Is History Rhyming Again? - Weekly Blog # 934

 

 

 

Mike Lipper’s Monday Morning Musings

 

Is History Rhyming Again?

 

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

 

 

 

Preface

Before the New Jersey Symphony’s inspirational playing of Beethoven’s Pastoral Symphony there was a brief concert by the New Jersey Symphony Youth Orchestra’s Academy Orchestra, who are gifted and wonderful. However, what was more wonderful was thinking that these talented young people not only learned their musical skills very well but also learned a bit of the history and discipline of classical music. Hopefully, it will give them the skills to manage the messed-up world we are passing on to them.

 

I couldn’t help my own burdened brain sitting there Friday night after what may have been the most important stock market week in some time. The Standard & Poor’s 500 pierced the low set in September. Classically trained market analysts will likely suggest how difficult it will be for this most important of all indicators to quickly recover the 10% loss from its high point. Pundits will likely blame the current military and diplomatic failures to end the war.

 

Those in leadership positions are not paying attention to ancient history. Iran is the modern name of what was called Persia for centuries. The rulers of Persia controlled much of what passed through the “silk road”, which not only passed new foods to the western world but also mathematics, science, paper money, and gun powder. Persia had a large and powerful army that kept would be conquerors away, although it was not particularly successful at adding to its piece of the Asian land mass.

 

I believe the main threat to the US and other countries is not their incipient nuclear warfare, but their successful sponsorship of proxies who damage other established governments and societies through the destruction of people and property. Recently, the US experienced a couple of wanton killings carried out by US citizens who received local training and support. We have seen the Iranians do this not only here, but in the UK, Europe, Middle East, and Africa. Because their sleeper cells easily entered the US through an open border, we don’t exactly know the size and capability of the problem.

 

The US has a history of winning wars and losing the peace because we are not very good as occupiers. Also, it is worth pointing out that Iran has never successfully been occupied by foreigners. In my opinion, the dream of a fully formed new government structure for the country appears naïve.

 

In exposing the problems which led to the market drop, we need to address an approximately 100-year period of excessive debt creation and the confusion between a top-down education and a bottom-up learning process.

 

This Week & Beyond

We got one violent rally this past week and could get one or more this coming week because a gap opened between the S&P 500 and NASDAQ on Friday. The gap must normally be filled before a sustained move can occur. Friday can perhaps be summed up in three numbers:

• S&P 500 -1.67%
• Price of oil +7.07%
• ECRI industrial prices rallied again to the 130 level, putting the year-over-year gain at +9.25%

In the first three days of the week there was a positive tone to US stock prices, but they were swamped with declines in the last two days, putting the SWX down for five straight weeks and on Friday it fell below its September returns.

 

The declines appeared to be coming from retail-oriented accounts, many of which were housed at large retail brokerage firms years ago. Coincidentally, both the number of listed stocks and the number of primary retail brokerage firms significantly declined during this period. They were replaced by larger more diversified firms whose brokers switched from commissions to fees, making them look more like “wealth managers”. However, many of them are still short-term oriented and prefer stock exchange listed securities for their accounts. Most of these new recruits to the business have not experienced a full economic recession and very few investors or investment committee members have any direct experience with depressions.

 

The latter point, in my opinion, is causing great risk to the market, not that I can estimate the starting date of a new depression. However, as someone who has studied old races and other ancient track conditions, I am conscious that bad things do happen. Thus, I feel a need when examining investment possibilities to include an alternative negative future in reviewing future strategies. There are not many investors or advisers who do.

 

Most down markets, but not all, are caused by a forced repayment of debt at an inappropriate time, like in William Shakespeare’s “The Merchant of Venice”, or in margin calls. We may be due for such a period!! Coming out of the expansion of most global economies after WWI in the nineteen twenties, there was a ballooning of debt creation. Borrowing against securities became popular with retail investors in the US and other countries, particularly by those of the farm community in the US. By the late 1920s, many US farmers, merchants, suppliers, and local small banks were heavily in debt, with their crops and land used as collateral. When the price for domestic crops was impacted by lower-priced foreign competition, it led to dire conditions. They appealed to their congressmen for help in putting tariffs on incoming food items and they convinced a reluctant President to enact The Smoot-Hawley tariffs, causing foreign governments to respond in kind. This led to the disruption of global trade, which was one of the initial causes of the recession. The recession was turned into a depression by a new government which needed a ten-year long depression and a new World War to pull us out of this self-administered trouble. I AM NOT PREDICTING THIS, BUT I AM SAYING WE SHOULD CONSIDER IT A REAL POSSIBILITY.      

 

Caution: As these worries are disturbing, they should not be discarded, even though none of us wish they come to be. However, prudence requires that they should be examined regularly to see ensure their chance of occurring stays small and doesn’t creep up to a higher probability. The odds still favor expansion.

 

Please share your views which can help us.      

 

 

 

 

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Mike Lipper's Blog: Bifocal Analysis: Short & Long-Term - Weekly Blog # 933

Mike Lipper's Blog: This week’s Dichotomy/Bifocals Needed - Weekly Blog # 932

Mike Lipper's Blog: Premature: Buying Program to Begin Soon? - Weekly Blog # 931

 

 

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We Are in a Training Exercise - Weekly Blog # 548

Mike Lipper’s Monday Morning Musings

We Are in a Training Exercise

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

         

We are Never too Old or too Rich Not to Learn
After almost ten years of a one-way domestic stock market we are experiencing some discomfort. Fixed income markets have been falling for some time and most commodities and currencies, ex the US dollar, are in bear markets. One might say that many investors in the US stock market over the last ten years have learned little and forgotten much.

Some of the realities we have forgotten:

1. Change is always present, but it becomes noticeable at different rates and times. From a portfolio standpoint, the time of maximum risk is often when each position is profitable.  The current prices of many positions are two to one hundred times their original cost. The danger herein lies in the belief that the size of these gains is permanent. Any detailed study of wealth over the years will show that it fluctuates and the only way to lose a lot money is to make a lot before one loses some or all.

One way to see the power of change is to examine the ten largest market capitalization companies in a series of ten-year intervals,1998-2008-2018. (See the footnote as to why the three periods were selected.) Only Microsoft and Exxon made the list in all three periods. Thus, there was an 80% failure to maintain relative market capitalization. One might say that any long-term investor who does not own these two for the next ten or twenty years is betting that they don’t survive at the top of the relative peak in market cap.

2. Perhaps, the most creative part of human nature is the ability to circumnavigate around an accepted standard. At one point in financial history the most important measure was yield, which was replaced with book value, which gave way to size and then to earnings per share. Now it is non-GAAP earnings. Usually, sellers of securities favor the old popular measure, where buyers prefer a newer version. Because of changes in accounting standards, tax rates, and regulations, private equity participants often use EBITDA (Earnings Before Interest, Depreciation, and Amortization). I prefer operating earnings adjusted for debt service. The one thing I am confident of is that in ten years the transaction price battle between buyers and sellers will utilize other analytical measures. The art of selling well and buying wisely demands nothing less.

3. One of the most valuable lessons that Charlie Munger taught Warren Buffett was that it was better to buy a good company than a good business. With the cycle of disrupting the old and replacing it with the new, there is a risk of buying into a copycat model based on the financial ratios of some currently successful company or venture. At one point there were some 300 US automotive companies, semiconductor manufacturers, restaurants, banks, insurance companies, and universities. According to Mr. Buffett, a good business is one that any fool could run and often does.

Defining a good company is not a mathematical or a historic exercise. The focus of the search is not on the “C” suite exclusively, it’s on the bulk of the people. Can they do the next important job? Do they have the trust of their clients and suppliers? Will they generate many of the new ideas and procedures that make both large and small differences. While too many annual reports state that their employees are their best asset, some do make that condition happen.

4. Market price liquidity is not important until it becomes critical. Most of the time price sensitive buyers and sellers keep prices and the spreads between them in check. During periods of stress the urgent price insensitive buyer or seller dominates the market and is a heavy user of the liquidity pool. As their insistent need to trade uses up much of the present liquidity, it frightens away some potential liquidity providers, leading to both greater than normal dispersion of prices and spreads between bid and offer levels. Often the price insensitive player is motivated by a need to meet an obligation. This could be an Authorized Participant or a Market-Maker keeping his book in balance. The biggest destabilizer is an owner meeting an immediate margin call.

There are some that say the unusually severe drop in the Chinese “A” share market was caused by the government’s concern about the quantity of  debt in China. They put pressure on the four major government-controlled banks to reduce the size of their loans. They in-turn called part or all of the loans to various entrepreneurs who pledged shares in their company. To meet the call they liquidated enough of their holdings to meet the banks’ demands.

Maybe one of the reasons  many NASDAQ stocks with good earnings and prospects fell more than other stocks is that large portions of their shares were owned by hedge funds, private equity funds, and senior employees who were meeting margin calls. This is the kind of market action that has been periodically happening ever since there have been collateralized loans.

At times, the size of the liquidity pool is more sensitive to sudden changes in sentiment than financial and economic numbers. Periodically, changes in political trends can cause driven investors and speculators to become price insensitive, causing liquidity providers to reduce their commitments or retire from the game.

Perhaps investors have learned enough from last week’s training exercise. Enough to know that when the real market reversal comes they will recognize what to do, before, during, and after a future “big one”. I hope so.

Footnote
2018 is ten years from the last major market decline and 31 years from the biggest single day decline, which was much more a market phenomenon than an economic one.

2008 was the first year of the great financial crises. This was the result of excess leverage by the private sector in response to a series of governments attempts to postpone a crisis in the economy, although they made future crises worse.

1998 was the year I sold the operating assets of Lipper Analytical to Reuters Group Ltd. It was a good company because we had good people who were dedicated to helping both our direct and indirect clients. 


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Price Insensitive Sellers Pay A Big Price

Introduction

Price insensitive sellers are forced to sell at whatever prices they can get. Emotionally they feel that they have no alternative than to convert their assets into immediate cash to meet pressing needs. On the other side of the trade are buyers who have innumerable choices both in terms of what assets to buy and what prices they are willing to accommodate the driven sellers. This is one of the two big lessons from last week's market turmoil. The other lesson are the answers to “what did we learn  about ourselves as investors?”  I plan to explore that subject in next week’s post.

Co-Venture Risk

One of the big failures in teaching investments is only using quantitative analysis of price, cash flow, earnings and book value. The approach  assumes that these factors, or if you prefer estimates, are operating in suspended animation from what else is happening in the real world. To me the real risk in a traded investment is not my changing perception of price, but what is happening to the thinking and actions of others who own a holding in the same or allied securities. Due to my more contemplative nature I make decisions slower than the quickest "gun" in the market. My method might be deadly in a gun fight, but it is not too dangerous if I am early and take cover while transacting.

Fundamental and Emotional Perceptions

In attempting this very difficult analysis of guessing the cards of the players opposite me at the gaming table, I find it useful to divide the effort into two parts. The first and easier of the two is what would cause the co-venturer to change his or her perception of our shared investment; e.g., a view on the appropriateness of management's actions, or a similar point. The second and more difficult effort is to attempt to fathom out changes in the financial or emotional needs of the co-owner who becomes highly motivated by internal pressures to sell for reasons other than price. In other words, what would cause my co-venturer to become an immediate price insensitive seller?

Two Price Insensitive but Understandable Sellers

As a manager of institutional and high net worth accounts, I am well aware of planned and unplanned needs for money. On any given day there are other investors that are meeting similar needs, but for the most part these transactions are relatively small in scope and do not have price moving impacts. When a very large or a group of large players come to the table for immediate action regardless of price, they temporarily become the dominant players in the market and therefore the settlers of price reactions.

To put last week's price movement into some perspective, instead of looking at market indices, I looked at the prices of some very high quality stocks and their prices to gauge the intensity of the sell-off. For illustrative purposes I will use a personal holding in JPMorgan Chase. On Monday the 24^th  of August it opened down from the prior Friday's close at $59.29 and quickly sold-off to $50.07 and to finish the day at $60.25 and the week at $64.13. The drop early on Monday was part of the rattling 1000 point fall in the readings of the Dow Jones Industrial Average.

While I am not a full time bank analyst, I saw nothing on Monday that would have dictated that kind of price action on relatively high volume. As a matter of fact I am beginning to think that banks’ exposure from loans to highly leveraged domestic oil and gas producers could be a problem. Accepting the questionable assumption that these loans will be defaulted, the issuer will go bankrupt. Thus the lenders will be forced to take over the borrowers temporarily. Due to substantial operating cost reductions, the banks are likely to find that the underlying equity to be sold to surviving energy companies will more than pay off the prime loans owned by most banks. Therefore, to my mind, the risk to most major banks' balance sheets is reduced. This is a classic example of an insistent seller meeting an immediate need for cash regardless of price. The seller could have been liquidating a margin call. (Under prior market regulations the stock specialist on the floor is responsible for maintaining orderly markets and would have to explain to the Exchange and possibly the SEC why it should not receive a large fine and lose the right to make that market on the floor.)

 
Another technique to understand what happened last week is to view the world (as I do) through the lens of  mutual fund performance. For the week ending Thursday August 27^th , there were only two types of fixed income mutual funds declining 1% or more, US General Treasury funds -1.3% and Emerging Market Local Currency Debt funds, also declining 1.3%.

The Chinese Government, the Big Seller

I have maintained for a long time that whether one invests directly into China or not the actions of what happens within China will be the single largest impact on global markets. This last week underlined the importance of China to our markets.

Excess cash has been flowing out of China from wealthy individuals pursuing various activities. At the same time, exports from China are growing more slowly. The combination of the slowing global economy and rising labor costs within the country, means that China is earning less than it did to fund infrastructure, food, and health requirements to sustain the ruling party in power. In order to meet these pressing needs the government has been selling down its huge hoard of US Treasuries and at the same time slightly devalued its currency. One needs to remember that short-term US Treasuries are an important collateral for many market sensitive loans. Any pressure on Treasury prices can and probably did drive some margin calls.

What most financial analysts focused on in terms of China were its financial assets and liabilities. They should have looked deeper into the generator of these elements which is the nature of its exports and imports. China’s favorable trade balance was shrinking at the very same time that the US swung to its own favorable trade balance in the second quarter, after two quarters of being unfavorable. Thus for the aware, the actions of the Chinese leadership should not have been a total surprise.

The Second Price Insensitive Seller

While the primary depressant last week was the actions that emanated from Beijing, the second insistent sellers were traders that had or were about to receive margin calls on their Exchange Traded Funds (ETFs). When looking for hedging devices hedge funds and others  have determined it was cheaper to use ETFs than to use futures. In the lackluster, thin market that had many stocks declining and only a relatively few momentum stocks rising there was an increasing need to hedge. In a period of low returns which we have been going through for more than a year, leveraging becomes attractive with its low manipulated interest rates. On Monday due to changes in market rules and some lack of demand in late August, approximately 1300 stocks on the floor of the New York Stock Exchange either could not open or had to be temporarily suspended. Approximately 500 of these were ETFs. One extreme example is an equally weighted S&P 500 index fund which in the first hour of trading was only open three minutes.

To take a somewhat longer term view of the impact of ETFs on the general market remember the performance of thee three general market indexes: S&P 500 -2.36%, DJIA -1.98% and NASDAQ -1.33%. There is substantially more invested in ETFs that track the S&P 500 than the other two measures. The 1% difference between the S&P and NASDAQ is of particular interest because in most market declines one sees greater falls in the over the counter market than the listed market, however the NASDAQ index had been stronger recently. Based on history one would have expected the prices on NASDAQ to fall the most, followed by the DJIA due to its heavier industry orientation and the least decline should have been the market weighted S&P 500. I believe the difference was the amount of money invested in ETFs  in the S&P compared to others.

Why did some of the ETFs momentarily perform worse than the indices or their related mutual funds?  Mutual funds have only one transaction price per day which is the closing price. ETFs are traded on the open market throughout the trading day. When one is dealing with the mutual fund it is a direct purchase or sale. With ETFs one goes through an Authorized Participant (AP). The APs are floor dealers that create or redeem $250,000 chunks of the fund. They get frequent intra day net asset values for the underlining fund. They use this to make bids and offers for those who wish to transact. Under normal market conditions the price differentials from the last known NAV is small, in part because there are other competitive APs. On Monday with a large number of large company stocks not open for trading there were not good NAVs to trade against. As a risk control measure the APs widened their bid/offer spreads and reacted to incoming orders. The price insensitive sellers were desperate to get immediate executions which used up much of the capital of the APs who could not off-load the redemptions  fast enough to stay within their own capital constraints. Later in the day trading returned  to more normal, but high volume day patterns.

In Summary

1. Be aware of co- venturers and the risks of them getting through the door first.

2. Understand the market mechanisms of what you own.

Next Week

I am currently planning on discussing what we learned about ourselves as investors last week.

Post-Script:  According to Blooomberg TV, Asian markets opened down, with DJIA futures off 214.

Question of the Week: What did you learn last week?   

__________   

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