Critical Time for Critical Questions - Weekly Blog # 518

Introduction

Critical Time

For the US stock market, we may be at a critical time or juncture leading to materially higher or lower stock prices. Are we pausing in a correction or are we on the way to a full bear market of about twice the decline already experienced, or worse? Are we in the process of successfully testing the February bottom?

To me, as both an analyst/portfolio manager and a handicapper trained contrarian, I think the odds are good for the first, but not the second. To me, as an observer at the  race track, favorites typically win about a third of the time. I look at sentiment readings and the mainstream media for clues. Given three choices, bullish, bearish, and neutral, the latest weekly survey sample of the American Association of Individual Investors (AAII) has pushed the bearish button to being a slight leader. Normally, most investors are bullish most of the time. Their views are being reinforced or led by large elements of the coastal media who are proclaiming the market slide as confirmation of the supposed failures of President Trump.

Using my training as a racetrack handicapper, I suggest the odds we are experiencing a successful test is better than 60%. Those odds are in the same neighborhood as investors’ own various mutual funds which are 67.74% in equity funds. (Strange how the 2/3 to 1/3 split is similar to the standard attack format for successful battles won by the US Marines.)

As focused as most investors are on the next general direction for the market, the key is not the tactical direction, but the answers to long-term strategic questions. Just as at the track, the key to walking away a winner in dollars is how one handles the betting money. The key to being a winning investor is reasonably answering the following strategic questions.

Critical Questions

The single most important question (usually not answered) occurs when someone asks for a stock recommendation. Until a stock is no longer trading, history suggests that it will have a plus sign in terms of its performance for some period. Thus, it is not whether this stock will rise in price, but whether it will rise over a pre-designated time span. Just as it is a mistake to bet on every race during your day at the track, it is also a mistake to have a single portfolio that one believes will be a winner for the current, intermediate, and long-term. This is particularly true today, with half the stocks disappearing over the last twenty years or so.

We have been an advocate for dividing institutional and individual portfolios into separate time-span portfolios. Different securities are likely to dominate the short-term or Operational Portfolio, Intermediate or Replenishment Portfolio, longer term Endowment Portfolio and the beyond the control of the current investor Legacy Portfolio. I would be pleased to work with subscribers to construct these portfolios. The following are not recommendations but illustrations as to what we would be looking for in the candidates:

• Short term/operational Portfolio - mutual funds with a balance of short-term high quality fixed income and high quality liquid stocks
• Intermediate/replenishment Portfolio - medium price/earnings ratio stocks paying average dividends
• Longer-term/endowment Portfolio - mutual funds of established growth companies with high return on tangible assets and p/e no more than 150% of market
• Legacy Portfolio -  funds or companies that look to the next generation of leadership e.g. Berkshire Hathaway*

*Held in client and personal portfolios

One of the most difficult questions to deal with is the measurement of success. To the extent that a portfolio is meant to produce capital (principal, income or total return), the clearest measure is absolute return. If there is a competitive need to be fulfilled, then an external index or indices are needed. (University endowments are in competition to get the best faculty and foundations are in competition to get grants.) The critical key in choosing a measuring rod is how the index is constructed and changed, the rigor of measurement, data availability, and whether the proposed portfolio will be restricted to elements within the index. I have a bias in favor of using mutual fund indices and averages when they qualify. Some of the areas they cover include market capitalization, growth, value, and core, world equity and debt, sector funds, mixed asset funds, various types of bond and credit funds, and different types of money market vehicles.

Be very careful not to lump conventional mutual funds in with Exchange Traded Products (Funds and Notes). While both are registered under the Investment Company Act of 1940, they are designed and largely used differently than the larger universe of conventional mutual funds. Exchange Traded Products do not have cash to buffer market price changes and flows, they have relatively fixed portfolios and are primarily used to express specific long or short points of view. The bulk of their volatile flows come from trading organizations or advisors who trade their accounts. Recently, they have not been particularly good at handling these difficult markets. According to The Wall Street Journal which tracked the price performance of 72 stock indexes last week, including currencies, commodities and ETFs, there were no ETFs in the top 21 or bottom 27 slots. This suggests to me is that the market is reconstructing the winning and losing groups.

The purpose of comparing performances of various instruments is to create awareness of what is going on and to manage expectations. The result of measurement leads to an understanding as to what portion of one’s portfolio is for investment or speculative purposes. The answer is not always found in the nature of the instruments, but how and why the owner uses them. The market needs both investors and speculators as they often trade with each other to enlarge or reduce their universe. The changes in the value of investments and speculative vehicles are dependent on these trades. Market prices don’t generally move a lot unless investors are selling to speculators or the reverse. For example, during periods of high price momentum, with the exception of scale orders to enlarge or reduce the size of a position, wise investors should leave the action to the speculators.

Questions of the Week:

How many, if any, sub portfolios do you use?
What is the ratio in your own account of investments to speculations?
__________
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 morning, please subscribe using the email feed buttons in the left margin of Mikelipper.Blogspot.com or by emailing me directly at Mikelipper@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.

On To Stock Peak; Mild Danger - Weekly Blog # 497

Introduction

Gift buying is strong selectively in US and China this week. While political leaders emote, speculations in stocks are increasing and fixed income vehicles are displaying fault lines. Current concerns produce hurdles, not walls that can’t be breached. One of the benefits of segmenting portfolios into sub portfolios based on time horizons is to be able to focus on the impacts of various influences. This is the rationale for developing the TIMESPAN L Portfolios^® and how we look at the current picture.

Next Two Years

While most investors swear allegiance to being long-term investors, almost all that they consume in the way of views is what to do right now and that will be judged on the basis of the next month, quarter, current year and next year. They over emphasize whatever near-term payment concerns they have and ignore the impacts on longer term needs. If that is the tune that investors are currently dancing to, I will display what I believe to be relevant to this period’s dance.

In a consumer driven economy one should look at shoppers. At the local high end mall Saturday night it was crowded with people carrying a small number of shopping bags. We got the sense beyond buying, that  shoppers were examining prices, styles, quality, and inventory. At the crowded Apple^* store there were lines of buyers that began in the morning and were still present in the evening. What is on sale for shoppers are items that they could buy either at many stores, or they came to buy in one particular store, online or both - but they came to spend money. There were so many of them at three of the restaurants within the mall that the wait for tables stretched to an hour or beyond. 

In China the wonderfully manufactured Singles Day apparently once again produced record orders for merchandise and services. The purchases broadened out from buying for someone special to the buyer to the buyer herself or himself.

These controlled shopping frenzies were also present in the stock and bond markets. In the US, S&P^* has developed a quality ranking array which is different from its credit ratings. In the credit ranking array the objective is to gauge the odds on timely payment of future payments of principal and interest. Balance sheets and their future projections drive the credit ratings. On the other hand, the quality rankings are based on the income statements and the ability to grow them. In the last month particularly (and also for the latest twelve months) the companies with the low to lowest quality rankings had the stocks that appreciated the most. Obviously these stocks were perceived to have prices that deeply discounted their futures.

* I personally own shares in these stocks

Individual stock investors as measured by surveys of the American Association of Individual Investors (AAII) have a similar view as to the shoppers. In the last two weeks the percentage of those surveyed has dropped their bearish views from 33% to 23%. While this is a very volatile time series on the basis of casual conversations, it seems to be reflective of current thinking.

Equity Fund Leaders

In the week that ended Thursday, the weekly 14 of the top performing 25 performance leaders for the week were the Natural Resource and Energy Commodity funds. Six out of 10 losers for the week were with bank-heavy financial services funds. 

The enforced hotel “guests” in Saudi Arabia are probably a stimuli for the leaders. UBS points out that 70% of the world’s growth in GNP this year was caused by rising commodity prices both in energy and industrial metals. The decline in bank oriented funds could be an over-reaction from a view that materially lower US corporate taxes will be delayed and may be smaller than expected. On both the up and down sides of the week one can see the influence of news/rumor on near-term prices. I maintain the long-term trend of future energy prices were not changed by the Saudi arrests nor have the tax rates for banks changed the long-term generation of earnings and dividends of banks beyond perhaps a one time bump in 2018 or 2019. 

Fixed Income Markets Display Longer Term Concerns

Most often stock market declines are preceded by weakening fixed income markets. We are seeing some concerns being expressed in fixed income prices/yields. High Yield bond prices fell this week. Normally these, in effect, stocks with coupons which is what one wag called junk bonds, fall with the increase in the expected default rate or an actual unexpected default. Moody’s^** who typically has the best, but not a perfect record on expected defaults, is now expecting the stock market to rise because of low and declining expected default rates.

** Owned in a private financial services fund that I manage.

The fall in junk bond prices could be a reaction to the discussed restrictions on the tax deductability of interest charges to 70% of EBITDA, Earnings before interest, depreciation, and amortization.  A large amount of refinancing is expected over the next two years -  particularly by the mid to smaller energy companies that could be placed in jeopardy and possibly bring on defaults. 

Each week I look at the fixed income fund performance data from my old firm, now a part of Thomson Reuters. I have noticed for some time that US Treasury funds have consistently done better than US Government funds that often pay more interest than Treasuries. This has been true for at least five years for longer maturity funds and at least three years for the shorter ones. This must indicate that for some reason Treasuries are more valuable than higher earning agencies. I suggest one reason for this is that US Treasuries are being used as collateral for loans where agency paper is not as readily acceptable. Further I suspect that this collateral is backing loans for dealer and hedge fund securities which include positions in Exchange Traded Funds and Exchange Traded Portfolios. It is significant to point out as to the level of speculation in these markets that Deborah Fuhr  of ETFGI reports that globally this year, listed  funds that leverage have seen their assets grow 14% to $77 billion.

One of my market structure concerns is that financing inventory positions for market makers, authorized participants, hedge funds and brokerage firms is normally done with call-loans. A call-loan can be called with very little, if any, notice. Often when the loans are called the only way to pay it off is to sell some of the easily traded holdings. These are not price sensitive sales but are persistent. As in the past this can be a cause of an internal market panic. I do not rule out a recurrence of such an activity.

Endowment Period Concern

The focus has been first on low productivity of human labor. Next it has turned to capital productivity which is being addressed increasingly by additional leverage. I am now becoming more aware of research and development productivity. In each of the three productivity challenges part of the answer is better selectivity of people, projects, and research targets. All of these are being addressed, but with limited near term success.

Part of the problem is that there are shortages of attractive alternatives. Hiring more, poorly prepared laborers; committing more financial resources to low return ventures; not achieving technological breakthroughs in research; and utilizing the wrong scale for development won’t solve the problem. We need to both make smarter decisions and examine the structural impediments holding back productivity including education, appropriate returns for risk capital, and avoiding unwise intellectual property constraints. Some progress is likely in the very long-term. I just hope it arrives quickly enough to meet the retirement needs for today’s workers and students.

Misallocation of Capital

One of the advantages of focusing on Mutual Funds and ETFs is while they are large contributors of capital to our global society, they are also part of the institutional and individual mind set. For the latest twelve months looking at positive net flows of money coming into mutual funds with aggregate flows into investment categories, there are six each bringing in over $20 Billion. Five out of the six were bond funds which may do relatively little to address the productivity issues raised above. The more additive value to longer term corporate investment are equity funds. Unfortunately in spite of very good investment performance recently they are in heavy net redemptions with Large Cap Growth funds shedding $76 Billion and Large Cap Value funds $49 Billion. These net redemptions are almost actuarial in that they were purchased years ago to meet future needs which are now apparent. In the past redemptions were met by new sales. Currently it is more profitable for the financial community to redirect flows to other products. While some at the retail level is being directed into ETFs the bulk of their flows are from trading establishments that have short-term holding periods and rarely buy new IPOs. Nevertheless ETFs on many days have more net flows than the much larger mutual funds. Over the same twelve months previously mentioned, there were six ETF categories that generated over $20 Billion each. Five went into equities and one into bonds. Their flows are not likely to provide the long term risk capital that is needed for increased productivity of labor, capital and R&D.

__________

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 morning, please subscribe using the email or RSS feed buttons in the left margin of Mikelipper.Blogspot.com

Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

Look to London When Seeking Global Views

Introduction

Too many American investors and managers do not search for investment wisdom beyond their national borders. For years Byron Wien wrote about "the world's smartest investor who has passed away.”

 I do not have the skill to identify the smartest investor. For decades I have been calling on some very smart investors in London. Some of these were clients of various fund data services and resulting consulting. Others were leading investment shops or investment trusts. I continue this journey.

This last week I accompanied my wife Ruth to London to hear our New Jersey Symphony Orchestra's wonderful music director, Xian Zhang conduct a superb concert at The Proms, held in the Royal Albert Hall. I took a ‘busman’s holiday’ and spent the rest of the week speaking with a number of great money managers, corporate leaders, old friends and former associates. As usual our far ranging conversations covered both the current global investment environment through to multi-generational investing.

Shakedown Cruise

Most of my British friends don't know what to make of President Trump. He is a definite interruption of the past policies and trends that they had become accustomed. The only way I could help them with their concerns was to explain that the current occupants of the White House have embarked on what the US Navy does immediately after it launches a ship. The Navy conducts a "shakedown cruise" where the crew learns how to handle as many of the problems that might occur in carrying out their missions. From a training viewpoint, the more problems the better. Over time they learn to solve most of the problems. At the beginning of the cruise the crew does not know how long the shakedown effort will last.

I reminded my hosts that the President learned command at military school. He is a product of a Queens County, New York real estate family. Using his threatening negotiating skills, he successfully attacked other New York City boroughs and regulators to accomplish his business goals.  

President Trump is going to be different. The intramural battles in Washington are what the founding fathers expected. They did not want an imperial king. We all are going to have to learn the new dance steps to unfamiliar music.

International Investors and the US Markets

For international investors putting money into the US, it is a double bet on the dollar and local stock prices. In the past these moved in the same direction which increased their total returns. More recently while share prices were rising, the value of the dollar was dropping. (One good technical market analyst believes the dollar is "bottoming" and will rise to new highs.) Due to a left leaning press, many in London tie it to Mr. Trump. I see it very differently.

To me the dollar should not have been strong for a number of years, which in part was a contributor to the 2016 Republican electoral wave, all the way down to state legislatures and counties. The reason the dollar was strong until recently was that almost all other currencies were weak in view of their own problems. The prospects in many of these countries are sufficiently improving to a point that the locals are reducing their conversions into dollars. (I have not yet seen a reversal where there is significant selling, just less buying.) This phenomenon is being recognized by US investors who have been replacing some of their domestically-oriented mutual funds with international funds, a trend that has been going on for many years. We are also participating in this trend for our accounts.

When I see very successful multi-generational families, I look at their investment portfolios and philosophies. Most of the positions in the trust-quality portfolios are not likely to be top performers, near term.  Thus, they won’t make the lists, to use a British expression, of the “Tops of the Pops.”  As it is almost impossible to always be in the most popular successful stocks, there will be times when these former leaders will under-perform. Thus their records will appear to be more cyclical than the somewhat slower moving secular growers.

Harking back to my first professional investment job at a trust bank, the multi-generational families opted for quality of management and products. Today the long-term concerns of multi-generational investors remain focused on quality and selectivity. We seek to answer these issues in the Endowment and Legacy segments of  TIMESPAN L Portfolios^®, though these portfolios may contain other instruments that are more price-sensitive as well.

Interesting enough, the striving for quality has a place in their portfolio investing in under-served markets and these exist in all societies. The keys to these investments is to be providing uplifting services to the underserved.

The new European regulations coming into effect in January, MiFid II will raise the costs of both investors and brokers, which will lead to a reduction of investment industry capacity and is likely in the short-term to reduce the support for smaller and many mid-sized stocks.

There is recognition of the large and growing global retirement capital deficit, but at the moment no one is addressing it in a major way.

Short-Term Concern

While we focus long-term, we do not ignore short-term. One of the short-term factors that we look at is the relative yield dispersion, what Barron’s calls Best Bond and Intermediate Bonds, based on credit quality ratings.  In the last week, the demand for Best Bonds drove their yields down by 12 basis points, and prices up,  whereas the Intermediate Bonds’ yields dropped by 5bps.  The increase in price of the Best Bonds relative to the Intermediates is viewed by some as a bearish signal for stocks.  

__________

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 morning, please subscribe using the email or RSS feed buttons in the left margin of Mikelipper.Blogspot.com

Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

Emotional Preparations for the Next Markets Using Top/Down and Bottom/Up Thinking

Introduction

To some degree we are similar to a group like teenagers enjoying our first kiss. This communication skill has set us up to be exposed to other kisses. Turning to our social, political, and investment lives we are regularly being planted with kisses. Unfortunately those kisses are from those who wish us to part with our approval, votes and money. As they besiege us with kisses as translated from their sales training exercises “Keeping It Simple Stupid” (KISS).

I am particularly turned off by oversimplified presentations or sound bites by various sales types, be they be politicians, salespeople, and especially client portfolio managers and other types from wealth management organizations. It is normally a mistake to interrupt them as they have to go back to their opening line and repeat their pitch. Don’t ask too many detailed questions. By the time one gets to the third level of questions or cross examinations they are out of their depths. The good ones will stop there and change the subject to more familiar topics. The others will guess which “solutions” can be amusing but have little lasting value. Nevertheless, these presenters do have worthwhile value. They are excellent at summarization and generating memorable quotes.

Before I select a mutual fund for my clients I need to spend time with the fund's primary portfolio manager. I ask lots of questions, some they may have not addressed before. The purpose of the exercise is to assure me that the portfolio manager, perhaps aided by analysts, knows more than I do and has some different views than I do. I buy funds when it is clear to me that they bring materially added value. Often these portfolio managers are not as memorable or glib compared with their professional presenters. I still remember spending close to two hours with a well performing fund manager peppering him with lots of questions. At the end of the time allotted I looked at my list of questions and did not have any answers to my questions. What was clear: I did not understand him well enough other than to appreciate his good record. Subsequently when as all good managers do, he had some less than stellar performance, he left the large fund group with a couple of accounts as it became clear that the group was only interested in good performance not the reasons for it. It took many years for me to return to this particular shop. On return the new group of portfolio managers were good communicators of their bottoms up  analysis.

The Necessary Three Inputs

One of the better market analysts that I know is asking his clients to be emotionally ready and to be prepared to act in the future when the markets become much more cyclical with major changes of direction.

In order to prepare for these changes I believe a good investor will need three inputs. The first is understanding the “big picture” scenarios of the top/downers. The second are the contrary indications from the bottom/uppers. The third is an individual risk management levels for different components of one’s entire investment and career portfolio. In this stew one will need to be judicious in what one eats and when, without the tempting need to consume all that is “on offer.”

Top/Down Stock Market Views

Charles Schwab’s team is expecting a pull back from current levels. This is overdue in that the S&P500 has not had a 5% decline in over a year. The only strategy in using elements in the “500” to decline in the second quarter was the S&P500 High Beta sub index. It was the second highest performer in the twelve months through June which clearly demonstrates the rotational or cyclical nature of the market. The level of enthusiasm does not yet fulfill a prerequisite for a major top; the American Association of Individual Investors' (AAII) consensus in its weekly survey had a bullish jump to 35.5% from 28.2% the prior week and a bearish count of 25.8% from 29.6%. Clearly most participants have a neutral view. This and other sentiment indicators are worth watching at least as coincident measures and when they go to extremes as contradictory signals.

Bottom Up Inputs

Contrary to popular views of many of the various pundits, mutual funds are beating “the market.” Each week my old firm, now known as Lipper Inc., an affiliate of Thomson Reuters, tracks fund performances of mutual funds around the world. For investors in SEC registered funds, it divides its list into various investment objectives. In the latest week it is tracking 69 equity oriented fund objectives. For the year to date period ending Thursday the average performance in each equity oriented fund investment objective was better than the performance of the average S&P500 fund in 39 investment objectives or 56% of the universe.

In the US Diversified Equity (USDE) group there were five better performing objectives, four were growth funds of various market capitalization levels. There were 9 sector objective winners, in addition  25  of out 26 world equity fund objectives were also winners.

The latter is not surprising as fund investors and their advisors have been buying non domestic funds for over a year while their older and more long-term fund holders were completing their USDE voyages to meet educational, retirement and estate needs. What is interesting and historically surprising is in the same year to date period there are 27 fixed income investment objectives with fluctuating net asset values. Every one of these averages were positive. One of these, the Emerging Market Local Currency average (with a gain of 11.45%) did barely beat out the S&P500 gain of 11.39%.  Often when stocks go up, bond and other fixed income securities decline in price.

An Important Breakout Despite Clues of a So-Called “Likely” Pullback

Some of the leading technical market analysts are pointing to the fact that both the S&P500 and the NASDAQ Composite have twice broken out on the upside with gaps. These are usually filled in before there is an extended move. This is underpinning to the belief that a pull back is likely.

A reversal to the reversal may be imminent. In the backing and filling of the NASDAQ composite index, NASDAQ created a classic “head and shoulders” reversal pattern which often presages a reversal of the former pattern, which was rising. However, instead of declining, the index is rising - if it continues for a little bit more it could create a reversal to the prior reversal pattern and predict an important breakout for the NASDAQ. This is of great interest to small cap and technology investors and could stimulate even greater enthusiasm for their holdings.

The level of naivety expressed by much of the various talking heads about the changes in US regulations and taxes is a bit breathtaking. If Congress is instituting the changes it is likely that the bill will be hundreds of pages long. If that is not daunting enough, the number of pages of specifics including contradictions will be a multiple of the legislative documents. For instance the controversial and badly drafted Dodd Frank Act (DFA) was 848 pages and the subsequent regulations totaled 22,000 or a ratio of 25 pages of regulations for each page that was finally passed into law. Remember currently the bulk of the employees that will administer these regulations are not sympathetic to the current US Administration. Further, when the new laws and regulations come before the Supreme Court or possibly the lower courts, they will review the testimony given to the relevant Congressional committees.

Thus, when and if we get a major piece of “tax reform” enacted, my fear is that the amount of taxes that my clients and I will pay will go up not down as the reductions of deductions and permissible expenses will cancel out any tax rate reductions.

Emotional Preparations

First I accept that I will not perfectly predict the peak or the beginnings of a major decline. Hopefully I won’t be too premature or too late. My primary defense mechanism is my TIMESPAN L Portfolio^® philosophy where I can expect to be able to be defensive in certain parts of our holdings and are willing to continue to hold other parts having our large gains converted into significant unrealized losses. One can accept these unhappy results if there is sufficient capital (largely cash) in the operating component. Without scaring them too much, I try to get clients to do the same. I accept a certain amount of substantial career risk and position myself to be able to pick up bargains during the chaos.

__________

Question of the week: How are you emotionally preparing for future economic and market declines?  They will certainly occur, perhaps sooner than expected.

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 morning, please subscribe using the email or RSS feed buttons in the left margin of Mikelipper.Blogspot.com

Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.