Preventing Investment Mistakes - Weekly Blog # 533

Confirmation and Anchoring

Confirmation and anchoring, according to a recent survey, are the two most popular biases of investment advisors. I suspect these are largely the biases of their clients. While these biases tend to drive investors at all levels into the most popular strategies and investments, they imply that the crowd is normally right, or at least it is safer when wrong to go down with a crowded ship than try to swim in lonely waters.


The Favorites

Those that search for popularity did not attend my first class in analysis of securities and people. The class was held on most days, including Saturday, in an open-air setting at various New York racetracks. The most popular horses had the smallest betting odds. These were called the favorites, as if they were like the most popular high school dates. The problem with chasing favorites is that on average they only win between 30 and 40% of the time.

More importantly, when they win, after deducting the portion of the winning pool that went to the track and state taxes, they do not generate sufficient winnings to cover the 60-70% of the time when they lose. (Like many investors, the winners do not recognize that they owe income tax on their winnings.)


Useful Information

Many investors believe that they are smarter or have more useful information than those on the other side of the bet or transaction. They quickly confuse temporary winning with greater mental capabilities. Just as various political leaders, central bankers, and pundits of all types view an errant morsel of information.

A new breed of binary judges is being marketed to investors as factor funds, which ranks and chooses securities by various statistical measures, such as revenues (Fortune), Market Capitalization (Standard & Poor’s and Russell), Earnings Per share Growth, Price/Earnings Ratio, Free Cash Flow, Current Yield, and others. Sometimes single factors are brought together into multi-factor portfolios. The problem with this approach is that if it were that easy various printers of financial statements would be the richest people in the world.

One of the early lessons from the track, security analysis, and topographical maps/photos is that these are given to all who can afford them. The key to more victories is what is missing, often in plain sight but not recorded for publication or correctly understanding the value of a corporation’s inventories, fixed assets, patents, and customers.

There are other occasions when both the buyer and seller are correct or wrong, one being an expected time span in ownership ranging from one moment to almost infinity. Another is completing a portfolio structuring or restructuring. A third might be the value of a shareholders’ vote.


Avoid Arrogance

Thus, to avoid unforced mistakes avoid the arrogance of assuming the party on the other side of the trade is dumb. Make a serious attempt to guess the motivation on the other side. They may know something that might be helpful.

The professors at Caltech believe that what we commonly call thinking is reaching back into our memory banks. There is a growing gap between those that have experienced either a bond bear market, deflation, or even a 1987 style stock market. Therefore, many investors make mistakes that seniors avoid. If you don’t know something it is easy to be arrogant and not look to understand the other-side of a trade.


Cross Winds

One of the big mistakes that far too many investors are guilty of is not examining a large enough set of inputs. Rare insights are often in plain sight but ignored by most. With that thought in mind, the following are some factoids that I saw this week which could impact some short to very long-term investment decisions:


Possible short-term inputs

The top three global market weekly advances were - Nikkei 225 +3.71%, Shanghai Composite +3.06% and S&P BSF Sensex (India) +2.48%. (Asians must believe that they won’t be hurt significantly by the trade politics, or there is massive short covering.)

Somewhat linked to the above is that the next two index risers were the NASDAQ 100 and the S&P 500 Info Tech Index. This was supported by the 18 of the best 25 performing mutual funds for the week, which likely held those types of securities.

Both the S&P500 and NASDAQ Composite were at record price levels this week, but their trailing price/earnings ratios were not higher than year ago readings. (This suggests that higher prices are being driven by reported earnings, not changes in valuation levels.) However, margin debt is continuing to grow at record levels. My guess is that margin debt is supporting speculative holdings of bonds and/or stocks.


Intermediate Term

Over the last year the average Taxable Long-term Bond fund’s total reinvested return was less than the average coupon on the bonds in the portfolio. This suggests that those investors spending their distributions are eroding their capital. To a lesser degree this has been happening for the last five years. Even though nominal inflation has been historically low, on a “real” return basis, they are eating into their spending power and are certainly doing so if they are tax payers.

With the global aging of developed nation populations, the result of longevity expansion and healthcare becoming more extensive, the underfunding of pensions is growing. This does not take into consideration the self-funding that many are or should be doing.

We may have entered into a world where the money cycle is more important than the trade or product cycle. One of the indications of the impact of technology on jobs can be seen in the oil patch, particularly for those involved with fracking. The number of employees used in extraction is flat to declining and the number used in energy service is growing and is larger than those used in extracting. It would be even higher if the service companies could find a sufficient number of truck drivers.


Longer-Term Considerations

In about twenty years, just 8 US states will comprise 49.5% of the expected population. Adding another 8 states raises the total to about 70%. These states are mostly on the east coast, California, Texas, and Colorado, although they are still unlikely to control the US Senate.

Nigeria will replace India as the home of the most poor people. While this is good for India, it suggests that Africa will likely be the home of most conflicts for many years. While I have been suggesting that the bottom performing commodity funds should be looked at for long-term investing, it may require too much patience as commodity players and farmers remind me that commodity cycles typically take 30 years.

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What does 2015 say about ’16?

Introduction

Does what happened in the markets in 2015 set a trend for 2016? In prior posts I have discussed trends and the general comfort in trend following as well as the advantages in terms of bigger profits or smaller losses while picking up early divergences from a trend. On the last weekend of the year it is difficult to separate the evidence between nothing new and as ordered in “Alice in the Looking Glass,” the lobsters continue their dance. Or can we identify future turning points? Let’s look at the current situation for clues.

Continue the Dance

What will continue in 2016? We will enter the eighth year of the second period of the key US decision maker being a woman. My concern is not that these were both women, but that critical decisions were made by people unelected and/or unconfirmed by the US Senate.  The first was the second Mrs. Woodrow Wilson and now Valerie Jarrett. In the first case, some of our British friends suggest the decisions made through the Woodrow Wilson White House set in motion both the lengthening of WWI and the critical impetus to WWII. Some may be seeing a similar pattern being caused by the current occupant’s last year in office.

The Federal Reserve is one of the worst forecasters in the US. No recession is in its forecasts at least until 2019. Moody’s won't go that far, it believes that the “wide high yield spread doesn’t mean a recession is nigh.” Further, “jobless rate and yield curve have yet to predict” a recession. Stephen Roach’s latest piece in Project Syndicate suggests the reason for this is “the Fed, like other major central banks, has now become a creature of the financial markets rather than a steward of the real economy.”

Wall Street focused pundits are at best predicting a flat to middle single digit gain for stock prices. Numerous pension plans and granting foundations are using portfolio gain rates between 5% and 8% in their planning for the next year. This relative caution could be the cause of business capital expenditures to decline a bit, but at the same time consumer expectations are higher than current readings. As of the last weekend of the year, the Dow Jones Industrial Average without benefit of dividends is down -1.5% and the S&P500 +0.1%. That is not the full story, the Dow Jones Transportation Index is down -16.6% and the NASDAQ 100 is up +9.1%. This dichotomy explains the results of most equity mutual funds with those focusing on growth particularly in global health/biotech providers showing average gains of +9.45%, which is the single best performing investment objective tracked by my old firm Lipper Inc, now a ThomsonReuters company. Whereas portfolios largely focused on manufacturing and transportation showed losses, they were not alone, a value focused portfolio produced flat to slight declines. Many hedge funds both equity and debt-oriented also showed negative results.

Using the handicapping tools I learned at the race track trying to find suitable bets on imperfect horses, I tend to pay less attention to annual moves of 10% positive or negative. Big gains and losses of significance come in packages with at least 20% moves, even if they are a bit abnormal in coming. Thus in my portfolio selection efforts for 2016 for investing in the year as well making choices for Timespan Portfolios with 15+years duration, I am noting but not dwelling on 2015 results.

Negative Inputs

1. Electronic trading, including high frequency trading (HFT) is dominating the trading in US treasuries and now investment grade bonds to such an extent that the short side in US Treasuries is now viewed as a crowded trade. (Crowded trades are ones when the bulk of one side of the market is dominated often by fast traders; e.g., Hedge Funds and Proprietary Trading desks. The risk involved is that these players may follow momentum at any price, thus creating extreme market movements unrelated to price and value.)

2. Globally the US dollar has become too attractive vs. other currencies. Thus, at the end of 2012 the Canadian dollar was trading at parity with the US dollar and now the Loonie, the Canadian dollar is worth about $0.72 cents.

Compared to most other countries the apparent political risks to capital in the US is less. Almost all markets reverse and some will find eventual bargains in other currencies selling some of their US dollars to buy attractive goods and services as well as securities. On a long-term basis I am looking to add to my Canadian holdings of management company stocks. On a very long-term basis I find the Australian superannuation (pension) business attractive and I am hoping to find some euro denominated attractive investments.

3. Moody’s regularly publishes the market interest rates being charged on operating leases. These are very sensitive to credit ratings of the issuer. What caught my eye is that the interest rate range for those in the investment quality group from the highest to the lowest is 2.05%. On the other hand the interest spread between the highest quality “junk” and the most risky credit available in the market was 5.41% with CAA credits having to pay 10.07% which is higher than the average High Yield bond.

One of my concerns about our manipulated low interest rates is that far too many loans are priced to cover the cost of capital and operating expenses and too little for the cost of credit. My worry, despite the Fed’s lack of immediate worry about a recession, is that the size of the credit losses will be larger than historically expected. In the case of the US as distinct from China, the growth of other financial lending (shadow banking) has grown to about 33% of total loans compared with about 4% in China. Therefore the US banks won’t bear all of the costs of distressed credits.

Positive Inputs

1. The lack of any well known pundit screaming about a major upside

move is probably the single most bullish indicator. One should always remember as in golf the purpose of the market is to create humility,

thus the chance to be embarrassed the most is missing the upside.

Various sentiment polls of global portfolio managers are also expecting limited gains in 2016. If they are wrong they will have to play catch-up ball and not only commit reserves quickly but switch out of some under-performing holdings.

2. Retail fund investors both in the US and Europe have been adding to their fixed income fund investments. The combination of rising interest rates and increased credit concerns suggests to me that flows out of bond funds will eventually find a home in equity funds.

3. We like to be ahead of the market and thus now are looking at 2017, the first year of the new US Administration. History shows the first year of a new Administration of either party is often the worst of the four years. Whoever is sitting in the Presidential chair  would be wise to bring on a recession as quickly as possible so it could be blamed on the former occupant. Also with four years to work with, the new President should be able to get the economy expanding and be seen to be creating jobs.

4. I am finding lots of companies in the financial arena that I would like to permanently own at current prices. Combining this with the knowledge that there is a large quantity of talent that is ready to move for the right opportunity suggests to me that there are lots of profitable opportunities ahead.

Bottom Line

Because I have a contrarian streak, I expect a different sort of year in 2016 and if I am wrong, I won’t be hurt much.

Question of the Week: What do you expect in 2016?

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Premature Selling Is Tough but Beneficial

Introduction

The vast majority of investment literature for professionals is about smart buying. Most professional investors pride themselves on their timing of purchases and thus focus on current conditions. While nothing in the art form of investing is easy, buying correctly is much easier than selling. But as active investment managers we should feel responsible for doing the difficult tasks to earn our premium pay over the mechanics, extrapolators and closet indexers.

From a career standpoint, unfortunately there is little difference from selling too soon and being considered wrong. However, any who have experienced the emotional trial of selling into a declining market have learned that it is even more difficult. All too often what appears to be a market break is a hesitation in a continuing bull market. Nevertheless, I believe I have an obligation to protect against significant capital losses for both my paying clients and the non-profit institutions I serve as a volunteer.

As many of my readers have learned I believe that my two great learning experiences were learning to handicap (analyze) at the race track and taking responsibility for my troops as an officer in the US Marine Corps. Thus I approach my current responsibilities today. Based on past analyses of recorded stock market bubbles, I believe that the odds are that some time over the next five years we could experience a major global decline in many stock and bond markets. While as Marines we would prefer to attack than defend, we have learned to capture an advantage after a hard fight. After more than doubling from the bottom of March of 2009, we should prepare our defensive positions. The enemies, or if you will the losers, that we won our advantage from will try to recapture their lost ground.

Excessive enthusiasm is not currently present, but momentum is growing

At the peaks of classic market tops, both professionals and the general investing public often plan lifestyle changes to take advantage of the wonderful new era that the markets appear to be promising. People pull cash out of savings and all too often the equity in their homes to put into the market. I remember commuting on the train with an acquaintance who announced that he would no longer be going to a well paid job at a major company. He was going to say home and day trade one stock from the Dot Com Bubble that was sweeping the country and much of the developed world.

As we examine the current US equity market, bear in mind that the NASDAQ 100 Index (the 101 largest non-financial stocks traded on the NASDAQ^* market) is selling at its highest price since September of 2000. Also the short interest ratio in these stocks has moved up to 5.02 days from 4.66 days just two weeks earlier. 

^* Disclosure: Owned personally and/or by the private financial services fund I manage.

We are not there yet. Confidence is improving both in the US and elsewhere, particularly in Europe and India with both Italy and India’s stock market showing 14% gains. Stock and bond prices are moving up with little in the way of earnings, dividends, interest income, or economic support. If this momentum accelerates and the gap between market prices and fundamentals gets to be too wide, a sharp fall could occur. Jason Zweig in the weekend edition of The Wall Street Journal summed it up well; “Those with unrealistic expectations are the first to panic after the slightest disappointment.” Unfortunately too many won’t panic as they will believe that it is just a temporary disappointment which will be reversed shortly. When the second or third disappointment happens, assets will be dumped at whatever the available prices are. The term complacency is being used frequently which indicates that investors currently are not worried. Also the same lack of immediate fear is shown in the CBOE’s VIX measure that is at its lowest level in more than a year.

Six items to consider when disposing of funds or managers

Our investment practice is to invest in funds, mostly open-end mutual funds. Recently we were asked in a formal Request For Proposal (RFP) to manage an institutional account what would cause us to sell or redeem a fund. This is an on-going process, but is taking on additional importance now that we are preparing for a peak and subsequent decline.

1. The first consideration is when a client’s needs change. We work with the client to anticipate changes both internal and external. Often in poor economic times various non-profits believe that they should increase their spending. We need to be able to support this change in planned spending rates. For corporate accounts poor economic conditions can cause lay offs which will affect retirement payouts. Also during poor periods some surviving companies see opportunities to make attractive purchases and thus cash is needed.
2. The second consideration I learned from the phrase used by the late Sir John Templeton which is that there are better bargains outside of the portfolio than in it. This is an easy choice when the client only pays excise taxes or none. For a tax paying client including in the switching costs are tax estimates including state taxes as well as federal.
3. The third consideration is when a portfolio manager or key analyst who is deemed to be critical to the investment results leaves or has significantly less time to devote to the fund. One needs to quickly assess the team around the manager who at least temporarily will manage the portfolio.
4. The fourth consideration is one of too much success. Can the existing portfolio manager handle a sharp increase in assets?  A related consideration is whether the very success of the fund has brought in more high quality competition that will make the job of the portfolio manager more difficult.
5. The fifth consideration is unexplained performance both on the upside as well as on the downside. Is the fund changing and why?
6. The sixth consideration is if the management company undergoes a significant change in ownership or organizational structure. This is of particular importance if it affects the fees and expenses of the fund and the financial/psychic income of the key portfolio managers, analysts, and traders.

Note that performance ranking is not a direct consideration. If we do our job correctly and particularly understand the underlying portfolio, the performance over time will take care of itself.

Please share with me publicly or in private communications what are your rules for switching investments and how are you preparing for the next bear market?  

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Copyright © 2008 - 2014

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