mutual fund portfolios.

Opportunity # 2:  Net cash generation

Chip Dickson's daily letter from his firm Discern focused on US (registered) non-financial corporations that are in the longest period of sustained excess cash generation in history. I suspect that companies all over the world are awaiting similar investment opportunities. Most of the US corporate spare cash is being kept where it was earned, overseas. Often commentators blame the uncertainty of tax rates for the unwillingness to spend cash. This is not completely true. In the US, we have had changes in taxes about every two years. The retarding issue is that there is a lack of vibrant demand in the US. In the 19 quarters since the beginning of 2008, again quoting Stephen Roach, consumer spending adjusted for inflation, has been growing 0.7% per year, compared to a more normal 2-3% in the recent past, and over 4% in our halcyon days. Some of this decline is due to deleveraging by consumers, particularly in housing. These people are scared about their future and I suspect they sense the current anti-capital mood emanating from the Beltway. As shown by online buying, they want to spend wisely. The opportunity comes when they feel more confident and start spending. At that point, so will the corporations of the world.

Opportunity #3:  Technology helps

Exxon periodically produces an incisive look at the future for energy many years out. Not surprisingly, it sees growth in the demand for all elements of energy consumption and therefore production. Most of the growth relates back to the first opportunity listed (the growing middle class in Asia), but also in Latin America and Africa. What I found of interest is that this substantial growth will only be partially offset by an increase in energy efficiency. Exxon fully expects that improved technology will help produce, transmit and consume energy. This is another testimonial to the likelihood of growth in demand for technology. My guess is that in an aggregate sense, spending on technology will grow at close to double the rate of growth in the overall global economy. This growth rate is not fully discounted in many technology stock prices.

How are you going to handle the fiscal cliff, or more properly the fiscal slide or slope? Please share your thoughts.  

Clarification:

In last week’s post I compared the ratio of various nations’ debts to GDP.  Further in the paragraph, I referred to “Europe’s deficit as a unit.” I should have written “Europe’s debt as a unit.”

Ruth and I wish a happy, healthy and prosperous New Year to all members of this blog community.

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Copyright © 2008 - 2012   A. Michael Lipper, C.F.A.  All Rights Reserved.