Fear of Instability Can Cause Trouble - Weekly Blog # 848

 

         

 

Mike Lipper’s Monday Morning Musings

 

Fear of Instability Can Cause Trouble

 

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

 

 

 

Instability Changes the Players

Historically, the perceived strength of allies provides comfort to all fearing future conflicts. Changes can lead to instability, including a change in leadership, an unexpected industrial and military technology change, and demographic change. Some of these changes may happen almost overnight, while others may take generations.

 

In studying what caused World War I, all too many focus exclusively on the assignation of the Archduke of the Austro-Hungarian Empire. I suggest the following causes which arose at least 50 years before the assassination on June 28, 1914.

1. The declining economic power of Austria, due to excessive spending by the government and the wealthy.
2. A population still loyal to their old national governments.
3. The unification of Germany, which came much later than the other European and Middle Eastern countries. Germany was also late establishing colonies in Africa when compared to Britain, France, Italy, Spain, Portugal, Belgium, and the Netherlands.
4. The evolution of shipping from wind to steam power, and the development of the land-based maneuver practiced by Stonewall Jackson.
5. The rise of the US as a global sea power during the Spanish-American War (Great White Fleet).

Applying the same type of geo-politics/economics to the US after the meaningful stock market drop that followed the decline in jobs. The following elements should be noted:

• The pundit led consensus was wrong on the President’s capabilities and many factors concerning the economy.
• The rapid fall in the quit rate points to a further decline in the employment cost indicator.
• Commodity funds are cutting copper positions.
• Fundamental changes in the structure of the US stock market: In the latest week, NASDAQ trading was 6.6x more than the NYSE.
• In July, the performance of the equal weighted S&P 500 was 3% better than the cap-weighted version. Among the stocks with positive performance for the week were: Apple*#, Coke#, and a number of insurance stocks. (* owned by personal accounts, # owned by Berkshire Hathaway)
• 77% of NASDAQ stocks declined last week, versus 66% for the “Big Board”.

As both a contrarian and someone who reads history, I believe that Mr. Buffett building his cash & equivalent pile is the most bullish view I have seen in a long time. Mr. Buffett is getting ready to make positive investments in the future, he is not building reserves. I hope all of our subscribers are preparing to be bullish, which does not mean buying right now.

 

 

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TOO MANY HISTORIC LESSONS - Weekly Blog # 786

 

Mike Lipper’s Monday Morning Musings

TOO MANY HISTORIC LESSONS

 

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

 

 

 

Are we looking in the wrong direction?

The most important task for any analyst is guessing the future direction his/her enterprise should take. The standard approach is to review history. The problem with that approach is most history is written by the surviving winners and told to us by scribes who feel the need to make history interesting, clear-cut, and supportive of the commerce of the payor of the scribe. I have played that role. My problem is that for myself and my accounts the picture is not clear, particularly now.

 

Current Picture

Today’s blog is being written on the Saturday of the weekend before the grand compromise of the US Debt Limit/Tax Expenditure Legislation. We should never have been put in this position! Our elected leaders have had full knowledge of the twin conflicts of debts and expenditures for many months. Hopefully a tactical compromise will be announced within days.

 

There is however a more depressing structural problem facing us. These two problems have been with us ever since our leaders first determined what amount to spend for the perceived benefit of the governed and where to get the money. I am sure there are written Middle and Far Eastern texts, but the first I know of came from the ancient Roman Republic.

 

Rome conquered the known civilized world through the strength of its Roman Legions and superior engineering. The money to accomplish this came from taxing citizens, effectively the free residents of the city of Rome. Citizens elected the Senate who then passed these taxes. These senators had political skills, which they used to get the votes for their leadership. They induced citizens to vote for them by providing “Bread and Circuses”, or in other words food from conquered lands and mass entertainment.  As long as the Senate provided these in sufficient quantity, they remained in power. Upon failing to do so they were replaced by emperors who felt the political need to continue some of the “bribes”.

 

To keep the food supply growing the Empire continued its military conquests, enabling them to award the legionaries the captured farmland which benefitted from the Roman roads and aqueducts. However, the fidelity of the farmers declined over time, as did the quality of their military skills. Consequently, the Empire was overrun by the barbarians.

 

The political lesson for today is that bribery works as long as it continues to increase.

 

There is another lesson, this time from The American Revolution. One of the rallying cries of the colonials was “no taxation without representation”. They got around that issue by placing tariffs (taxes) on imports, and later through the power of inflation reduced the future value of the dollar.

 

In an aging world all governments need to address the increasing requirements of the elderly. China is under pressure to raise the retirement age from 50 for women and 60 for men. We have seen the difficulty France is having in attempting to raise its retirement age by just by two years.

 

Two Different Views

In general, the evolving political views of many Americans parallels their investment views. One group wants the government to be funded by taxes on the “rich” to pay for their growing needs. The second group wants to be able to provide for their families and their needs with their own funds, sharing equitably with those less fortunate.  In most cases the first group believes it will benefit as the economy continues to grow. The second group believes it will be increasingly difficult to create sufficient economic growth to meet everyone’s needs.

 

The second group sees the following signals as anti-growth:

1. Labor productivity is growing less than inflation.
2. Well established investment bankers and law firms are selling out, partially due to the views of the dominant partners.
3. The following financial firms, after studying the issue, are meaningfully reducing the number of staff in tech and operations: Wellington, Capital Group, and JP Morgan.
4. Some Private Equity firms are selling positions at a discount.
5. Consumers have shifted their buying habits from Best Buy to Costco.
6. Shortage of landlords.

 

Search for Conclusions

Please let us know your opinion on whether this is a time to buy risk assets to be sold in one to five years.

 

We close this Memorial Day blog with a quote from Theodore Roosevelt “We must dare to be great; and we must realize that greatness is the fruit of trial and sacrifice and high courage.”

 

 

 

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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.    

  

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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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Europeans Win, Experts Lose, Trading Opportunity vs.1848

Introduction

The essential difference between market followers and sound analysts is the former follow short-term momentum and the latter long-term directional changes. I embrace the second responsibility. Brexit, in my opinion, is the beginning milestone on the march to an era of more freedom of consumption and investment which will lead to better lives for many Europeans. Note I am focusing on people not present political countries.

The Perils of Over-Confidence

The focus on the needs and desires of most people is exactly what the expert class was not doing. They did not see or hear what the working class and much of the middle class were saying. The colossal surprise of the upset is only a surprise in that the expert classes of economists, political scientists, politicians, portfolio managers, senior investment people and media pundits had never considered that they were wrong. They had no plan “B.” In the US Marine Corps young officers are instructed you will only be judged on what you execute which will largely be plans “B,C,D, E, or F.”

This tendency of overconfidence will be part of a panel discussion this week at the New York Society of Securities Analysts celebrating the work of Benjamin Graham, the father of value investing. At the meeting I will be focusing on mistakes investors make keying off some of the mistakes that Berkshire Hathaway has made over the years. I have been asked about the single biggest cause of professional investment mistakes. I will discuss the overconfidence which has led to sizable losses. A similar pattern was in evidence in the London approach to Brexit. 

What Actually Happened: A tale of Three Countries

In Great Britain the London-centric experts thought the campaign would be won focusing on the fear of economic disruption. They were not listening to the people of the North of England and Wales who were primarily concerned with the loss of national sovereignty in terms of immigration and Brussels’ determined justice and procedures. These working classes and much of the middle class were fed up with what they perceived was likely to happen to them.  

One of the signs of this great division with those who wished to remain is the number of voting districts where the winning side polled more than 60%. We are used to seeing a split in many voting areas similar to the final 52/48%. The wider spread indicates to me that both sides were effectively only talking to their own and not engaging with the sizable undecided or opposed. The London-centric people initially bet over 90% of the money with the book makers that they would win only in the last few hours of the referendum, bet 90% on Brexit. (Too bad the Londoners didn’t know their history. More on that later.) Since the bulk of the more active institutional and trading money is intellectually based in London, over the preceding days they were heavily buying securities and sending similar thoughts to other markets. Interesting when the shock of the results became clear, the UK stock market declined one of the smaller falls in the world in part because only 35.5% of the indices’ revenues were domestic to the UK.

German investors suffered a 12% decline in part because 72.4% of their revenues are international in scope. One corollary measure is in the US, the Vanguard Europe ETF fell 11.3% as noted by my friend Jason Zweig.

In the US with approximately 70% of our revenues produced domestically, the main stock averages fell in the neighborhood of 3%.

This needs to be put into perspective. First, the decline essentially corrected the last several days’ rise based on our trading fraternity believing what they were hearing from London as well as significant short covering by hedge funds and similar traders. I believe the over 600 point fall in the Dow Jones Industrial Average was caused by the absence of short covering and algorithm-driven quant funds that sold as various price levels were violated. People at JP Morgan believe that from this source some $25 billion dollars were thrown on the market. If there is a continuation of the sharp decline they are looking for up to $300 billion more to be added to the market.

For those of a trading mentality I suggest at some point a near-term bottom will be reached, possibly on Monday. Current prices for many securities are back down to the bottom of their recent trading ranges which could well hold. If these trading bottoms do not hold further, declines will find other bottoms. Whenever the bottoms are found, subsequent rises could be dramatic because of the absence of positioning capital on trading desks.

While I recognize a potential trading opportunity, at the moment I do not see a substantial reason to change fundamental investment strategy. In terms of our four chamber TIMESPAN L PORTFOLIOS^® I might adjust the second chamber or the Replenishment Portfolio’s equity trading account to either take advantage of some cheaper merchandise or reducing risk if there are more violations of support levels. I would not change either the Endowment or Legacy Portfolios.

Londoners Had the Answer

The intelligentsia in London had the answer if they knew where to look. I do not know whether or not the restaurant that was in the downstairs floor of the residence of Karl Marx is still functioning. One evening my wife Ruth and I climbed the rickety stairs to his apartment which still had no electricity. At the request of the German Communist Party, Karl Marx authored the Communist Manifesto in early 1848. (A side note: because of his subversive activities in Europe he was never allowed to become an English citizen even though he was buried there.) He believed that it was in England that the revolution of the proletariat would begin because of its class structure.

1848

The main reason to focus on Karl Marx is the year 1848. This was the year of some 50 revolts by the working and middle classes throughout Europe and Latin America. These brought down a number of governments including in France. There was widespread dissatisfaction with the political leadership. Nationalism was on the rise in France, Germany, Netherlands, Denmark and Italy among other places. The violence of the revolts and the desperation of the people led to massive migration into “the new world” which in one generation proved to be a major brain drain. Lenin summed up what happened. “There are decades when nothing happens and there are weeks when decades happen.” (Courtesy of John Mauldin)

Perhaps the bureaucrats in Brussels and the current political leaders on the Continent are now seeing the risk to their structure. As is natural their first instinct is to punish the interloper, the second is to become defensive and the third hopefully to negotiate and evolve. Possibly Dr. Brendan Brown of Mitsubishi UFJ Securities is correct when he says. “The referendum result marks the start of A European journey out of a failed EU.  Britain is in the lead…There are serious grounds for hope (for) greater economic and political freedoms, prosperity and European harmony.” Greater Europe has for centuries developed official and more informal trade patterns that has produced satisfactory results both in peace and war and I would expect that to continue. In that light I believe that Europeans need the British as much if not more than the British need various European elected and non-elected states.

What to Do?

Many of the better US managed international funds have significant portions of their portfolios invested in Europe. I suspect over time these will be good investments and could find places within sound Endowment and Legacy Portfolios. For those whose preference is individual financial services securities, on a long-term basis they may wish to examine INVESCO, Franklin Resources, and Goldman Sachs all three are long term positions in our private financial services funds and have been under pressure recently. There are similar long-term attractive non-US domiciled financial service companies that I will be happy to discuss with our readers.

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Investing with the Uncertainty Principle

Introduction

Valuable insights can be derived from the same principle when making decisions for investing in securities and betting at the race track. While I am a senior trustee at Caltech, I do not claim to understand quantum mechanics. What I do recognize is that in 1927 Werner Heisenberg identified a way of thinking now called the Uncertainty Principle. He found that there is a fundamental limit to the precision of measuring unequal objects. Stripping out all the math, which is beyond me, the mere act of measuring the difference changes its precision. Translating this to my dollars and sense world means that the value of a comparison in terms of utility declines the more it is measured. In effect the more popular an analytical relationship becomes the less valuable it is.

One Successful Asset Manager’s Application

Marathon Asset Management of London starts a section in its well-written monthly report entitled: TOO MUCH INFORMATION, with a quote from T.S. Eliot. “Where is the wisdom we have lost in knowledge? Where is the knowledge we have lost in information?”

What Marathon is decrying is the frequency that the modern publicly traded company is supplying information to the market directly or through analysts and the media. This flow of information is augmented by trade associations and others’ intra-period industry data. Market prices move in the direction of the perceived value of the information only to be reversed often on the interpretation of the next morsel of information. This leads to stocks turning over much more rapidly than in the past. I have noted that the increase in individual stock turnover has led to a general increase in active mutual fund turnover. Unfortunately, this trend has not added to investment returns. 

Through June 9^th on a year to date basis in the fund asset class identified as US Diversified Equity funds - with one exception - the two best performing groups were the Mid-Cap Value funds + 7.80% and Small- Cap Value funds +7.68% (S&P500 Index funds were up +4.23). What is more interesting to me is an almost double gain from the one exception of +13.00% for Equity Leverage funds. This suggests to me it is not the fund’s selection skills but the use of borrowings (margin) and derivatives. One would think we are describing hedge funds. However, two others fund performance statistics tell a more complete story: Dedicated Short Bias funds -14.20% and Alternative Long/Short Equity funds -0.10%. I have now transmitted to you too much information.

Marathon would believe that the information above is a dump not a filter in terms of data discrimination, giving equal weight to each factor. There was no attempt to fathom what is missing. (I have often found that what is missing from an investment proposal is more important than what is provided.) The frequency of information input or overload leaves little time for deep thinking and pondering not only what is missing, but what weight one puts on each factor considered and how much to value what is unknown. The last exercise is critical to avoid the single biggest contributor to large losses, overconfidence. The last step often leads to a decision not to do something. While not axiomatic, lower turnover funds produce higher on average results over long-term investment periods that we favor.

Unfolding Brexit Pictures

We have one more weekend before the referendum. I hope in next week's blog post to devote more space to its impact and probabilities. However, in reaction to last week’s blog plus some conversations I had at a meeting sponsored by the London Stock Exchange on the value of listing funds at that exchange, there are three thoughts that I would like to share:

1. Unless the spread between the Remain and the Leaves is greater than 10 percentage points, the odds favor other elections on this and related topics in the UK and within the EU.

2. Regardless of the result, the 2017 elections in both Germany and France will be impacted possibly in different directions.

3. The use of foreign political leaders and foreign media comments can prove that such outside influences are counter-productive to the mass of voters.

Has the Commodity Cycle Bottomed?

As noted above, the US Diversified Equity funds have produced low to middle single digit returns year to date. There are ten sector funds that are showing on average double digit returns. Not only are these Precious Metals funds +88.89% but also Energy, Base Metals, Agriculture and Infrastructure funds. Clearly these are recovering from deep multi-year bottoms. But when the average Sector fund is up+9.58% compared with the US Diversified funds’ gain of 3.26%  are the markets telling us something? This is exactly the kind of question that Marathon and I are both calling for some deep thinking. The data above was compiled by my old firm, Lipper, Inc., part of Thomson Reuters.

A Professional Analytical Pause

On most weekends I draft these posts on Sunday, but this week because a significant concert of the New Jersey Symphony Orchestra, I am beginning to draft Saturday afternoon. But I am going to suspend my scribing to watch the 148^th running of the Belmont Stakes. For many track followers this is the single most important race for three year-olds. Its importance is similar to the senior prom in many US high schools. In both cases this one event will be remembered for a lifetime and a point of passage for these equine adolescents. In almost all cases this is the only time they will be asked to race for a mile and a half. The winner will initially be highly valued as a sire of future champions.

I will be watching not only from a racing standpoint, but also from an analytical viewpoint. Earlier in the week the weather looked for rain at race time. In theory this would have helped the favorite who has won in the rain several times in the past. The backers of the favorite were hoping for a repeat set of conditions and therefore results. This may be like picking a fund on the basis of superior past performance in down markets. But in each case for the very moment the question is how will the candidate do with a change in conditions?

Conclusions After the Belmont

As is often the case, lessons from one field have application in others. The race was won by a long shot meaning the experts and the bulk of the betters were mistaken. The interesting thing for me is the application of the Uncertainty Principle. It did rain right after the race, but that did not appear to be the deciding factor why the favorite (while close during the race) faded at the end of the race to finish almost last. If one filtered all of the past performance data and only looked at what could have been expected to be the interim best time at each leadership position, one could have deducted that this year’s Belmont Stakes had too much early speed and took the favorite too much effort to get to the front and couldn’t easily overcome the early leaders. In addition, there were a couple of fresher closers at the end.

From an investment point of view there were some lessons:

Past performance needs to be carefully analyzed and broken into components. The weight of past victories in terms of money earned was not a deciding factor. Finally, betting on future trends even when right, (the rain), the timing can be slightly off and not workout as forecasted.

In Summary

We should recognize that we live and must invest in an uncertain world. We need to focus on critical subsets of information. Finally our confidence should be measured to avoid overconfidence.

What do you think?

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Copyright © 2008 - 2016

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