2 Presidential Lessons to be Learned/NASDAQ Clue - Weekly Blog # 673

 

Mike Lipper’s Monday Morning Musings

2 Presidential Lessons to be Learned/NASDAQ Clue

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

 

For Want of a Nail

For want of a nail the shoe was lost.

For want of a shoe the horse was lost.

For want of a horse the rider was lost.

For want of a rider the message was lost.

For want of a message the battle was lost.

For want of a battle the kingdom was lost.

And all for want of a horseshoe nail.

A similar proverb has been coming to us for many centuries, in many languages, showing the critical importance of micro elements on macro events. As a bottom-up analyst I have learned to build macro views from the micro, distinct from many top-down thinkers who believe a macro view is appropriate for investment decision making.

Learning from Past Presidential Mistakes 

Before the current administration attempts to dictate its top-down views it would be wise to review the consequences of prior Presidents’ actions, which had the opposite effect of their intensions and led to severe repercussions for the world, country, and investors. In two cases, the party affiliation of the president did not save him from important mistakes.

FDR

The current administration is described as the most “progressive” since FDR, whose effort to redeploy the population and redistribute their wealth, took a bad recession caused by unsound debt policies and turned it into a long Depression lasting to the needed World War II. (Note, depression is a psychological term and is not designed for an economic period.) The lesson coming from this 12-year period was the central government being as much a part of the problem as the solution. In the eyes of potential aggressors, the US was weakened and would be slow to respond due to a lack of demonstrated political will. (Including, shifting government spending from buying to producing, a weak and outdated military, raising taxes on productive portions of society, and making it illegal for Americans to own gold.)

Richard Nixon

Became an advocate for Keynesian contracyclical spending and closed “The Gold Window”, which prevented  the US from buying gold from foreign nations for dollars and ignited the sharpest rise in inflation in modern times. While he did open the door to China, he saw it in military terms and did not contemplate the commercial plusses and minuses. 

Influences on the Stock Market

There are three mega market concerns: 

1. Economic/political concerns
2. Corporate views and earnings
3. Market structure changes

I am delighted most investors view the market impact in the order listed. As a contrarian, I take the reverse order as more important. Looking for “The Nail…”. A basic rule of investigation is to not believe the owners of the “printing presses”, demonstrated by the Federal Reserve’s terrible record on predicting economic turning points. One of the reasons that their record is so bad is that the Fed and the government use tax data for individual income. (I am sure everyone reading this blog attempts to show the maximum amount of possible income on their tax forms.) 

Corporate earnings releases have become very “plastic”. “Adjusted” financials now take prominence over audited statements in letters from the CEO. In the era of ESG and Diversity, commentary is about wishes and intentions, not current conditions. Thus, I put much more credence in securities transaction reports, even though I am conscious of trades occurring “off the market”. In addition, for historical reasons I have a lot of confidence in mutual fund data. It is from these vantage points the following views are offered.

Current Briefs

1. In the current week ended Thursday, mutual funds gaining more than 10% for the week included: 5 Value funds, 4 each in small and mid-cap funds, and 2 each in Core Commodities and Global funds. While smaller and mid-cap value funds were generally favored, individual stock selection was critical.
2. Six of the top 25 for the week invested in Japan and 8 of the bottom-10 were invested in natural resources.
3. Net fund flows for the week focused on portfolio attributes as well as immediate performance.
4. The JOC-ECRI Industrial Price Index year-over-year is +75%

New York Stock Exchange vs. NASDAQ

1. Volume year-to-date through Friday:  NYSE -25.57% vs. NASDAQ +25.14%                                                                                                                           
2. New Highs, New Lows, Number of Securities Traded

                 NYSE     NASDAQ

New Highs    820        784

New Lows      95        231

# Traded    3419       4322

NYSE is more bullish, but NASDAQ is Savvier, as shown on Thursday with the 400 plus point drop.

What Do You Think? Did I find a nail? If not, what would be?

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

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

https://mikelipper.blogspot.com/2021/02/did-something-happen-last-week-weekly.html

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Did Something Happen Last Week? - Weekly Blog # 670

 

Mike Lipper’s Monday Morning Musings

Did Something Happen Last Week?

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

Great Discomfort, Almost Panic, Large Growth Funds, Long Treasuries

Market participants apparently reacted to the further steepening of the US Treasury yield curve, with higher interest rates for longer maturities. (This was not a surprise to me, I have been focusing on higher inflation for a while. This week the JOC-ECRI Industrial Price Index reported a +47.91% rise from over a year over year. Also, my wife noted that supermarket prices are rising.) 

The impact on large “growth” stocks, as measured by large-cap growth mutual funds, declined by mid-single digits for the week. The connection between rising long-term Treasury yields and stock prices for companies with large amounts of cash and relatively low debt, surprised much of the public and some in the media. In theory, growth stocks are valued at what the market believes are their future stock prices, discounted by the cost of money until they are sold. The lowest discount rate used is the yield on long-dated treasuries. Thus, the reaction to the steepening of the Treasury yield curve makes growth stocks less valuable. Approximately ten of these stocks have been the engines of superior price appreciation in large institutionally managed portfolios.

Investors do not reveal the motivation driving their decisions and commentators consequently we use circumstantial evidence to ascribe motivation. As a skeptic, I look for other non-publicized explanations. 

Questioning the Gospel

The new administration has been fortified by the naming of the Treasury Secretary, a former chair of the Federal Reserve and former labor economist. For more than a year the previous administration believed in the long-term continuation of low interest rates. This belief comes from their indoctrination into Keynesian economics and has become the accepted dictum for governments since President Nixon announced, “We are all Keynesian, now”. Without any constitutional or legal authority, the function of government has now been determined to be the management of the economy to produce full employment. 

In John Maynard Keynes’ “General Theory of Employment, Interest and Money” published in 1936, he laid out the principle of the government (the people) funding contra-cyclical spending, providing money to hire out of work people through deficits or higher taxes.

Apart from the recent Trump tax-cuts, I don’t believe there have ever been tax cuts, other than as a “peace dividend” after a military war. Part of Keynesian policy was to set interest rates low during a recession and raise them in good times. To no one’s surprise there has never been an example of deficit reduction in good times. 

Keynes’ policies resulted in lenders being unable to make up for losses from defaults or late payments, which were critical in restoring the capital of lending institutions. That Keynes came up with this scheme in the mid-1930s is not surprising. In the US and around the world there was a movement toward more authoritarian government. Is it possible that this week’s “taper tantrum” was some glimmer of thought that governments might be responsible for the level of employment through low interest rates under Keynesian economic principles? Only time will tell, but very surprisingly it could happen now or in the immediate future.

What the Market Says?

The first two months of 2021 is now in the record books. The five leading mutual fund peer groups through Thursday night were:

   Natural Resource Funds         +26.38%

   Energy Commodity Funds         +24.80%

   Base Metals Commodity Funds    +18.36%

   Global Natural Resource Funds  +16.37%

   Small-Cap Value Funds          +15.83 %

Clearly, we are seeing energy and base metal prices rising, although some believe it’s not the result of short-term shortages. What is perhaps most interesting are the gains of the small-cap value funds. For years, small caps underperformed larger caps and “value” underperformed “growth”. On a year to-date basis the average small-cap fund has gained more than the average mid-cap fund, which in turn was up more than the average large-cap fund.

This change in performance leadership is broad and meaningful. The NASDAQ composite is leading the Dow Jones Industrial Average (DJIA) and the S&P 500 in both directions. I believe the reason for this is that most large index funds and closet indexed portfolios focus on NYSE listed stocks in the two senior indices. The more volatile NASDAQ attracts a higher percentage of traders and has a greater number of would-be growth companies.

The price chart for the NASDAQ is completing a “head and shoulders” reversal pattern, with the price pattern of the other indices not far behind. Valuations are high for the S&P 500, which has a price/earnings ratio of 21.5x, compared to 15.8x ten years ago. Also, because of both lockdowns and cash from the government, savings are 20.5% of after-tax income.

Investment Conclusion:

We may be near to both a short-term top and possibly a major revision in the long-term thinking of investors. 

Share your views, please.

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

https://mikelipper.blogspot.com/2021/02/debt-inflation-and-markets-weekly-blog.html

https://mikelipper.blogspot.com/2021/02/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/02/adjust-investment-tools-for-next-phase.html

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A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

More unconventional thoughts while waiting for the Metro

I am preparing this post on our drive back from a four-day birthday celebration in and around Washington, D.C. The location was picked first because it was convenient for four of the celebrants, and second that the Metro (DC's subway) made it easy for what could have been sixty people to meet for various activities. On Thursday, I was able to go from Pentagon City to the middle of the District for a business appointment in under 15 minutes. On Friday night the return trip took one hundred and five minutes. This “performance disparity" strikes at the efficiency of the government in Washington, albeit a local government responsible to the US Congress. In a related thought, I am fearful of what will be the middle-of-the-night debt ceiling compromise. I cannot predict the outcome, but what I can do is think about the inevitability of the conflict.

Unwritten elements in all constitutions

Whenever there is an unexpected crisis in a family, tribe or nation, a plaintive cry goes out to"do something." The leadership group fears that if they do not do something quickly, they will be replaced. One of the continual crises that governments attempt to address is the need for jobs. (Look to last week's blog addressing the need to focus on work, not jobs.)

The Bad Manual

Since the 1930s, almost all governments have been instructed in the writings of Lord John Maynard Keynes, a University of Cambridge scholar and British civil servant/speculator who advocated for governments to lower taxes and increase spending during poor economic times, and to raise taxes and cut spending in good times. Any realistic analysis will show that the first part has not worked most of the time. The second part (particularly reduced spending) has not been tried, thus rainy day surpluses have not been created in any sizable amounts. The theory is still widely taught and believed by economists. Economists like the theory because it places card-carrying economists in senior powerful government positions. The theory rests on the wisdom of the government elite to manipulate the economy for the benefit of the less fortunate who did not study under them in an ivy-covered hall. Early economists were professors of philosophy centered on ethics. Their thinking was based on the thought that rational humans would do the right thing if they were presented with all of the facts. The latter day economists and their political masters did not totally trust the populace to do the right thing and thus they manipulated the facts to force people to do what the politicians wanted.

Three clear examples of this current trend toward manipulation are first, the bailing out of those entities that were deemed too big to fail. Strangely, they did not realize that after every bankruptcy, the sun came up; new or different entities undertook many of the same functions at appropriate price/wage levels. The managements, equity holders and some debt holders became wiser as to the risks they were taking after experiencing their losses. The second current example is the Federal Reserve, buying treasuries to lower overall interest rates and thus stimulate lending. The result of quantitative easing was to make investment in emerging economies and commodities more attractive. Just as prior Fed manipulations created the dot-com and sub-prime bubbles, this time we may have created the biggest bubble yet in the form of significantly overpricing US Treasuries. The third manipulation was created by actions at both ends of Pennsylvania Avenue (the White House and the Halls of the Congress)for the last seventy years. The current impasse caused by the debt ceiling curiously comes as a surprise. The truth is that in deciding what is good not only for our own people, but many overseas, we have been bribing them with assets that that they couldn't afford.(Yet we treated these debts as good assets that would be repaid until periodic write-offs occurred.) We should have known that we had a government that we and the rest of the world could not afford.

What is going to happen now?

As I have already indicated, I do not know, but I fear that the result will not be well thought-out and efficient in terms of our resources, taxes and debt capacity. What should be happening is to examine the implications of an eventual default. First, at some point the risks overseas will appear to moderate, and the flight into the "safe currency" of the US dollar (and therefore our Treasuries) will become less intense and could reverse as higher and perhaps sounder interest rates will become very competitive to US paper. We should not blame only the scared foreigners for forcing up the price and lowering the yields on Treasuries. A good bit of the demand is generated by sophisticated US investors. These investors are looking for both the combination of higher return and escaping the presumed forthcoming wave of inflation. These smart guys/gals are buying commodities and other assets on margin. Guess what? They are supplying treasuries as the collateral for their leverage bets. A default could crunch the value of their collateral which supports leverage multiples of 50 times or more. If temporarily the value of the collateral should decline, unless they have other uncommitted assets, they will be forced to sell. I am hardly the only analyst to see this connection, thus any dramatic fall in the price of commodities may not be a function of inflation but a need to reduce leveraged positions. Less exposed, but tied to the US credit, are the assurances of various government agencies, e.g., FDIC,FHA, FNMA, SBA, etc. The prices of their paper also might react violently if the market really believes in a long lasting default.

Why is this happening now?

Around the world people are turning on their ruling political leaders because what they did in their attempt to do something is clearly not working. They are not producing new jobs. People want all of the benefits "promised," but they want someone else to pay for it. Their ability to achieve the retirement of their dreams is in tatters. For some time now I have questioned whether there are any truly popular governments, better than the other party or parties. However, all ruling political leaders are, or should, feel threatened.

This brings us to the current UK headlines on hacking. I am certainly not a defender of violating the privacy of individuals (including disclosures of the illness of a former Prime Ministers’ child). While there has been some apparent breeches of non-political leaders’ privacy, the strident calls for the hackers' heads is coming from the politicians and in some cases politically-oriented entertainers. If all of these people were as pure as the driven snow, they would have nothing to fear of the disclosures about their public positions or indiscreet activities. Clearly, they are human just like you and me. They must have some private feelings and doings which they would choose not to share. Apparently, that is not what the hackers in general are seeking. They want to catch the "Big Man or Big Woman" in a compromising situation which could cause the exposed person to lose face, if not power. If the people in power were secure in their popularity, probably no disclosure could unseat them. The focus on hacking in some respects is good for the powerful, in that it diverts immediate attention away from the continuing fiscal imbalances, the desires for current/enhanced services, and the unwillingness to pay for them.

What to Do?

Having the above thoughts, I am questioning the next steps in terms of our clients’ portfolios. Perhaps some of you in this blog community will share your thoughts. In the meantime, I will be patrolling the periphery of the markets to try and catch a fundamentally changing trend.

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Why Some Individual Investors Produce Better Results than Investment Committees

This statement seems counter intuitive to the practice followed by most of our great non-profit institutions. I am going to use as my point of departure a talk given by Jeremy Grantham, a very original and thoughtful thinker who is the CEO of GMO, a Boston-based investment management group. Jeremy’s October 7th, 2009 talk was entitled “Friends and Romans, I come to tease Graham and Dodd, not to praise them.” The talk focused on the potential disadvantages of Graham and Dodd-type investing. A little background may well be helpful for the members of this blog community who are not professional investors and/ or securities analysts. Columbia University is extremely proud that both Benjamin (Ben) Graham and David Dodd taught at Columbia and wrote the fundamental bible for analysts, not surprisingly titled “Security Analysis.” I had the great experience of taking the course under Professor Dodd when Ben Graham had fully returned to his investment management activities. The essence to the text and the course was to seek out value as the basis for investing in both bonds and stocks. This task was to be done by professional analysts using financial statements to find stocks and/or bonds selling below their current value. I remember arguing with the good professor, that while finding price disparity was nice, it was likely to produce a lower return than by finding prices that did not adequately reflect future value. While Professor Dodd did not totally disagree with me; he felt that there was less risk of loss by pursuing value than by following a future-focused growth approach. (At the time I was not conscious of the investment career of one of Ben Graham’s students, Warren Buffett. When Buffett looked at an underlying business, he created sensible measures of quality not found in financial statements, thus adding immensely to the valuation equation.)

Grantham's Criticism

Jeremy’s main criticism of the value-oriented investors is that they are not sensitive to the extremes in the marketplace. The value investor conducts his or her investment search the same way in up and down markets, always looking for the cheap jewels in the expensive weeds. This practice can lead to many years of gains which leads to value investors focusing exclusively on the search for value, as defined by low price/book value. Jeremy points out that when cataclysmic changes occur in the market, these investors are not prepared. At the 1932 bottom, 41 years of previous gains were lost. Ben Graham lost 70% in that market collapse, in part because he was on margin (using borrowed money). Among the others who lost a bundle earlier in currency speculation were Lord Keynes, also a user of margin. Some more trading-oriented investors recognized the extremes, like Roy Neuberger, who was short (selling shares that he did not own, but borrowed) going into the crash.

Two Critical Questions

Two critical questions came out of this experience. The first is to question the effectiveness of diversification, an accepted part of investment dogma today. The goal is to hold many assets that don’t go down at the same time, thus preserving capital. The only problem with this principle is 2008, when practically every asset class around the world rolled over into a decline of mammoth proportions. There were some, very few, investors who did not suffer substantially. I personally know of no investment committee-led institution that avoided the decline, but I do know of a few individuals who appeared to have escaped the onslaught. This realization leads us to the second critical question: Why did so many investment committees, made up of honest, hard working, investment professionals (our British friends call them “worthies”) have such bad performances?

"Prudence"

There are two parts to the answer. The first is that the legal charge to fiduciaries is to act prudently. The guiding principle comes down from the ruling by Judge Putnam in 1830 in Harvard vs. Amory, where Harvard lost the case because it did not act prudently. “Prudently” was defined as how other men of intelligence and prudence would have acted in their own accounts. In effect this set up peer-focused comparisons. This was the intellectual foundation of the Lipper Mutual Fund Performance Analysis, which made money by creating appropriate fund peer groups and measuring performance for mutual fund directors. Thus, a fiduciary that is doing approximately the same thing as his/her peers, is being prudent whether the account is going up or down in value. While this prudence fulfills the minimum requirements and answers the career-risk issue for trustees and investment managers, it does nothing to fulfill the desires of the client. The non-profit needs to pay operating expenses and occasionally capital expenses, therefore it may not be well-served by “prudently” losing money. Why then are some individuals better able to produce results than the combined brain power of a group of the worthies?

The second answer is best summed up in a quote that Jeremy uses from Warren Buffet. “The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merits, the investment is inevitably too dear and therefore unattractive.” The very function of an investment committee leads to prudent actions. I am currently chair of three different investment committees. I find that after an informed, polite discussion, a consensus is formed which rarely calls for taking an extreme action. Members of all of my committees are well-meaning people who have volunteered their time (and quite often their capital) to the institution. We almost never have the sharp disagreements that often occur within corporate or family partnerships. I wonder whether the pleasant decisions are of the same quality as the more intense discussions?

Individual vs. Group Decisions

I believe that Warren Buffet would suggest that at critical turning points, an individual’s decision-making is better than even an intelligent group decision process. Buffett might even favor a strong personality over an agreeable one. I know that trustees that do not ask the tough questions are not acting in the long term best interest of their institutions. They should find their friends elsewhere.

One of my sons and I will see whether Warren comments on this topic while we attend his annual meeting next Saturday. Stay tuned.

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