Stress Tests - Weekly Blog # 740

                                    

Mike Lipper’s Monday Morning Musings

Stress Tests

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

Next Phase

Investors are not happy with the current phase of the market, which could be labeled a transition starting in late 2021 or January of ’22.

We left a stimulated expansion and rising US stock market for a contracting “bear market” and likely economic recession. 

The stock market performed its traditional function by discounting the future and falling before an economic contraction began.

The Federal Reserve was on its original mission, performing the function that it is perhaps best suited to accomplish, the protection of the banking system. (One can question the wisdom of assigning other responsibilities to the Fed.)

The Fed has learned that banks should have balance sheets assuring their survival in potential economic contractions. The Fed consequently required banks to show they could survive possible severe economic conditions, without necessarily predicting them. 

The tool used created very severe stress tests. The way the Fed used these tests limited the bank’s commitment to expansion and dividend increases. All banks passed the minimum requirement in the last stress test, although JP Morgan Chase and Citi were refused permission to immediately raise their dividend.

Many were shocked that JP Morgan was not given permission to raise its dividend. Afterall, the country’s largest bank had styled itself a fortress to defend its depositors from major problems. (Including ourselves) From the Fed’s perspective the bank was expanding too fast, especially if a very serious economic contraction materialized.

Surviving investors learn from changing conditions and I am now applying stress tests to how I manage money for clients and my family.

How Deep & Long a Decline

Applying an overly stringent set of filters to the oncoming contraction is creating stress for me and our accounts. Over the last two weeks the US and Chinese stock markets rose, while bond credits and commodities declined. A rise in stock prices is normal during bear market rallies on below average volume. 

The decline in the other asset types is worrisome, as they tend to be owned by more risk aware investors. In general, these asset types generate less capital appreciation than the average stock and are time constrained. Stock investors often view moves within the fixed income and commodities markets as warnings for the stock market.  

An offset to this bearish picture is to remember that falling prices and low volume should be viewed as an opportunity. Howard Marks, an old data client and very successful investor is quoted as saying “Today, I am starting to behave aggressively”.

Strategic Selections

Picking the highest performing strategy at the exact right time will produce great results, but good luck achieving that. 

For prudent risk-aware investors, a more comfortable strategy is the right combination of a limited number of strategies. This is an artform that great portfolio managers demonstrate most of the time.

My personal stress test perceives the adoption of at least five logical strategies as we exit this interregnum phase.  

Five Strategies

1. There have only been a small number of bear markets without a follow-on recession. One example is the Fed’s gigantic growth of money supply during the Trump period. It came so fast that a “value investor” like Warren Buffett did not have the opportunity to buy large amounts of good companies at fair prices.
2. In a “normal” cyclical recovery, asset prices for stocks drop to sounder levels as probable results are discounted. 
3. Structural recessions usually address economic imbalances through the liquidation of debt, which often requires a well-known financial player to collapse in some financial crisis. Currently, the largest debtor relative to revenues is the US government. (The continuing obligations of the US government are materially greater than its tax revenues, leading to increased levels of deficits.)
4. A depression is triggered by the political establishment policy mistakes intended to solve short-term problems requiring deep social restructuring. A classic example was the tax and tariff policies of the late 1920s, followed by the radical restructuring attempts in the 1930s. This turned a 5-year cyclical recession into a 10-year depression.
5. Stagflation occurs in a period of slow revenue growth combined with high inflation and unwise regulation. We suffered such a period in the 1973–1982-time frame.

The five strategies listed are in rough order of the shortest expected lapsed time in a bear market without a recession, and the longest stagflation. Another critical time scale is your expected investment period. For the longest periods, e.g., a grandchild’s college endowment, very little in the way of reserves are needed. More reserves are needed to offset potential losses due to unfortunate timing in shorter time periods.

Selection Guidance

Over extended periods, the aggregate performance of “growth” and “value” are about equal. However, there are two main differences in the selection process; tolerance for volatility and how the main financial screens are utilized.

Growth investments tend to be volatile based on news. You consequently need to pay intense attention to any element impacting the income statement, particularly net cash generation excluding all uses of cash or buying power.

Value investments appear less frequently in the media and thus tend to be less volatile. This is particularly true if they pay a regular dividend, which is hopefully growing. The adjusted balance sheet is the most important document in their selection and includes the current pricing of all assets and liabilities. Additionally, the value of people, customers, brand name, patents/copyrights, or under-utilized resources need to be added. You need to add all reasonable contingencies, including the shut down costs of work sites and people. In many cases, a forensic accountant and bankruptcy lawyer is needed.

WHICH DIRECTION?

The main reason this blog is titled “Stress Test” is that there are currently “green shoots” of positive information as well as disappointing signs. Reasonable analysts may disagree on both the importance and characterization of listed items in the proper category. Nevertheless, I pay attention to all as possible signals of things to come. 

I welcome all views that agree and disagree the view expressed.

Positives

• The JOC-ECRI Industrial Price Index weekly change was -2.47%
• The AAII 6-month bearish view was 46.7%, vs 59.3% the prior week. (This was a move back from a very extreme position the prior two weeks, viewed by market analysts as a contrarian indicator.)
• Copper prices are recovering from a high price in April due to rising Chinese demand.
• In last 3 months, M-2 money supply growth was only 0.08%.
• Fed funds futures prices are dropping.
• The bond market appears to be capitulating,
• The combination of China producing both a hypersonic stealth bomber and a 4th generation aircraft carrier, should be good for defense spending.

Negatives

• According to the American Farm Bureau annual survey, the cost of a July 4th picnic has risen 17% in the past year to $69.68.
• Tech companies, among others, are laying off workers.
• The Atlanta Fed is forecasting a second quarter contraction of 1%. 
• I wonder how much of the relatively low trading volume on Friday was short-covering before the long weekend.
• The claim that the market is priced more attractively now than earlier in the year looks questionable, as pundits are using current prices and what I believe to be “stale” earnings estimates. The severe drop in June sales may have led to considerable write-downs of inventories and prices. 

IT IS IN PERIODS LIKE THIS THAT INVESTMENT MANAGERS EARN THEIR FEES.

 

Please share your thoughts for the next great investment idea.

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

https://mikelipper.blogspot.com/2022/06/switching-prime-focus-weekly-blog-739.html

https://mikelipper.blogspot.com/2022/06/are-markets-getting-too-far-ahead.html

https://mikelipper.blogspot.com/2022/06/pick-investment-period-strategy-weekly.html

Did someone forward you this blog? 

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2022

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Building Your Future Winning Portfolio - Weekly Blog # 724

 

Mike Lipper’s Monday Morning Musings

Building Your Future Winning Portfolio

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

Personality Shapes Portfolio Architecture 

One hurdle we give little thought is the modern mass production of clothes, foods, jobs, schools, and financial instruments (portfolios). Staunton Military Academy and the US Marine Corps were contributors to what I am today, but like everyone else I want to be unique. In that search to find myself, both my wife and I have turned to history to learn how others developed their identities. 

Focusing on how others have navigated their successes and failures, I am particularly interested in learning how to minimize losses. Large failures are typical of those who have achieved measurable success. Psychologists who measure the impact of winning and losing believe we feel at least twice as bad from losing. (I believe some of us feel even worse about losses. Losses delay our commitments to successful actions and use up some of our precious time.) People experience both successes and failures and some learn from their defeats, using that knowledge to build subsequent victories. For example, both George Washington and Abraham Lincoln suffered multiple losses before their victories. 

We Alone Are the Senior Architect of Our Investments 

While we may consult with various professionals, family, and friends, we are ultimately responsible for creating our investment portfolio and our lives. I have prepared an a la carte menu for you to choose from that is specific to meeting your investment personality needs. Instead of each alternative having prices or calories as a guide, I list a very rough risk/return identifier. (Through your own experience you can modify my judgements.) 

A la Carte Menu of Portfolio Vehicles 

Type             Risk Orientation

All on a single bet      Favored by entrepreneurs (Henry Ford 

                         was twice bankrupt before success) 

Concentrated holdings    Limited number of large bets with 

                         common risk characteristics 

 

Actively managed fund    Account/fund of less than 50 names 

Passive Index Fund       Fully invested + low turnover 

Combined Approaches      Risk avoidance limits upside 

Personally, I plead guilty to the last choice. Our big positions are centered on domestic and international financial services companies and funds. I use actively managed funds and fund management companies when I do not have confidence in particular companies, but believe their focus is correct. In doing so I use a fund or fund like vehicle as a common denominator play. 

Types of Declines and Expected Influence Structures 

The US stock market has been in decline for some time. In some respect you could go back to 2019 or earlier. The expansion of the NASDAQ Composite since the financial crisis may have ended in November 2021. Using that as a measure we have entered a bear market for at least two days, but it is not yet convincing. Both the Dow Jones Industrial Average and the S&P 500 have entered a correction phase, falling more than 10%. (The media called both the bear market and correction phase but cannot tie it to an economic or market measure.) Nevertheless, this may be a good time to assess the types of market declines and appropriate tactics and strategies: 

Correction Phase - According to S&P, the market is up +9% one year later. 

Bear Market - One year later the market is up +13%. (To the extent that the market indices represent one’s holdings and the account is eventually taxable, it doesn’t make sense to liquidate unless there is a specific problem that questions the future of the company. Most, but not all recessions lead to bear markets, so it is not a specific call for portfolio action. 

The real risk is an activist top-down government taking a normal cyclical decline and turning it into an active depression lasting a couple of years or more. If this is expected, the proper strategy is to cut expenditures as much as possible and shrink the portfolio in terms of capital commitment, but not names. In The Wall Street Journal, Jason Zweig recounts the incidence of Sir John Templeton buying 104 stocks trading for under $1.00, including 34 that were in bankruptcy. This was in 1939 before the US entered WWII. After the war he made a profit on 100 of the positions. (I do not expect a similar experience for the country, the market, or an investor, but the lesson shows the value of long-term investing, staring with low prices on the NYSE.) 

Which is Best Now? 

History does not offer a direct parallel. The closest that I have seen is the 6 months prior to the declaration of WWI. The immediate causes were the weak, isolationist, attitudes of the US government, plus the assignation of the Archduke, which was part of the unrest in Eastern Europe. Our fear is China supplying military goods to Russia as requested. This conceivably could bring a third world war.  

In deciding what to do, I suggest putting both the stock tables and the annual reports down. Evaluate your holdings as companies. Would you like to own all the company and never sell it? Warren Buffett views companies based on whether your children would be buyers of their products or services. 

After many successful years of investment, you may have an oversized highly profitable position and may have large loss positions to “harvest”, if you don’t think they will recover. These losses could be used to bring balance to your portfolio by recognizing the losses and simultaneously reducing some of the overweight positions in your winners. The freeing up of cash from both losers and slightly reduced winners creates a fund for reinvestment at a time when prices are reduced. 

Final thoughts: Understanding that making a series of correct investment turning point decisions is very rare, allow yourself to make mistakes, learn from them, and generally stay the course.

  

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

https://mikelipper.blogspot.com/2022/03/does-decline-influence-recovery-weekly.html

https://mikelipper.blogspot.com/2022/02/successful-investing-expects-unexpected.html

https://mikelipper.blogspot.com/2022/02/we-are-progressing-weekly-blog-721.html

Did someone forward you this blog? 

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Selectivity over Factors - Weekly Blog # 551

Mike Lipper’s Monday Morning Musings

Selectivity over Factors

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

We are entering a new phase where successful investing will be different than successful litigation and gatekeeper buying. The classic way to judge the strength of a civil law case is to follow past precedents. The same reliance on history carries the day with most institutional gate keepers and investment advisers. Their standard phrase is “Past Performance does Not Guaranty Future Results”. Nevertheless, soon after delivering this dictum they mouth such and such factor or manager has the following good record compared to other records, except when things change.

I believe that underneath the volatility we have seen in 2018 we are seeing greater dispersion in the returns of factors and mutual fund classifications. This ranges from pseudo mathematical certainty to the art form of selectivity. Increasingly the differences in performance are more important than the similarities. Another way to look at it is that instead of looking at any giving picture two dimensionally, we search for a third or perhaps other dimensions. This leads to different views being developed by different observers. The more successful observers will be much more valued than those who are just model makers until the next changes in the investment picture.

POSIBLY BIGGEST CHANGE IN 100 YEARS
Practically all of those who have been schooled in Liberal Arts courses believe that it is the government’s function to stimulate the economy out of a recession. From this requirement it follows that it is the government’s responsibility to control the economy. Modern governments, whether elected or command controlled, translate that into job creation. Increasingly, leaders are becoming frustrated with their inability to get their economies (people) to comply with their desires. Part of their problem is that their favorite handmaiden, the central bank, has not been as effective as desired. The institution that studies the central banks with the most detail is perhaps The Bank for International Settlements (BIS). The head of the BIS’s Economics-Research Department is quoted as saying “politicians have come to rely on central banks to stimulate growth since the (financial) crisis.” Yet, with very rare exception, constituent economies have produced below normal historic results. Central banks/governments have kept short-term interest rates below the levels needed to cover  non-paying loans, whose interest rates are too low. A still greater penalty has been levied on economies by the misallocation of resources during recessions. Far too many people continued to be employed by failing organizations kept alive during the recession, instead of transferring that human capital to sustainable activities. In the face of these challenges some governments have reduced administrative burdens and tax levels, but this will probably only have a modest impact. The more people and businesses recognize that central powers are attempting to manipulate them, the lower their confidence in their own ability to build their own futures.

As is often the case, I am fulfilling the function of the prudent analyst gazing at the various futures ahead. Clearly I am ahead of the current thinking of those in power and most of their opposition. Nevertheless, I am beginning to ponder the impact of an appropriate investment strategy in response to the relative ineffectiveness of the top/down thinking of the central powers. The following topics should be explored by those charged with the responsibility to make payments to multi-generational beneficiaries:

1. Will the coming recession be largely caused by cyclical or structural causes? If largely cyclical, we have been there before. We know how to play that game, which is mostly based on sell/hold/buy decisions in the same securities. If structural problems are the main cause of the recession, the decision process centers around which areas and instruments should be employed and which should be abandoned.
2. What is the probable length of the recession? Typically, a cyclical recession is quicker because prices can adapt quickly. A structural recession involves the transfer of productive resources from one sector and location to another. This raises the question as to how quickly critical employees can be found and trained, not only in manufacturing but also in sales and service roles.
3. What will be the new measure of success in the post-recession recovery period?
4. How much of our economic and personal lives will be disrupted by technology applications? There are some that have concerns about the world of Big Data and its impact on individuals. Due to internal security concerns China will be the leader in that world, even more so than Saudi Arabia was in a world run on oil.
5. In a recession, particularly one caused by structural factors, corporate and personal defaults will likely be higher for credit instruments than for underwritten bonds. However, with the shrinkage of the number of brokerage firms and commercial banks, who will do the underwriting? It may be easier to distribute credit instruments directly to pockets of wealth rather than through a syndicated underwriting of bonds. (In the latest week, focusing only on financial organizations, two  yields tightened and six widened.)

SHORT-TERM POSITIVE
As mentioned in past blogs, market analysts believe that significant price moves are unlikely if there are price gaps between trades, particularly when comparing price ranges day to day. Gaps in price charts need to be filled before a sustained move is likely. Of the three main stock market indices, two had price gaps filled by declining prices this week. There are only six weeks left in this calendar year to avoid breaking a fifty-year rule, that bonds and the S&P 500 do not decline in the same year. Bonds are off this year. The only fixed income funds positive on the taxable side are Ultra Short Obligations, Short Investment Grade Bonds, High Yields, Short US Governments and Money Market Funds. With only the US Diversified Equity Funds macro group being positive, the only way to avoid breaking the fifty-year rule is for there to be a pretty broad stock price increase in the next six weeks. Because no one expects it, there is a chance that we could even reach record levels by year-end.

A MAJOR WORRY FOR GRANDCHILDREN
In the weekend edition of the Financial Times there is a three-page article about the opening-up of some of the secrecy surrounding the long-term outlook for the US military. What becomes very clear in the article is that the current administration is worried about the growing technological skill of the Chinese. It is quite conceivable that at some point in the future the Chinese military establishment could surpass the US capability to an extent that could be extremely upsetting to the US. (I firmly believe that this is a more important concern for this administration than the loss of manufacturing jobs in the US.)


Question of the week: 
What actions are you contemplating based on the changes you foresee?


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

https://mikelipper.blogspot.com/2018/11/history-guide-not-map-or-trap-weekly.html

https://mikelipper.blogspot.com/2018/11/things-are-seldom-what-they-seem-weekly.html

https://mikelipper.blogspot.com/2018/10/we-are-in-training-exercise-weekly-blog.html


Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.