Investors Need to be Wrong to be Right – Weekly Blog # 515

Introduction

Investing is an art not a science. In science the search is for a repeatable answer under every identified condition. As strong as it may seem to many, the search is not in the end the largest performance number. The search is the delivery of the required funds to meet the accepted needs of the beneficiaries; be they institutions or individuals investing within the realms of prudence. Thus, the investment manager’s primary function is to aid in the feeling of the well-being of the beneficiary. According to a recent report on happiness as applied to nations, well-being is based on income, healthy life expectancy, social support, freedom, trust, and generosity. It is far easier to contribute to well-being through sound investing. I believe our clients hire us to provide sound investments for them in order to accomplish their well-being. Thus far I have been able to deliver. But much of this is not based on the certainty of math and science that I learned in school and university, but as a handicapper at the New York racetracks. From an investment standpoint what I learned at the track that is useful can be summarized as follows:

1.  The objective is not to win every race but to finish the day as a winner (including expenses).

2.  Don’t bet on every race, there could even be days when no bets are made as the payoff odds are not appropriate to the probabilities foreseen.

3.  Occasionally the most popular bet is logical in terms of expected results, but the payoffs are too low because it doesn’t take into consideration what can be called “racing luck.” At these times it could make sense to invest in the second or third most logical horse if they are being offered at reasonable odds for second or third place and turn into larger money makers if racing luck overcomes the favorite. This is a good bet as favorites rarely win, even half the time.

4.  After concluding the most logical result, the real analysis begins, which is how much should be bet on this horse in this race? Weighting one’s bets can make the difference of a nice win vs loss record and walking away as a winner for the day.

5.  Accepting that I was wrong an uncomfortable number of times, but learning from the experience by re-examining both my analysis and how I handled my money and to a lesser degree my expenses.

Thus, I believe that, like other investors, I will be wrong in terms of market direction, sectors, “factors” and selections. To defend our beneficiaries’ interests I have adopted a policy of having a number of different bets at the same time, but with the recognition that unlike at the track where races end, the investment process continues through many cyclical periods.

“Goldilocks” May Be Leaving

Liz Ann Sonders of Charles Schwab among others is raising concerns about the future. After all, for at least nine years it has been somewhat easy to ride the secular rise in the US stock market. (Shorter periods for other stock markets.) This issue brings up a number of questions: evidence of impending change and what should be the correct investment policy going forward. In terms of evidence of impending change there are two important elements:  flows into stocks are from traders not investors and credits may be mispriced leading to fixed income not providing stable values. This week some in the press for the first time are heralding significant flows into the equity market from “funds”, which shows the Public is buying the current conditions. The truth, according to Thomson Reuters’ Lipper Inc., is that $20.4 Billion came in net, but $18.7 Billion went into domestic oriented ETFs with $8.2 Billion going into the SPDR S&P 500 and $3.1 Billion into PowerShares (Invesco*) QQQ. Both of these are favorites of hedge funds and other traders. In numerous cases ETFs and ETNs are being used by these players as substitutes for futures which are more expensive. I am noting that a number of investors have sold short some ETFs that represent over 10% of their assets and in at least one case over 100%. What may be more disturbing is that a number of independent investment advisors and a number of advisors working through brokerage firms are managing discretionary accounts exclusively in ETFs/ETNs. Some of these are probably good, but I suspect many do not have any successful background in market trends, sectors, “factors” and the selection of individual securities. They may be, along with others, contributing to a much higher turnover rate in ETF/ETN portfolios than conventional mutual funds.

*Invesco is held in a private Financial services fund and personal accounts that I manage.

Credit Concerns

Remember that most significant stock market declines begin after a period of fixed income market declines. Through March 15th most bond funds are showing a slightly negative total return, which includes both their income and their market movement. The only domestic groups that are not negative are loan participation funds, some specialized credit vehicles, and ultra short maturity funds. I don’t know when the next recession will commence, but I expect it will be within this first term of the President. I do know that during a recession bankruptcies and other financial difficulties occur and they are not being priced into the market. Institutional term loans are being priced at only 3.2% above prime corporates, compared with 3.1 % before the crisis that began in 2007-8. Further, while banks have much more capital than they did before the last crisis, their book of derivatives is somewhat higher.

In a talk at a Futures conference last week, my old friend Tom Russo, formerly General Counsel to Lehman Brothers, mentioned that when a counter-party believes it was duped, the entire class may be considered illegal as an auditor will have difficulty claiming the asset is worth 100 cents on the dollar. He said, according to the Financial Times, that “when you owe a little bit you call your bank - when you owe a lot you call your lawyer. “A good bit of derivatives are directly or indirectly financed through the credit market.

What Should Investors Be Doing Now?

There is no special reason for long-term investment policy to be changed as long as it contemplates that there will be periodic market declines. This is similar to money that is invested in what we label Legacy and Endowment Timespan L Portfolios®. For those with a shorter focus of at least five years, they should be making two lists of equities and equity managers.

The first list should be of items that at higher prices would become risky if the general stock market rises at a rapid rate. (There is some chance of this happening as new money rushes in on the basis of buy-the-dip or FOMO fear of missing out.) The risk is that such a surge most often leads to a major fall, which could lead to structural changes. The second list should be labeled “Hopefully not to be used, but probably will be.” It is a list of sound companies and managers who may be slightly damaged in a decline but will survive and prosper. Both of these lists should have names and prices scaled to avoid emotional price reactions. Five or ten price points could be prudent.
__________
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 - 2018

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

Danger Ahead, New High Stock Market: Is Capital Preservation with Appreciation the Answer? Weekly Blog # 514

Introduction

At the end of February I was about to suggest that both the high and low for the year 2018 were in place. If either price was violated it would be troublesome. After the first nine days in March I am getting much more concerned about a breakout above the January highs.

Why are Higher Prices Dangerous?

Perhaps I am jumping to the wrong conclusions, but for many the 400 point rise of the Dow Jones Industrial Average on Friday can be chalked up to volatility, but others may see it as a successful test of the February lows. (I would have preferred a lower test with more volume of trading and statements of discouragements.) But the realist needs to accept reality, not wait for the perfect. There is a good chance that others will see it as a successful test, encouraging buyers with significant power to return and drive the next upward move. Using the very volatile sample by the AAII, 45.2% of their surveyed members are now neutral, which is higher than both their bullish and bearish members. This is a rapid change from just three weeks ago where the neutral tally was 32.6%. In the recent week the top 25 performing mutual funds had gains between +7.77% and +6.07%. All but one of these were growth oriented and or specifically science & tech oriented. 

Thomson Reuters tallies analysts’ earnings estimates and in their latest report the analysts expect the S&P600 Small Caps to have earnings growth for this year of +24.1%  compared with +19.45% for the S&P 500 and +37.67% for the Russell 2000. Both the fund performance leaders and earnings estimates are based on a belief that the future is going to be good, led by positive future developments in terms of technology, politics, and economics. (Perhaps they will be correct.)

After nine years of rising markets, I have been on the lookout for signs of an inevitable market decline. In terms of magnitude of decline a normal cyclical decline is in the range of 25%. These happen normally once within a decade. Not too many people are psychologically wiped out in these declines and usually return to the stock market within a few years after the decline.

A much more serious fall, that is often labeled a collapse, happens infrequently, normally once a generation and is generally in the range of 50% from the peak and has investors leaving the marketplace never to return, This type of fall is in the passing on their distrust of the market to the next generation. The individual and societal losses from these collapses are relatively small compared to the forgone profits from the recoveries, which impacts the rest of their lives and often also the next generation’s. As both a fiduciary and an investor I would like to avoid these results. I attempt to do this with an eye on a number of different market histories.

The major traumatic collapses start with apparently successful investing, that not only turns a small amount of money into a larger amount of money but inflates the investor’s belief in their own investment skills. Often this confidence leads to the use of borrowed money in the forms of margin or derivatives. A speculative fever takes over the crowd, while they recognize there is some risk their confidence is such that they can get out without large losses.

The driver of these “animal instincts” is based on an unshakeable view of the future. These speculative markets are driven by sentiment, not researched fundamental investing. This is why I am paying more attention to measures of sentiment, along with attention to internal financial calculations.  One of the fuels of a major top is the sucking into the market of all or most of the available cash.

Assuming the US and perhaps other markets pierce their former highs, the various pundits, including non-professionals, will proclaim that those not participating are stupid. They have never studied handicapping at the racetrack where in each race there is likely to be at least one horse with a good, very current record receiving a disproportionate amount of the betting money. This is the favorite of the crowd, no different than the current market where leading funds are heavily invested in a select group of multinational tech companies. At the track, while the favorites do win at short odds, they don’t win enough money to cover the losing bets the majority of the time.

I am concerned that over the next year or so too many investors, including those institutions that are de-risking, will get sucked into the market. My fear is not for them alone after their disappointment of losses from the next peak, but for the opportunity losses in a future recovery. Unfortunately in our society these are the losses that are socialized for the rest of us to pay.

What are the Signs to Watch?

Currently, the most visible largely speculative source of flows into and out of the market are the Exchange Traded Funds (ETFs). Much of the current activity in these securities is by traders, often at hedge funds, who are using ETFs rather than more expensive derivatives. In the last week, while the larger mutual fund industry had a small net inflow due to net purchases of non-domestic funds ($2Billion), ETFs had a net outflow of $12.6 Billion with $10.3 Billion in one ETF invested in the S&P 500. This is a sign of a trading market that has lots of speculation occurring.

The second item to watch for soon is mutual fund advertisements heralding their ten-year performance results, which had been trailing more current periods. It is easy to look good from a bottom in March of 2009.  These market efforts could bring a lot of unsophisticated money into the stock market, which will entice the so called sophisticated players to trade the market on the way up convinced that they can get out in time.

What can a Wise Investor Do?

In an over simplification, portfolio strategies can be divided into two buckets: Capital Preservation and Capital Appreciation. For some of our clients, particularly those who have worked hard for their money, their primary concern is capital preservation. This is particularly difficult today if one is concerned about after inflation and after tax earnings. Around the world, governments in theory are sponsoring inflation as a way to create jobs, by ballooning the income of businesses and individuals. What they are actually doing but not discussing is lowering the purchasing power of the loans that they are repaying. This is a continuation of a trend, as governments since their beginnings have debased their currency as a way to payback less value than what they received. 

To the capital owner and the individual, inflation is another form of taxation. In the current environment income taxes are not the only source of pain. Because of the recent changes in the US tax code, I believe we will see an aggregate increase in fees, tariffs, sales and use taxes, as well as various forms of value added taxes. If the job of capital preservation is to maintain the purchasing power of capital, it must earn more than inflation, all taxes, and other distributions. I suggest that in the current market, high quality bonds can’t produce the necessary income. (That is why in our TIMESPAN L Portfolios® we should only have fixed income in the Operational Portfolio.)

At this juncture, until we see much higher real interest rates, the best suggestion is high quality stocks whose yields are in the range of the ten year treasury and have a history of periodically raising dividends roughly in line with inflation. One would like to find dividend payout ratios below 50% of earnings, if possible. In truth that is going to be difficult to do with appropriate diversification.

As a practical matter many accounts are going to have to dip into the capital appreciation bucket. In selecting funds or stocks I would array them based on a guess of how many years into the future the particular issuer will pay a dividend that would qualify for inclusion in the capital preservation bucket. In some cases this may be in only a few years. In others, like with Berkshire Hathaway* and Amazon, the indefinite future may be too short. In these cases the willingness to periodically sell off some of the appreciation to fund the preservation bucket could allow the position to be in the portfolio.

* Owned in both a financial sector fund and personal accounts that I manage

<b>Questions of the week:

What portions of your portfolio do you consider Capital Preservation and Capital Appreciation? Do you expect to change these based on market cycles?  

Misunderstanding Technology Can Be Dangerous - Weekly Blog # 507

Introduction

Investors do not understand the current stock markets. Globally most stock markets are rising and most have reported record highs in spite of political instability. The driving forces are both normal and novel. In many economies we are experiencing a normal cyclical recovery as both confidence is rising and memories of past crises are receding. What is more novel is the exponential growth in the use of technology to address many problems.

One of the advantages of being part of this blog community is that we have a large number of thoughtful members. One of the most responsive members has called to my attention a Financial Times article by Jim McCaughan, the CEO of Principal Group Investors with the intriguing title “Investors must get to grips with impact of technology.” While contemplating this article I examined a report on the S&P and the Dow Jones Sharia indices. These various stock market measures show that in many of the emerging markets and frontier markets that cater to those who wish to follow the Sharia laws for investing, that information technology is the best performing segment. This is appropriate because the growth of technology is accelerating economic growth. When illiterate farmers can price quotes and weather forecasts daily on their cell phones, they will manage their own economics better. Their families will also benefit when they can react with professional medical and nutritional experts. Perhaps these advantages will become the most effective birth control devices the developing world has ever seen.

In my continuing search for understanding why so many very intelligent people continually make more economic and perhaps political decisions that prove to be unfortunate, I suspect that they are using faulty memories of incomplete and in some cases faulty data. It almost seems the more PhDs and other credentialed “experts” that analyze a problem the odds of finding the “Aha moment” decreases.

Measuring The Impact of Technology

I suspect that no class of financial institutions has more learned PhDs than the central banks, particularly the Federal Reserve System. Yet as a mass they have been surprisingly unsuccessful in predicting inflation as it drives their policies. For example they rely on payroll data and other information from the IRS. There is little attempt to capture unreported income. In many countries the “informal economy” is of sufficient size to question the aggregate, growth, and relative ranking in global tables.

Perhaps the biggest failure to capture the economic reality is in the measurement of consumer and commercial prices. On the surface it is reasonable to assume that technology is deflationary otherwise it wouldn’t be bought. The deflation is not just in reported prices, but more significantly the added value that brought through technology. For instance how much are we better off in general with cell phones than landlines? What is the net benefit of shorter transportation time due to speed and safety of mass transit? These are not easy calculations but suggest that the real economy has been growing faster than realized due to the deflationary technological input. Is this the reason that no developed country has hit the 2% desired inflation target identified by the New Zealand central bank?

On the other hand we should also be measuring and understanding the disruption that technology has caused in terms of unemployment and wasted capital resources. Hopefully, we will see more re-engineering and rebirth of former sites. For example some shopping malls are becoming education, health, and service providers. Once services providers can demonstrate value added through sales and retention skills, these wages will move back to old industrial levels. They will accomplish this through smart applications with personal choices through the use of technology.

What Does The Future Hold for Investors? Avoid Reliance on Numbers

First, the question is flawed. The biggest single mistake most individual and institutional investors make is to think of the future as a singular event. One of the reasons we have evolved our TIMESPAN L Portfolios® is to force investors to allocate their resources to different timespans based on their own needs and proclivities. The allocation of capital and intellectual resources is the single most effective method to reach most goals.

Second, is how to handle the various types of price declines (seasonal, cyclical, secular, normal, abnormal). As we can’t avoid them, we need to set some policy goals as to which we “grin and bear it,” make partial adjustments, radical change, or more appropriately different actions for different timespan portfolios and/or different levels of fiduciary and commercial responsibilities.

Third, questioning to perceived wisdom based on unadjusted history. For instance, searching for persistence. Looking backwards for various periods of time which are heavily influenced by beginning and ending conditions there appears simplistically little persistence particularly in top quartile performance rankings. Most individual and institutional investors are goal oriented not ranking oriented. History suggests that the main value to an investor is the timing of the initial investment as well as flows into and out of the account. By definition the biggest gains come from buying into a lowly regarded price and selling into excessive enthusiastic prices. Persistence is rarely found in humans, sports teams, and political leaders. Allow me to demonstrate with the use of fund performance statistics from my former firm, Lipper, Inc., now part of Thomson Reuters.

For the five years ending Jan 18th, 2018 the average S&P 500 Index fund had a compound growth rate of 15.36%. Not only is this way above a historical average it is better than all other mutual fund investment objectives except five, including Large-Cap Growth which had a 77 basis point better return. This may show the advantage that we have maintained for a long time that for some remaining fund holders net redemptions can be a positive, as all portfolios can use some pruning. More importantly, performance while it does impact sales, is not particularly related to redemptions which are more time based. Referring back to the main topic of this week’s blog: technology, the best single performance group was the Global Science/Technology fund which gained 22.09% vs. the average S&P500 fund that gained 15.36%. While I don’t know who will be the winners for the next five years, I think it won’t be the S&P500 index or the Global Science/Technology funds.

Some Straws in the Wind

Before a significant storm often, there are some straws in the wind. The following anomalies are noted:

Barron’s Best Grade Corporate Bonds yields went up last week 8 basis points which means their prices went down a proportionate amount. However a similar index of intermediate credit grade bonds yields only went up 4 basis points. Typically high grade investors are more safety oriented and credit investors more income focused. The possible importance of these observations is to not worry about the safety of high grade corporates paying off their obligations in a timely manner. I believe the significance of the price decline is that these investors and their dealers are worried about their near-term bond prices because of a surge in the supply of high credit bonds. If these fears grow it can create instability in the bond market which could impact the stock market either because a change in outlook or a credit shortage supporting the stock market,

The AAII bulls are running again with 54% of their weekly sample bullish compared with the pull back experienced the prior week of 49%. The bears pulled in their teeth with a reading of 21% compared 25% the prior week. Momentum is continuing.

__________

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 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

Better Portfolios from 14 Questions - Weekly Blog # 503

Better Portfolios from 14 Questions

The initial fourteen questions are:

1.  When will the money be needed?

2.  How would you rank these portfolio drivers:

      a) Economy

      b) Stock Market

      c) Bond Market

      d) Political Swings

      e) Popularity

   

3.  What are the triggers of change anticipated?

4.  How do you define a cash conversion timetable?

5.  How would you structure the replenishment of the Short Duration portfolio?

6.  What are the tolerable levels of Absolute and Relative Risk by TIMESPAN Portfolio?

7.  What is the sustainable spending relative to inflation?

8.  What should be the appropriate performance measures for each TIMESPAN Portfolio?

9.  What allocation or weightings should each TIMESPAN Portfolio receive?

10. What is the client's tolerance for known absolute and relative losses?

In addition, the following need to be determined:
 

11. Governance Procedures

12. Turnover of portfolio 

13. Legacy Requirements

14. Termination Procedures

I would be happy to discuss privately with any of our subscribers if they are having difficulty answering these questions and how the answers might impact their better portfolio construction.

Introduction

Portfolio construction and management is an art form and at worst an alibi for failed results. The way we practice the art form is to recognize that it is an expression of deeply held personal beliefs as well as reactions to client needs vs. desires and current conditions. Structuring each portfolio is a continuing discussion and can encompass aggressive and conservative tendencies which can be executed through individual securities and/or open end mutual funds as well as diversified holding companies.

Diversification & Weighting

Diversification is a method of risk control.  Component weighting provide brakes and accelerators for portfolios. The more difficult tasks are after the initial portfolio construction is in place as market prices shift the relative contribution of each component.

A key determination is what should trigger purposeful changes to the weighting in the portfolio?

One should review the portfolio weightings of the components. This review can be done at regular calendar intervals or as a reaction to expected or actual market conditions. The portfolio weightings will eventually become distorted by performance. Due to the good performance of some of the components they will rise in importance in the portfolio and by that fact alone reduce the importance of other components. Both should be examined closely. 

If only one-third of the big gains can be attributed to operating earnings gains, not published eps gains, the rise in the market prices will be due to perceived valuation changes. If the valuation measures are close to or exceed past record levels, there is increased risk which should be addressed. Any cutback or elimination does not prevent risks returning in full or partially. The more difficult task is when the defensive positions lose enough relative weight due to the bigger gains of the winners or some temporary price declines. If the weights of the defensive positions drop by more than 50%, they may not have sufficient weight to substantially reduce the fall of the entire portfolio when there are periodic market declines. In these cases moving some money out of the winners to the more defensive positions should be considered.

In addition to the 14 listed above, additional questions need to be answered before the investment structures to be used in each portfolio are determined.

Questions for the Short Duration Portfolio

This portfolio’s payments could include all payments, truly an operating expenditure bank. Or it could be used exclusively for short-term emergencies, as a reserve for the unexpected; e.g., repairs, health emergencies, and other unanticipated costs.

One of the most critical question for the Short Duration Portfolio is: how much of this account should be available to convert to cash within one to three days and how much within thirty days?

Questions for the Replenishment/Feeder Portfolio

What is the likely exhaustion date of the account before replenishment? This can be triggered by the minimum value of the account before replenishment and will impact construction of this portfolio.  Also you will need to decide whether replenishment capital will be partial or complete in one transfer. In addition, you will need to establish the level of inflation risk that can be accepted before adjusting replenishment moves.

Questions for the Endowment or Lifetime Account

1. What are the expected governance procedures as the key investment decision maker ages or is no longer competent or alive? 

2. How should the replenishment and short duration portfolios be refunded and will they change their nature over time? 

3. What will be the risk tolerances of absolute/relative losses, inflation losses, and appropriate benchmark measures? The tolerance for risk assumptions moving through various market cycles will frame part of the equation for the long-term success of this account. 

4. What is the expected longevity of this account? 

5. How should the turnover procedures for the final legacy account be determined?

Questions for the Legacy Account

What will control the duration of this account, the exhaustion of the money or people involved in fulfilling a mission? Is it to be thought of as a perpetual account?

Will the Legacy account also need to setup and manage a separate short-term account with its own replenishment device?

Our Investment Approach

Each of these accounts can be managed aggressively or conservatively. Individual securities, both publicly traded and private assets along with open-end mutual funds can be used. 

Each account should reflect the wishes, beliefs, and focus of the capital owner.

Seasons Greetings

Ruth and I wish you a Merry Christmas, a Happy Boxing Day and a Healthy, Wealthy New Year.

A Note to our Email Subscribers

Last week a small number of email subscribers received a fake email from me offering supposed documents to be downloaded from “The Cloud.”  We are taking the following steps to reduce this type of cyber-risk:

1. We are tracking those email addresses targeted by this fake email and other similar phishing.  Please let me know if you receive this type of fake email, BUT PLEASE DO NOT OPEN IT. 

2. Next month we are changing the email delivery system for subscribers who receive the blog with the subject line: “Mike Lipper’s Blog.”  We seek to reduce cyber-risk and to make the blog more convenient to read. We will give you sufficient notice.  

3. Those who receive my blog post’s title as the subject line of their emails from me (“Single Portfolio Cannot Do Multiple Jobs, Weekly Blog # 502”) will not notice a change.

__________

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.