Reading What is There and What Isn’t

Introduction

We are all information junkies. I am always questioning trying to find out what might be important. Thus I am absorbing both hard and soft data in my investment diet. I never know what can turn out to be a good source of facts, knowledge, or perspective; for instance my dentist, who is something of a data hound about his practice. While I was a captive in his chair and being a bit upset he was not streaming the daily programs from Bloomberg TV as usual, we were instead discussing the importance of data. He then gave me a bit of insight. On the cover of his data notebook there was  the following quotation:

“Everything that can be counted does not necessarily count; and everything that counts cannot necessarily be counted.” -Albert Einstein

Not only did this make sense but I am a bit addicted to Dr. Einstein as a great mathematical physicist. My wife Ruth and I have stayed in the rooms that were used by the good doctor at the Athenaeum, the faculty club at Caltech where he visited regularly. In thinking about what Albert Einstein contributed it occurred to me it was not new data that he discovered, and not only to recognize the meaning of what was known, but also what was not captured in the data. He identified what was missing.

If only the pundits who were wrong about the outcome of both the BREXIT referendum and the last US election knew how to look at the data that was and wasn’t, they wouldn't have been so embarrassingly wrong.

I am going to review a set of investment inputs which cross my desktop screen to seek to extract both their meaning and what is missing.

China

To my mind there is no more important topic for long-term investors to track than China. Many believe that it is only a matter of time before China will become the largest economy in the world and all that occurrence implies. We would be badly misled if we applied the lessons from our own history to China. First, we come from political cultures where our leaders for the most part were trained in law, military, or farming. Most of the current leadership in China spent time learning engineering. As part of that experience they were indoctrinated into rigorous planning as a dominant discipline. While there may be periodic disruptions there, their life is much more orderly than is what is experienced in the developed economies. 

When Premier Li, states that there will not be a hard landing as their economy shifts to fulfilling internal demand for goods and services from being export driven, I am reasonably confident that the record, as published, will show that the Premier was correct. His was not an idle boast. The Chinese political school attempts to study every conceivable possibility. They want to be good generals that are never surprised (or defeated) like Julius Caesar who claimed a great victory in what is today's France and then spent the next three days burying his dead. Also as Steve  Roach from Yale University has written from his long experience in China, the leaders know that shifts in global leadership are gradual not abrupt. Their planning doctrine allows them to be patient as long as they are making progress every day.

In the real world not everything goes as planned. For instance the public traded price of Huishan Dairy  dropped 85% in one day. From what I have been reading, many successful entrepreneurs are involved with many different activities. These men and women, are often highly leveraged, possibly with bank loans from friendly local/regional banks which they have significant stock positions.

What was not there? First disclosure, in this case the entrepreneur was missing for at least one day. Second, there was no market mechanism to slow or halt the decline, (nothing exists in China and other places like the old US specialists on the floor of the New York Stock Exchange) or in this case similar to other markets after a ten or fifteen percent drop, trading is suspended. Third, there is no equivalent to the Glass Steagall and similar Acts to avoid commercial interests affecting loans and stock purchases of banks. I suspect in a still planned central economy we will see these holes filled. Nevertheless, Western investors need to recognize the practical differences between their home markets and the newer markets in China. (This is why my accounts prefer to use mutual funds that are managed by specialists who have been trained locally.)

While in the US we are still waiting on the surge in infrastructure spending to repair our railroads, roads, bridges, tunnels, and airports, China is well ahead in its construction phase. What is quite different is that in their drive for the "One Belt, One Road" strategy they see it as a way to export their overcapacity in steel and related industries. They want to do this for trading purposes and bringing other nations and markets closer to them. Perhaps more importantly it would somewhat lessen the reduction in heavy industry jobs. I also believe like with the Eisenhower Interstate Highway system in the US, the "one road" program would aid the shifting of military people and goods where needed quickly both internally and to the borders.  All of this is dependent upon detailed planning and a high level of engineering.

United States

Applying Dr. Einstein's approach to two US focused factoids may give us some pause for thought:

Credit Suisse notes that the number of publicly traded stocks in the US has dropped in half from 1996 to the present, 7300 to 3600. (I think that is an over-simplification and could be those stocks just listed on the exchange; nevertheless there is not doubt that the number of public companies has declined.) Whatever the actual number except in industries where there is significant capital risk (technology and consumer demand for fashions) entrepreneurs are preferring to stay private until they receive an appropriate bid for the company. I know that was my idea. Not only are investors disadvantaged by this trend, it is quite possibly the economy will suffer also, as private companies with less debt will tend to be smaller in terms of revenues and job creation. The current Administration wants to reduce regulation to address this problem. I suggest they also need to focus on death taxes on private companies. There have been too many family farms and businesses that had to be sold to pay death taxes. This was a concern for me.

Combined with the reduction of the number of publicly traded companies there has been a twenty-fold growth in the number of CFA^® Charterholders (Chartered Financial Analysts) which did not serve as a barrier to entry that some may have wished. If the number of eligible securities is down and the number of analysts is rising, the odds of analysts discovering new worthwhile investments is declining.

One of the results of the difficulty of finding a lot of new worthwhile investments is the growth in popularity of Exchange Traded Funds and Products. Some analysts, portfolio managers, and security salespeople have gravitated to ETFs and ETPs.

The theory behind this was that the markets move in broad trends and the prices of ETFs would mirror the performance of the underlying stocks. Increasingly this is not exactly the case. Starting with July 8th 2016, my birthday and the birthday of the Dow Jones Industrial Average, the yield on the 30 year US Treasury went up 48%.  An ETF that was meant to mirror  the move in the 30 year Treasuries was up only 43%. The 5% difference was attributed to fees, interest expense, volatile derivatives, and a shorter bond life. Admittedly this is an extreme occurrence.  If there is an increase in volatility, as expected by some, it may be difficult for the ETF managers to exactly mirror the index they are meant to be tracking closely. All of life is cyclical. At times market prices will track very closely to the center of their universe and this is called concentration. At other times the target universe experiences more diversity. I think we have entered such a phase and we will see an increase that various passive products are not tracking  the performance of their universe because they don't own enough of the winners and too many of the relative losers.

Question: What are sensible investors missing?

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Copyright © 2008 - 2017

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

Investment Stimuli: Short-Term, Intermediate-Term and Long-Term

Introduction

Almost every moment we are exposed to various stimuli. Often we are not aware of being exposed to factors that are going to impact us at some point in our lives. One of the reasons that I conceived the Timespan L Portfolios^® is to be able to focus on the known factors that will impact investment success. As we live in a nanosecond world of instant global communication and too many instant communication devices, we are besieged by the very current items, and longer term implications are drowned out. As a defense against this condition I have attempted to assign inputs into different time buckets. While the assignments are undoubtedly imperfect, the pigeon holing helps to clear the plate to give more time to each of our client’s needs that we will attempt to fund through wise investments.

Short-Term Inputs

As an investor I try to read into the current markets for insights to the immediate future. I have found that too few investors examine the changing market structure for clues. These are some of the elements that I am seeing:

• Most people last Friday  afternoon were mesmerized by the announcement that the FBI found additional emails that conceivably will have an impact on the US Presidential election. While that is in the immediate future, to me there was a major signal to all investors. Within a period of about one hour the Dow Jones Industrial Average, the stodgiest of stock indices fell 160 points, approaching 1%. By the end of trading most of the decline was recovered. The key to me is how "thin" the market is. My apprehension is that if we have a serious negative input the rapidity of the fall could be greater. Having just come from an investment committee meeting that was in the process of changing allocations to reduce risk to the orderly payment of needs, I am very conscious that on any particular day or hour when stocks are to be sold to generate a particular sum of money, execution prices may be temporarily lower. If one uses the VIX ratio the current market is trading significantly below its historic average and way below its peak, Thus I believe we need to be prepared for substantially more intraday and daily volatility.

• High quality bond prices have been weak globally. Some point to China as the source of the instability. Spot commodity prices in Shanghai for non precious metals have been moving sharply higher recently, aluminum and zinc in particular. I suspect that the increase in demand is not an increase in likely Chinese industrial production, but a reaction to a government edict. In order to reduce a surge in heavy truck accidents, the government has lowered the size of cargo that can be carried. A further concern longer term is the fact that factory gate prices recently rose for the first time since 2012. Thus, China is no longer exporting deflation. (More on China in the intermediate input section.)

• Often mutual fund net flows can be a reaction to changing conditions. For the last four weeks it has been reported by Lipper, Inc., that there has been positive flows into financial funds. (I am the portfolio manager for a private financial services fund.)

• Once again the so-called experts have been proven to be wrong on the impact of Brexit on the UK economy. A survey of expected UK retail sales predicted a 2% decline. The latest results showed a gain of +21%. Particularly now around important elections, I question the accuracy of various predictions and pools.

Intermediate Inputs

Steve Roach, now teaching at Yale, points out China is directly or indirectly through other nations, producing just about all of the world's growth in GDP. At the moment  China is in the midst of a transition from a heavy industrial exporter to a more consumption  product and services user. While there are lots of opportunities for "hard landings" on the switch, they haven't happened yet.

In reviewing the third calendar quarter reports for brokerage firms, asset managers, and banks there seems to be a trend to reduce some of the high priced customer-facing people and building up the "tech gang." Unless revenues rise dramatically there is a good chance that some of the more expensive tech people will follow some of the investment bankers out the door. Part of the digitalization of the financial community is the awaking interest in Bitcoin, which in theory can reduce back office personnel.

One of the conundrums in dealing with the growing deficit of retirement capital globally is the individual savings rate. The FT points out that in the aggregate, the savings years are on average between 25 and 65. The periods before and after the savings years are the consuming years. While most of the developed world is experiencing little or no workforce growth, the average lifespan is growing and there is an increase in healthcare spending as we get older. Many believe that the "new normal" will include low productivity and increase costs. (I believe that there is a chance that through technology we will partly address these concerns.) However, people are worried. In a recent survey people were asked what was their single biggest worry. Of the respondents,  61% indicated that they were most worried about "Corruption of Government Officials." My guess is that people are particularly concerned about their healthcare expenditures in their retirement. I am not suggesting that the level of corruption is any worse than in other parts of our society. Just that people feel increasingly vulnerable at the end of their lives to regulation that deprives them of deemed care.    

Long Term Inputs

Often I find that a concept or thought pattern from one area in my life can have  application to other portions. For example, I have just returned from a three day offsite annual meeting of the Caltech board of Trustees. As you might expect, much of the discussion was on what the senior management of Caltech thought about what they should be doing about their future. Below are some of their topics which I have translated into our investment world:

Concentrated Excellence - Assemble only the best investments and talent, others won't do. Don't accept average.

Fearlessness & Reinvention - Don't be afraid of challenging conventional thinking and imaginatively reworking old problems. (The final proving the correctness of Einstein's 100 year old theory took 50 years of study that started with disbelief in the ability to prove it.)

Intersection of Disciplines - combine knowledge and instincts of fundamentals, price/volume studies, trading inputs and techniques with international market patterns.

Pick important hard problems - Seek large volume solutions

Heisenberg Uncertainty Principle - The mere focus on a problem changes the nature and extent of the challenge.

Committing to a funded Space Based Solar Power Initiative which will beam back to earth solar power from space could in time be a major input to our needs for energy

In summary wise investors in securities and investment organizations should strive to lead and not follow through concentrated "smarts."

Question for all of us: How do we apply these and other inputs to our portfolios and investment work?   

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Copyright © 2008 - 2016

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

Almost Everyone Is Really Bullish

Introduction

After listening to amateur and professional investors for a lifetime, I have concluded that I should largely disregard what most people say and write. What matters is what they actually do. 

At the moment, market volumes are low, people are not selling their tangible investments (including their homes and the artwork in their homes or in secure free port locations) en masse.  We are not seeing smart, investor-focused companies liquidating. In other words “TINA” (There Is No Alternative) has been replaced by “FOMO” (Fear Of Missing Out). These are two arguments as to whether or not prices will be higher. There is some stroking of one’s intellectual chin as to when and how big a valley we must ride through to get our rewards.

Two Arguments

The favored ways of reaching these conclusions are (1) reliance on our faith that the cyclical secular bull market that has existed in the US and elsewhere for two generations will continue; or (2) like my fellow numbers oriented addicts, they can pour over the current and future dispatches from the global investment fronts. As is often the case, faith wins out in terms of our emotional and psychological stability. As a continuing student of history, particularly of unfulfilled predictions, I can not say this is a wrong approach. However, in this era of microsecond overload of so-called facts and figures, I can not escape my predilection for gathering and sorting almost every morsel in the hope of finding at least temporary clarity. The rest of this blog post is designed to help my fellow missionaries as they look deeply for investment truth or at least a higher level of certainty.

The US Stock Market

We have now gone through what seems like a lifetime of not achieving a new high. It has only been one year. I remind readers that it took the Dow Jones Industrial Average sixteen years from the first time it hit 1000 until it finally surpassed that number in a meaningful way. Market analysts characterize a long flat period as either one of accumulation or distribution. If there is a sustained price rise going through the old high it is labeled accumulation. Likewise if the range-bound price level is broken on the downside it is labeled as a distribution. 

In an oversimplification, market analysts attempt to characterize the flow of money from strong players to weaker ones. History suggests the weaker ones are largely driven by emotions (as the disappearing individual investors) and the strong players are felt to be the professionals.

The Financial Services Sector

As many know I follow financial services companies intently. Most publicly traded brokerage firms with large retail business are not reporting commission income gains. This is seconded by many mutual fund management companies whose individual equity businesses are not growing. Many institutional investors continue to experience positive net flows from contributions and other sources. However, this is not just a two-sided battle between long-term institutional investors and retail public investors. In addition there is the trading community including hedge funds. As they can be long and short, they tend to magnify the intra-day volatility because of their leverage through margin and the use of derivatives.

My View

As with most who are gathered under the FOMO banner I believe that we will see meaningful new highs. Notice I did not put a time tag on the prediction or indicate how low the market may go before reaching a new high.

Index Funds, Revisited

Some foolish investors believe the way to play this dichotomy is through Index funds. The reason that it is foolish is not that it won’t participate in the move. It is exactly that it will participate, but not optimally.

According to one public survey some 71% of retail Index fund investors believe they are taking less risk than in actively managed funds. They are confusing the somewhat muted daily volatility of a broad based index with a concentrated fund portfolio. I believe this advantage is lost, as over time market emphasis shifts and leadership changes. Further, Index funds do not carry cash and rely solely on “approved participants” to bring in or take out securities.  (In our managed mutual fund portfolios we use both passive Index or like Index funds as well as concentrated funds.)

The Real World

We normally think of snow in terms of the winter. Gamblers often refer to a stream of bad luck as snow.  After recovering late in the first quarter, the global economy hit snow in April. The first confirmation to me was a luxury company that announced April sales were 15% behind a year ago. When the wealthy cut back they are sensing something. Globally, almost every company that we follow experienced what I hope is only a hesitation. This is an April phenomenon as, according to ThomsonReuters, 73% of the 493 reporting companies in the S&P 500 beat earnings estimates. (Normally the beat ratio is 63%.) What is more worrisome to me is that only 52% beat the ratio in terms of revenue estimates, suggesting some financial engineering is at work.

Are Yields Heading Back Up?

The fixed income marketplace is broad and deep and it is a bit unfair to use only two yields to identify a trend that could be something of the canary in the mine as a warning to equity investors. According to Barron’s the average yield on a group of intermediate quality corporates last week rose to 4.93% from 4.58% the week before, but still a little lower than the 5.09% a year ago. Minor changes in yields for the highest quality corporates perhaps should calm us. Money Market Deposit Accounts also bounced up.  In this case from 0.22% to 0.25%. This may indicate some tightening of the available money for consumer lending.

Two Former Morgan Stanley Thinkers Worth Reading

1.  Byron Wien, now with Blackstone, for years was reporting on his conversations with an unnamed influence he dubbed the “Smartest Man in Europe.” Unfortunately, the investor, Edgar de Picciotto, Chairman of Union Bancaire Privée in Geneva, recently died.

Wien recounted Picciotto’s numerous investment successes and his philosophies. He clearly was early onto numerous investors that did very well. I believe he had very concentrated investments. He foresaw opportunities that were considerably less risky than they appeared to others who came in later. He used his mistakes to improve his thinking. Contact Byron for a copy of his latest blog.

2.  Steve Roach for Project Syndicate has once again highlighted the US dependence on China. (He headed Morgan Stanley’s Asian business after a career as its global economist.) His view is that the US is growing by absorbing savings from China. He is concerned that this source of support for the US will not continue. Roach believes that the US needs to be generating sufficient savings to invest in its own growth.

Other Asian Views

Matthews Asia, a Pacific oriented fund group is re-positioning one of its funds. The Asian Science & Technology Fund is broadening out to become the Asian Innovators Fund. Matthews Asia sees this new focus as a much bigger mandate, as not all innovation is produced by technology. Many commercial and financial activities are benefiting from non-tech innovation. (We have been shareholders of the prior fund.)

Much of the flows into and out of Exchange Traded Funds (ETFs) is caused by shorter term traders. For example in the first four months of 2015, $65.4 Billion went into Global/International funds. In the first four months of this year net redemptions were $5.9 Billion.  In only one of the four months was there was a net inflow of $4.2 Billion. Not surprising in the first two months of the year $10 Billion exited. This kind of volatility was magnified by the thinness of most overseas markets and particularly some of the Asian markets. Investors can use this to their advantage if they counter-time their moves to the regional headlines.

Patience will be required as both “TINA” and “FOMO” are functioning, but one needs to be prepared for temporary reverses.

Monday is a Memorial Day holiday in the US, where we recognize all those who have served their country in times of war and other troubles.

_________________

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

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2016

A. Michael Lipper, C.F.A.,

All Rights Reserved.

Contact author for limited redistribution permission.