Predictions Suffered Last Week - Weekly Blog # 789

 

Mike Lipper’s Monday Morning Musings

Predictions Suffered Last Week

 

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

 

 

 

The price movement of various securities indices reported in the electronic and old form press is believed by the public and some not very sophisticated investors to be insightful. What is worse is that the current readings compared to past readings are considered predictive of future readings.

 

On Wednesday afternoon the Federal Reserve announced that it was not going to raise interest rates. The chattering media and pundits proclaimed that this would send a false signal of a new bull market. We saw a substantial increase in trading volume compared to the rather low transaction volume seen in the second quarter. If this was meaningful, we should have seen a continuation of higher stock market prices. IT DIDN’T HAPPEN. The percentage of declines on the NYSE for the week was 1.8%, and 4.9% for the more market savvy NASDAQ. The VIX volatility indicator was near its low for the year.

One of the lessons on betting (handicapping) at the track is to first read the conditions of the race, which may be different for each race. The fixed income market is often ahead of the equity market, particularly in terms of risk. According to Barron’s, the average yield on 10 high-yield bonds jumped 50 basis points compared to a similar measure of mid-quality bonds, which declined 7 basis points. There is good reason for rates on high-yield bonds to go up, as there have been 30 defaults in the last 5 months, with 11 in the last month. This is concerning after worrisome conditions for the race changed.

Most market worriers focus on the probability of a recession, which is often quickly over, generally lasting under two years. Stagflation is another and possibility worse outcome, generally resulting in more than ten years of anemic growth with rising inflation. The Fed is watching what they call core services, which is largely influenced by the level of inflated wages.

The key background for investors was a press conference following the announcement, which was devoted to the reasons the Fed was skipping a rate increase and considering two rate increases for the rest of the year. My belief, denied by the Chair, was recognition that the Fed has become more politically conscious, much like the Supreme Court. It appears that it was difficult to get enough governors and senior staff to cogently agree to a specific policy.

This highlights a growing lack of confidence in various speakers, be they officials or pundits. Making no decision is in effect making a decision. The biggest problem facing long-term investors is attempting to meet the need to pay for future obligations. Based on past experience, the relative price of solving future needs will be higher than average prices in the same category. I expect to pay at the high end of future interest rates. Thus, in many cases my future needs will be more expensive than they presently are. I must therefore grow the capital committed to meet future requirements.

On an intermediate term basis, the cutback in the level of employment in the financial sector opens up risk to the rest of the financial losers.  It reduces potential sales for the industry, resulting in less capital and higher interest rates for the users of capital. Additionally, some departing the industry were tasked with preventing errors of omission and commission.

The soul of long-term investing is the growth and use of capital. On a long-term basis this relies on population growth and the skills of people, which are changing. Below is a table projected by some experts of the five leading countries in 2022, 2050, and 2075:

Five Leading Global Economies

2022               2050            2075
USA                China           China
China              USA             India
Japan              India           USA
Germany            Indonesia       Indonesia
India              Germany         Nigeria

While I might somewhat disagree with this array, I need to ponder these things for the benefit of my grandchildren and great grandchildren. I welcome any thoughts from our subscribers.

(This draft was partially written on a delayed flight from Newark. The United Captain explained that the delay was in part due to COVID. A number of aircraft controllers did not return to their jobs and the government actions* have been slow in replacing them. This may be one of the frictional problems leading to less efficient delivery of services. We can measure this in the overall lower productivity of labor as much as expected.)

* For example, adding politically motivated holidays when each non-working day can lower productivity by half of one percent (.5/200)   

I must make our capital work harder when interest rates drop, and stock prices do not correspondingly rise due to low productivity and government actions. We can’t afford to wait too long before we raise our commitment, even if we temporarily miss possible future bargain prices.

Conclusion

Beware of quick and easy solutions.

 

 

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We Allow Our Investment Professionals to be Lazy - Weekly Blog # 776

 

Mike Lipper’s Monday Morning Musings

We Allow Our Investment Professionals to be Lazy

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

  

 

 

The Indictment

Short-term investors are often confused with speculators. While they may produce the most trades, long-term investors own the most securities. This is why the financial media is jammed with views of short-term consequences, e.g., the next announced move and statement of the Fed.

 

Whatever the Fed does, the impact on long-term assets will be minimal at best. The key numbers for long-term investors in declining order of importance are:

1. The purchasing power in local currency at the planned terminal date.
2. An discounted valuation caused by a premature sale.
3. Third is the aggregate value of distributed income while the asset is held. This could conceivably be larger than the first case on very long-held assets in a generational transfer.

Most pundits would rather pontificate about near-term prices than speculate on the three long-term numbers which are difficult to guess and won’t be known until many years in the future. These very long-term guesses are however what owners need in selecting the current assets that should be owned. While it is almost impossible to determine the exact future valuation, it is possible to come up with relative value ranges. In many long-term portfolios there are bonds and other securities with contract relationships. What is far from certain is the price and value of these instruments.

 

Historically, possibly bigger but more uncertain returns are earned from risker equity investments than from more predictable bond-like instruments. Bonds are also characteristically less volatile, but can only possibly recover their face value plus interest.

 

Nevertheless, the lure of higher potential returns attracts investors to equities and with it higher compensation for the advisors involved. This is the ballpark I choose to play in. To do so I take the inherent risk of attempting to make reasonably accurate projections regarding the relative performance of various equities and equity funds.

 

The Playing Field

As most of our clients are US dollar-based investors my primary interest is in US activities and how non-US actions impact US beneficiaries. The following is a list of primary concerns I have about the future of the US from an investment perspective. These current conditions are rarely discussed by the popular pundits.

1. Productivity is declining, which means the US is producing less sales and profits for each dollar of investment or hours of work. Productivity translates into long-term price gains in the marketplace. In last week’s blog I noted that the S&P 500 Index had gained an annualized return of over 10% since 1871. Prior to Covid the S&P 500 rose 9% per annum. We are growing even less this year. Depending on which prediction you choose, the expected gain is between slightly above zero and 7%. My guess is that “social spending” by industry and government has cost us at least one percent. The FTC, reshoring, and energy policies are likely costing at least another 1%.
2. We have lost the drive to win a war and the related peace after our conflict in Korea, Vietnam, Iraq, and Afghanistan. Our military now has a social mission, not primarily a military mission. To win we must want to win. Our current military is underfunded and not structured to win.
3. Excluding immigrants, we like China, are not growing our native-born population. This is not going to help improve productivity. Before 2050 India will have the largest population and by the turn of the century, Nigeria and possibly another African country will likely be the leader.
4. We are likely to see a new generation of global political leaders, possibly with more authoritarian tendencies. US industrial and commercial leaders will also change.
5. US schools are producing a generation of students who do not want to work hard and effectively. Our leading STEM oriented universities will produce good managers for a while, although some of the best will leave. That is too bad. Note the number of top leaders who are foreign born or first-generation Americans. We shouldn’t lose these leaders, we need them to replace some of the current politically adept CEOs.
6. China is likely to remain the fulcrum of world growth, they work harder and smarter.
7. From an investment standpoint, private companies are growing faster than public companies due to leverage and incentives. Incentives eventually lead to these companies becoming publicly owned, which requires public markets to not be overly burdened by government policies.

 

Restructuring How We Do Things

(The following is just one example of what may occur)

Our medical/insurance complexes have become gigantic bureaucratic political bodies, where patients are cogs in a machine. For instance, a patient living in the UK who has been in remission for over 2 ½ years is likely expected to return to the East coast to see his doctor every six months. Why can’t he go to a UK medical location and electronically tie in with a US facility. If these types of arrangements can’t be worked out, the real estate implications are enormous.

 

These are the types of changes we are looking to invest in.

 

Brief Initial Thoughts on Silicon Valley Bank and Credit Suisse

Both were victims of their own business mismanagement, poorly informed clients, and poor government/industry regulation. I wonder in the long run if our society is better off letting them fail rather than partially bailing people out. I don’t know if the victims learn anything. More importantly, do investors in general learn to be more careful. I am most concerned by the last group.     

 

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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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Chinese Disruption Around the World - Weekly Blog # 524

Introduction

Most of those who think about the future of the Global economy believe that China at some point will probably replace the US as the global leader, until perhaps after a generation it is replaced with India. Based on current population trends,  Nigeria will have more mouths to feed in the future than India.

China Influences all Markets

Size, in and of itself does not guarantee a good place to invest. At this point investors, no matter what they invest in or where they invest, need to understand the ability of China to heavily influence, if not disrupt, almost all investing in stocks, bonds, commodities, real estate, art, and racehorses. While I intuitively agree with Charlie Munger that there are more investment opportunities in China than in the US, I lack sufficient confidence in my understanding as to how the winning game is played.  Nevertheless, I feel compelled to invest in China and Asia. The way I do it for my clients and myself is through selected Asian specialty funds.

The inclusion of some of the “A” shares in the MSCI indices is in response to demand from institutional investors to put money to work into China very quickly. There is more than the normal amount of risk being created, for the list of included stocks is based on size, not quality or other investment factors. This is particularly significant to what is likely to be a rash of China ETFs. When the financial reports become available there could be a positive fleshing out of how business is done in China.

Racetrack Influences

On Saturday the South China Morning Post, which is now essentially a vehicle for the Mainland government, published an entire section devoted to Horse Racing, with the kind of statistics we used to see in the US in the popular press and specific publications for racing fans. What is impressive to me is that the paper had extensive records of the leading jockeys and trainers. What is notable is that neither the leading jockeys nor trainers win over 20% of the time. This highlights my reluctance to embrace the most popular stocks most of the time.

The Chinese interest in both racing and more important breeding future champions, was again highlighted on a sloppy track Saturday afternoon when Justify won The Preakness. This is the second title to the Triple Crown after Justify won The Kentucky Derby for its largely Chinese syndicate owners. Competitors are labeling Justify as a “super horse.”

The newspaper has the same type of mutual fund price (NAV) listings one sees in London. These are paid placements which often represent the key profit item for the paper. Recently I co-chaired a panel at the International Stock Exchange Executives Emeritus conference in Hong Kong. In our lead off session with the Chair of Value Partners, I was somewhat surprised to see a good sized list of Value Partners funds and their classes in the newspaper. They even had some funds quoted in New Zealand’s currency. Most of their competitors are UK and Swiss groups. For historic and cultural reasons, only a few funds appear to be offered in the US.

Xi Jinping Cites People’s Liberation Army “Principles”

On Thursday the same paper had a front page article with a headline “President calls for stronger military science studies.” In the article Xi Jinping, as chairman of the Central Military Commission said, “Innovation has to be practical and closely based on warfare and combat issues to create advanced military doctrine suitable for modern warfare and embodying the PLA’s unique characteristics.” (Bear in mind the People’s Liberation Army has not been at war in a generation. During that period the US has almost constantly been in small wars.) Notice there is no particular emphasis on defense, which suggests offense is important and could be in the President’s plans.

The leading economic thinkers viewing China internally as well as externally are very conscious of developing economies running middle income growth to the limit. There is a fear that they become old before they become rich, as on balance China has an aging population. Japan and most of Europe  are laboring under demographics that reduce the proportion of productive human labor and an increase in the portion of the nation’s wealth spent on healthcare. (With US fertility rate at an all time low, we hope that US leaders see a similar long-term risks that needs to be addressed quickly.)

A number of funds investing in China have been shifting their emphasis away from exporters and basic industries, investing instead in consumer-oriented stocks and services. Many global and international portfolios cover their China bet with one or two stocks, such as Alibaba and/or Tencent. From a stock price standpoint, most of the time their prices parallel the so-called “FAANG” stocks, not China-focused developments.

Balance Sheets More Useful than  Income Statements

My old Securities Analysis professor David Dodd might have enjoyed my late conversion to paying initial attention to balance sheets rather than income statements. In the class (taught by the co-author of our text book) we had discussions on the proper methods of security analysis. I had the temerity to argue with him in favor of the primacy of income statement analysis. He shut me off once when we were discussing a specific security, which just happened to be in Graham and Dodd’s portfolios. He ended the discussion by informing the class and this doubter, how much money they had made on that position. Thus, it is ironic that I bring up balance sheet and related cash flow concerns in dealing with Chinese investments.

The very successful export drive that led to China being the fastest growing large economy for a number of years was based on exporting industrial goods and consumer products. On my visit to Hong Kong and Shenzhen* I was very impressed with the new infrastructure that has been put in place in under a generation. At the same time the US and most developed countries experienced deteriorating infrastructure, Hong Kong is expected to require an additional airport in 2019. (Our returning flight was slightly delayed in leaving as it had to coordinate with flights from nearby Chinese airports.)

*I would be happy to share by email the field notes of my visit to the fascinating BYD headquarters in Shenzhen.

China Experiencing Downsides to its Growth

However, there are a couple of downsides to the growth in the Chinese economy. After the farmers flocked to the cities, they used their savings to buy apartments, quickly followed by a cars, resulting in crowing and auto pollution. For this reason, the government is heavily subsidizing the production and sale of electric and hybrid cars. Thus China is the manufacturer of half of the world’s electric vehicles. This led to BYD leveraging its flows and balance sheet to a point where liabilities equaled or exceed assets. BYD is not worried however, as its loans are from state controlled banks.

One Belt, One Road Linkages

A further extension of debt was used to finance infrastructure in Africa and along the promoted “One Belt, One Road” connections from China to neighbors on the way to European markets, which will probably make use of the excess steel and cement capacity that is not being used internally in China. I am not predicting the future but rather asking prudent investors to study the history of debt-driven expansions in railroads in North and South America, and the financial history of the car business.

I will be happy to learn from subscribers about prudent ways to invest in China.

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

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Contact author for limited redistribution permission.