Anticipating Topping US Stock Market for Portfolio Managers vs. Stock Pickers - Weekly Blog # 662

 

Mike Lipper’s Monday Morning Musings

Anticipating Topping US Stock Market

for Portfolio Managers vs. Stock Pickers

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

                           

                   

                           

Warning: How Markets Approach Tops

Perhaps fittingly, markets reach tops in a similar fashion to countries going to military wars. There are two phases. The first can go on for a lengthy period of a year or more, with the slow destruction of the ability to successfully fight back. The second is an immediate event, which galvanizes the opposing forces into military action. The assassination of the Archduke in WWI and the Attack on Pearl Harbor in WWII are two examples. In both cases the general population was not paying attention to the deteriorating conditions and they were truly surprised by the triggering events. Those in power were not surprised that an event could trigger hostilities and there were premature warnings if one looked for them.

With the US stock market nearer a probable peak than a bottom, I sense an oncoming peak followed by a meaningful decline. I just don’t know when, although I have a pretty good idea who will be blamed for it.

Topping Signs

The first sign is the public’s wish for a better year than the last, often expressed as a bigger gain in the US stock market. The raw gains for the Standard & Poor’s 500, with dividends reinvested, was +18.40% for 2020. A level roughly twice the long-term average of +9% to +10%. The average S&P 500 index fund, with $1.9 trillion entrusted to them, gained +17.91% with dividends reinvested and management, administrative, and transaction expenses deducted. As good as these results were, they were below the average return for US Diversified Equity Funds, a gain of +19.14% on $10.3 trillion in assets. Even with the history of a strong November and December being followed by a year producing returns of +10% or more, one should be cautious in expecting the 2021 return to be better than 2020. 

Excessive speculation with increased leverage weakens all but the strongest financial structures.  Excessive speculation is often an open invitation for enemies to embark on bold adventures (Pearl Harbor). There is no doubt we are experiencing rampart speculation, 2020 had the fastest bear market and included a record level of IPOs and an equal number of SPACs (Special Purpose Acquisition Company). In addition, 2020 saw a record level of margin debt and a new generation of inexperienced investors rapidly trading on home computers, somewhat like the “roaring twenties”. 

Accelerating inflation also weakens the defense mechanism of a society. The JOC-ECRI Industrial Price Index ended the year at +24.44%, with 81% of the weekly prices rising in the weekend edition of the WSJ. Other cracks are also visible in the economy, with landlords and their banks speculating on when and if their tenants will pay their rent. One also hears of some officially unemployed workers only willing to work off the books. Integrity is often forgone in periods of speculation and inflation.

We should not attempt to remove all speculation from the markets, as we would be killing opportunities to take risks that have paid off very well in 2020, shown in the performance of the following mutual fund averages:

Alternative Energy Funds     +92.89%

Global Science & Tech        +65.00% (C)

Science & Technology         +52.21%

Multi-Class Growth Equity    +42.89% 

(C) Canadian Information Technology stocks +80.65%

Typical Stock Pickers Play Differently

Picking stocks is an old art form encompassing both short-term gambling and long-term investing. One of the main mental attitude differences between an almost exclusive focus on picking stocks and portfolio management, is that stock pickers focus almost exclusively on the performance of individual holdings, whereas professional portfolio managers focus on the performance of the entire portfolio. This usually leads to a stock picker having a more limited number of holdings, with many driven by the same market dynamics. Many newer stock pickers are entertained by the frequent examination of price volatility, intending to hold if his/her stock prices rise relative to other immediate alternatives. The focus is often on what is happening in the market and/or in the headlines, not on the fundamentals of the company which happens to have the same name as the stock. If the stock disappoints, the player sells and either buys something else or totally withdraws from the market, until a new wave of speculation gets his/her attention. In viewing the history of stock-pickers, one is reminded of what is said about pilots “There are old and bold pilots, but there are no old bold pilots.” 

That speculation burns out many inexperienced traders is unfortunate, not only for them but also for the nation. We have reached a point where the number of new companies equals the number retiring, either voluntarily or involuntarily. Among the reasons are demographics, labor and other capital productivity, regulation at various levels, and tax rates. One of the reasons US productivity was a world leader was the birth rate of new ventures and the success of some. Among the biggest advantages a stock picker has is that he/she does not have to play and record of results is not known. If the record is self-disclosed, it may not be believed. 

The Professional Portfolio Manager Plays a Different Game

The biggest risk for most professional managers is career risk, either losing employment or reputation. Furthermore, the portfolio manager is constantly being measured against supposed peers and externally identified time periods. At times absolute and relative investment performance are paramount and at others presumed risks is critical, whereas for some accounts cash generation is most important. For example, in 2020 the same account could be a relative leader or laggard and finish the year with very acceptable results, depending on the period selected. In some cases, when an institution borrows money during a period of economic strain, cash generation or volatility is critical to making payments or maintaining credit ratings. Because of COVID and a disruptive economy, some institutions have become much more sensitive to short-term results, whereas others look at the same characteristics through a longer-term lens and see new opportunities and risks.

In contrast to the stock picker, a portfolio manager looks at each investment not only in terms of its investment merit, but also its role in creating the appropriate balance in an account in terms of risk and reward. While a stock picker would ordinarily be delighted to have every one of his/her holdings do well, a professional portfolio manager would be concerned, fearing a change in the impetus driving the market could make the portfolio a very risky vehicle. In income-oriented portfolios, the timing of flows is critical to meet payment obligations and that can put constraints on the structure of the portfolio.

Unlike the private investor, most professional portfolio managers can’t afford to be out of the market, as most outstanding performance requires ownership on key turnaround days. The best a manager can do if the market is moving differently than what is perceived to be correct long-term, is shift the relative volatility of the portfolio, with a willingness to move quickly into higher volatility when the trend is what it should be.

How are You Protecting Against Unwarranted Speculation?

• Ignore?
• Raise Cash/Short-term vehicles?
• Change Volatility?
• Prune holdings which don’t help?
• Or something Better?   

I like quoting Ben Graham, not only because of his well-earned knowledge but because of the New York Society of Securities Analysts gave me an award named after him. He is quoted as saying “the essence of investment management is the management of risk, not the management of returns.”

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

https://mikelipper.blogspot.com/2020/12/stud-poker-new-swamp-game-weekly-blog.html

https://mikelipper.blogspot.com/2020/12/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/12/searching-for-surprises-weekly-blog-659.html

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

The Art of Portfolio Construction - Weekly Blog # 615

Mike Lipper’s Monday Morning Musings

The Art of Portfolio Construction 

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

This week had attention getting headlines that might be important to prudent investors.

1. The Barron’s Confidence Index dropped by an unusually large 2 points as high quality bond yields rose less than intermediate credit yields.
2. The 30-year yield to 3-month yield spread narrowed. 
3. The Baltic Dry Cargo Index was down 30% from a year ago (negative for world trade). 
4. SoftBank failed to raise the capital anticipated.

Despite all the news that has made headlines this week, we professional managers and serious investors must continue to manage the portfolios entrusted to us. Many professional journals are full of articles about Artificial Intelligence (AI), suggesting the management of investment portfolios can be done entirely “by the numbers”. Contrary to that view, I believe that portfolio management is an artform, similar to life in general.

That is not to say that math and related science has no place in portfolio management. The great artists of the world, either consciously or not, use mathematical principles in producing their art. It is the same with portfolio managers. Just as a painter looking at a blank canvas needs to contemplate the organization of the space, selecting the right colors to convey his/her point of view, so too do portfolio managers, particularly the successful ones.

One of the first choices the portfolio manager must make is whether to utilize many choices or just a few. Some portfolio “artists” will fill the space with many details, while others only use a few, concentrating on a limited number of opportunities. As someone studying investment portfolios for most of my life, I have come to some working observations.

1. The need to quickly convert some of the portfolio assets into cash in order to meet responsibilities focuses attention on liquidity. In markets of limited liquidity and occasional sharp price moves, owning a large number of securities often suggests the portfolio has a good amount of liquidity. This is not always true, but many portfolios do not need a great deal of liquidity.
2. The next consideration for portfolio strategists is career risk, as portfolio managers are rarely employed under long-term contracts. This is particularly true in the mutual fund industry, my preferred research laboratory. Termination is often triggered in one of two performance directions, up or down, depending on which is the greater fear. By definition, there are a limited number of individual securities that will be up significantly in any given period. If that is your goal, the best portfolio structure is to own only the big winners. On the other hand, career risks could be triggered by falling more than peers or the market and/or exhibiting an unnerving level of volatility. In that case, portfolios might include a large number of individual issues in order to generate returns similar to peers or market indices.

As a manager of portfolios of mutual funds, we utilize both extremes in some combination to meet the expressed or perceived needs of the account. Where possible, we want to use concentrated portfolios to give us better than average performance, accepting some additional downside risk. We offset these concentrated funds with a selection of portfolios that have numerous securities. They often look similar to market indices or are actual index funds.

I have great empathy for the managers of concentrated portfolios, as I for many years have managed a private concentrated portfolio investing in global financial services stocks and funds. I am not soliciting new members, nor am I recommending the purchase of any of the financial securities I will mention shortly. I am using a brief discussion of my experience to highlight some of the attributes of one particular concentrated portfolio, which might apply to other concentrated portfolios. The following are elements that may be found in concentrated portfolios:

1. During a recent period of positive performance for the portfolio and negative results for the benchmark/peers, only 7 of the 19 positions rose. The portfolio outperformed in part due to the two largest positions being the two best performing stocks and totaling 25% of the portfolio. The use of weighting is an important tool.
2. More important than what we own, might be what we don’t own, life insurance and large commercial banks.
3. Financial services can be used effectively beyond brokerage commissions and deposits to address other needs or fears. For example:  
1. Using ADP and Berkshire Hathaway to participate in GDP growth
2. Using Franklin Resources and Invesco to hedge the value of the US dollar.
3. Using NASDAQ for a general level of speculation.
4. Using Allegheny Corp. and Berkshire to participate in rising casualty insurance premiums.
5. Using the London Stock Exchange through Thomson Reuters to participate in the evolution of global stock exchanges.
6. Some of these options could also be considered hedges in a financial services portfolio.

Conclusion: Concentrated portfolios can work both offensively or defensively when appropriately structured, but need to have better security selection than portfolios with a larger number of issues.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/02/significant-turnaround-two-fearful.html

https://mikelipper.blogspot.com/2020/01/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/01/is-it-always-brains-over-flexible.html



Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

Significant Turnaround? Two Fearful Histories - Weekly Blog # 614

Mike Lipper’s Monday Morning Musings

Significant Turnaround? Two Fearful Histories

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

Current Pictures 
All three popular US stock market indices have price charts indicating a top of some magnitude. Market analysts view these tops as a sign of a reversal of a major trend. The questions facing investors today:

1. Is this a correction of perhaps 10% and an opportunity to buy a favored cheap stock?
2. Is it a cyclical top with a potential decline in order of magnitude of about 25%?
3. Is it a less frequent structural change that might cause a displacement of 50% or more?

2020 is still very young, but current markets as reflected through mutual fund performance are showing dramatic trend divergences. Year-to-date through last Thursday, the only mutual fund investment averages above 4% were: Global Science & Tech +4.86%, Large Cap Growth +4.09%, and the more domestically oriented Science & Tech +4.07%. Declining Equity Mutual funds were Natural Resources -8.38% and Basic Materials -5.15%. Commodities declined even more: Energy -11.35%, Basic Metals -7.18%, and Agriculture -5.02%.

After generating net sales earlier in the year, High Yield mutual funds and ETFs suffered significant redemptions this week, while higher credit bond funds continued to draw positive net flows. The Wall Street Journal' s weekly chart of 72 securities indices, currencies, ETFs, and commodities, only saw 24% of them registering gains. The spread between the price of gold and gold mining stocks also narrowed. These data points are  not encouraging for those looking for higher stock prices.

The task for professional analysts and portfolio managers is to examine the current data and look at possible alternative future directions. Most bright futures take care of themselves and the job is simply trying to optimize the rate of return. The less frequent downsides need to be reviewed more carefully, because for professionals there is much greater career risk.  The owners of capital need to blame someone other than themselves for major declines, but often take all the credit on the upside! I therefore periodically examine the chances of cyclical and structural declines, without excessively focusing on when they will occur.

What's Wrong? 
A top followed by a significant decline is usually identified with an event that focuses people's attention, although it often has little to do with the underlying cause. How the underlying cause for most wars is explained is a classic example. For example, school children are taught that WWI began because of the shooting death of Austria's Archduke by a lone anarchist. The truth is, the balance of power keeping competing nations in check after the Napoleonic era was breaking down. The growing strength of Germany, combined with weaknesses in France and Russia, led to them creating self-defense alliances with weaker states. Note, hostilities did not begin until six months after the tragic murder. It was the movement of Serbian troops threatening Austria that brought Germany and Russia into military conflict.

Somewhat like the US entry into WWII being caused by a single attack on Pearl Harbor, resulting in a Declaration of War by the US against both Japan and Germany, plus Italy. The Coronavirus is similarly be blamed for the decline in most stock markets around the world. The virus has led to one hundred or more deaths of the thousands infected. Unfortunately, there will be more, but it will eventually be contained and cease to be a problem. What it has done is to dramatize the importance of China to World Trade. Although China has contributed about half of global GDP growth, it still represents a relatively small number. The markets were showing weakness for some time before the advent of the virus and many industrial stocks and commodities were flat or declining in the latter part of 2019, if not before.

The 1929 peak in October marks the begin date of the Great Depression, but few realize that by December 1929 the Dow Jones Industrial Average had fully recovered. (Perhaps, there is still hope for stock traders this year.) There are always a number of factors that contribute to making a top and its subsequent decline. The current ballooning expansion of credit is one of the conditions shared by events leading up to the 1929 crash. "Bubble or Nothing" is the title of a study by The Jerome Levy Forecasting Center LLC, which makes the following observations:

1. The last three US recessions were ended by ever larger inputs by the federal government.
2. Economic recoveries were successively smaller after each recession.
3. Private credit has expanded at a faster rate of operating assets and operating income.
4. Most national governments are already operating with a deficit.

I would add that astute bond investors are already conscious of these conditions and are shifting their purchases to the highest quality non­-government issues, reducing their immediate commitment to high yield. Also, I find it very interesting that the performance spread between the price of gold and the price of gold mining shares has narrowed. In the modern world, other than when currencies become worthless, the main reason to buy gold is in anticipation of inflation. However, there is none in the government published data.

What to Do?

1. History has favored buying high quality and holding it for long periods of time, if it remains high quality. 
2. For US individual investors, the step-up at death is one of the best ways to pass wealth on. (That may not always be the case!)·
3. It does not mean we all abandon buy and hold strategies and become traders. However, it does force investors to focus on the timing of planned cash expenditures. 
4. The size and composition of the payments reserve needs attention, recognizing that guessing the future is fraught with mistakes. Based on present conditions, I suggest that payment reserves for the next five years be invested only in high quality paper, with up to 50% in maturities under one year. 

What about Long-Term Money? 
The history of greed and fear cycles indicate we cannot avoid periodic tops and declines. I suggest that intermediate length accounts be prudent and hold reserves of at least 25%, with maturities of five to seven years as a limit.

For those investments meant to be long-term or legacies, recognizing that within a generation you are likely to experience a structural top. As long as there are sufficient payment reserves, I would not add any additional reserves, except for those who can use opportunity reserves effectively. Many fiduciaries can't or won't.



Congratulations to Clark Hunt for his team winning the Superbowl, demonstrating the value of teamwork.



Question of the Week: What is your sense of timing as to the market and how is it expressed in your portfolio?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/01/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/01/is-it-always-brains-over-flexible.html

https://mikelipper.blogspot.com/2020/01/architectural-sway-points-and-current.html



Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

Is it Always Brains over Flexible Policy in Investing? - Weekly Blog # 612

Mike Lipper’s Monday Morning Musings

Is it Always Brains over Flexible Policy in Investing?

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

Two questions:

1. Why don’t smart people always make money with their investment responsibilities?
2. When is the time to fix a leak in the roof, when it’s sunny or when it starts to rain?

The answer to the second question is obvious, when it is sunny. Why then do so many smart people fail to adjust their investment portfolios when the market is fairly, if not fully priced? Could it be that selecting good investments is emotionally more rewarding than focusing on policies that could direct future movements within the portfolio?

None of us knows for sure what the future will bring in the periods ahead. A characteristic most of us share in the developed world is the necessity to compete. We measure our results against perceived peers, or in their absence against artificial indicators that were not necessarily designed to replicate our real-world tasks.

For most investors, their responsibility is to convert the assets they manage into a series of known and unknown payments for various future periods e.g. paying bills. In order to accomplish this, they must make some difficult guesses as to the size of the bills due. Whether they like it or not they should be thinking in terms of investment survival. However, they also need to grow capital in the account to pay more bills than would be possible with current assets. This introduces a difficult and unknown risk/reward equation.

Far too many investors focus on competing with peers or indices and not on the risk/reward equation. Some professional investors also add career risk into the calculation. If they fail to please the owners of the capital, they risk losing the client and account or jobs. Unfortunately, most owners of capital and many investment executives don’t know how to evaluate their managers, except statistically or by comparison. I know of one very successful sector analyst that kept his fund from investing in it. His timing was excellent and when that sector collapsed, he was rewarded with a partnership. He eventually became the managing partner of a successful fund management firm. Charlie Munger and Warren Buffett have often said that individual investors can make better investment decisions than many institutional managers because they are not facing career risks.

Now we come to that leaky roof. The best time to fix the roof is when it is not raining or snowing. On Friday the three main US stock market indices reached a new high, as they have many times over the last three years. Stocks go up in price because more buyers than sellers believe the future will be better. They may currently be correct, but at some point in the future they won’t be. There is an old saying from the floor of the Stock Exchange that bulls and bears make money, but pigs get slaughtered. (Maybe they will be shipped to China where there is a pork shortage.)

Will the US market continue to go up? I hope so. However, in thinking about leaks in the roof I’m seeing some dark clouds that might carry rain. While the world will need more goods and services in the future, they might be in short supply at current prices. Because of geo-political fears in the US and much of Europe, the capital expenditures necessary to build additional capacity has been slim. Another capacity constraint is the working age population, which is already declining due to the falling birth rate. (It is possible that Southeast Asia and Africa will be the source of additional physical and human capacity, which is why we’ve invested some capital there.)

Should we be paying so much attention to geo-political events? I recently saw a study that looked at 21 such events, from Pearl Harbor through the killing of the Iranian general. Only 4 sent the S&P 500 Index down 10% (which is normally called a correction). Pearl Harbor was the worst both in terms of the 19.8% decline and the 307 calendar-day recovery. The average historic decline of 5% is interesting because it falls within the 3%-7% collection of 2020 institutional expectations for the S&P 500 Index. With the indices at a record high, the general’s death did not appear to affect the market. For long-term investing, JP Morgan believes you should be guided by long-term trends and not events.

What clouds are we seeing other than long-term capacity constraints? Conditions are becoming more speculative, with the NASDAQ continuing to lead the other markets. The growth of alternative styles and different trading instruments is also a concern. Furthermore, we are seeing many “conservative” institutions shift from 60% in equities and 40% in fixed income to 70/30 allocations. In the first two weeks of the year we have seen growth and tech-oriented funds gain over 4%, which translates to approximately doubling over a year if continued.

Another unsound extrapolation is that over $40 billion went into bond-like funds during the first 16 days.  This extrapolates to annual rate of $1 trillion. We are already seeing intermediate interest rates moving up. Intellectually, I suggested that it would make sense to short the 30-year US Treasury. (The trend of universities issuing 100-year bonds is spreading overseas. Caltech has now done it 3 times and I believe Cambridge is considering it too. With the average US government debt maturity under 10 years and the UK’s under 14 years, we would like to see a lengthening of maturities.) With gains in many cases over 10%, 2019 was an outstanding year for bond holders. I suspect it will not be wise to own bonds for quite awhile.

Sir Isaac Newton is an example of someone considered to be among the smartest of people. He was a young Cambridge Professor who first conceived the three laws of motion and in so doing formed the basic principals of modern of Physics. He was so respected that he was knighted, very unusual for a scientist. He became the master of the Mint, a high honor. At that time in England the government had not yet set aside money to pay its debts, so they created a lottery. The lottery involved the newly formed South Sea Company, which had dubious prospects, but the potential odds were attractive. Sir Isaac recognized the fallacy of the issue and sold his shares. However, he got seduced by the skyrocketing prices and went back in. He is thought to have lost his investment, which may have been 22,000 pounds in 1722. After the Bubble popped, he was quoted as saying “I can calculate the movement of the stars, but not the madness of men.” Clearly a very bright person who made a big investment mistake.

Subscribers, please help me and yourselves from getting sucked into the concluding whirlpool when the current enthusiasm subsides.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/01/architectural-sway-points-and-current.html

https://mikelipper.blogspot.com/2020/01/how-much-will-markets-decline-10-25-or.html

https://mikelipper.blogspot.com/2019/12/repeat-past-history-probable-or-just.html



Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

Tis the Season to be Mislead - Weekly Blog # 558

Mike Lipper’s Monday Morning Musings

Tis the Season to be Mislead

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

                                                                     

Standard Review and Outlook

I have written and read many reviews and outlooks over my career, both as an investor and a fiduciary manager. These documents are interesting and represent the most positive thinking of the writer, editor, supervisor, key sales people and compliance officials. Most spend a good amount of space describing the immediate past, with a slight alibi for under performance. For the most part the outlook is an extension of current conditions, likely to turn out to be benign. Those who know me would expect a contrary point of view. I hope not to disappoint. Even if I am wrong, some of these views will give depth to the more popularly expressed views.

Career Risks

This may well be the first outlook to start with this topic, but it hopefully will cause professional investment people and senior politicians to focus their actions on reducing the chances of repeating their 2018 performance, or worse. The best that than can be said about last year is that the results were reasonable considering the prior good times when waves of enthusiasm carried stock prices and political popularity to new highs. In some respect we have come back to earth. The only problem with the small net progress made in 2018 is that it reduced the longer-term growth rate, which is the underpinning of our current position and its remuneration.

Faced with the somewhat disappointing results of 2018 there is a natural drive to do something to improve results. In most cases this translates to committing more assets to short-term solutions, often by reducing reserves. While 60 of the 72 prices representing stock market indices, currencies, commodities, and ETFs rose last week, there may have been an excess investment of reserves, which is often a precondition of both bear markets and recessions. These asset allocation shifts don’t cause bear markets and recessions, they just make them more painful. Let’s place this microscope on three careers to raise some concerns.

Investment Professionals

Over time most professional investment people have delivered good performance relative to client’s actual constraints. In a period when most security prices rose in tandem with market indices or sector indices, passive vehicles looked to be more attractive than active choices. (This view was reinforced as commission brokers became fee charging investment advisors). Recently, instead of a steady increase in the number of new firms, hedge funds and mutual funds, the opposite has been happening. Organizations are merging to get control of assets that are no longer being won through sales efforts. In the merger, one of the back offices is eliminated and the best of the investment and sales people are retained. Even with this group of survivors, once their guaranteed employment period ends there will likely be a second round of layoffs. By the way, there is no evidence that the ultimate client is better off after these mergers. Seeing the prospect of this on the horizon, current employees may elect to push more aggressive strategies, even after a ten-year expansion.

Publicly-Traded Corporate Executives

Many corporate C suites are like the old fighter squadrons where there were bold or old pilots, but no bold old pilots. Often, the executives that rise to the top have more political skills than vision and help select boards of a similar nature. Most of the Fortune 500 CEOs are in their corner chair for five years, which is generally not long enough to go through a recession and a recovery. Thus, they tend to opt for capital preservation rather capital growth. This is not new, which is the reason why wise entrepreneurial companies with much less in assets outgrow their larger competitors. New technology’s disruptive forces wait for no one and some foreign companies may have what it takes to win business away from slower moving behemoths. Often, being a little bit bold is insufficient to hold off competitors. At some point boards, with or without activist sponsorship, demand a bold replacement or sale of the company.

Political Leadership

Both the “Big Two” (US and China) are trying to keep their expansions growing to protect their employment base. Further, in the US the opposition party is led by individuals older than the US President. Both leaders would prefer to focus on the longer term, but they are being forced to prolong and accelerate current growth. This is the trap that will increase the pain when the economic slump occurs, as happened in Ancient Rome, to Louis XIV and to Herbert Hoover/ Franklin Delano Roosevelt. Economic and military wars lead to deficits and tax increases, where opposite measures might cushion the decline and accelerate the speed of the recovery. But this kind or restraint would necessarily need to accept a slowdown, along with the political risk of a rise in unemployment, which would need to be managed.

If !!!

If corporate and political leaders are slow to support a decelerating economy, they might put off the inevitable recession by finding new and younger leadership.

Watch Emerging Market Bond Yields

Franklin Templeton (Franklin Resources*) 2019 outlook was entitled Distortion, divergence, and diversification. This thoughtful piece had three themes and was written by their head of equities, chief investment officer of Templeton Global Macro, and CIO of Multi-Asset Solutions:

• The state of the world which investors have become accustomed to will change, with low correlation and low probability of outcome.
• Local-currency emerging markets are showing the highest level of undervaluation.
• Opportunities exist globally, as disparities narrow between the US and other countries.

I was particularly interested in a chart of two-year bond yields which compared the US yield of 2.8% with Mexico 8.5%, India 7.2%, Indonesia 7.3%, South Africa 6.2%, and others. My interest is that these countries are represented in equity mutual funds we own long-term for clients and personal accounts.

(*) Owned in a financial service fund and personal accounts that I own.

Question of the week: 

What return do you need in 2019 for it to be a considered a good year?

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2018/12/2018-lessons-should-be-learned-weekly.html

https://mikelipper.blogspot.com/2018/12/cash-is-four-letter-word-weekly-blog-556.html

https://mikelipper.blogspot.com/2018/12/news-focus-may-drive-investment-success.html

Did someone forward you this blog?

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

History a Guide, Not a Map, or a Trap - Weekly Blog # 550

Mike Lipper’s Monday Morning Musings

History a Guide, Not a Map, or a Trap

(a long read)

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

         

I have often said that when an analyst is scratched a historian bleeds. While this is true, it should not be a trap that automatically leads to a set of decisions. Beginning to prepare this blog on the early morning of the 243rd birthday of the US Marine Corps I am struck at how much is different from our Corps tactics, strategies, and missions. To fund the military, General Washington ordered the marines,  to guard the transport of silver from New York to Philadelphia so that the troops and suppliers could be paid. This particular mission is no longer required, but the movement of critical assets for future use has become endemic to me as a long-term investor for clients, family members, and beneficiaries of non-profit groups.

Just as the specific tasks assigned to the USMC has changed, so have those who we work for as investment advisors and members of investment committees. One axis of our work is generational, the consideration of essential needs of families for their senior members through contemporaries, children, grandchildren, great-grandchildren, and the unborn. In a somewhat similar way, members of a university investment committee focus on the different needs of the present and future donors, students, faculty and staff. I also focus on delivering the capital necessary to fund the attraction of the best future students and faculty.

With this multi-generational self-imposed mission, I have concluded that there are a number of different attitudes that have to be identified and placed within the range of possible extremes. History is useful in identifying past extremes but is far less useful in drawing up a map of necessary future actions. (There were numerous roads from New York to Philadelphia, but only some were considered relatively safe and suitable for moving heavy, wealth-laden vehicles and consequently only one was used.) In developing investment policies for delivering wealth, answers to the following questions will have an important impact on the choice of the best road to travel.

1. The primacy of spenders vs. savers, or phrased differently, focusing on today vs. tomorrow. Spending addresses the identified immediate need, whereas saving addresses future known and unknown needs through the power of uncertain compound annual growth rates (CAGR). The selection of the appropriate mix is dictated by emotional management and political skills. 
2. Dependency on self, internal forces, or third-party forces. Since the American Revolution we have seen a number of other social revolutions. Two of which have enormous investment implications. At the time of our Independence, individuals and close family members functioned as the primary deliverers of health solutions and capital for growth and retirement. Today, the bulk of the population is dependent upon third-parties to provide these services, at a cost of less freedom of choice. 
3. Coping with the past as the primary model for the present. The cook book model borrows from science, by repeating past experiments in order to produce known results. What passes for judgement is essentially a memory of the real or imagined past, extrapolated to the future. The problem with this very popular model is that it does not include a risk quotient. What are the risks of fundamental changes from the past? Ignoring the potentials of changes is dangerous, as one can lose the purchasing power of capital and/or the loss of opportunity. While surviving change is good, waiting for it can be expensive. Having meaningful reserves can be performance limiting and for managers is a career risk.

Questions Shape Portfolio Construction
Each of the three questions raised, if answered, should have some impact on how both individual and institutional portfolios are constructed and will be addressed separately.

1. Some people and organizations plan to spend their last dollar while taking their last breadth. The critical question for them is the shape of the glide path of expected payouts. The account should be measured on a total (reinvested) return basis. Other accounts hope to be perpetual or have an expected maturity so far into the future that mathematically it is the same. A critical political question is how to balance the current spenders vs. capital accumulators and postpone spending for future generations. Historically, income beneficiaries believe they have the first right to the income produced. Often this is expressed in terms of dividends and interest payments and does not include realized and unrealized capital gains. Unless there are rights of invasion. Capital belongs to the “remainderman”. With these dual responsibilities, most of these accounts are managed similarly to balanced mutual funds. These accounts typically own bonds and high-quality credit instruments, along with various forms of equity. In most market cycles the balanced nature of the account produces a less volatile price pattern than a full equity or bond account. In the current market cycle, the unspoken difficulty is dealing with inflation. (I suspect for individuals or high-quality institutions, the inflation rate for the "best products and services" are higher than published inflation rates.) High-quality bonds and credit instruments have yields pretty close to published inflation rates. Many dividend paying companies attempt to keep their dividends growing at the rate of inflation, but often fall behind in a rising stock market. It takes the combined skill of a politician and investment manager to keep all of the beneficiaries happy all the time.
2. Relatively few investors have the same attitudes of a pioneer entrepreneur, or a misanthrope wanting to be independent of other parties' control. Most people cede various accident risks to insurance companies or governments and most employees in the US and elsewhere are coaxed into retirement accounts or pensions. In the past, individuals provided for their own needs, but unfortunately most people today are not endowed with the discipline and appropriate skills. One of the dangers to long-term general investment returns is this tendency to cede control, particularly by younger generations. This is a global trend. The savings from the massive buying power of a central force, be it a private health insurance plan and/or a government agency, is dissipated by the large bureaucracies which follow rigid regulations. This causes general expenses to rise and they will be also borne by those who can escape these services, even though they are paying for them directly or indirectly. From a long-term standpoint, despite some current disruptions, we expect after-tax and after mandated expenses to rise on a secular basis. From an investor's point of view there may be an increased desire to buy into disruptive companies, away from high-quality fixed income which will have difficulty producing returns after inflation and taxes.
3. Part of investors and politicians "physics envy" is developing a set of immutable laws that are always right. Far too many investors look to statistical histories for physics like certainty of future developments. They have forgotten their sports days. Whether it be baseball, football, golf, tennis, or horse racing, the real purpose of winning or losing streaks is to see when and by whom the streak is broken. The following is a list of time series that have generally been predictive, as well as the direction of their predictive power:
1. For the last 50 years there has been no single year that bonds and the S&P 500 have both fallen. (As of last Thursday, only 7 out of 27 fixed income mutual funds are positive year-to-date. Only 9 out of approximately 100 equity fund investment objective performance averages are up. Few if any, are predicting a double hit to accounts.)
2. Sentiment changes – The American Association of Individual Investors' weekly sample survey in the past three weeks has gone from being 28% bullish to 41.3% bullish, an almost 50%turnaround. (This is a highly volatile indicator and I often view it as a negative or reverse measure.)
3. Much of chart analysis follows principles similar to those of architecture. Foundations for large buildings should not have gaps in their underpinnings, likewise the three major US stock market indices shouldn’t either, although they currently have  two each. (Thus, on average it is unlikely they will go to new highs until there is a down market to fill in the gaps.)
4. The Wall Street Journal publishes 72 price changes each week   for stock index, currency, commodity and ETF prices. During the latest week there were 20 that gained over 1% for the week; one was a commodity, 1 a currency, and 1 an ETF, with 17 being stock indices. (This suggests that this week 's movement was trading related, perhaps a relief rally with little economic support, not a good sign.)

All that I know is that each week we move closer to a significant stock market decline, perhaps with a recession. While there are few bears in the market place, in general there is little capital in visible reserves.

A Possible New Portfolio Structure
Perhaps it would be wise to structure a portfolio so that it is comprised of three unequal buckets.

1. The first bucket for American investors is an opportunity bucket to hold securities and other assets that are expected to appreciate over an investment cycle. 
2. The second recognizes that from time to time bargains show up, often briefly. The use of these resources requires courage of conviction to avoid "falling knives" that will plunge the stock out of existence. 
3. The third bucket would rarely be used, but is intended to take advantage of fundamental changes which arise when various statistical streaks are broken and things that shouldn’t happen do. 

To put this new structure into place, using only someone's age as a rough measure of maturity and responsibility, the following table could be a good point of departure for an individual investor. The Institutional investors could require a different structure:

Initial Age Opportunity Bargain Purse Changes
    20           100%            0%         0%
    30            90            10          0
    40            80            15          5
    50            70            20         10
    60            60            20         20
    70            50            20         30
    80            50            20         30

Questions for the Week

1. What do you think of the questions that shape portfolios and do you have any others?/
2. Am I am being too pessimistic as to the reliance of third parties impacting investment returns?
3. What do you think of the two "new" reserve elements of bargains and changes?

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2018/11/things-are-seldom-what-they-seem-weekly.html

https://mikelipper.blogspot.com/2018/10/we-are-in-training-exercise-weekly-blog.html

https://mikelipper.blogspot.com/2018/10/committing-reserves.html


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A. Michael Lipper, CFA

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Handling Two Big Future Investment Losses

Introduction

None of us know the future of our investments. Unless human nature is altered we should be prepared for two important losses. According to the Marathon Global Investment Review, the great Ben Graham* (in the Intelligent Investor)  warned investors of the probability that most of their holdings will fall by "one third or more from their high points at various periods." I see no reason not to accept his warning today. This is the first investment loss probability ahead of us.

*I feel drawn to any views expressed by Ben Graham. He and my old Professor at Columbia University David Dodd wrote the Bible for our business entitled,  Security Analysis. I am particularly susceptible to quotes from them. The New York Society of Securities Analysts which Ben helped to found honored me with the Benjamin Graham award for services to the society.

The second big future loss ahead of us is our reaction to seeing our wealth decline, perhaps materially. After each major market decline some investors in their mind retreat from taking on any more risk and withdraw from investing. Often they blame their loss on what the popular press claims was the culprit. That way it is easy to, in effect, give ownership to the bad people and policies that they think led to their realized loss. Rarely do they examine their own behavior and naiveté as a contributor to the loss of supposed value in their portfolio. Thus, they can transfer all of the responsibility to these external factors. In other words, the government, the leaders, acts of nature, new products, foreigners, etc., were the causes so they have passed the ownership of the calamity to others.  Actually, this is a small part of the real long-term loss. The real shortfall is the subsequent loss of opportunity. Fortunately, we live in an equity world that after each serious decline the surviving market prices rise and eventually top all prior peaks and of course valleys. Bottom line: one must be a participant in the game to gain the benefit of the recovery.

For many there is a third risk of loss, a different type of risk: career risk. We are already seeing investment professionals lose their jobs. Often the layoffs start at the bottom of the ladder. Today I know of good analysts, portfolio managers, institutional traders, and various administrative types that have been cut from investment advisors, brokerage firms, hedge funds and some market-making facilities. Hopefully after some difficulty many will survive and quite possibly start or get involved with the new entrepreneurial activities that will become tomorrow's winners.

There is another group who indirectly suffer from the career risks of others, their customers. The current environment, after years of mild investment progress, has had only eight months of slowly accelerating progress except for the last couple of months, when it has been gaining faster. Many careerists have not bought into the current rise, so their portfolios have risen more slowly than the popular markets. This is the final straw that breaks some of their clients’ backs or their investment committees. Many investors can tolerate middling performance when the markets are slow, but when momentum sets in, they want a higher level of participation. Except for race horses that are bred for and trained to come from behind, few come from behind and win in particularly long races.

What To Do Now

Others may disagree with my global belief that we have entered a different phase of the equity markets. Prices are generally rising and have passed out of the comfortable range in terms of average valuations. One clue to this is that most acquisitions are shifting to all or largely stock rather than cash deals. We are seeing proposed deals based on the breakup and sale of the various deal’s parts. Is this a signal that we should withdraw from the global stock markets?

While life is never easy for a conscientious professional investor, a good one can identify the appropriate tool kit for various markets. I believe we have entered the phase where sentiment is more important than published financial information. What is important is not the current facts, but how the market is interpreting the new facts in terms of views as to future stock prices. For example, as is often the case, one can see a lesser risk orientation in the corporate bond market. For the moment forgetting the narrowing spreads for high yield paper versus Treasuries because many of the new buyers are disguised equity buyers, they focus on intermediate credits. Barron’s publishes an index of intermediate grade bond yields. Since the beginning of this year the yields have come down 13 basis points and 100 basis points over the last year, indicating an increased demand for this paper. Similar yields for the highest quality bonds have actually gone up 5 basis points and declined only 21 basis points over the last year. All this arcane algebra is flashing the message that in the most conservative sector of our markets buyers are accepting higher credit risks. They perceive less chance of bankruptcies than a year ago and particularly since the beginning of the year. 

Many of the more retail-oriented sentiment indices are slowly beginning to move. One  indicator has me particularly interested: BlackRock believes that individuals are replacing trading groups as the main buyers of its Exchange Traded (ETF) index funds. I believe BlackRock’s retail investors are principally going into its Large Cap index funds, just at the same time there is a continuing trend of what I believe are mutual fund investors redeeming their Large Cap funds after reaching their investment goals. Actually I believe the main way BlackRock is seeing flows is from retail-oriented brokerage houses, often discount brokers. I am wondering if the flow is from brokers or investment advisors who are playing catch-up from being behind for a long time? Their clients are outer-directed and easily led. (I see fairly little signs that do-it-yourself, inner-directed investors are moving into Large Cap indices.) The reason for my skepticism is that when all the stocks in an index move together or are highly correlated, the low or no management fee is attractive. Today we are seeing that tight correlations are coming apart. Rank almost any industry in term of stock price performance now and a year or more ago. You will see the performance spread between the best and worst performer growing. If you want to get the best performance one needs to be in the better performing stocks or shorting the worst.

If I am close to being right, the move of the uninformed public being guided by career risk advisors is an important sign of a top.

In addition to sentiment indicators, a good technical market analyst can be useful. One that I follow has been writing about a major top within the next few years. Others have different views and timespans.

Winning Attitudes

Two wise investors from many years ago are worth paying attention to, even though they are very different. The previously mentioned Ben Graham became quite a stoic so he could tolerate the cyclicality of the market and be prepared to buy cheap stocks with good dividends and operating earnings. Jesse Livermore made and lost fortunes as a market trader. (He may have done some of his trading through my Grandfather's firm.) He is quoted as saying, "The desire for constant action irrespective of underlying conditions is responsible for many losses in Wall Street even among professionals." Further, he said, "It was not my thinking that made big money for me. It was the sitting." 

I have had the privilege to converse with some of the great mutual fund investors over the last fifty years. In terms of the market and their funds during cyclical declines they were stoic and accepted the declines as a normal part of their business even though tension producing. However, one of the reasons that they were so good for so many years was they wanted to chat about their "mistakes" and what they learned from each other, and for the most part they did not repeat. Like all of us they made new mistakes. but they were always learning.

Compliance Adjustment

In last week's post I discussed the shareholder letter released last Saturday of Berkshire Hathaway. Since I did not reference the stock, I failed to proclaim that in both my personal and the financial services private fund I manage, that we own some shares. I hope no one was treating the post as a buy recommendation. My attitude is that we can learn a great deal from Warren Buffett and Charley Munger that is worthwhile beyond their stocks.

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Copyright © 2008 - 2017

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