Reactions from a Contrarian - Weekly Blog # 814

 

Mike Lipper’s Monday Morning Musings

 

Reactions from a Contrarian

 

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

 

 

 

Surprises Pay More Than Consensus

Consensus, when right, is not highly rewarded. Contrarians are correct less than consensus suggests but they receive greater rewards. Over time, the bigger winners start out by being relative loners. With these guidelines, I review my reactions to media comments. (Remember, my absolute right to be wrong.)

 

The Indices are at yearly highs; therefore, we have entered a “bull market.”  Not necessarily! In some cases, these are not all-time highs. Additionally, the indices need to be measured in the most valuable currency in order to enter a new market cycle. Trading volumes are also not impressive. We live in a global world with the US dollar declining, so we ought to adjust the peaks and valleys accordingly.

 

Possibly the best summary of market moves comes from Bank of America, which describes it as emotionally bullish but intellectually bearish.

 

When the Fed pivots it will be a seminal event. Possibly, but odds are it will be late. For those predicting a pivot, they are like football fans calling the pivot wrong six times in a row. They could be right, but their odds are no better than 50/50.

 

There are at least three other reasons to question the timing of an interest rate cut.

1. The original ignition of the inflation fire was caused by the Administration pouring an excessive amount of cash into consumer’s hands and restricting domestic trade.
2. Congress pushed the responsibility for full employment to a bunch of financial economists at the Fed, which led to it becoming politicized.
3. Most importantly, the largest factor in the US economy is not the production of goods, it is services. In general, service providers don’t need to borrow money for capital expenditures and inventory.

 

Current Market Focus Does Not Address Long-Term Problems

Almost all the attention of market participants is focused on short-term events, which are expected to determine short-term results. Media performance reporting on minute by minute, day by day, week by week, and year by year results view this as the only essential reality. These short timeframes are essentially important to traders, but of little value to long-term investors.

 

Most money invested in the market is for retirement, or longer. The assumption ought to be that the average worker probably still has 25 years before retirement and a somewhat similar period in retirement. Many institutions can have indefinite lives. Thus, the things that are really important to these investors are actions impacting the long-term progress of their assets and liabilities.

 

One of the reasons good analysts and portfolio managers study history is to get an understanding of market cycles, which are caused by insufficient supply of goods and services in the minds of consumers and investors, followed by periods of too much excessive production. These trends take a long to very long time to evolve. However, their terminal stages often occur swiftly and rarely reverse.

 

Three Trends That Hurt Investors

1. Political skills are paramount over operating skills. Most large organizations are comprised of collections of people with different backgrounds and strengths. Those who rise to the top are most often chosen for their political skills, with less attention paid to their operating and investment skills. These leaders recognize that their positions have finite termination dates, so their decision process is relatively short-term, with little regard for long-term implications.
2. The costs of developing and maintaining military strength reduces the available supply for other funding. There are a relatively small number of nations with significant power. The US has historically cut military spending sharply during “peace time”, as it tends to fall behind the ambitions of autocrats. Considering the current crop of political leaders and their tendency to cut military spending after inflation. Today there is no large military power that has any respect for the current US power base. They however recognize our potential, much like Germany and Japan did prior to WWII, making the world an increasingly less safe place. The leaders of Western Europe recognize that they cannot defend themselves. One leading expert believes that Germany needs 30 years to build its own independent force to safely defend Germany.
3. By far the biggest threat to the US, both commercially and militarily, is our youth. Based on global test comparisons, US students rank below mid-point in math and not close to the top in reading and science. Remember, we probably have the most expensive educational system in the world. To protect professors the US government measures academic college success over six years. In the UK, the normal college period is three years.

 

 Other Items of Concern

1. John Authers, now at Bloomberg and formerly with the Financial Times, believes that we should expect US defaults, particularly of regional banks.  Altman Z scores are the lowest since 1987.
2. China has stopped publishing youth unemployment data. (This habit of putting out just positives raises more questions than answers.)

 

 

 

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Mike Lipper's Blog: 3 Senior Lessons + Upsetting Parallel - Weekly Blog # 813

Mike Lipper's Blog: A Cyclical World + Consistent Results - Weekly Blog # 812

Mike Lipper’s Blog: Recognizing a Professional: Ratings vs Ranking – Weekly Blog # 811

 

 

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Manageable Risk - Weekly Blog # 790

 

Mike Lipper’s Monday Morning Musings

Manageable Risk 

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

 

 

 

Uncontrollable and Controllable

Every day in almost every activity we can increasingly be the victims of bad things. That is certainly true of our investment activities. Short and long-term weather, misjudgments of governments, inflation and deflation, as well as other accidents. Essentially, these are beyond our personal control. We can try to anticipate or at least recognize these risks and attempt to take some defensive measures.

 

Controllable risks can be addressed by our own actions. In our investment actions we should be aware of the various mistakes we could make. Both large and small errors should be avoided, usually by being more patient. In making investment decisions it is wise to remember what our changing attitudes bring into the decision process. This summer may be a particularly important time to recognize that we may have entered a new phase of the market.

 

The Game May Have Changed

If you pay attention to what various pundits in the media, political office, or investment circles are saying, we are either in a "bull or bear" market. Quite possibly we are in neither and have not been in either for some time.

 

Market cycles don't follow calendars or the movement of selected indices. Investments don’t move in lockstep with one another either. My particular laboratory is the weekly performance 109 identified mutual fund sectors invested in equity, debt, currencies, commodities, and combinations of largely publicly traded investments.

 

For a two-year period ended Thursday, 83% of the individual sector averages were negative. The 28 sectors showing gains were led by Japanese funds, Energy and Natural Resource funds, Capital Appreciation funds, Alternative funds, S&P 500 index funds, Short-Term funds, and Money Market funds. (Some stock indices also reached higher price levels in this period.)

 

Two Down Years Suggests a Change

We have quite possibly entered a different phase of the market and economy. We may have entered a period of Stagflation. In the last century there were two such periods, the Great Depression into early WWII, and the mid-1970s to late 1980s. The latter period killed a popular view of buy and hold forever. In both periods there were periodic and unsustained rallies of 20% or more for the indices, and much more for individual stocks. Both periods of stagnation were led by government actions attempting to prolong an aging economic expansion. These government actions hurt investor confidence levels and suggested to the public that the economy was better off left alone in returning to equilibrium.

 

Some investors currently have equity money hiding out in bonds and money market instruments. These investors are itching to bring their equity commitments back up to "normal" level. They view declines as good opportunities, which they occasionally might be, but not often. Investors should not be impatient. If we are in a period of stagflation, averaging in with a small percentage during disparate time periods makes the most sense.

 

Long Shot

We all gamble on the future and have two choices about predicting the future-extrapolation of the present or making changes to it. On a day-to-day basis extrapolation is the most likely. The longer the time period, the more extreme the changes. There can also be periodic Minsky moments of great change.

 

What happened in Russia this weekend was a dramatic event that will undoubtedly change what happens in Russia for some time. The long shot is what could happen in how the US is governed. This is not a prediction, but an examination of what could happen.

 

First, we should understand what happened in Russia this weekend. Russia does not have a large, disciplined, and battle trained army. Consequently, it had to use a number of private armies, the biggest of which was the Wagner Group led by Yevgeniy Prigozhin who disagreed with the leadership of the regular Russian army. He claimed the Russian army told Vladimir Putin that Ukraine was going to attack Russia with the help of NATO. He also complained that Russian forces were killing Russian sympathizers in Ukraine. The feud got so bad that Putin ordered Prigozhin be arrested. This caused Prigozhin to send his troops to within 120 miles of Moscow, before some settlement was reached and the arrest warrant was dropped. It was arranged for Prigozhin to go to Belarus, a Putin friendly country.

 

The key point for the US is that Putin now has less confidence in his advisers. When powerful leaders lose confidence in their people, it is often like a disease or plague potentially leading to isolation. As this plague can impact any dominant, semi-isolated person, it could impact the current White House. There are many observers who say the current "Obama White House" and Cabinet is possibly the worst performing the US has ever had. If the President is re-elected, he will be a lame duck, making him an unattractive boss for any rising politician. Thus, major changes are expected, either for career choice reasons or due to the President's wishes.

 

Changes in interest rates will have a relatively small impact on the economy. Considering inflation is generally caused by excess demand over supply driving prices higher. What is needed are customers willing to pay higher prices for more attractive goods and services. This, however, is not what Washington is looking to do,  so there may be a change.

 

Future Outlook Appears Troubling

• After a trend is recognized investment groups often change their published outlook for the period ahead.
• It has become popular to expect business conditions to get increasingly more stressed, with interest rates rising and loans becoming more difficult to get.
• China, the second largest economy is facing its own debt problems, both at the provincial level and in real estate. The big difference is how they are handling a problem similar to that in the US. They are doing it differently.
• The latest US academic test scores show 13-year old's materially declining in reading and math. Perhaps most damaging is a drop in reading for pleasure, which appears to be at a record low.
• The Chinese central government has outlawed tutoring children in order to create greater equality, although parents and grandparents feel differently. A recent article in The Financial Times shows "illegal'' tutoring thriving, at least in the top cities. Tutoring is viewed as a way to improve a student's chance of getting into better schools and universities and consequently getting a higher paying job. When constructing investment portfolios, you should consider the consequence of a decline in US secondary school learning and a decline in college applications while China and other countries show improvement in preparing future leaders.

 

Conclusions

Investors need to recognize change while continuing to focus on long-term goals.

 

 

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Mike Lipper's Blog: Predictions Suffered Last Week - Weekly Blog # 789

Mike Lipper's Blog: Head Fake, Unrecognized Opportunity, or a Minsky Moment - Weekly Blog # 788

Mike Lipper's Blog: The Course to Explain Last Week - Weekly Blog # 787

 

 

 

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The Other Side - Weekly Blog # 677

 

Mike Lipper’s Monday Morning Musings

The Other Side

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

Approaching a Trade

Both buyers and sellers are essential ingredients in making a market. While I am an advocate for buying and owning securities to produce desired returns in a particular timeframe, most participants don’t consciously follow that approach. Many buyers and sellers ignore probable returns for a period, other than in the current trading environment. Consequently, many transactors deal with similar sets of information but have different views.

How to Develop an Investment Position

When I was the chairman of a non-profit investment committee, I wanted an investment committee similar to a Mid-Western Pension fund’s external investment committee, composed of outside investment professionals guiding a competent internal investment staff. However, I went a step further and included an experienced bear as a member of my committee. The questioning our bullish views forced us to consider the alternative and do better research. In one case, because it looked washed out to him, he recommended investing in a sector that had produced very large losses. Because of his normal bearish attitude, we paid attention to a rare bullish suggestion which turned out to be one of our best investments. This experience taught me to look at the “other side” of the argument in executing each investment.

The Purpose of This Particular Blog

Almost all commentators on the market and the US economy are bullish. Readers don’t need me to add my voice to the commentary on pent-up demand, the supply of savings, and the use of government money. You can get lots of “happy talk” elsewhere. What may be helpful are some brief points from the “other-side”. This is particularly true in the study of market cycles, where a characteristic of reaching a turning point is the almost total rejection of thoughts contrary to the dominant trend. 

Points to Consider (Not Necessarily to Accept)

1. Quarterly earnings growth rates will decline. Many companies will experience the largest percentage increase in the forthcoming cycle. The habit of comparing the current quarter to the same period in a prior year is meaningful but can be misleading. For many companies, the second quarter of 2020 was impacted by the biggest lockdown ever. Starting with the third quarter of 2020, the recovery began and accelerated in the following two quarters. For some, current earnings are a function of addressing pandemic generated shortages, which will not continue. This may be particularly true for so-called value stocks, which are often cyclical performers. A more useful comparison for many companies would be the same quarter in 2019. To claim a specific company as a growth company might require double-digit growth from the prior best seasonally appropriate quarter.
2. Recognize some of the probable drivers of inflation now and in the future. The JOC-ECRI Industrial Price Index is up +101.01 % compared to a year ago and up +2.85% in the latest week. The increased reliance on corporate tax collection drives up inflation. There are two main forms of tax collection, sales/use taxes/fees and income taxes. In many “blue governed” states and municipalities, we will likely see increases in fees for services where deficits are common. A bigger source of future inflation will likely come from an increase in income tax rates, both at the corporate and individual level. When a company is faced with a tax rate threatening after-tax income, they take steps to lesson its impact. These include raising prices and reducing expenses, the largest of which is probably labor. They might also move earnings to more favorable locations and reduce quality.
3. Understand the implications of the current size of the Majority in the House, which is 6 members. The senior vote counters are worried about the 2022 Congressional election and their solution is to pass HR1, their first bill of the year. This bill would federalize the election process and remove the states regulatory power over elections. HR1 supporters have already attacked, without reading, the latest election law in Georgia.  They now plan to bring a proposed expansion of the number of Supreme Court Judges to the floor. 
4. This weekend, the deep political division in “the chattering class” was very evident in two half page articles in The Wall Street Journal and The New York Times. The headlines for the two articles are instructive: “How a Physicist Became a Climate Truth Teller” (WSJ) and “Learning From a Family’s Investment Mistakes” (NYT). The second article fails to mention it is a repeat of a Biblical question to Jesus, asking if it is proper to pay taxes to a government not seen as carrying out God’s work. Looking at a coin and seeing the image of Caesar, He intoned “Render Unto Caesar the things that are Caesar’s; and to God the things that are God’s”. The Ford Foundation saw it differently, much to the disappointment of Ford’s heirs. (As an analyst, I believe you can make an investment portfolio grow in numerical value over time, with difficulty and some mistakes. One of the hurdles in reaching that goal is learning what and whom to believe. It is relatively easy to make judgements in terms of dollars, expenses, and reputation. The sources of verifiable truth in the “good deeds” arena are much more difficult, as truth and beauty are in the eyes of the beholder). Because of this need to find “the truth”, The Wall Street Journal interview with Steven Koonin is so valuable. (Before briefly mentioning his views, I need to identify my biases. Steven Koonin was a Provost at Caltech, where I am a senior trustee. Additionally, two members of my family are past and current students at NYU, where he started and ran their Center for Urban Science and Progress.)  His base case seriously questions man being the main cause of climate change. From my days as a geology student, I was taught how the geology of the earth apparently evolved as measured by the different levels of sediment making up the earth’s crust. At one point our midwestern region was underwater and the Sahara Desert was rich with plant life, all before man walked upright. I agree with him that we should instead be focusing on the dangers and causes of pollution impacting our health. One of the policy problems that needs to be addressed is the bailing out shore communities after repeated flooding. We need a more truthful analysis of the problems we face and how to voluntarily modify human behavior.
5. Do large commercial banks know something about credit? The leading banks made two moves this week, JP Morgan Chase (*) sold $13 billion in bonds and Bank of America (*) sold $15 billion. These sales were easily absorbed, as net flows into mutual funds and ETFs were increasing. Along with other mega banks, they also reported meaningful increases in deposits, even though interest rates on demand deposits fell to 8 basis points from 10. At the same time, they reported a decline in the amount of loans. Thus, banks are not making loans after being flooded with deposits and the proceeds from the sale of bonds. Is it possible that under the flood of stimulus cash they are seeing a smaller number of credit worthy borrowers? (*) Shares owned in personal accounts.
6. Charles Schwab Corporation (**) reported a record number of new account openings, excluding those that came in from acquisitions. Many of these accounts were young, first-time investors buying into more speculative securities, in many cases on margin. One leading market analysis group commented on the extended historically high bullish sentiment in the American Association of Individual Investors sentiment survey, saying the “lack of AAII fear is a fear itself”. (**) owned in private financial services fund and personal accounts.
7. For some time I have maintained that on balance the investors in the NASDAQ stock market are more investment savvy than those investing in the New York Stock Exchange, in which I was a former member. This is due to the NYSE attracting more non-price sensitive passive buying. This past week, 20.8% of the stocks listed on the NYSE recorded a high, vs only 11.4 % of the shares on the NASDAQ.
8. The two best performing fund peer groups for the week were commodity funds focusing on Energy +5.03% and Agriculture +3.14%. There were another 11 peer groups that gained between 2% and 3%.

In order to remain comfortable with their holdings, fully invested subscribers likely believe the somewhat negative indicators mentioned are sufficiently wrong. Please let me know privately what you believe.           

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https://mikelipper.blogspot.com/2021/04/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/04/respecting-opposition-market-weekly-bog.html

https://mikelipper.blogspot.com/2021/03/the-biggest-risk-we-all-face-weekly.html

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Watch Energy and Guns on the Trip to the Peak

Introduction

Unlike drones and more like electrocardiogram plots, investments rarely go in straight lines but undulate; frequently reversing directions which is normal.  As has been stated in my past posts, I believe that our current journey will take us to peak equity prices. Unlike Irving Fisher’s comment in 1929, I do not believe that when we reach the peak in the future that we will achieve a permanent price plateau. After the peak, there will be a measurable decline whose fall will in part be a function as to how extended the rise is above a reasonable value base. Beyond the decline we will also have future rises to other peaks.

This seesaw pattern is why I am a firm believer in subdividing one’s portfolio into time horizon and perhaps other components to protect the ability to accomplish the majority of one’s investment goals.

Signposts

No two market cycles behave exactly alike. Nevertheless, there are a number of indicators that I watch and compare with previous cycles. One of the best contrarian indicators is bond prices. A decline in bond prices is caused by the current owners not wanting to own their existing merchandise and/or refusing to buy newly offered bonds. This will lead to the need for higher yields both for the existing and new offerings. The year 2013 was the first in many that prices of bonds and the performance of bond mutual funds declined, which in turn led to bond fund redemptions. When stock prices drop some of their owners may flee the fall and buy into bonds and bond mutual funds. This is not happening now.

A second important indicator is commodity prices. At any given moment the quantity of a commodity in the hands of buyers and sellers available for immediate shipment including movements from or to warehouses fluctuates. New production from newly planted crops, new mines, and new refinery and smelting capacities will not be available immediately. Rarely will new supply come to market at prices lower than current prices. Thus, falling commodity prices are both a sign of reduced demand and expectations. These lowered expectations, along with regulatory changes, are the reasons why major Wall Street brokerage firms are exiting the commodity brokerage and dealing businesses. (This reduction in commodity capacity at some point will lead to shortages and strong commodity prices but not now.)

A third current indicator and a very volatile one is the level of stock trading. The folk law of “The Street” is that as the first trading week predicts January activity which in turn is a good, but not perfect guide for the year. The thinking behind these views used to be based on when Wall Street bonuses were paid out, but in a more modern era of a shrinking financial community, the new flows are expected to come from defined benefit and defined contribution retirement funds which would have just received their cash contributions. For whatever reason, including weather or market volume, this last week was lackluster and most prices moved very little. Some of this sleepy behavior could be attributed to a strong December and a way-above-expectations 2013. On a purely technical basis the ratio of shares sold short to the average trading volume theoretically generates the number of trading days that would be needed for the shorts to purchase enough stock to cancel out their short position. With the NASDAQ market producing much better returns than the other organized markets, some shorting, hedging, or tax management activities were done in December. This year the short ratio of the number of trading days needed to cover declined approximately 21% from the prior month to 3.79 days. This has the potential impact of fewer shares being needed to cover and therefore less demand.

Sages

One of the many blessings I have is that I know a number of very thoughtful and accomplished people. Some of them share their views in writing with others. Two in particular have said or written pieces of particular interest at this time. Jason Zweig in The Wall Street Journal (subscription may be required) suggested that we were not in a bubble. He described a bubble as similar to the South Sea Bubble of 1720 based on the presumed ability to become the principal trading partner between Europe and the New World. This is the bubble that sucked in, as prior posts have mentioned, Sir Isaac Newton. In the bubble some investors temporarily made ten times their initial purchase in the unlikely event that they got in early and sold at the top quickly.  I agree that I do not see a bubble on today’s scene, but this does not reduce the risk of an eventual meaningful decline.

The second sage that I (and a lot of others) pay attention to is Byron Wien. Each year for many years he comes up with a list of ten possible surprises. While these are clearly not meant to be viewed as predictions, he believes that his surprises have better than a 50% chance of occurring while other people would not give them more than a 33% chance. A good example is his prediction that the price of West Texas Intermediate crude would exceed $110 a barrel. He is correct that others would find this to be a surprise. A recent panel of investment “experts” were almost unanimous with predictions of $80-90. All of these people are more expert than I on the price of oil and energy in general. However, in the search to find sources of capital to invest it has occurred to me that large portions of capital invested in energy are good sources for re-circulating capital.

The energy trap

As global GDP grows there is little question that the use of energy will grow with (it if not ahead), as people become greater users of energy as they get wealthier. Therefore I do not doubt the long-term demand side of the equation. What I am doing is to raise the question of excess supply and flat to falling prices. There is no question as to the increase in US production benefiting from horizontal drilling for oil and gas. Hardly a day goes by that the US or other countries’ claims of large reservoirs of gas are being published. The costs to develop all of this production are very large. For political reasons almost every government is adding to the operating costs structure. One of the better global investment managers that I know is a great believer in the capital cycle which in its essence is that building too much capacity too quickly will lead to lower prices. I raise this concern as a potential problem for those with large energy holdings on a longer-term basis.

In my model if you have at least three time horizon components to your portfolio, I would:

1. Utilize rising prices this year to reduce some of my equity commitment for your shortest-term portfolio.
2. For the intermediate portfolio I would recognize the cyclical nature of the market and be upgrading the quality of my holdings in both the stock and bond elements. You will suffer less when the decline hits.
3. For the truly long-term portion I would keep focused on likely future markets when you intend to convert your securities holdings to spending requirements.

Guns can shoot down asset allocation.

The past year has been difficult for many who practice the art of asset allocation. For those who use domestic and international equities and debt, plus commodities, real estate, venture capital and private equity there were too many negative or single digit returns, particularly if these investments were housed in a hedge fund or a fund of hedge funds. Smart asset allocation works well if a patient investor will allow the various cycles to work out to the advantage of a long-term relationship. However, I fear the normal cycles will be interrupted.

President Ronald Reagan noted that every war that the US got into happened when others presumed the US was weak and lacked political will. The black flags flying over Ramadi and Fallujah, two cities in Iraq that US Marines and others fought hard for and managed well for the inhabitants is the latest instance of weak US reaction to a significant threat to the World. Syria and Libya are other elements of concern. As an accidental offset, Iran may become somewhat less of a problem as it may fear that it is being surrounded by battle-trained Sunni warriors. Russia, China, and a good bit of Europe and Africa may become unstable due to these conflicts and our collective lack of response.

Perhaps, some additional reserves are warranted in our investment portfolios. What do you think? 

_____________________     

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Investment Implications of November’s Inflection Points

There is a good chance that when we look back at November 6^th to November 14^th, 2012, the period that includes the US election and the Communist Party Congress in China, we will recognize an important secular inflection point.

The key was to sell

There are three time scale references that are useful in looking to the future. The first is that the media and other pundits focus primarily on the tactical or temporary time slots; e.g., when in last week’s post I recommended selling on the day after Election Day. I was wrong that there might have been a relief rally on the basis that one unknown was now known. The key to the recommendation was to sell because of the large number of remaining unknowns which were not likely to be decided until the spring of 2013. On a short-term basis the decision to sell last week was correct. Several astute investors have informed me that they reduced their 60% equity allotment to 30% on Wednesday. Another smart investor decided not to take advantage of the drop in stock prices as there were too many unknowns.

Cyclical periods

The second time frame (and the one most used by institutional investors and members of investment committees) are cyclical periods which go on for a few years. Election cycles, crop cycles, fashion cycles, economic cycles and market cycles are examples of outside forces that somewhat predictably influence market prices and portfolio returns. To participate in these cyclical periods, consultants like three years, older CEOs prefer five years and younger CEOs favor ten years as calendar periods to capture most of the other cyclical behaviors.

Always is a long time

For those of us who are managing money for succeeding multiple generations and/or institutions who believe in their eternal lives, secular time periods are more appropriate. The demographic trends, the technological changes and long-term medical developments are some of the factors that impact secular growth rates and the attractiveness of various investments. I have always been more focused on secular changes than shorter term phenomena, particularly today. I am writing the first draft of this post Saturday night, the 10^th of November, the 237^th  anniversary of the US Marines Corps. Marines believe in lots of practical virtues, but our motto is Semper Fidelis, which is Latin for ‘always faithful.’ Always is a long time and it is from this background that I look to our future, including our financial future.

November Elections

In a period of under 10 days the US and China, the two largest economies of the world conducted elections (albeit differently) that may be viewed as inflection points to the future.  The practice of analysis rests heavily on an examination of past actions. There is a well-documented history of the rise and fall of empires, or if you prefer, dynasties. The characteristics of large empires that go into declines over many years, and in some cases centuries, start with public displays of moral decay, demographic changes that create distrust between elements of the population, excessive spending by central governments, inflation leading to the practical devaluation of the currency and weak political leadership which translates into too cautious military and naval deployments. While empires fall because of their internal problems, they are finally subdued by new empires that are led by hard-working populations that want more. Often the rising empire is to the east of the falling one.

The victors in the US election and the California Proposition 30 referendum ran on the platform of raising taxes on others, temporarily defined as wealthy income generators. Few of those who supported these policies stopped to think that in the long run these impacts will be self-defeating. Ultimately, if the wealthy do not physically move, as from France to Belgium, California to Nevada, US to Singapore, or change their cost structure (employing fewer people), they will raise the prices for their goods and services. Some of the price increases will be disguised as reduced services and support, as well as less quality. This phenomenon is called inflation. We know that the impact of inflation tends to be retrogressive. The poor will suffer more than the wealthy. Central bankers around the world desire inflation which will lead to the practical devaluation of our fiat currency compared with hard assets. We are setting up a weak dollar, which will be dangerous if combined with a less capable US military/naval force.

To the East of the US is China, beginning the installation of the fifth generation of its collective leadership this week. The composition of the Politburo Standing Committee (expected to be seven) was determined by the retiring fourth generation leadership, and to some extent the third generation leaders. On November 9^th, China Daily published an advertisement in the Financial Times as to the progress that has been made under the fourth generation. The results compare 2011 data with that of  2002, which can be summarized as follows:

·        Percentage of Urban Population: 51% vs. 39%

·        Private Vehicles: 79 million vs. 10 million

·        Foreign Students: 293 thousand vs. 86 thousand

·        Fortune 500 Chinese Companies: 69 vs. 11

·        Refrigerators per every 100 rural families: 62 vs. 20

·        Cell Phones per every 100 rural families: 180 vs.15

and many other measures of physical and financial progress.

The expected fifth generation leaders have prepared detailed plans which have apparently been approved.

Investment Implications

Near-term (tactical) events move markets; thus volatility will pivot on news from both Washington and Europe. While stock market volume will probably remain relatively mild, there will be an increase in selling by taxable investors trying to avoid higher capital gains taxes. It is possible that the number of insistent sellers could create some bargain prices.

Cyclical investors should recognize that the odds are that an economic cyclical recovery has already started; led by housing, replacement/replenishment cycles, Sandy-induced repair and rebuild needs and perhaps some longer-term attention to prevent severe damage from future natural disasters. Casualty insurance stocks will get a boost when they announce their premium increases.

The secular investor needs to recognize that the next generation is going to hinge on the opportunities and problems emanating from China. Successful investing in China is problematic for us who are used to Western accounting and contract law. However, there are three other alternatives. There are some mutual funds and other institutional investors who may well be able to be successful investors in China. A second alternative would be a handful of US, UK, and European companies that expect a large part of their future growth will come from China. The third alternative would be to invest in those areas that can be critical to Chinese growth, such as Africa, Australia, Brazil and Mexico.

One secular trend identified by Sir John Templeton years ago is the shortage of high quality shares to buy. The combination of cash acquisitions and stock buybacks is reducing the pool of available shares for purchase. To a similar degree, the credit problems facing many bond issuers have reduced the amount of the highest quality paper that is available. As these needs become apparent, I have no doubt that the investment and commercial bankers of the world will try to fill the void; the question will be the quality of the new paper. Under these conditions, and I speak with bias as an owner of shares in a number of investment bankers, I would rather own them than the paper they sell.

It’s your turn

What portion of your investments do you assign to your tactical, cyclical and secular buckets?

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