Bear Market Thinking Prevents Future Gains

Introduction

Most people react to present investment conditions in terms of the dominant financial conditions when they first became aware of financial markets and influences. Very few young people entered the financial community after WWII until the mid to late 1950s. I was part of the second wave when I became an investment trainee working for supervisors at least thirty years older than myself. These gentlemen were operating under the canopy of their parents’ experience during the Depression. They were not prepared for the growth experienced in the late fifties and most of the 1960s. Thus their investment accounts underperformed and they in turn were easy to be replaced by a group of young, inexperienced analysts and portfolio managers. 

I was somewhat prepared for this turn of events.  In 1957, I had the honor of taking Securities Analysis under Professor David Dodd who co-wrote the book of that title with Ben Graham. The course stressed risk reduction by using financial statements to represent value. I used to argue that expected future growth was important as a way to make money. While I did not know it at the time, Warren Buffett reached a similar conclusion.

Replacing an investment committee member

Recently I had two meetings with some very bright people that were being handcuffed by the current market conditions. The first was with members of an investment committee which had an opening. I suggested that it might be wise to add someone who understood commodities. The idea was rejected as supposedly the commodity thirty year super cycle was over and commodity prices were now tied to China which was slowing. This thinking is focused at the beginning of price trends and not what I think should be the focus, which is the terminal price.

Future investors

Later that day I met with undergraduate and graduate members of a university investment club. Some of these bright people were interested in being employed within the financial community and/or wanted to learn more about investing.  By their questions they were reacting to their media-driven views of what they thought was happening in Wall Street.  I tried to suggest that they focus on the future; e.g., global shortage of retirement capital and the loss of jobs due to changes in minimum wages driving technological replacement of human labor.

Classic bear market thinking

In both cases and along with the majority of those who follow investments they were demonstrating classic bear market thinking.  Reacting to past stresses they focus on the current and look for proven results.  In today’s time that means placing great emphasis on statistical value including looking at average price/earnings ratios for the last ten years, (including C.A.P.E. which was discussed in last week's blog.)  One way I attempt to learn where we are in the cycle of investment thinking is to look at what periods of time investors are using in their price/earnings calculations.  When people are being governed by fear they use the past earnings of the latest quarter, year, or ten years.  We are not today seeing anyone quoting P/Es or yields based on their estimates of future 5 and 10 year results.  Historically when we do see these, the market is much higher than markets priced on current or past results.

Today’s investments for tomorrow’s needs

My professional responsibilities include managing money to pay future tuition and faculty paychecks, new laboratories and building maintenance and replacement.  The money to pay for these things will be needed many years in the future, so I must look at today’s investments as to what they will produce in the future.

I must be doing something right as numerous of the present holdings that I am responsible for today are yielding 5% or 10% on current dividends on initial purchase prices.  Thus the money can fulfill the capital generation needs of the beneficiaries entrusted to me.

Speculation isn’t new

Investing with an eye to the future is not new.  Much of the European investment into the US and elsewhere was based on the belief that in aggregate, the investment would generate future capital.

Another investor who focused in part on future returns was the advisor to a number of US presidents, and a friend as well as a fellow park-bench sitter with my grandfather, Bernard Baruch.  During the congressional committee hearings in the 1930s, certain congressmen felt that the Depression was caused by speculators.  They got Mr. Baruch to identify himself as a speculator, which meant that he was a cause for the collapse.  “To the contrary,” he explained the Latin derivation of the word speculator, “a speculator is one who sees far out (to the future).”

In last week’s post I expressed a view that the problem facing the global and US domestic economy was not primarily the lack of cash or credit which can be seen in surplus, but the lack of perceived long-term opportunity.

Being a bit of a contrarian and a disciple of Baruch and Buffett/Munger, I believe now is the time to be looking for long-term growth opportunities.  I believe this is wise for the beneficiaries of my long-term investment responsibilities even though there are substantial odds of a major market decline over the next several years.  I am much more confident of my long-term views than my ability to retreat from the market and then reengage.  Over the cycle very few have been able to do that and produce better results than those who intelligently invest throughout the cycle.

Additional thought

Each day our personal, family and corporate real and contingent liabilities grow.  The growth in liabilities without an offset will reduce our net worth.

Question of the week

Where are you investing for growth and when will you increase your growth portfolio?

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A. Michael Lipper, C.F.A.,
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How to Survive Banner Headlines

Introduction

Investors and the public in general tend to believe in big headlines and invest in the direction of the headlines. Often this is a mistake. On the front page of The Wall Street Journal last week there was a five column banner headline trumpeting “Broad Gains Power Historic Rally.” A sub headline stated that for the first time since 1993 that six closely watched indexes rose in the first half of the year. (The indexes were two from Dow Jones - DJIA and Commodities; two from MSCI - World Stocks and Emerging Markets Stocks;  as well as indexes for Gold and Bonds.)

The financially sound investor would quickly point out that the flow into tradable elements was caused by people getting out of cash money. Institutions and individuals were recognizing that excessive borrowing to meet or prolong deficits and the central banks manipulating interest rates has caused a twenty year recognition that in today’s world cash is trash.

Those of us who have any knowledge of how people (particularly investors and voters) react will recognize that when there is a large imbalance of opinion that the majority will win for a relatively short while to be followed by major disappointments. Such may well be the case this time.

How do I know? Years ago I learned from a very sound investor who happened to be one of my accounting professors that I should read financial statements from the back forward. I should spend as much time reading the footnotes and auditor’s certificate as I would in reading the CEO’s comments even though the CEO’s comments were designed to be more easily understood. I suggest that all who wish to be informed and to have the ability to change one’s views to read the small articles at the end of the pages in most newspapers. If you do you might come up with what I am seeing.

Bits of information important to me

1.      In the last week the average interest rate paid on bank deposit accounts (MMDA) went from 0.37% to 0.43%. In most weeks there is no change or only minor moves of .01%. This 16% move could be for some technical reason or could be that banks, mostly retail banks, are starting to make loans and need more deposits.

2.      The five month increase in CCC (low credit quality) loans is up 17.2%.  At the same time there was a decrease in high quality loans being sold.

3.      Moody’s ^* is concerned that the combination of below trend profit growth and above trend borrowing will lead to an increase in defaults.

4.      Two very respected investors from quite different vantage points, Stephen Roach and Wilbur Ross, are worried about too much easy money. Steve is one of the leading experts on investing in China and Wilbur Ross has had a very successful career investing in distressed securities both in the US and elsewhere.

5.      Bank for International Settlements (BIS) which is the international bank that provides credit to banks globally is warning about “euphoric markets.”

Applying concerns to portfolios

As a professional investment advisor I need to be concerned each day as to how the accounts that I am responsible for are positioned. In almost all cases these accounts must be in the market to meet their long-term needs. Today, with interest rates in the range of perceived long-term inflation, (if not lower, as shown by the WSJ banner headline), the bulk of the accounts are balanced accounts with a preponderance in equities.

Regular readers of these posts have learned that I am worried about a major, once in a generation, drop in equity prices. Up to now I have been focusing on stock prices to generate sell signals. Increasingly I believe I should focus much more attention on fixed-income markets. The triggers to the last major declines were caused by the failure of Lehman Brothers ability to finance itself and the widespread fears of residential mortgage defaults. These were fixed-income problems that severely impacted stock prices.

I want to learn from other investors and investment managers. This is why I prefer in most instances to invest through funds managed by bright people. This week someone sent to me a copy of Schroders^* latest investment letter. In the letter Schroders divides its outlook for the future of its accounts into scenarios. The most probable is an extrapolation of present trends. However, the letter mentions seven other scenarios which could be important. I have listed them in order of their probability according to Schroders:

• Capacity Limits
• G7 boom
• China Hard Landing (Steve Roach believes the increasing codependence on China could hurt the US if we don’t come to a better relationship.)
• Secular Stagnation
• Eurozone Deflation
• Trade War
• Russian Rumble

^*Owned by me personally and/or by the private financial services fund I manage

While each of these could be the problem that sets off the market decline, to me the key is the proportion that Schroders gives to the most probable outcome, the essential “muddle through” scenario which is at 65%.

Why I am limiting equity exposure

Coincidentally because of my concerns after five good market years and below average economic years, I think it would be wise to limit equity exposure in a conservative balanced account to 65%. While I expect we could have one more major, almost skyrocket selected stock price move, I would be moving lower in terms of equities, if I could find some reasonably safe fixed-income alternatives producing above inflation rates of return.

The equity exposure mentioned is for those accounts that will have funding responsibilities in the next five years. Longer-term accounts could selectively be higher, except I am beginning to worry about long-term endowment type accounts. In the past I felt that this account should be invested all in equities as the best way to get the benefits of disruptive technology and favorable demographics. I am beginning to worry that pricing competition could be too fierce. 

In terms of demographics, I believe that the US will accept more legal and if not illegal immigration. My concern is as to the quality of our young labor force today. I find it disturbing that in the US Army’s reported view, only 29% of the population could be accepted. (I don’t know what the experience is for the US Marines, but we only wanted “the few”). Without the right people our long-term returns will not match our needs.

Please share with me your views.   

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Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2014

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