Both Elections & Investments Seldom What They Seem - Weekly Blog # 860

 

Mike Lipper’s Monday Morning Musings

 

Both Elections & Investments

Seldom What They Seem

 

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

 

 

  

Gilbert & Sullivan nailed it when they titled one of their songs in H.M.S. Pinafore “Things are Seldom What they Seem”. This title should be attached to every article that discusses the investment implications of the next election and future elections. Currently, almost all the chatter is about the Presidential election, which also gets exclusive attention overseas. This is naive in the extreme for the following reasons:

1. Whoever is going to be sitting in the Oval Office will not likely be there for another term. Thus, they will likely have limited political power on Capitol Hill.
2. The House must start all tax and spending bills and both parties are split along ideological lines.
3. The Senate, with 6-year staggered terms, requires critical legislation to be passed by 60 votes. They wish to terminate the filibuster rule. Politically, the senate is even more divided than the house. Additionally, a number of senators are interested in having a seat in the White House and they typically have larger financial estates than members of the House.
4. Both political parties believe Washington should dictate what Americans purchase by using grants and tariffs. (Democrats favor “EVs” and labor union produced voters, while Republicans seem to favor tariffs. Our economic history shows that countries supporting consumer choice grow faster and sounder.)
5. With deep divisions on Capitol Hill and changing legislative leadership, including the chairs of committees on the Republican side, it is going to be difficult to get bills passed.
6. The role of the Supreme Court will be critical. The present Court believes it is responsible for determining when cases comply with the written Constitution. This Court decided that a prior court decision on Roe vs. Wade was unauthorized. The issue was not about abortion, but whether the “Warren Court” 50 years ago sanctioned abortion under the Constitution. The Founding Fathers limited the powers of the Federal government to those items specifically enumerated in the Constitution, leaving all other decisions to the individual states.   

 

Possible Peak Two Fridays Past

Some investors are more focused on their long-term investment responsibilities than political decisions. However, too many economists have become mathematicians and too many political scientists have become statisticians.

 

Some of the signs that all is not well:

1. AAII’s weekly sample survey of investor sentiment changed dramatically. Two weeks ago, there was 20 percentage point advantage in favor of the bulls for the next 6 months. In the most current week, this position shrank 7% points.
2. The weekly share volume on the NYSE declined 42,209 shares, while NASDAQ volume rose 3,034,261 shares. (Considering prices fell during this period, the increase in volume is bearish.)
3. Standard & Poor’s tracks 32 indices weekly and only 1 rose last week, by only 0.05%.
4. The underwriting of speculative bonds rose sharply in late September and thus far in October. The sharp increase in underwriting was well beyond the need to refinance existing debt. This suggests savvy speculative bond issuers see higher rates ahead when they need to sell more debt.

 

Question: How do you see interest rates in late 2025, 2026, and 2028?

 

 

 

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Mike Lipper's Blog: Melt-Up, Leaks, & Echoes of 1907 - Weekly Blog # 858

Mike Lipper's Blog: Stress Unfelt by the “Bulls”, Yet !! - Weekly Blog # 859

Mike Lipper's Blog: Mis-Interpreting News - Weekly Blog # 857

 

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Markets Are Time Frame Exchanges - Weekly Blog # 796

 

Mike Lipper’s Monday Morning Musings

Markets Are Time Frame Exchanges

  

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

 

 

 

Who is in Today’s Crowd

The bulk of investors are not currently active. August is normally a low volume month, but it appears we are not in normal times. There appears to be less conviction as to where we are going. A reasonable bet is that the majority of opinions regarding future direction are wrong.

 

This week we heard two opinions which the media suggested were in contrast with one another. Fitch lowered its credit rating on US Treasuries by one notch to AA+ from AAA, while Jaime Dimon stated that no large country has a stronger credit condition. Actually, they are probably both correct, the difference is in their function. The Chairman and President of JP Morgan Chase was reassuring depositors that the US government was currently the safest place to invest. Fitch as a credit rating forecaster, was suggesting future political battles within the US could delay the promptness of the US government in making payments on all its obligations. Both could be correct.

 

Jamie Dimon is probably correct that US government payment dates will not currently be violated. (This excludes delays in payments on various government contracts, which are not funded obligations.) Fitch raises the question as to when the political process in the future could lead to some delays. These are important concerns, but it is not the total picture as far as investors are concerned. 

 

A funder of the US government who will be repaid in devalued dollars due to high levels of inflation. An added concern is the foreign exchange value of the US dollar in a world that is increasingly measured in other currencies. Both geopolitical and economic factors may make the dollar worth less when purchasing essential items from overseas providers. (Energy, clothing, critical medical resources, etc.)

 

Looking beyond the next few years the picture looks less promising due to aging populations in the US and around the world. Both the US government and private sector are failing to build up the reserves necessary to pay retirees likely to have health issues. Historically, the next generation utilizes their working years to pay for their own retirement and the care of their seniors. That is not happening now. Many workers currently spend all they earn and do not focus on long-tern cash generation.

 

Other Disturbing News of the Week

1.  The current President looks to FDR as a great, if not the greatest, president. FDR believed his greatest achievement was the National Recovery Act of 1933 requiring competitors to meet and agree to wage rates for their employees. The higher the better. The act was ruled unconstitutional by the Supreme Court.

2.  The UAW is demanding the “Big 3” give their workers a 40% increase. (This is the same union that forced the US auto companies and their suppliers to raise wages, leading to an increase in foreign manufactured car imports and a decline in US auto exports.

3.  One investment adviser called to my attention an article by Bob Kirby, the great salesman from the Capital Group. His article, written in 1975, showed how each generation fails to learn from the past. Bob earned enough during his lifetime to endow 5 scholarships at leading universities, hoping to correct this situation. Caltech was a recipient of one of these Robert Kirby scholarships.

4.  Xi, the Chinese Leader, measures national success in terms of technical self-sufficiency.

5.  For the past week only 2 of the 31 Dow Jones-Standard & Poor’s market indices were up, these were select micro and internet services.

6.  Only 5 of the 72 price indices published by the WSJ each Saturday were up this week. Three were energy and two were currencies. Wheat and corn were the two biggest losers.

7.  A US Navy Petty Officer was caught supplying detailed photographs of an attack amphibious ship to a Chinese agent. (One of the many difficulties facing an amphibious landing on Taiwan is the lack of amphibious ships and their training. Over 60 years ago I served on such a ship as a USMC Combat Cargo Officer.)

8.  Last week, volume in NYSE stocks declined 59% vs. 62% for the NASDAQ.

9.  Major advertising agencies are cutting their estimates for the rest of this year because their clients are cutting budgets.

 

Conclusions

The Fitch credit rate cut was not the only bearish news that caught my attention last week. The comparisons with the FDR led Depression is a bit unnerving. What is clear is that while the bulk of the US focuses on the general movement of the dollar, many in Washington are focused on the probability of votes, particularly at the top of the tickets.

 

What are you seeing and believing?

 

 

 

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Mike Lipper's Blog: Possible Investment Lessons - Weekly Blog # 795

Mike Lipper's Blog: Cross Winds - Weekly Blog # 794

Mike Lipper's Blog: Two Cycles Are Worth Watching - Weekly Blog # 793

 

 

 

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Can Credit Ratings Be Sexy?

The Mae West quote that “too much of a good thing is wonderful” reflected her playful method of sexual innuendo and is the way many investors view credit ratings. Upon her other revelations, I do not believe that the burlesque queen, movie star and stripper was conversant on how bond credit ratings affect relative stock price performance. But that is the dilemma that I have been working on this week. I come to view this issue from two divergent vantage points .

My challenge

I manage a number of balanced (bonds and stocks) accounts for institutions as well as wealthy individuals. As part of our responsibility for one client with multiple accounts we have the task of managing an all fixed-income portfolio in separately managed fixed-income securities and fixed-income mutual funds. In connection with this client I am reviewing and updating the account’s investment policies. At the time of the inception of the account in 2007 certain quality and diversification standards (or what now appear to be constraints) were mandated. As mere thoughtful mortals drew up these policies they did not consider the current tiny short-term interest rates and their manipulation by the major central bankers of the so-called developed world.

High quality, poor relative performance

My associates and I have been reviewing various stock investments of certain equity funds to understand their past two years of relative under performance compared to their perceived peers. In these cases the absolute performance of individual stocks and funds has produced positive results. However their relative investment performance was disappointing. The one common characteristic of the portfolio managers of these funds is that they are oriented toward owning high quality investments, a bias that I share. On average many of these relatively underperforming stocks are higher quality than those found in their relatively better performing peers.

These formerly successful funds are believers in investing in quality companies many of which would have sounder balance sheets and higher margins than found in their relatively better performing peers.  The market recovery phase started in 2009, accelerated in 2012 and continued thus far in 2013. During this period of extremely low interest rates the less credit worthy companies were able to borrow money at historically low rates. With new capital they expanded their capacity and were also able to lower their selling prices which put their higher quality companies at a disadvantage, at least in the eyes of the stock market.

The fiduciary’s selection dilemma

On the one hand we need to set the filters so that managed accounts can meet their funding requirements under practically all absolute conditions. And on the other hand we seek to earn relatively good intermediate and long-term investment performance.

One of the characteristics of all professions is to use codes to abbreviate concepts. In the investment world one very important code set is bond credit ratings. These are thoughtfully issued by three major credit ratings groups Moody’s^*, Standard & Poor’s^*, and Fitch in various stylized alpha numeric abbreviations starting with the most secure, AAA and declining in terms of potential defaults down to D. On average and over time these ratings have done a more than reasonable job of alerting investors as to forthcoming defaults. However, as with all work done by humans, they are not perfect. As a practical matter investors worldwide recognize as far as taxable issuers are concerned that the first four full ratings are so-called “investment grade.” The term investment grade came out of a case in the 1930s that decided that the first four grades  (AAA, AA, A, BBB or their equivalents) were appropriate as high quality investments for fiduciaries. Since then the lower credit ratings were referred to in polite society as non-investment grade or high yield but the in argot of  “the street” as junk. Notice this whole exercise deals with the probability of timely payment of principal and interest, not whether they are good investments particularly in considering current prices.

Funding vs. performance

There is another decision tree axis which is not quite as well known, but in many respects more important. The filter for this matrix is the earliest expected involuntary pay back or maturity date. Once one is assured that the debt will in all likelihood be paid back, the twin questions facing the investor are how long will this stream of income be delivered and (in many ways much more significantly) the interest earned on the reinvestment of the interest received. For long-term bonds, under “normal” conditions, the size of repayments of principal, total interest received and the income earned on reinvestment are listed in reverse order of aggregate size. For instance even a low 3% coupon payment reinvested for 30 years in available, high-quality paper will be significantly greater than just adding up the interest payments paid on the bond, or the return of the original issue price. While this concept of interest on interest is mathematically correct, for many individual and institutional investors it doesn’t work that way. The reason they own fixed-income securities is so that they can consume the interest payments to meet their various funding needs, for example to make grants, pay for maintenance of people and facilities, etc.

Investment Policy Statements

One of the advantages of blogging is that occasionally one can see the discontinuity in one's thinking. Investment Policy Statements (IPS) are legal documents typically imbedded within contracts or board minutes. Often they are drawn up by lawyers or at least blessed by them. As with the U.S. Constitution, essentially they are limiting the powers; in this case the investment manager or investment committee. IPSs do not focus on how to make money for the account, but detail what not to do. This blinding realization came to me as I started to write about credit ratings, recognizing credit ratings can be sexy.

AAA vs. AA

We prize high credit ratings in an IPS, the closer to AAA, the better. In terms of attempting to make money for the account, as an analyst/portfolio manager and investor there are times that I question the cost to the investor of an AAA rating. Let me give an example of two holdings in my private financial services fund. Both Automatic Data Processing^* and Berkshire Hathaway^* are major beneficiaries of the floats of their clients' money. At one time both companies had AAA ratings. Now ADP has the highest rating, Berkshire does not. (Berkshire was downgraded to AA some time ago.) ADP is one of a handful of large US companies that has an AAA. The reasons given for the downgrade of Berkshire was the increasing risks inherent in its reinsurance activities. Both of these companies have had a practice of acquiring other companies. ADP has slowed down in these activities while Berkshire has not, as it has been buying large and mid-sized companies. While both companies' stocks and bonds have risen in price, the AA has clearly outperformed the AAA. Many analysts believe if ADP could find suitable acquisitions that do not threaten the perceived quality of its large short-term float, the prices of its securities would have done better.

Betting against dropping ratings

Recently Moody's^* announced that will be lowering the ratings on four of the leading financial services companies; JP Morgan^*, Goldman Sachs^*, Morgan Stanley^* and Wells Fargo^*. For the moment Moody’s is leaving the ratings on Bank of America^* and Citigroup^* unchanged. Interesting the two unchanged companies have very recently done better shedding their endangered zombie species. The bulls on these two stocks will acknowledge that they are work in progress with the hope that they can approximate the returns of the four leaders.

^* Owned in a wide range of sizes by my private financial services fund or by me personally.

The official reason for the downgrade is the belief that if any of the four leaders ran into financial problems the levels of bailout will be less. Quite possibly true, but I wonder how germane? As an investor and entrepreneur addicted to the long-term, I would much rather own the businesses and more importantly the people of the four leaders than the two turnaround candidates. If protecting their credit ratings and other fortress-like characteristics has prevented them from intelligently expanding their activities or handling their leverage better, the lower ratings could help us shareholders.

I could use your help

I am still struggling with what to put into an institutional IPS in terms of its fixed-income investment accounts to meet some specific needs as well as general strategic balancing needs. Please contact me with your views.

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All Rights Reserved.
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