An Uneasy Week with Long Concerns - Weekly Blog # 884

 

 

 

Mike Lipper’s Monday Morning Musings

 

An Uneasy Week with Long Concerns

 

 

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

 

                             

 

The Week that Was

Harkening back to an old London-based television program focused on the week’s changes, the following items of interest and perhaps importance crossed my computer screen:

1.  Two brief bear-market type rallies.
2. The US dollar broke par on Friday, finishing at 100.102. (Marcus Ashworth of Bloomberg believes that as much as some try to find a successful substitute, it can’t be found.)
3. Price signals – The Baltic Dry Index fell to 1274 vs 1729 a year ago; The ECRI industrial price index fell to 113.27 or -4.33% from a year ago. (This index measures the prices of industrial materials needed for production e.g. metals.)
4. Only Precious Metals and Dedicated Short mutual fund averages gained for the week ended Thursday.
5. Volatility increased in the week, with InfoTech stocks leading with gains of +9.67% while the Hang Seng Index fell -8.47%. (Normally the high/low spread is closer to high single digits than 18 percentage points.)
6. Market liquidity may be a major contributor to the market indices ranking year to date; DJIA -6.94%, S&P 500 -10.43%, and NASDAQ -15.14%.
7. Both analysts at Morgan Stanley and those contributing to Seeking Alpha Quant Ratings downgraded mid-cap investment bankers and mid-sized fund manager stocks. (Compared to their larger peers they rely almost exclusively on their brains, rather than a combination of brains and capital.)

 

Longer-Term Implications

• Howard Marks believes we have seen the best economic period in history.
• Marcus Ashworth believes we have entered the beginnings of a new phase this week.
• President Trump has told associates that he can tolerate a recession, but he is afraid of a depression.

 

Question: Do any of the elements mentioned in this blog aid or lead to a change in your thinking?

 

 

 

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Mike Lipper's Blog: Short Term Rally Expected + Long Term Odds - Weekly Blog # 883

Mike Lipper's Blog: Increase in Bearish News is Long-Term Bullish - Weekly Blog # 882

Mike Lipper's Blog: Odds Favor A Recession Followed Up by the Market - Weekly Blog # 881

 

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Not Yet! - Weekly blog # 800

 

Mike Lipper’s Monday Morning Musings

Not Yet!

 

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

 

 

 

The Thinking Behind Blog 800

When I realized the 800^th blog was coming up I tried to think of something special to discuss, like a critical turning point at the beginning of a new long-term market cycle. I see a turning point in the future which will begin a new corrective cycle. It will address multiple imbalances facing the US stock market, a reflection of increasingly problematic domestic and global problems.

 

However, it now appears we are likely going more toward a shallow dip, which could be labeled either a “soft landing” or a ripple in a stagflation period. Regardless, the underlying tensions continue to build and they will eventually lead to a deep corrective stage. With the 100^th blog less than 4 full years away, I have high confidence we will see a major correction.

 

Regardless of the timing and depth of the correction, we remain largely invested in equities and stock funds. These funds will need guiding principles to survive the correction and prosper from the following “bull” market.

 

Sources of My Guidelines for Long-Term Successful Investing

• Fidelity has published their views on 5 mega trends.
• Marathon in London has written about the benefits of low turnover and stable managements.
• Howard Marks expressed his views on escaping extreme investing.
• Finally, my own observations on the investment decisions of funds, commuters, and actuarial lessons on betting.

 

Productivity/Profits- Fidelity

Fidelity probably invests in almost every investment any place in the world. They serve different types of clients in many capacities and countries. Of the 5 Mega Emerging Trends, the most easily measured is the slowdown in the growth of productivity, more specifically in the productivity of labor. Labor is easily measured in terms of the number of hours committed to work, likely for compensation. (What is not evaluated is the quality of the work.) The number of hours worked in the US is in the upper portion of the lower half as shown below:

   More than US      US    Less than US

UAE          2709  1892   UK        1866

India        2480         Germany   1783

China        2392         Australia 1669

Mexico       2220         Canada    1664

South Africa 2154         France    1565 

Thailand     2108

Poland       2085

Indonesia    2043  

Philippines  2039  

Russia       1965

 

Implications

1. In a world that has higher interest rates and is short of opportunities, there are more places competitive with the US.
2. When US proclaims politically motivated holidays, such as Labor Day.

 

In an article by Howard Marx, he warns about extreme stock prices. When extreme enthusiasm pushes prices to record highs or lows, investors sell stocks priced for perfection, or buy/retain stocks which can never generate good news. Most of the time securities trend in one direction or the other. A dangerous condition is when all opinions on a security are totally one-sided. Very few investors understand that it is rare for there to be no salvage value for knowledgeable investors with patience and legal backing.

 

An example of too many one-sided beliefs was the 50 institutionally favored stocks in the early 1970s (Nifty Fifty). It was believed that these stocks could be bought and never sold, after the recommendations of the leading institutional brokerage houses didn’t work out. In 1972 the list contained Eastman Kodak, Polaroid, Sears, and Kresge. In the years that followed, all four disappeared through bankruptcy. To demonstrate how much reputational power these stocks had. One senior investment officer was an early promoter of Polaroid and managed to ride that performance into being hired as the senior investment officer at a New York based mutual fund house. He didn’t last long in a company that was studied daily, including its longer-term performance.

 

Marathon in London has a successful record with its European fund and others. They are a low portfolio turnover shop who pay a lot of attention to industrial and corporate capital cycles and meet with long-term senior management extensively. They are very proud of the 26% of their portfolio that has been held for more than 10 years in the European fund. Those positions represented 45% of that portfolio at the end of the period. When I visited them, I was amazed at their detailed knowledge of their companies, managements, and critical competitive information.

 

There are many investment lessons I have learned from just observing and listening to people. For example, I suspected the market was getting frothy in the late 1960s when a person I commuted with on a 6 AM train mentioned he had gotten a personal computer and was going to stay home and day trade a handful of stocks. He was a mid-level executive at a famous financial institution and appeared to have average intelligence. I was working for a firm that had a very active trading desk that regularly dealt with some of the sharpest trading shops. Very occasionally I heard one-side of a phone conversation between the traders. I felt I needed a translation regarding their words and tactics. I am sure my former train buddy knew no more than I did about institutional trading. Hopefully he learned quickly or found a new job. I never saw him on the train again.

 

I owe UPS a gift for the two investment lessons I learned from them this week. There was a public announcement that the company was offering early retirement to 167 senior pilots. Each of their planes carries about 30,000 packages and is designed to fly every day. Consequently, in terms of delivery capacity, it meant UPS would deliver 1.8 billion fewer packages or these packages would be flown by less expensive junior pilots. It suggested to me that UPS was expecting less business after their expensive settlement with their truck drivers. Within the week our friendly regular UPS driver delivered some low value drug store items, which may have come from a warehouse or a local store under half mile away. In either case, it was not a bullish indicator for me.

 

During the very same period institutions were locking into long-term investing in the nifty-fifty stocks, there was a more valuable lesson a few miles from Wall Street. On a Saturday in June of 1973 the Belmont Stakes was run. It was not much of a contest. Secretariat won by 31 lengths, setting a track record. While that was interesting, the real lesson of the day was that I didn’t bet on what was clearly the best horse in the race. More importantly, I did not bet on any horse in the race. When Secretariat won, the horse paid $2.20 for each $2.00 bet. What I learned was that even with the best horse in the world things can happen, or if you will “racing luck” might happen. (Sounds as if I was conscious of Howard Marx’s avoiding absolute certainty.) I was practicing good actuarial science, which excludes events so rare that they are unlikely to reappear. What I learned was that to not bet is a bet. Wagers should only be made when the odds of winning are high enough to cover losses in the past or in the future.

 

Conclusion

Investing should not be considered a single chance to make or lose money. The more you are aware of the world around you, the better your chances of finding some winning investments and keeping your losses small.

 

 

 

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This Was The Week That Wasn’t - Weekly Blog # 761

 

Mike Lipper’s Monday Morning Musings

This Was The Week That Wasn’t

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

            

 

 

In the earlier days of popular US television there was a program of satirical commentary. It was an American version of a British program with the same name, abbreviated TWTWTW.

 

Looking for leads related to writing my weekly blog I studied the four-day Thanksgiving week and concluded there really wasn’t much there. Evidently, much of the normal global trading around “turkey day” saw volume at about half its normal level.

 

Nevertheless, there were some snippets which may point to significant trends in the coming weeks. I found the following briefs of possible value in thinking about future periods:

1. The dollar index has dropped to 105 from 115 recently.
2. Taxable bond fund inflows were the largest since the week of January 8^th, 1982.
3. The 2-year treasury yield remained stable at 4.48%, while 10 and 30-year rates were 3.70% and 3.75%, respectively.
4. S&P warned that the corporate default rate could double if inflation remains high.
5. Goldman’s strategist believes the bear market would last into ’23.
6. B of A predicts 2023 gains of 25% for copper, 15-20% for gold, 12-13% for US investment grade bonds, 7-8% for US Treasuries, and 5-6% for oil.
7. My son Steve commented for Royce Partners that small-caps on average gain 12% and 16 % in even numbered years during the November-April period. (These are Presidential and Mid-term years)
8. Howard Marks reminded us of the inevitably of change. He also commented that the private equity and venture capital markets are too crowded. (Remember the losing percentage of favorites at the racetrack.)
9. China Region US registered mutual funds were the worst performers in the shortened week. (Over the weekend there were riots in the industrial and financial capital of Shanghai and elsewhere. These riots were the response to hardships caused by lockdowns to prevent COVID-19 spreading. (Apparently the Chinese vaccine is not as powerful those produced in US and Europe.)

 

Many will view this list as bearish but recognize that pundits and at least half the politicians are bullish. They believe we have seen a stock market bottom and are discounting a rising economy. It is possible they may be correct.

 

To those who have studied economic and market history it would be ironic if they were right, as it would be just a matter of time before a major recession/depression occurs. Societies often need these dislocations to initiate the kind of structural change necessary to correct for deep imbalances.

 

Please share your thoughts with me.

 

 

 

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Mike Lipper's Blog: Trends: Deflation, Stagflation, or Asian? - Weekly Blog # 760

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Mike Lipper's Blog: Are You Getting Value from Numbers? - Weekly Blog # 758

 

 

 

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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

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What is Next After the Next Next? - Weekly Blog # 625

Mike Lipper’s Monday Morning Musings

What is Next After the Next Next?

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

Most people focus on the current conditions. However, as someone who has always been influenced by repetitive history, I wonder whether we are approaching a significant turning point. While I do not know, I believe it is worth pondering. Allow me to sight three events that identified turning points that changed the pursuits of individuals and nations around the world.

1. An important change in the direction of human behavior after an extended period of time. 
2. An event or a series of events that distinctly break with the past. 
3. Prominent actors primarily focusing on current problems and being oblivious of the long-term implications of their actions. Three examples are: The end of the Dark Ages in Europe, World War I, and World War II. Each example resulted from the following:

• A different kind of pivotal leadership
• A weakened old order, both politically and economically
• A relatively small invention that changed many lives
• The introduction of a period of rapid change
• People willing to participate in radical change

The end of the European Dark Ages was caused by changes initiated by Henry VIII and his daughter Queen Elizabeth, Martin Luther, fundamental scientific discoveries, and Gold from Latin America.

It was not WWI itself, but the failure of the peace in solving the political problems facing Europe and its place in the world. The development of the airplane changed the modern world, ending geographical isolation and igniting the rapid development of mass arms manufacturing and radio as political weapon.

WWII relied on political leaders inciting their populations to go to war, the development of long-range missiles, nuclear energy, and substantial improvement in medicine/hygiene.

Current Condition
During the current pandemic, many political leaders across the world have put their citizens on a war status, by limiting their movements and working conditions. They are also rapidly developing specific therapies and hopefully cures. The US and other stock markets around the world have ended an expansion driven by lenient and inexpensive credit restraints for both the private and public sectors. We entered the fastest bear market ever, in an economic and financial world measured instantaneously. Whether it is over is subject to debate.

Readers of these blogs know that I identified the March 18th low as a “stealth bottom”. It was successfully tested on March 23rd, which was lower but did not bring on new waves of selling. There are a significant number of market followers, perhaps 1/3 of the financial community, who believe a lower low is coming. They could be correct but utilizing my odds tracking experience I don’t think so.

The following statistical sample utilizes the average mutual fund performance from 3/19 to 4/16, which arrays in a pattern seen in the last bull market: Growth funds +17.27%, Core funds +14.87%, and Value funds +13.48%. The more narrowly focused funds were led by Global Science and Tech. +21.16% and Real Estate +20.46%. These were followed by mid and small-cap funds.

The leading performance of narrowly based funds is significant because they do not have the same market liquidity as the larger and more diversified funds. Investors appear to be willing to accept more risk, suggesting they may believe we have seen the bottom.

If there is going to be another major down-leg, there is lots of “dry powder around to absorb it. Money market fund assets have reached record levels, with retail investor’s cash reserves now representing 14% of their allocation. Last quarter clients of JP Morgan Investment Advisory accounts added $75 Billion in liquid reserves, while redeeming $2 Billion in long-term accounts.

Those who follow the investment management business are familiar with Howard Marks. (I have known him since he was a portfolio manager of a closed-end convertible securities fund in the early 1980s.) He has been a very successful investment manager since his early days. Recently he sold control of Oaktree Capital to Brookfield Asset Management, retaining his ownership in the company. His public intention is to raise $15 Billion in a distressed securities fund. One can read this two-ways, he may be anticipating a lower market where he can buy cheap assets, or he could be anticipating an opportunity to sell assets at higher prices.

The Next after The Next
There is a good chance the investment world will not return to “normal” once we declare victory on COVID-19. I believe this period of working from home in various forms of isolation has fundamentally changed our behavior patterns. How we live, operate, invest, shop, entertain, receive healthcare, contract for loans/insurance, and how we conduct family and other relationships. At some point we will come to the realization that we have become too fixed-asset oriented. I expect changes in shopping, education, and healthcare. Furthermore, we will become more dependent on technology for all these things, through instruments like the Apple Watch, cell phones, and other instruments not yet on the market.

As investors we may be paying less attention to physical assets and more attention to leadership, applied to our specific needs. Management will need to get out of their offices, plants, and laboratories to learn of our desires and how they can solve our problems. I expect the world of my grandchildren and great grandchildren will be quite different than they are today, creating an additional burden on me as an investment advisor. Please help with any suggestions you have. 
 


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https://mikelipper.blogspot.com/2020/04/long-term-investors-mistakes-ahead.html

https://mikelipper.blogspot.com/2020/04/time-to-get-out-of-foxhole-weekly-blog.html

https://mikelipper.blogspot.com/2020/03/where-we-are-depends-on-where-we-have.html



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Crashes & Cash - Weekly Blog # 542

Mike Lipper’s Monday Morning Musings

Crashes & Cash

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

      

Did we Escape the Rumblings of the Next Crash?

Was the Financial Times headline: “Traders lost bet blows hole in post-crisis safety net” the announcement of the Arch Duke’s murder? The loss results from a more than $160 million default on margined futures trades at the NASDAQ(*) clearing house facility. Morgan Stanley(*), UBS(*) and Norway’s State Oil Company will have less than 48 hours to cover their defaulting counterparty. We think they will, but the size of their risks may give the professional market cause for concern as to the general risk in the market place. The implications of this default may take a while to be grasped fully. It took about six months from the Arch Duke’s death before the armies started to move and begin World War I.  Earlier this week I was asked by a group of retired, semi-retired, and active portfolio managers and analysts to give a top-down view of the market. My first point was that we should all prepare for a coming bear market. I hope my timing was not too prescient.

(*) A long position is held in these securities either in a financial-services fund I manage or in personal accounts, if not both

Current Odds Favor Upside

A very good friend gave me a book this week titled “Financial Market Bubbles and Crashes” by Harold L. Vogel. In the book the author lists 12 characteristics of a bubble, some are present, but not the complete list. (I will supply the list to any subscribers that send to me an email.) As bubbles are much more an expression of extreme sentiment than financial and economic data, I pay attention as others do to measures of investment sentiment. As I mentioned in the past, I look at a sample survey of the American Association of Individual Investors (AAII). Three weeks ago the most popular choice was bullish at 43.5%, by this week the bulls represent only 32.1%.

The Growing Risk Side

One of the traditional causes of bubbles is that there is too much borrowing. Too often this borrowing is used to buy or leverage financial assets, not operating assets. We have that set of conditions today, where major corporations are borrowing to buy their stock. While there has for a long-time been borrowing for home and auto financing outside of the bank and bond markets, it has recently grown much faster. Almost every major financial institution is utilizing the credit market and/or raising money for it. We are seeing a good number of these companies raising money on easier terms than in the past. This week the spin-off of Thomson Reuters (*) to a joint venture with a number of private equity funds led by Blackstone was able to sell paper which allowed the equity owners to receive dividends without the permission of the credit holders. This is a global phenomenon. BYD(*), a Chinese car and battery manufacturer asked its equity shareholders to allow their company to guaranty the debt of their auto finance subsidiary. 

Build Cash

One of the other points I made to my fellow members of this investment discussion group was to build cash. At current short-term interest rates one is much closer to breaking-even with inflation than in the recent past. There are other advocates of the value of cash. Charlie Munger and Warren Buffett at Berkshire Hathaway(*), while still buying a few companies and stocks, have built up over $100 billion in short-term investments. They have a very promising record of getting very high returns by coming to the rescue of very large, generally quality companies, in periods of distress. Reviews of Howard Marks’ new book speak about the optionality of cash. This means that he can deploy it to quick advantage.

Two Other Points Made

With the Chinese stock market falling, it would make sense to buy some of their better companies, or well managed mutual funds specializing in Chinese stocks as hedges against existing US and European stocks. If they go down further in value, the odds are favorable that the other holdings will go up in relative value.

The second point, in opposition to the focus almost exclusively on current prices of stocks and derivatives, is to practice some time span diversification. Only for example, one could take some of the asterisk names as being appropriate for middle age children without a great interest in investing. One of the mentioned stocks might also be appropriate for grandchildren in the hope that they will live in a less polluted world.

If YOU NEED HELP

We can discuss your needs and swap ideas  

  

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A. Michael Lipper, CFA

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The 3 Cs Dangers – Weekly Blog #534

Consultants, Career Risks, and Cash can hurt professional money managers as well as many individual investors who think like “the Pros”

Consultants
A recent Financial Times column by John Authers starts off by recognizing that it is hard, but necessary, to accept the responsibility for mistakes. It is the reason that many investment committees and other fiduciaries hire consultants. The column goes on to describe the results of a ten year study of consultants’ manager selection recommendations. The academic study found that the recommendations underperformed the market and were worse than the performance of the managers that were not recommended. This was also true in the selection of allocations to various sectors. However, the recommended managers’ performance hugged the benchmark better. (Perhaps the consultants recommended closet indexers.) I suspect the buyers of the consultants’ services expected those results. They knew the value of the John Maynard Keynes quote “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” In another quote from Farnam Street discussing Howard Marks’ book, The Most Important Thing, “first-order thinkers look for things that are simple, easy, and defendable.” Howard makes the distinction between first-order and second-order thinkers. First-order thinkers are only interested in the current time period, whereas second-order thinkers are focused on how the present sets up a number of future scenarios.

Disguised Consultants
Many of today’s investment advisers were impacted by the changing economics in the financial community, from being a fixed fee adviser or a commission driven broker to becoming a registered investment adviser charging a management fee. Since many investment advisors have no rigorous training in securities analysis, they focus their client bets on sectors and factors, using statistical measures, current news, and trends. As with manger selection, consultants are often first-order thinkers and produce similarly unappealing results.  One tip off as to their performance is the weekly data from my old firm’s publication of the Lipper Performance Report. During the latest week, all twenty categories of US Diversified Equity funds showed positive results, comprising the management of $8 Trillion in aggregate. In contrast 18 out of the 28 sector equity funds showed losses, comprising only $1 Trillion in aggregate. The difference between the two is that the diversified funds owned some of the best stocks in the sector portfolios and had enough diversification to produce less volatile results.

Nervous Contrarian
With the consultant’s focus on short term results, echoed by a number of investment committees and other insecure fiduciaries, the ability to predict short term market moves is critical (This is not true for long term investors.) The current stock market is being driven much more by changes in sentiment than fundamentals. Most transactions are originating from non-price sensitive transactors and the markets are reacting to changes of sentiment driven by news, fake news, and rumors. To see the rapid changes of sentiment, look in Barron’s for the results of the weekly American Association of Individual Investors (AAII) sample poll shown below:

View Latest Week     2 Weeks Ago   3 Weeks Ago
Bullish                    34.7%                   43.1%                  27.9%
Bearish                   24.9                       29.2                     39.3
Neutral                   40.4                       27.8                     32.6

As a contrarian I get nervous if I find myself betting with the crowd. Thus, if neutral approaches 50% I will be forced to make a decision and not just bet against the bulls or bears. At the moment my short-term inclination is to go to the bearish side and maintain a bullish position for the long term.

Career Risks
The challenge for the professional investor is to play according to the consultants’ rules, or attempt to produce extraordinary performance by being different, which almost guarantees underperformance some of the time.

Is Cash an Asset Class?
Last week I attended a Pershing Conference for Investment Advisers. I was particularly impressed with a discussion that included Rob Sharps, who chairs the growth equity committee at T. Rowe Price and is an important input into their best in class target date funds. (I am biased in the favor of T. Rowe, having known each of their chairman back to Mr. Price himself. We are users of some of their funds both personally and for clients, and also hold a position in our private financial services fund. I took particular note when he said that at the margin they were de-risking for the first time this cycle. In addition, State Street is raising the question of cash, pointing out that the current rates of return on US Treasury Bills are closing in on the Fed’s targeted inflation rate.

Years ago I studied the performance of various mutual funds that raised cash defensively. In major declines only funds that had about 25% of their assets in cash like instruments had a meaningfully smaller decline in the market. The longer term problem with these funds is that do not recommit to the equity market fast enough, so that when the market regains its prior peak they underperform and are meaningfully worse as performers.

Avoiding Poor Recovery Syndrome
There are two ways to avoid the poor recovery syndrome. The first is not to raise a great deal of cash but instead move heavily into low risk stocks that pay good dividends and a have a shareholder base to support liquidity in the stock price. We used to call them warehouse stocks. The classic one was the old AT&T, not the current stock of the same name. The second approach is to replace the portfolio manager with the next generation, a generation not burdened by the knowledge of what won’t work because it didn’t in the past. In recoveries, the combination of new enthusiasm and momentum will be early stage winners. The trick is then to replace the successful youngster with a more rounded manager.

Bottom Line
Be prepared to move away from the crowd, examine defensive tactics, and don’t fall in love with cash.

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A. Michael Lipper, CFA
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Statistical Correlations are Costly

Introduction

Why are most stocks down in the first two weeks of 2016 and far too many down in 2015? I submit that our brains are wired to use statistical comparisons rather than to accept uncertainty. Far too many of us learned about investing through academic institutions or pundits. Rarely do investment discussions go beyond the second sentence without relying on accounting terms and comparisons with popularly available indices or their derivatives. I suggest that we have gotten too far away from the early successful investors of merchants and farmers.

The “Modern” Investment Mind

In the pioneering work done at Caltech and other places on the motivations and actions of brain functions, scientists have discovered that different parts of the brain light up when dealing with fear and greed but essentially brains are memory devices. We store our own experiences and in some cases others. I believe what we store are the differences or deltas between the experiences and expectation.

This factoid is more easily stored than “we did better or worse than the “model” +100% or -50%.” This mechanism explains our need for comparative data. Bear in mind this is where the current state of the art is, but two quotes from Caltech suggests future refinements or changes.  A motto of the Jet Propulsion Laboratory (managed by Caltech) is: “Dare Mighty Things” and a quote from a Life Trustee Charles H. Townes, the only person to win both a Nobel Prize and a Templeton Prize, “The fundamental nature of exploration is that we don’t know what’s there. We can guess and hope and aim to find out certain things, but we have to expect surprises.”

Confession of an Index Maker

As someone who probably created more mutual fund indices than anyone, I know  something of the black art of creating indices for use by others. The critical building blocks were finding statistics already accepted by professionals individually and combine them to find a central tendency with a reasonable level of dispersion. For example, in a recent study to guess at future investment expectations, I was able to look at the various mutual fund sub-indices of funds in a client’s account for the last ten years.  The top two doubled over the 10 year period with annual gains of 7.52% and 7.30%. Perhaps more significantly was that an index of Balanced funds (owning stocks and bonds) gained only 5.43%. The significance of this finding is that as a US foundation with an IRS requirement to distribute at least 5% of its corpus, if inflation exceeded 0.43% a year the purchasing power of the foundation would decline and thus its grant making capability.

In a somewhat similar matter the popular securities indices were put together by publishers or brokers to capture the central tendencies of a market. There was no attempt to assemble a prudent portfolio for an individual or more significantly an institution to own. With that understanding I find that it is unsound to use these vehicles even in their index fund or ETF versions for fiduciary comparisons. With the majority always wanting to take the easiest comparisons not only are these indices being used as comparisons but also as correlation devices.

As bad as the general market indices are, what is worse is the sector/industry indices that are being used. The components of these indices are based on the principal products being sold as found in the US Government’s Standard Industrial Code (SIC). As an old specific industry security analyst, in numerous cases I found much greater differences in companies I covered rather than the products they sold. (Note I said sold rather than produced - either totally, white labeled or just assembled.) No wonder the stocks and bond prices for these entities move differently.

More Difficult to Define But Better

Believing that good analysts and portfolio managers are closer to artists than accountants, I think at any given time the single most critical element in wise selection is one of four attributes. While each of the four are almost always present from an investors’ standpoint, one or possibly two should be identified as the basis for comparison in building a properly diversified portfolio. Some of this thinking is parallel with Howard Marks of Oaktree Capital, whose latest thoughtful letter I will discuss below.

The four critical elements are: Supply, Demand, Time and Talent. The use of a firm’s capital to address the needs for expanded supply or increased demand is of particular interest to Marathon Asset Management in London who in a recent study identifies where in a capital commitment cycle a firm is. In an initial stage often the market will absorb all the supply that is available, be it in raw materials or semiconductors. That is until supply overcomes demand and then the critical focus is generating sufficient demand at reasonable prices. With many new product/services companies their initial focus is creating demand in the first place. Often this is the first business need for intellectual property companies.

The third critical element is Time. This needs to be looked at from both the producer and investor standpoints. From a producer’s position the time to produce and deliver is a competitive challenge. The first to be able to deliver in quantity and appropriate price will command the market as long as this condition lasts. From an investor’s viewpoint time issues involve average expected holding periods, payments to wait, expected terminal prices, and possibly certain critical performance dates.

The fourth critical element is talent management throughout the organization. This is critical regardless of size and it starts with the top but also includes, developers, client-facing staff and appropriate control and regulatory elements. The absence of a working plan to secure all of these creates substantial risk for the investor and in the long run for the employees and customers.

While I have yet to see funds or managers show their portfolios in terms of these four elements, some of the smarter ones can and do discuss their portfolios this way. To me this approach allows me to be a longer term holder of their portfolios.

During the kind of decline we are currently experiencing, I am seeing too much cross correlations with stocks in multiple industries, but very similar investment characteristics. Thus, in effect they have become a singular investment which we can use by providing our own diversification by marrying the questioned portfolio with other managers or funds. However, we would have to reject the singular focused fund as not appropriately diversified for some accounts.

Bullets from Howard Marks' Paraphrased Wisdom

Howard’s latest letter is over twenty pages. Below are brief thoughts from his letter:

1. In order to be a successful investor you need to understand psychology.

2. Strike a balance between offense and defense strategies. (single teams)

3. Too many overlook negatives until they capitulate.

4. Daily markets are a barometer of sentiments.

5. Perceptions swing from flawless to hopeless. (Apple?)

6. Investors know less than they thought.

7. There is false belief in investors’ rationality and objectivity.

8. Expectations should be included in transaction prices.

9. Illiquid assets + capital flight = investment disaster.

10. Markets move from yield focus to recovery potential.

Question of the Week: Would you like to discuss any of the points mentioned?

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Copyright © 2008 - 2016

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