The Biggest Risk We All Face - Weekly Blog # 674

 

Mike Lipper’s Monday Morning Musings

The Biggest Risk We All Face

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

Self- Inflicted Risk

While many try, nobody commands how we make decisions. That is why each of us are ingenious in building our own strict prisons. Our jailers are what we choose to believe or not believe. It is that process which leads to our single biggest investment risk: Conformation Bias. While we are very conscious of the endless sources of facts and opinions in this modern era, the way we deal with too much information is to ignore much and accept some of the inputs. 

I cannot improve on your own selection process but will attempt to aid you in assessing the strength of your convictions. In this way I hope to improve the consequences of deeply held beliefs. For centuries, most people held firm to the belief that we lived on a flat earth. The consequence of that firm belief led to the economic disadvantage of not finding other parts of the world and not understanding weather patterns.

With apologies to subscribers for another example of learning from my most important educational source, the racetrack. The ranking of other bettors’ beliefs before each race are the winning odds on each participant, measured by the number of bettors favoring a particular horse multiplied by the amount of money bet. The generally known percentage history of the most favored horses winning is way below half and closer to one-third. Few pay attention to the percent return on each successful horse, which tends to be much bigger. For example, in a race where the most favored horse pays off at even money, a bettor would cash a winning $2.00 ticket for $4.00. If a 10 to 1 shot is the winner, the winning $2 ticket receives $22, or 5.5 times the cash payoff of the even money winner. (The payoffs are after track fees and local taxes.) The job of a good portfolio manager, using this example, is to pick at least one of three races vs. the even money bettor.

In the long run it is more profitable to somewhat invest in greatly unpopular securities and funds rather than those that are popular, which is why understanding Confirmation Bias is so important.

A Self-Administered Test of Your Confirmation Bias

The following is a list of controversial statements, not necessarily my beliefs. There are six alternative buckets for your beliefs: Believe (80%-100%/40%-60%/10%-20%) and Disbelieve (80%-100%/40%-60%/10%-20%). Where appropriate, place the strength of your belief or disbelief in each of the columns, as shown in the italicized example below:

                                                                                                

                                                                                                                  10%-20%/40%-60%/80%-100%

Statement                                   Beliefs       Disbeliefs 

“Money is the Mothers’ Milk Of Politics (1) 80%-100%        10%-20%                                           

1. “Money is the Mothers’ Milk Of Politics   

2. Redistribute Capital to Redistribute Votes 

3. Need More Union Dues Contributions

4. Higher Taxes, Lower Growth

5. “Value” Better than “Growth” for 10 Years

6. Drawdowns 34%-49% (2)

Complete the table below by placing a check under one of the belief columns and one of the disbelief columns, answering for each of these six questions above. 

               Beliefs                        Disbeliefs 

      80%-100%  40%-60%  10%-20%      80%-100%  40%-60%  10%-20%

1.

2. 

3.

4.

5.

6.

1. A statement by Jesse Unruh, speaker of the California House and supporter of each of the three Kennedy Brothers.
2. In the last 23 years, the annual decline of the S&P 500 was -49% in 2008 and -34% in 1987, 2002 and 2020. 

If your beliefs or disbeliefs are dominant in either column, you are at risk of Conformity Bias and should examine the opposite point of view. This will enable you to set up an early warning signaling the pendulum is swinging in the opposite direction to your basic beliefs.

What to Do?

The most difficult job of a good portfolio manager is to periodically balance different points of view and quickly recognize early warning signs of a change. (At the track, a sudden shift in odds indicates new money has a different view, which should be re-examined to see if it contains new information which merits a change of opinion.) 

It is rare for our fiduciary portfolios to not have elements of growth and value. This is particularly true when the portfolio is broken down into sub-portfolios based on different payment and volatility needs. Currently, another major focus is domestic versus international, with China being under a controlled slowing and the US possibly being under a dangerous induced expansion.

Brief Updates 

Each of the following could be developed into its own blog, but I will spare you, although I’m happy to discuss these items with subscribers offline.

1. There are rumors of the administration thinking about instituting a tax on miles driven. Also, there is talk of an excess profits tax on those individuals and companies that appeared to have made money due to the pandemic and lockdowns.
2. Union membership has been cut in half since 1975, when it was 20% of the workforce, but it has risen a bit very recently.
3. The NASDAQ vs NYSE, which is the leader? In terms of year over year volume, NYSE -34.69% vs NASDAQ +30.50%. New lows in terms of the percentage of issues traded, NYSE 7.6% vs NASDAQ 11.9%. The relative absence of passive investors in the NASDAQ may be causing the difference.
4. The JOC-ECRI Industrial Price Index year over year is +83.7%. (Closer to home, Ruth mentioned that not only are food prices going up at the supermarket, but also paper products. It would be reasonable to assume packaging costs are increasing too. Paper, and energy for trucks, are part of the JOC index.)
5. The AAII bullish/bearish reading is 50.9%/20.6%
6. The largest free cash flow sector is Financials.
7. Large commodity speculators are increasing their short positions over their growing long positions in copper, crude oil, gold, live cattle, silver, T Bonds, wheat, and the Yen.
8. Small-Cap Value mutual funds are the leading diversified mutual fund peer group +20.46%. Mutual Funds should be important to other investors as 47.4% of US households own mutual funds.
9. James Mackintosh mentioned in the WSJ that the three stages of debt expansion are: speed, stimulus, and inflation, as evolved by Hyman Minsky.
10. The Congressional Budget Office (CBO) believes it would be too difficult to cut the existing budget to cover all the new administration’s planned expenditures.

Special Announcement to my fellow Analysts

Over the weekend the New York Times (NYT) published an article on the death of Bernadette Bartels Murphy. She was a former President of the New York Society of Security Analysts, as was I. Bernadette re-popularized chart reading and helped put the Market Technicians on their feet. When I talk with portfolio managers who have survived the cyclicality of the marketplace, they rarely couch their thinking about market analysis, as many benefitted from her efforts. We and the market have lost a major contributor to our progress.

 

PS

Early Asian trades are reacting to rumors of substantial forced margin account liquidations, probably from hedge funds. This could be a problem for the US Monday morning.

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

https://mikelipper.blogspot.com/2021/03/2-presidential-lessons-to-be.html

https://mikelipper.blogspot.com/2021/03/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/03/next-race-winner-weekly-blog-671.html

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Value Can Lead – Weekly Blog # 531

A Possible Turning Point

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

Utilities               +2.25%

Telecom Serv      +1.18%

Real Estate          +1.06%

Energy                 +1.03%

vs.

Information Tech         -2.19%

Financials                     -1.93%

Consumer Discretion  -1.87%

Health Care                  -1.79%

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

A Positive for Value

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

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

Cash Flows

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

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

Stability Leads to Instability

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

Shifting Sentiments

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

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

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

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

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

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

__________

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A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

Behavior Patterns Help and Hurt

Introduction

Investment professionals and seasoned investors prize numbers including repetitive patterns. With these abstractions of reality we can build nice neat statistical formulas that give us a good chance to be correct most of the time. The problem with that belief is the recognition that we won’t be right all of the time and some of the time when we are wrong the results are costly. Probably the best known user of numbers was the physicist Albert Einstein, who was lured away from Caltech to Princeton by more money (again numbers).  According to John Mauldin’s latest letter the Professor had on his desk a sign which read “not everything can be measured and not everything which counts can be measured.” Clearly he was recognizing that the “unknown unknowns,” as Donald Rumsfeld has said, make us understand that we can not have complete confidence about both the understanding of the current situation and our ability to predict the future.

Behavior

Many learned institutions around the world, including Caltech have been studying how various elements in the brain’s circuitry light up repetitively as reactions to (or possibly causes of) specific behavior patterns. Of the work that I have seen, the connections between the specific brain waves and human acts are pretty simple and rely on learned memories of past pleasures or pains; e.g., digesting food when hungry. So far I have not seen how our minds react to indirect stimuli. This is important in that we live in a dynamic world where threats of bubbles and forgone opportunities are present at a much accelerating rate.

Opportunities

My study of history indicates that every single day some people are not only making money, but each day someone begins the climb to real wealth. Often those periods when great fortunes were ignited were described by the headlines of the day as troubled. Many investors, some seasoned and some not, are perturbed by the level of real unemployment or underemployment throughout the age range, but particularly for the youth with or without college education. They are concerned by the political uncertainties in most democracies. The low level of interest rates manipulated by the major central banks is leading many into uncomfortable, and in some cases, unusual investments. In other words, many investors lack confidence and are unhappy. On the other hand, currently most economic and financial conditions as reported are not getting worse. The relatively low level of financial and investment activity is reassuring to some that are current market participants, as there are less chances that global transaction prices go crazy, with the exception of extreme high-end real estate.

Perhaps in the real world that is beyond the financial and political communities, people are coping. They are getting on with their lives and new hard-worked fortunes are beginning. What our academic friends have not yet captured is the ability of humans to cope with conditions that they have no historical preparations. Think in terms of the recoveries of people in London, during and after their bombings, New York City after 9/11, Japan after the Fukushima disaster, and in Boston after the explosions at their Marathon. Humans can eventually figure out how to survive and then prosper by using their developed problem-solving abilities that have no direct historical parallel. I believe we are in such a period now. Coping is working slowly and we are making some progress. We have a framed motto in our home from the US Marine Corps which intones “Adapt, Improvise, and Overcome.” People all over the world are doing just that.  This is not to say that everything is wonderful for all or that in the future we won’t suffer from human-induced bubbles.

Bubbles

Many keen observers of market prices have written about bubbles for hundreds of years. The most famous in the English language was Charles Mackay’s “Extraordinary Popular Delusions and the Madness of Crowds.” Other insightful authors were Charles Kindleberger and Hyman Minsky. Not at the same level but an effective scribe is John Mauldin who is promoting his latest book through his weekly letter, quoting others that have written well on bubbles.

Most of the time financial prices act in a rational fashion often extrapolating near-term trends into the nearby future. Major price swings are largely absent and can be easily explained. In other words most investments are dull, which is the best possible operating conditions for disciplined traders. However, what the media and the amateur investors focus on are bubbles which distort for a period of time the normal price trajectories. I have not seen a good definition of a bubble so let me suggest one:

 

     An exponential price move (multiple doubles) in a relatively compressed period of time, normally 250 or less trading days on the way up and a similar (or more frequently, a smaller number of trading days in decline). 

     Unless one is in control of one’s investment emotions these not infrequent disruptions can destroy a sound careful investment strategy.

What is particularly disturbing about bubbles is that they start out as recognition of some important price trend outside the normal trading markets for most investors. While the mathematical description of bubbles is remarkably consistent, the external factors are different. There is the so-called Kindleberger-Minsky Perspective of five stages. The first is heralded change to the perceived order of things the widespread advent of electricity, radio, nuclear power, Internet and new debt instruments. In the second phase early adapters enjoy a boom. By the time of the third stage almost everyone has joined in the Euphoria. 

I remember the bubble in transistors the forerunner of semiconductors. We were told to think about how big the market would be for transistor radios when they penetrated each village in India and how much better the world would be. This in turn led to the fourth stage or crisis. (Something happened between the bullish case of the 1960s and now when cell phones are helping lower-earning farmers to negotiate better prices for their crops knowing what the markets are paying.) What happened was over-capacity and under-financed marginal companies bombed the prices for transistors. The final stage of the cycle is one of revulsion. I remember one large mutual fund in the 1960s that was heralded for having little to no investments in electronics. It was the equivalent of having a closet full of Nehru jackets or for women having skirts of the wrong length.

I do not know when and from what sector a bubble will appear. Others have identified bubbles in 1929, 1962, 1987, 1998, 2000 and 2008. I might add some others that I have lived through. The main point is that we could be due for one which will be called an upside breakout to recognize how productive the world will be in the future. What has me particularly concerned is that various studies at Caltech and elsewhere have found that many participants in a simulated bubble knew it was risky, but were playing the so-called “bigger fool theory” that were paying too much but believed that they could sell at a bigger price. When the eventual decline is underway the most likely panickers will be the bigger-fools turning on themselves.

Statistical hurdles

In trying to convince investors of the soundness of any manager or investment thesis, back-tested results are brought out. Notice none are shown that put the proposed concept at a disadvantage. While I am skeptical about all back-testing I am particularly cynical of ideas that do not show the purported annual performance since 1990. Better yet would be quarterly performance since 1985. The comparisons should be against live, expense-paying competitors not a publisher’s collection with its own biases.

Investment applications

Far too many investors and some managers are using Index funds, ETFs and closet indexers to meet the investment needs of their institutional and individual clients. These are closed minded systems that only change their holdings when required to by outside forces that have nothing to do with sound investment judgment. One of my real concerns is  that in the rapid acceleration phase of a bubble; e.g., the run-up of Apple’s price to $705 in NASDAQ and other portfolios created all kinds of risks. This was just the parabolic performance impact of one stock; imagine the long term impact of a bubble on the whole index. This may well explain why the NASDAQ Index is still well below its peak during the Internet bubble of the 1990s even though many of the companies within the index have prospered.

Professor Einstein had it right when he focused on what we can measure and what we can’t.

What are you not measuring that you should?           

_______________________

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
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