What is the NASDAQ Saying to Whom? - Weekly Blog # 649

 

Mike Lipper’s Monday Morning Musings

What is the NASDAQ Saying to Whom?

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

Prior to Friday, the performance of the NASDAQ Composite Index led all other stock price indices in performance, and in my opinion, was an indicator of the future direction of the more diversified market.

Then on Friday we experienced an October surprise. The President of the US, the most prominent media political personality in the world, was diagnosed as having contracted COVID-19. An “October Surprise” has been a feature of American presidential politics and some believe it changed enough votes to swing elections. One should remember that voters do not take a verified test as to why they voted the way they did at the time of voting. There is some evidence that voters tell pollsters what they believe they want to hear, or who they think will win. Thus, there is no verifiable way to know how any specific individual voted, or why.

Most people responsible for the ownership of common stocks are long-term investors, and although they participate in the parlor game of expressing their view that it motivates their voting, it does not. Thus, the movement of stock prices or indices is not guaranteed to be predictive of voting results.

NASDAQ Against the World

Trading began on Friday after the announcement of the President’s medical condition, sending stock prices down by more than 400 Dow Jones Industrial Average (DJIA) points. Sharply fallen prices brought buyers into the market and by the end of the day the DJIA was down only -0.48%. What alerted me to something potentially signaling a major change was the NASDAQ falling -2.2%. Since reaching their all-time high on September 2nd, the S&P 500 and NASDAQ have been falling. (Remember my warning that due to changes in composition and weighting the DJIA is likely to be less reliable due to its greater tech orientation.) Until some time passes, the S&P 500 will be a more useful than the dollar weighted market indicator. By Friday’s close, the S&P 500 had dropped -6.49% for the month since achieving its high point. Over the same period the NASDAQ fell -8.14%, the difference being Friday’s price movement. Thus, Friday’s bigger decline could be significant.

What Did NASDAQ’s Friday Bigger Drop Signify?

The NASDAQ index is labeled “tech-heavy” and consequently the performance of tech stocks is disproportionately important to its investors. The only two mutual fund investment category averages gaining over 30% through the Thursday year to date period were Precious Metals +35.68% and Global Science & Tech +35.27%. (Five other investment categories were up in excess +20%) 

Someone with an eye on the political statements made by the leading candidates, and more significantly by some other political leaders concerning the large Tech companies, might ponder the implications of Friday’s tech stock price movement. The popular view is that the Democrats would like to see the economic marketing power of the leading tech companies restricted. Is that the reason the “tech heavy” NASDAQ Composite Index declined materially on Friday? (Prior to Friday, the NASDAQ’s decline from its peak was right in line with the fall of S&P 500.) What makes this view curious is that most CEOs of Tech companies are major Democrat supporters. (It is not unusual for successful candidates, upon being elected, to turn on their supporters and attempt to broaden their mandate.)

Changes in Marketplace Structure Could Be More Important Than NASDAQ Price Movements

While most investors only pay attention to the movement of the prices of their stocks, I also focus on the “inside baseball”. Who is executing and initiating the orders and how their marketing efforts are influencing what we think about their investments. It is interesting that there is rising concern over the marketing power of major tech companies, while there seems to be a parallel concern in the investment marketplace. Recently, it was noted that the five largest asset managers, in aggregate, manage more dollars than attributed to the US GDP. Even greater concentration was indicated by two announcements this week.

Wilshire Associates, a data supplier and asset manager, was sold to two private equity managers willing to provide more capital to expand Wilshire’s business. Also this week, Trian Fund Management announced that they have taken a 9.9% position in both Invesco and Janus Henderson, and announced that there should be greater merger & acquisition activity in the investment management business. These smart people were successful with their investment in Legg Mason, generating a gain of 55% for them. This area is of great interest to me, as I manage a private fund invested in Financial Services stocks.

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

https://mikelipper.blogspot.com/2020/09/there-is-incredible-shortage-weekly.html

https://mikelipper.blogspot.com/2020/09/headlines-excite-dictate-or-respond-not.html

https://mikelipper.blogspot.com/2020/09/mike-lippers-monday-morning-musings-who.html

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The Art of Portfolio Construction - Weekly Blog # 615

Mike Lipper’s Monday Morning Musings

The Art of Portfolio Construction 

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

This week had attention getting headlines that might be important to prudent investors.

1. The Barron’s Confidence Index dropped by an unusually large 2 points as high quality bond yields rose less than intermediate credit yields.
2. The 30-year yield to 3-month yield spread narrowed. 
3. The Baltic Dry Cargo Index was down 30% from a year ago (negative for world trade). 
4. SoftBank failed to raise the capital anticipated.

Despite all the news that has made headlines this week, we professional managers and serious investors must continue to manage the portfolios entrusted to us. Many professional journals are full of articles about Artificial Intelligence (AI), suggesting the management of investment portfolios can be done entirely “by the numbers”. Contrary to that view, I believe that portfolio management is an artform, similar to life in general.

That is not to say that math and related science has no place in portfolio management. The great artists of the world, either consciously or not, use mathematical principles in producing their art. It is the same with portfolio managers. Just as a painter looking at a blank canvas needs to contemplate the organization of the space, selecting the right colors to convey his/her point of view, so too do portfolio managers, particularly the successful ones.

One of the first choices the portfolio manager must make is whether to utilize many choices or just a few. Some portfolio “artists” will fill the space with many details, while others only use a few, concentrating on a limited number of opportunities. As someone studying investment portfolios for most of my life, I have come to some working observations.

1. The need to quickly convert some of the portfolio assets into cash in order to meet responsibilities focuses attention on liquidity. In markets of limited liquidity and occasional sharp price moves, owning a large number of securities often suggests the portfolio has a good amount of liquidity. This is not always true, but many portfolios do not need a great deal of liquidity.
2. The next consideration for portfolio strategists is career risk, as portfolio managers are rarely employed under long-term contracts. This is particularly true in the mutual fund industry, my preferred research laboratory. Termination is often triggered in one of two performance directions, up or down, depending on which is the greater fear. By definition, there are a limited number of individual securities that will be up significantly in any given period. If that is your goal, the best portfolio structure is to own only the big winners. On the other hand, career risks could be triggered by falling more than peers or the market and/or exhibiting an unnerving level of volatility. In that case, portfolios might include a large number of individual issues in order to generate returns similar to peers or market indices.

As a manager of portfolios of mutual funds, we utilize both extremes in some combination to meet the expressed or perceived needs of the account. Where possible, we want to use concentrated portfolios to give us better than average performance, accepting some additional downside risk. We offset these concentrated funds with a selection of portfolios that have numerous securities. They often look similar to market indices or are actual index funds.

I have great empathy for the managers of concentrated portfolios, as I for many years have managed a private concentrated portfolio investing in global financial services stocks and funds. I am not soliciting new members, nor am I recommending the purchase of any of the financial securities I will mention shortly. I am using a brief discussion of my experience to highlight some of the attributes of one particular concentrated portfolio, which might apply to other concentrated portfolios. The following are elements that may be found in concentrated portfolios:

1. During a recent period of positive performance for the portfolio and negative results for the benchmark/peers, only 7 of the 19 positions rose. The portfolio outperformed in part due to the two largest positions being the two best performing stocks and totaling 25% of the portfolio. The use of weighting is an important tool.
2. More important than what we own, might be what we don’t own, life insurance and large commercial banks.
3. Financial services can be used effectively beyond brokerage commissions and deposits to address other needs or fears. For example:  
1. Using ADP and Berkshire Hathaway to participate in GDP growth
2. Using Franklin Resources and Invesco to hedge the value of the US dollar.
3. Using NASDAQ for a general level of speculation.
4. Using Allegheny Corp. and Berkshire to participate in rising casualty insurance premiums.
5. Using the London Stock Exchange through Thomson Reuters to participate in the evolution of global stock exchanges.
6. Some of these options could also be considered hedges in a financial services portfolio.

Conclusion: Concentrated portfolios can work both offensively or defensively when appropriately structured, but need to have better security selection than portfolios with a larger number of issues.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/02/significant-turnaround-two-fearful.html

https://mikelipper.blogspot.com/2020/01/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/01/is-it-always-brains-over-flexible.html



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Committing Reserves - Weekly Blog # 547

Mike Lipper’s Monday Morning Musings

Committing Reserves

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

Any student of military history will be presented with the reasons why important battles were won and lost. Often the critical decision was when and how reserves were committed, both in defensive and offensive phases. The same thing can be said for managing portfolios. The standard battle structure used by the US Marines for maneuver units is, two up and one back, plus support units. On offense, reserves are committed to replace the tiring front line units so that fresh troops can pick up the pace of an attack. On defense, if the front line forces are pushed back, troops held in reserve are committed to stop the breakthrough, where enemy's troops are expected to be tired and somewhat disorganized. The keys to committing reserves are the factors of time, surprise, and location.

Applying these military lessons to portfolio management, the following principles come to mind:

1. Reserves need to be of sufficient size to maintain or regain the momentum. The two up and one back suggests that reserves should be in the range of 1/3 of the active forces.
2. Reserves should not be committed piecemeal, as they lack sufficient force to accomplish the main objective.
3. Reserves should not be committed too early, suggesting a 25% decline from the prior peak might give sufficient space to pick up bargains.
4. After committing reserves, be prepared to assign additional assets in order to preserve critical resources.

Husbanding Reserves
This week both Goldman Sachs and Morgan Stanley reported unexpectedly good earnings, which the market treated positively. In carefully reading their release and listening to their conference calls, there were some cautionary notes. Both are watching very closely for any weakness in their credit extensions.

Awaiting Direction
Along with other money managers, flows were slower than earlier periods. Modest earnings gains are expected by various analysts. The biggest gains are expected for the Russell 2000, which may be influencing the proportion of firms becoming profitable.

The average Large-Cap growth fund is up +9.09% YTD and +12.72% for five years, with both exceeding the average S&P 500 Index Fund performance of +4.78% and +11.52% respectively. The period of superior performance for index funds may be over for a while.

Major Commitment
Finally, on Thursday there was the announcement of Mass Mutual selling Oppenheimer Funds to Invesco for approximately $5.7 Billion, largely in stock.

In looking at the price, there are two interesting points. First, the rumored price was $5 billion in cash. This is roughly equivalent to $5.7 Billion in stock, in my opinion. Second, the seller wanted to stay invested in the mutual fund business. I view both as a vote of confidence in the business. Invesco has good distribution capabilities in Europe and Asia, which may be effective in selling the Oppenheimer Funds.

 Mass Mutual as a knowledgeable seller becomes the largest shareholder in the combined company and obtains a board position. They like the outlook for the business but probably don’t like the outlook for Oppenheimer’s retail fund operation. Mass Mutual has retained their ownership of Barings, an institutional player.

My clients and I own positions in a number of their domestic and international fund management companies.

Prudential Needs Smaller Reserves
Prudential Insurance is no longer labeled as a SIFI (Strategically Important Financial Institution) It did not have to contort itself as Metropolitan Life did to shed the title, it just had to be more patient and work Washington well.

Risk Management, not a Perfect Defense
Risk appears to be singular but in reality it encompasses a number of known and unknown risks. This multiplicity of risks makes it difficult to model as a single risk factor. This is particularly true due to a growing list of unknown risks. Thus, there is no such thing as a riskless investment.

Some Portfolio Managers Reduce Market Risks
The following brief comments are derived from reading the quarterly institutional reports from T. Rowe Price and Wasatch Funds, that we and our clients own. They are derived  from portfolio managers who also look at broader issues that may be of interest to our subscribers.

1. In the third quarter and continuing into the fourth quarter, security valuations didn’t seem to matter much. High Price/Earnings ratio stocks outperformed those with lower Price/Earnings ratios.
2. Investors remain complacent to the potential of future shocks.
3. A number of portfolio managers are pruning their portfolios by selling into strength.
4. At least one perceptive portfolio manager is taking advantage of the fall in Chinese stocks prices by broadening and deepening her commitment to non-tech Chinese stocks.
5. Concern for the housing outlook favors beneficiaries of short-term and longer-term lower commodity-priced inputs.
6. Trimming some Software-as-a-Service stocks.

In our private financial services fund I personally own shares in the publicly traded T. Rowe Price stock.



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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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The Worst Price and Long-Term Bargains

Professional investors and their political economies are very much interested in the price discovery functions of the securities and commodity markets. Prices translate into performance. Unfortunately, past performance leads to future individual investment decisions and asset allocations. In viewing the results for any given year, the last or terminal price plays an important role in the calculation of the resulting performance. Thus the December 31^st (and to a much lesser extent June 30^th) prices play a disproportionate role in the calculation that produces rankings, bonuses and job longevity. (Our actuarial friends would prefer multiple-date averaging calculations to “Last Trade on Last Day” as a better representative to what was happening.)

For 2014 in particular, I suspect the quality of the last prices will be weak. Due to restrictions as to the size and deployment of capital on various trading desks, the normal capital absorption capacity will be limited. Further, many organizations have already determined the size of gains and losses that they wish to sustain for the year. Thus there will be less buying power available on the last trading day of the year. Remember, the absolute final price on the last increment of trading will determine performance. In some prior years we saw a concerted effort on the part of performance players to ramp up prices of what they held in the last hour of trading. In some extreme cases there were efforts through short sales and other techniques to lower important prices for securities owned by specific competitors.

Ahead to December 31, 2014

At the moment I expect a slow Year-end day, but I am prepared for a spike in either direction on the last day which could be well reversed on the first trading day of 2015. In a relatively dull performance year the level of distortion is likely to be 1% or under.  From a performance analysis viewpoint I will pay more attention to year-to-date performance through November and/or the latest twelve month performance through the end of January, 2015. These mathematical machinations have some value in managing portfolios that have limited duration found in operational and some shorter-term replenishment portfolios. It should have no impact on decisions for endowment and legacy portfolios.  These refer to our Timespan L Portfolios™, which are segmented by investment period focus.

Better performance warnings

After a week when some of our holdings from bottom to top gained 5%+, for example T Rowe Price^*, I start to get nervous about rising volume sucking in sidelined cash. (NASDAQ OMX^* stock volume almost tripled from 773,829 shares to 2,225,599 shares in two days.)  These reactions need to be put into perspective. My old firm, now known as Lipper Inc., produces a daily index for each of 30 equity investment objectives. The components of these indices in the more numerous groups are the thirty largest funds.  In the smaller groups the number of components can be as small as ten. Examining the performance roster I noticed the Large-caps were up 10%, Multi-caps 9-10%, Mid-caps slightly under 8%, and the Small-caps 1.7%. What this suggests to me is that in a period of declining liquidity, institutional investors continued their Large-cap affection. Small-caps were the best performing investment objective asset based group in 2013, demonstrating their recovery potential.

The first warning in terms of a possible blow off will be when Small-caps become once again performance leaders and the investing public throws an extra $100 billion+ into Small caps which can happen.

The second warning is excessive focus on market capitalization as a screen for choosing investments. I note that on a five year compound annual growth rate basis there is little to separate the different investment objective groups’ performance; the entire range for these indices was a low of 13.92% for Large-cap Value, to a high of 15.77% for Multi-cap Growth funds. This narrow performance spread reminds me of one of the phrases that I learned at New York racetracks: one could throw a blanket over the leading horses at a heated finish line. In other words, even with all the traditional handicapping skills, the results of close races can not be successfully predicted. I would suggest that if in the future we have another five year like the last, investors should be pleased to be under the blanket of a 13.92% to 15.77% performance range, and not try too hard to pick the single best winner.

Target Date funds may not be optimal

There is another factor that may change the level of flows going into equities. The most popular inclusion in many 401(k) and similar plans are Target Date funds. The plans that are adopting these relatively new vehicles would be doing their beneficiaries a favor if they instead had chosen the mutual fund industry’s original product which was the Balanced fund where the managers made investment allocations between stocks, bonds and cash based on their outlook.

Lipper Inc. has 12 indices of Target Date funds broken down largely by maturity or retirement dates with performance on a year-to-date basis of +4 to +5%. None of them has done as well as the Lipper Balanced Fund Index gain of +7.03%. In the right hands, most potential retirees would be better off in a Balanced fund. Often the better performance of a Balanced fund is due to its investment into reasonably high quality equities.

Benefiting from discontinuous forecasting

I have often said that I can and want to learn from smart people, thus I read Howard Marks’s letters. Howard is the very smart Chairman of Oaktree Capital and an old friend. He devoted his latest insightful letter to what can be learned from the current decline in the price of oil. He focuses on the failure of most forecasts of the price of oil. These failures created what Wall Street Journal columnist Jason Zweig has called the “Petro Panic” which dropped stock and bond markets globally. Howard focused on the fact that oil price predictions were extrapolations of the past, adjusted perhaps by plus or minus 20%. This is similar to most predictions coming out of the financial community. I would suggest that these are not really helpful on two grounds. Most often the impact of the forecast is already in the price of the stock or bond in question. In addition, big money is only earned or lost when the old model is disrupted.

Three long-term items on my screen

In our Time Span Portfolios approaches, the final portfolio which is the Legacy Portfolio is expected to include securities from various successful disruptors. While there is a place at the right time and price for investing in secular growers, they are not usually the sources of extraordinary gains. These are what I like to find. I do not have the same scientific background as many of my fellow Caltech Trustees; therefore it is unlikely that I will invest client money on the basis of what is in a laboratory. I need to enter into the process later when my reading and some of my contacts can guide me in the right direction. Let me share three examples that I am looking into:

1.  The first is the global shortage of retirement vehicles. Almost no nation has sufficient retirement capital in private hands to meet the increasing retirement needs of large portions of its population. Europe is particularly troubled or should be with more people going into retirement, living longer, and fewer competent workers. I believe some of these needs can and hopefully will be met by mutual funds sold wisely to the public. Two of the investments in our financial services private fund portfolio address these needs. Both Franklin Resources^* and Invesco^* have strong retail and institutional distribution in Europe as well as in Asia. Their current stock prices are based on the perceived value of their present business and are paying little to nothing for their potential. At some point I believe either or both will show more earnings power internationally than domestically.

^*Securities held personally and/or by the private financial services fund I manage

2.  The second item is one that I have only a tiny direct exposure; it is an expected exponential growth in the service sector within China and some of its neighbors.

3.  The third potential actually ties back to the concerns created by the Petro Panic that is the announced long-term strategy of Toyota to get rid of gasoline cars. I am trying to determine what else will be needed as people change their driving habits.

  

Question of the Week: Please share how far out are you looking and what are you seeing?

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