Two Questions: Length of Recession, Near-Term Strategy Choices - Weekly Blog # 600

Mike Lipper’s Monday Morning Musings

Two Questions: Length of Recession, Near-Term Strategy Choices

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

Authors Note # 1 
This is our six hundredth blog. I hope you have gotten some worthwhile ideas to help with your investment responsibilities. My goal is to provide at least two ideas a year that make you think about your process, either differently or more thoroughly. As we are approaching our 12th year, I want to thank our subscribers who have shared their thoughts with me. These thoughts have helped me to reach our goals. I also want to thank my two editors who have been long term associates, the late Frank Harrison and his successor Hylton Phillips-Page. They have turned into English my too long Germanic sentences.

Length of Next Recession 
Any study of nature and economic history will show repeated periods of expansion (fat years) and contraction (lean years). In studying history, I believe they are not only inevitable, but required. It is important to separate economic contractions, which we call recessions, and market crashes. They are often in close proximity to one another, but not always. Economic recessions have a much greater impact on investment portfolios than so-called stock market crashes. For example, while much media focus continues to be on the October 1929 market crash, there is little mentioned that by December of that year the Dow Jones Industrial Average had risen back to its October levels. Thus, the crash was a technical dislocation and was not in itself a cause of the recession, or the psychological term that’s been applied, The Great Depression.

The historic reasons for contractions after periods of expansion, either in nature or economics, is an unsustainable expansion. There are many causes for unsustainable expansions:

• Changes in climate
• The outgrowth of war on both the victor and victim
• Confusing secular growth with cyclical growth to meet a temporary demand vacuum
• Too low or too high prices
• Leaders of governments and/or businesses attempting to extend a tiring expansion
• Loose credit that keeps both companies and individuals seemingly solvent, but creates zombies awaiting bankruptcy
• Excess capacity creating excess supply, driving prices lower among competitors 

If recessions are inevitable, what is the question for investors? 
The question is the time span of the recession. Most modern recessions, as reflected by the stock market, have a duration of about 2 years (1-3 years). Considering the folly of those who have been correct in spotting a price peak and then have being wrong about the bottom and subsequent tops, I will not attempt to call an end to the current dance.

Considering my focus on long term investment accounts, it raises some questions. Does one stay with sound portfolio holdings enjoying the expansion, on the belief that their past gains will carry them through a roughly two-year decline. While not publicly admitting that this is their strategy, most individuals and institutional investors are currently following this strategy. There are however other issues that should be examined:

• The current US stock market expansion is over ten years old.
• Governments around the world are actively pushing nominal and inflation adjusted "real" rates down, creating zombies out of both corporations and individuals who should be exiting their debt. 
• Not fully understanding that technology drives prices down, changing purchasing habits and creating deflationary trends which are often elements of a financial collapse. For example, there were those who believed we had seen peak auto production in the 1990s in Japan and in 2016 in the USA. These beliefs resulted from changing demographics, living habits, ride sharing, and the growth of US public transportation. Without a strong auto industry politics would change, as well as many other things. 

If our next recession lasts five or possibly ten years, shouldn't we be change our portfolios?
The problem with equity type risk in stocks, high yield bonds, and private equity/credit, is what to change it to? While mutual fund investors are not always right, it is interesting to note that the largest net flows are currently going into money market funds, followed by high quality commercial bonds.

As usual, Jason Zweig of The Wall Street Journal had some things to ponder. He reported that in 1929, on the basis of the radio boom, the Radio Corporation of America had a price/earnings ratio of 73 times and a price to book-value ratio of 16 times. Amazon, because of the promise of "the Cloud", recently had the same numbers if not higher.

Author's Note #II 
In the early 1960s I was a young analyst awaiting the boom in color television. After many years it finally happened, with RCA rising above its 1929 peak. The color television boom grew slowly because of the difficulty in producing acceptable quality television picture tubes. There were only a handful of suppliers and RCA was late in converting one of its factories in Pennsylvania to a color picture tube plant. Thus, I and many analysts visited the plant, followed by lunch with their management at the local country club.

The meeting date was November 23rd, 1963. It began and effectively ended with the announcement that President JFK had been shot and later died. Clearly, there were lots of unanswered questions at that time. One that struck me came from a well-know, but nameless analyst “what was happening to stocks on the American Stock Exchange?” This was significant because the largest manufacturer of color tubes was listed on the ASE. My guess is that he personally held that speculative stock with a large borrowed balance. The markets quickly closed to prevent a panic which would have wiped out many, including those on borrowed margin.

It was a very silent time on the train ride home from Pennsylvania that night, but it gave many of us a real understanding of the risks we were taking and how volatile markets can react to the unexpected. This kind of experience shapes one’s thinking for a lifetime. The US markets reopened the following Monday morning to reassure buyers.

Near-Term Strategy Choices 
In my role of selecting mutual funds for clients, I am always looking to balance the risks and rewards of investing. My associate Hylton and I do this is by reading financial documents and visiting many successful managers. This weekend I reviewed the strategies of a number of successful managers. I am happy to have a discussion with subscribers to see if any of these strategies fit within their responsibilities. The following list is not in preference order, but in the order of when I read their latest report:

1. Import substitution (A bet on lessening globalization)
2. Mid-Cap Opportunities (Not particularly unexploited)
3. Better stock prices in China (Taking advantage of retail selling)
4. Overweight financials (Contrarian bet on rising interest rates, which seems inevitable)
5. Market share can be better than reported earnings if it is profitable and leads to higher EPS
6. Cautious on momentum (already happening)
7. Illiquidity is expected to get worse
8. Investment decisions are based on current prices, not macro views. 
9. Absence of bargains (Warren Buffett's complaint) 

Questions for the week: 
What portion of your portfolio could successfully survive a long recession?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/10/things-are-seldom-what-they-seem-weekly.html

https://mikelipper.blogspot.com/2019/10/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2019/10/contrarian-bets-and-other-risks-weekly.html



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A. Michael Lipper, CFA

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Investment Journeys with Worries

Introduction

Investing is similar to a journey or a voyage. We start from a known location usually expressed as a sum of money and we set sail for unknown futures, some short-term and some long-term including possibly some beyond the time we personally are onboard, but our money is. The wise investment traveler before he, she, or they get started consults the known histories or charts and they scan the horizon looking for possible dangers. Only time will tell whether some of the perceived dangers are real. Some will be mirages or just shadows. And some will not be foreseen and surprise us.

If one wants to survive the voyage one should begin to catalog the beginning dangers and add to them as time and travel produce new ones. In many respects this is the job of the investment managers, at least in my opinion. The way I categorize the dangers is by the most likely time frames when they can do the most danger.

Near-Term Worries:  Sudden Sentiment Switches

At this very moment the biggest worry is that many investors have left the comfort of fundamental investing and economics. Notice how much of the punditry is based on the outcome of political analysis. These “authorities”  including many portfolio managers and analysts as well as salespeople are proclaiming their analysis of various political decisions and even more absurdly, their outcomes on security prices. 

Many of these predictions were brilliant, that is they were brilliantly wrong about recent political events, but even more wrong about the significance of their outcomes. It is true we have recognized that the main drivers to securities prices for almost a year have been changes in sentiment, however there have been very few of these pundits who have been correct; to use a betting term, the "daily double" (which is difficult to win) of getting various political decisions right as well as their significance. The risk to market prices is that when the "experts" are proving wrong in one or both directions; for instance large, one- sided positions are quickly reversed creating high intraday volatility and bouts of illiquidity. If against historic odds the overwhelming opinions of the experts prove out, there will likely be far less movement because the more active players are in a favorable position.

While I can not accurately predict the future, my instinct from my handicapping racetrack days is to bet against the favorites. That way I have more upside and less downside than following the crowd.  Thus, I suggest that long-term investors not get shook out by bouts of volatility and perhaps take advantage of them when they occur  - as they surely will. This will be true for just about all asset classes that have substantial followings.

Bonds Can Hurt Stocks

This week in The Wall Street Journal  there was the headline "Bonds Flash Warning Signs." The Journal was reacting to the continued and accelerating purchases of bond funds. We have seen the same pattern in many markets around the world. Both individuals and institutions are desperate to attempt to close the gap in their retirement capital in their chase for yield. 

I have often said that if one cuts the wrist of a security analyst, a historian will bleed. While I try to learn from my and others' historical mistakes, it appears that most investors and markets do not. The postmortems on the last major global financial crisis ending in 2009 blamed the underwriters and credit rating agencies. In many cases they did not cover themselves with glory. But there were two other parties that contributed heavily to the crisis: the political structure including the central banks and the buyers themselves. The buyers bought into varying levels of residential mortgages without an understanding that house prices could decline. Again the buyers did this in many markets. Have we entered a similar situation about ten years later?

The fearsome drive for yield can be seen this week in the 3.28% yield on what Barron's called the best bonds, meaning high quality. This yield is in the same range of a number of sound dividend-paying stocks. Over time many of these stocks have a long history of every year or so raising their dividends. Currently the dividend increases are equal to or exceed the common perception of inflation. Thus, over time the income from owning some stocks will be bigger than from owning high quality bonds. Having mentioned inflation one should look at the probable price movements of bonds and stocks during periods of inflation. (Almost all central banks have been trying to increase the rate of inflation in their countries.) Since bond interest payments are meant to be fixed and dividends on stocks do rise periodically, it stands to reason that bond prices during an inflationary period will decline until maturity and stock prices rise.

I wonder when the media, politicians, and "strike-suit" lawyers will look for culprits to the mis-selling of bonds into unsophisticated senior citizen accounts. These actions can be helpful to the financial community which may be dealing with illiquidity issues that at least by rumor threaten various counter parties.

To the extent that the bond buying phase continues it could lend itself to bigger fraud instances due to the available leverage opportunities.

Long-Term Worries: The Absence of "Middle Men"

In the history of organizational changes we seem to play accordion, going through periods of contraction and expansion. Almost every industry or group of people start with an increasing number of players which reach a phase of competitive destruction which shreds the weaker players. Often the surviving stronger players concentrate their resources on what they do well and outsource small, difficult, and time consuming functions to others. Thus a group of small, agile, and tightly-managed middlemen evolve. At some point, particularly when the majors sense that they are slowing down, they choose to capture or in some cases recapture the functions that have been the job of the middlemen. We have seen this pattern in almost every industry; airlines, autos, chemicals, financial, retail, etc. On the surface the large acquirers reduce their external expenses and secure some skills that weren't within their base. I have personally seen trading, investing, underwriting, research and money management go through these consolidations. 

I suggest that in time this consolidation of the supply chain will work against many of the mammoth players. While there is a good history of large companies in development of major products and services, most of the startling new products and services are incubated in small, agile companies. Many of these are run by entrepreneurs who work many long hours at low current pay. Small companies have less fringe benefits than their acquirers, which is compensated for by sharing in the proceeds of the buyout. Once the entrepreneur and his/her staff are in their big new homes, their lives and incentives become different and often lead to lower productivity and certainly less risk taking. I suspect that this is one of the reasons that US productivity has declined.

Over a twenty year period the number of publicly traded companies is down by about half. While there have been a limited number mega mergers, most acquisitions have been of large companies acquiring  mid and small companies. A number of savvy portfolio managers have recognized these trends and have specialized in mid-cap investing. In the US they may have less luck than in the past because there are fewer publicly traded mid cap companies.

As usual when there is a need, the markets provide  solutions. There are two trends to answer these needs. The first is that more worthwhile companies are staying private avoiding all the hassles of being public. In some cases they go through the intermediate step of working with and through a private equity group to their eventual mega buyout or IPO. 

A second solution is found in the missing creativity of middlemen in the US, which is increasingly being supplied by activities overseas, both in the developed and the developing world.

I view this evolution as somewhat worrisome, events won't be as smooth as they were in the past and it will cause the larger companies to slow down their growth and/or in some cases see a more halting progress pattern. I am also worried about the skill level of the managers in the major corporations to manage all the elements of the previous middlemen successfully. They are different.

Question: What are your systemic worries?

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