Faulty Comparisons - Weekly Blog # 682

 

Mike Lipper’s Monday Morning Musings

Faulty Comparisons

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

                          

Judgement Traps

When asked how his wife was an old comic replied, compared to whom? While that generated a laugh, it highlighted that some important considerations are not well decided by quick comparisons. Unfortunately, far too many investment decisions are made largely by comparison, with extreme performance judged to be better. 

As someone who has largely devoted his career to making and using statistical comparisons, I am the first to suggest that historical comparisons are not good “divining rods” for making investment decisions. When dealing with the public the SEC requires that a warning be included indicating past performance is not indicative of future results. Unfortunately, this warning is not attached to all comparisons. For example, size, yield, book value, return on asset, equity, sales, operating earnings etc. All that these measures tell us is what happened, not why they happened or even the conditions that may have contributed to the results.

The main reasons there are betting favorites at the racetrack, political campaigns and possibly at the entertainment awards, is that there is a belief that the “smart money” knows something and therefore is worth following. I was recently in contact with some very bright student investors who used a lot of statistical measures to make investment decisions. One of their newer tools was the size of mutual fund holdings and possibly transactions in a stock. I felt this was an oversimplification in their search for the “smart money”. I suggested they separate the fund universe into three buckets:

1. Passive/index funds
2. Funds with net inflows
3. Funds with net outflows

I would totally disregard the passive funds because they are not making considered judgements on individual securities. They should pay only partial attention to funds growing through net inflows and pay particular attention to funds in net redemption. 

Portfolio managers of funds with net inflows generally use the money to either buy more of what they own or begin a position in a new name. If the new name attracts additional future dollars of inflows, that could be of interest. The job of the portfolio manager experiencing net redemptions is quite different. He/she may love all their holdings but must still raise cash. Consequently, it is likely securities with the worst near term prospects will be sold. That could be the most interesting factoid of the exercise. For further insights, I have found it worth following specific funds, particularly when they invest in a new name. (This is exactly the type of SEC warning that would be appropriate, past performance does not predict future results.)

Part of the fallacy of comparisons is a misperception of the appropriateness of the index used to compare a particular stock, fund, or investor. Currently, the largest number of investment accounts hold 10 to 30 stocks and have less than $5 million invested. In these cases, performance comparisons with the major indices are inappropriate. Indices, in terms of the number of securities, represent a small percentage of the number of available securities. Additionally, unlike mutual funds, most stock accounts do not face daily liquidity needs. Most pension funds have limited need to make unplanned sales, thus liquidity is not paramount in their decision process also.

As a young junior security analyst, I thought comparing a steel company in Chicago with those in Pennsylvania was not useful. The Chicago producer mainly sold to nearby customers and had a transportation cost advantage, which they used to get higher prices. Similarly, the degree of internal production of critical auto parts was a major differentiation between auto companies. Thus, I at an early questioner of comparisons without adjustments. 

Applying Comparisons to Future Market Direction

As is often the case, intelligent analysts and portfolio managers see the US stock market going in one of three directions:

1. A major economic expansion
2. At half time in a continuing bull market
3. At a pause before a market storm

In each case, their primary argument is based on a comparison with an indicator. I have listed their views and indicators below, allowing subscribers to make up their own mind.

“Mother of All Recoveries”

This is an economic forecast based largely on a combination of government stimulus and recovery from the lockdown.

Half Time

“Half Time” in a long-term bull market trend, with an occasional correction and a change in market leadership, supported by market analysis.

A Rounding Top that Could Lead to a Bear Market

Through Thursday, the Dow Jones Industrial Average (DJIA) -1.64% and the S&P 500 -1.81% are down from their peaks on May 7th. The NASDAQ is down -4.77% from its peak on April 26th. While the first quarter was quite positive, it is possible the second quarter will be flat to down, with earnings per share gaining the most in the second quarter this year. In the latest week, Precious Metals Funds were up +7.16%, with 118 new lows on NYSE and 230 new lows on the NASDAQ. In the week tax payments were due, Money Market Funds attracted $25.2 Billion.

What Are the Odds of a Top in the Next Six Months?

Mother of All Recoveries   25%

Half Time                  35%

Rounding-Top               40%

Based on these projections, I would prepare to trade portions of the account and be prepared to raise 50% in cash. For accounts with a five-year time horizon, a cash holding of 20% to be redeployed once the market has moved beyond a 10% decline, makes sense. For accounts looking beyond five years, no additional cash is suggested.

Please share what you think?

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https://mikelipper.blogspot.com/2021/05/extreme-views-can-be-good-lessons.html

https://mikelipper.blogspot.com/2021/05/where-is-stock-market-going-next-weekly.html

https://mikelipper.blogspot.com/2021/05/mike-lippers-monday-morning-musings.html

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Did Friday Begin a New Up Cycle?

Introduction

Market and economic historians like to date the beginnings and ends of various phases. They usually pick the ultimate peaks and bottoms of a statistical array. When possible I find it more useful to pick a date or a range of dates when attitudes change. If the financial markets are performing their function they should be discounting the future path not purely reacting to late reports of the economy. The problem is to define how far out in the future the markets are discounting. Most of the time markets look to different futures based on their needs for duration and safety of their segments.

Friday could have been such a turnaround in market sentiment. The surprisingly strong markets could have been a function of realizing that in the long-term, Brexit could produce some positive results that the “experts” who were wrong in their referendum forecast were similarly wrong in their completely one sided forecasts as to the consequences of a vote to “leave” the EU.

On Friday, July 8^th , two price movements contrary to each other were reached. (This was not in celebration of two birthdays, The Wall Street Journal and my own.)  The S&P 500 came within one point of its all time high price reading a bullish sign. On Friday the yield on the ten year US Treasury hit an all time low. Normally a low high quality bond yield is a sign that investors will accept a very low yield for safety because they fear that the worst is forthcoming. These twin occurrences on the very same day suggest to me two things. First, that different segments of the market are discounting very different futures. Second, that past valuation approaches are no longer working. (In future posts I will raise  questions as to the relevance of unadjusted financial statements.)

Fund Performance Numbers Reveal

On Friday the Dow Jones Industrial Average gained +1.4% and the S&P 500 was up +1.53%. Since the indices are not burdened with either low returning cash or expenses including commissions they often perform better than managed funds. Despite having cash redemption reserves and tactical reserves plus expenses, average Large Capitalization Core Equity funds as well as Large Cap Growth funds equaled the S&P 500 daily performance with the average Large Cap Value funds performing 10 basis points better at 1.63%. My old firm, Lipper, Inc.,  did not provide to The Wall Street Journal an analysis as to the performance of the ETF universe broken down by investment objectives, but it is my impression that the bulk of the ETF assets are in passive Large Cap vehicles who probably did not equal the average performance of the active Large Caps. For those of us who manage portfolios of funds we were pleased to see Mid and Multi-Cap funds on average rise between +1.96% and +1.65%. The big winners of the General Diversified funds on Friday were the Small Caps on average up over 2% led by the Small Cap Value Equity funds +2.25%.

If these relatively better results can be maintained they will answer the rather dour forecasts for the fund industry by Barron’s and McKinsey and some others. Like the Brexit Leave experts they do not study the fund and asset businesses very well. They focus on net redemptions which is the net result of an aging fund ownership population needing more income and perhaps less volatility. These negative reports also highlight poor sales due to the higher profit sales of competing products who over the long-term on average haven’t produced good results.

As someone that invests both in mutual funds and fund management companies, I am delighted to find negative indicators. As I have said in the past, negative indicators tend to be more consistently wrong than positive ones. However, to be fair and balanced I need to remind my readers I could be guilty of confirmation bias which only sees things that favor my point of view.

Brexit Updates

Fitch is reporting that beneath the surface, pre-negotiations are already going on across the channel. Whitehall is already reaching out within the UK government circles and the commercial world to look for experienced analysts and negotiators. We suspect many of the old countries of the Commonwealth are already seeing an opportunity to increase their trade with the U.K. on more favorable terms with the elimination of various EU rules on British trades.

I believe too many people see the local reactions as anti-globalization. I suggest when you again look at the data, one can see a fundamental reaction to expensive governments who impose their social expenditures  on to the commercial world which pass on their costs to the consumers in higher prices. For instance, in the US we are currently seeing wage and benefits rising faster than sales which is causing profit margins to decline. I believe all over the world the costs of big government are depriving consumers money which could help them in addressing both their education and retirement needs which are growing faster than their economy.

Modern Lessons from Europe

As readers may know, I have drawn the parallel between Brexit and the 1848 disruptions. The one person that played the most successful role for the next forty years was Otto von Bismarck, the consolidator of Germany who successfully played on each political side from time to time and maneuvered the other nations brilliantly. He has many great quotes and lessons attached to him. The first is the basis of my continuing analysis of good and bad performance. “Only a fool learns from his own mistakes. The wise man learns from the mistakes of others.” Hopefully these blog posts aid in that effort. The second quote is very useful for most of the world which will go through contested elections from now through the end of 2017: “ People never lie so much as after a hunt, during a war or before an election.”

The third lesson is the failing attempt to unify Europe from the time of Julius Caesar to the present. We should be able to relate to this problem when we look at how many large mergers actually work. Takeovers initially have a better chance but only if in the end they enlist the taken over into the new structure and leadership.

Working Conclusions

Brexit will lead to vital changes in trade, politics, technology and most importantly of all, consumption. From an investment view point we should try to spot as many winners as possible because only some will be long-term winners. Thus an active portfolio management strategy has the best chances of reasonable rewards and relative safety.

Question of the Week:

What are the questions you would like to ask me? 

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A. Michael Lipper, C.F.A.,
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The Failure of Investment Failures

Introduction

This past week I had several opportunities to chat with Tom Rosenbaum, the new president of Caltech; in one session he asked for suggestions as to what additional subjects should be taught. I suggested a course that covered most of the world’s major scientific failures. My thinking was that there may be a common theme to what has gone wrong. I later realized that this was a half-baked idea. On the one hand the very nature of most scientific discoveries is through experimentation. Some scientists however keep changing various elements until they get the result that they want to achieve or recognize that what they did produce is surprising and a good but unintended result. What is often missing from this application of the scientific method is that there is no attempt to learn from what went wrong or at least what did not turn out as expected. 

In the investment world we also examine why something doesn’t work out as expected. As many regular readers of these posts are aware I believe that essentially I learned security analysis at the race track. In some ways my most valuable time (after not cashing a winning ticket) was spent re-examining the prior records of both the winning horse and my losing bet as well the actual racing conditions. I often found that I had overlooked some critical set of facts and my expectations were sadly out of kilter. I humbly suggest that the 2014 investment performance through this week gives scope to look at a number of investment theories that have not produced the expected results. We should not fail to learn from these failures.

Friday's failures

After a week of significant global stock market losses, on Friday the Dow Jones Industrial Average (DJIA) rose +1.63% easily beating gains of +1.29% for the Standard & Poor's 500 and +0.97% for the NASDAQ. I believe the message from this data is that more of the gain was achieved in the indicator with the smaller number of securities which would demonstrate to me some lacking of enthusiasm for most securities. This view is reinforced by looking at one of the DJIA components, JPMorgan Chase^*. On Wednesday the stock hit its low for the week at $54.26, on 37.9 million shares. On Friday the stock closed at $56.20 on 19.5 million shares or little more than half of its high volume day.  Don’t look at Friday’s rise as the beginning of a major recovery.

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

A number of my market analyst friends suggested that the pickup on Friday was to correct a significantly oversold condition and represents a sales opportunity rather than a buy opportunity. This pattern is present in numerous countries' stock markets. Those focusing on the US expect another test of the recent Standard & Poor's 500 lows. Nevertheless they perceive a good chance for a substantial rally in the winter; but a failure to go to a new high in late 2014 or early 2015 would suggest the potential for a major decline.


Mis-reading fund flows

Many market participants jump on aggregate net fund flow data to ascribe a level of demand for stocks and bonds without understanding the broader implications. First, the published data is often based in part on the net differences between fund purchases and sales. To me there is an analytical difference between a $10 Billion net inflow made up of gross income of $11 Billion and gross redemptions of $1 billion compared to a situation when $25 Billion is incoming and $15 Billion is leaving.

Further some analysts add the flows of Exchange Traded Funds (ETF) and conventional mutual funds together. There are two problems with their approach; the first is mutual funds are typically owned by individual investors directly or through financial  institutions that are long-term in nature, like the accounts that we manage, whereas many ETFs are owned by hedge funds and other short-term trading accounts. In the week ending October 15^th, $17 Billion were invested net into equities by the ETFs. Of this, approximately $12 Billion were invested net in S&P500 ETFs. The analysts at my old firm Lipper, Inc. believe that a good bit of this inflow was created by the authorized participants who are largely brokerage firms and other institutions who offer these shares to short sellers in exchange for the interest earned on the short positions. The net effect of this activity is that a major portion of the supposedly supporting purchases to the broad market are betting on a decline.

US fund investors redeem domestic funds

For the last six months fund investors have been redeeming US oriented funds and buying International funds except those that focus on European investments. I believe that fund investors like much of corporate America are concerned about the near-term future for the country. The failure is to treat fund flows as a single-dimension.

Poor economic analysis

I write this post from Washington, DC, where the US Congress sits in the Capitol, a building whose inhabitants usually do not understand capital and the need to make it.

Some want to stimulate through throwing taxpayer money on infrastructure and other ways to fuel the US and other global economies. What they fail to understand is the only economic quantity that is of commercial concern to many of us is the opportunity to make money for beneficiaries. Both cash and credit are in surplus. If the politicians really want to invigorate the economy they should reduce the burdensome bureaucracy.

What are your investment failures?

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Copyright © 2008 - 2014

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Fears of Buyers and Sellers

Introduction

Often the price battle between buyers and sellers is described as the battle between fear and greed. Currently I see the conflict as being between two vastly different sets of fears with very little greed motivation being shown. The focus is on not whether the proverbial glass is half full but rather, what will be the forces that change the water level? What is interesting is that both sides are being driven by fears.

Buyers’ fears

Today’s buyers are afraid of 2013. They are fearful that the near-term stock and bond markets will accelerate and once again they will be shut out of producing index-like returns. One can label this as a competitive threat that another period of underperformance will cause investor accounts to move. On a personal level the fear is the absence of bragging rights at the next gathering of smart people.

While in reality hedge funds are not a separate asset class, the popular image is that they represent highly sophisticated, smart, aggressive managers. In some cases this is an accurate description of managers who have richly rewarded good long-term records. The above average gains of the general markets in 2013 surprised many who significantly under performed. They don’t want this to happen to them again in 2014. This year the markets have incrementally advanced. Last week the S&P500 for the first time closed above 1900. To avoid a competitive repeat of 2013, certain managers are increasing their use of historically low interest rate leverage. We see this in the different directions of net flows in Exchange Traded Funds (ETFs) and similar portfolios of mutual funds. In April, equity ETFs attracted 17.6 billion compared to 12.6 in March, all of the gain was in World Equity ETFs.  

Large ETF positions in hedge funds include those that invest in emerging markets, gold and long-term bond indexes. (During the same periods Small Cap mutual funds saw over $2 billion in net redemptions as compared with net sales in March. Normally small caps are favored by some institutional investors, including hedge funds because it takes less money to move these stocks.) In the past the hedging method favored by some funds fearing price slumps in the S&P500 was the purchase of VIX contracts. In the latest week these contracts hit their low for the year, clearly indicating little fears of declines.

Adding to buyers’ fears, Germany’s DAX Index reached an all time high on the Monday holiday when the US markets were closed.

Sellers’ concerns

Normally buyers are more future-oriented than sellers. After all, since the beginning of the history of the Dow Jones Industrial Average the market has gone up two years out of three.  Thus for the buyers, when the future came it was positive. Today the sellers look at the future and see the past. They see many of the elements that led to the 2007-2009 financial markets crisis. They can be persuaded to slowly sell some of their long-term positions as market prices rotate upward.

Manipulation by governments and central banks

Once again we see activist governments and their central banks attempting to offset slowdowns in their general economies by pushing up the demand for housing. Just recently US federal agencies have been urging the lowering of the underwriting standards for residential mortgages. Combine this with artificially low interest rates and the result is the residential housing market getting injected with venom that can be dangerous to the markets as well as the whole society. Based on past experience it is reasonable to expect that an increasing number of these mortgages will default. When faced with large unpaid debts the past practice of these activist governments was to socialize the losses through various forms of bailouts financed through higher tax realizations. (They ignore past financial history that finds that after a collapse new and/or sounder financial organizations come into being to provide the necessary functions that lead to the overburdened debtors’ collapse.)

The fundamental problem with artificially low interest rates is that it underprices both credit and inflation risks. Within the payment of interest there should be, in effect, an insurance payment for slow to non-payment of the loan and interest. At the current low rates, credit risk premiums are not being effectively paid. They can get away with this for awhile as the huge underfunding of global retirement needs is driving savers into chasing for yield. (CCC-rated paper and bonds are being urgently sought after.) This is a long term problem with only an estimated one quarter of Americans saving for retirement.

Investors appear to be fearful that the central banks will eventually succeed in creating enough inflation that their nominal economies will expand at an acceptable rate. The goal of many central banks is to have a 2% or higher rate of inflation. To protect themselves, institutional and individual investors are plowing into TIPS (Treasury Inflation Protected Securities) to such a degree that the price on the 10 year TIPS is now yielding 0.297%. Clearly current interest rates are not covering credit and inflation concerns.

A Time Span Portfolio Solution

My favored approach is to divide the investment responsibilities into four time-spans based on funding needs and goals.

Under the current “new normal” interest rate environment, the shortest duration portfolio (the ‘Operating Portfolio’) will run out of money sooner than expected. The second portfolio, (the ‘Replenishment Portfolio’) has to carefully trade off liquidity for current yield. This could mean lengthening duration from three to five years. I recommend investors search for reasonably well protected and growing dividend streams. The third Time Span Portfolio,  (the ‘Legacy Portfolio’) should be all equity that can survive a normal recession and still build purchasing power in excess of spending. The fourth portfolio or (the ‘Endowment Portfolio’) should be positioned to recognize and take advantage of commercial disruptions that can lead to outsized returns after inflation, expense creep, and relevant taxes.

A question facing all of us

What are we going to do with the capital liberated by selling that won’t be sucked into either spending or chasing prices?

Memorial Day

This blog post has been delayed one day due to the Memorial Day weekend. 

On this day we are thankful for all of those who sacrificed their lives so that we may be free.

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Did you miss Mike Lipper’s Blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2014

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

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