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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Different Forts: Misconceptions on Risk-less Investing + 3 Reasons for Equity Mutual Fund Redemptions - Weekly Blog # 497

Introduction

Attorneys in court often arrange “the facts” to support a conclusion. Economists and Professors of Finance suffer from “physics envy” of immutable laws. Politicians and pundits speak in sound bites. Investors, like other good judges, look at all of the information found in hard and soft data. Most importantly, investors should avoid accepting any proposition on the face of what is presented. Wise investors have learned to probe for a more complete understanding of what is on offer. 

Is Risk a Number?

Pity the poor professor introducing investments to a class. He or she finds it easy to introduce the concept of gains. It is essentially one of addition or in some cases multiplication. The problem is to introduce the concept of losing which is similar to subtraction. The real issue is to come up with a way to measure potential rewards vs. potential losses to get to a conclusion as to the risk of an investment. In the search for a mathematical answer rather than a deeper understanding of the different kinds of risks facing different investors, academia came up with the movements of US Treasury bond prices.  They measure the price pattern of the desired investment versus the volatility of Treasury prices. Thus, the idea of a “risk-less” rate of return was born. Investment sales forces deducted this so-called risk-less rate from the actual performance of a stock (and more frequently a fund or other portfolio) to create a comparison of favored investments, adjusting for risk.

While it is true that often the movement of treasury prices captures a reasonable amount of the general volatility in the stock market, for investors risk is the penalty for being wrong that causes changes in spending plans. It is these risks that cause pain to investors and their beneficiaries plus create “career risk” for hired professionals.

The use of Treasury prices presumes that there is no fundamental changes in the future of the Treasury market. Because of the changing market structure I believe that there will be periodic changes in the Treasury markets. In this weekend’s Financial Times John Authers has a column that is headed “Liquidity looms as the real challenge facing new Fed Chair Powell.” While he doesn’t spell out the problem, it is clear in the future he is properly worried that the various central banks led by the Federal Reserve will be cutting off credit through the banks to the fixed income market. While the Dodd Frank Act curtailed the commercial banks and large investment banks in their market-making efforts in securities, it did not really address the banks’ extension of credit to the few remaining market-makers. These credits are much larger than the banks’ own securities positions. There is already a shortage of repurchase agreements or repos at present. One sign of structural disequilibrium is that for ten year Government bonds, the US is paying 100 basis points more than the UK pays for its bonds and 200 basis points more than the German bonds. This suggests that the US paper is worth more. Why? I believe the reason is that it is the best collateral for loans that support borrowings for the purchase of derivatives and currencies which can be extremely volatile. Since most loans are immediately callable, there is the sort of risk that started the problems that led to the 1987 and Lehman crises.

  

Thus the ownership of a 4% yielding common stock or fund with a payout ratio of 40% or less and a price/earnings growth rate in the single digits versus a holding in US treasuries may be more dangerous in terms of risk to the investor and career risk to the professional. But these are unconventional thoughts.

Investors Rejecting Equity Mutual Funds

The constant drumbeat that retail investors are deserting mutual funds in favor of ETFs needs much deeper analysis than the pundits are giving it. For a number of months industry headlines have been screaming about the net redemptions of equity funds and this week is no different. Except they are missing the motivation behind the redemptions and its significance. The largest amount of redemptions is coming out of the Large Cap Growth funds. I do not believe that it is performance-related. On a year to date basis through November 2^nd,  my former firm, Lipper Inc., reports that Large Cap Growth funds, on average, have gained 26.03%.  No other non-leveraged, General Equity fund category has done as well this year or even in the last five years. The only other domestic funds that have done better are the Science & Tech funds. Some International funds have done better in part due to foreign exchange considerations.

Why are there so many redemptions?  There are three answers. The first is simple, the second is structural and the third has to do with the changes in the brokerage market.

The simple answer is that the Large Cap Growth funds have more assets than any other investment objective. Thus, logically over time it will have more redemptions. 

The structural answer is that investors put money into funds to meet future needs. The very day that someone invests in a fund, a future redemption is set up in the indefinite future. Because of the way many estates are settled, usually liquid investments are sold to distribute as much cash as quickly as possible so funds are not often directly inherited.

The third cause of redemptions relates to the fact that a large portion of investors in mutual funds was sold by commissioned-paid brokers. At the time of many of these transactions the commissions of mutual fund sales were among the highest rewards to the sales force. Currently many of these salespeople have morphed either into registered investment advisors or have changed firms for understandable reasons. In their new shops they are no longer motivated by commission sales but by investment advisory fees. As their books of business mature, there is little attempt to replace stock mutual funds in their aging accounts. These investors are converting their investments into either fixed income funds (whose sales are booming in spite of the likelihood of higher interest rates/lower bond prices), or into Exchange Traded Funds. In the latter case the investment adviser will charge an annual fee that within a few years will more than compensate for the loss of mutual funds sales commissions.

Hints For the Future

At some point before the current market suffers a major decline, there will be a more general recognition as to the risks in the fixed income market with higher yields driving fixed income prices down. The credit cycle in high quality paper will contract. It is likely that we may be surprised by the levels of domestic and international bankruptcies which won’t be isolated events.

On the equity side grudgingly we are seeing enthusiasm growing. In the last two weeks sentiment has become more bullish as measured by the American Association of Individual Investors (AAII). It will have to be sustained for a considerable period of time to fulfill a bear market indicator. In addition to Large Cap Growth funds and stocks doing well, industrial metals commodity prices are also ahead, showing a year to date gain of 25.11%. One of my senior analyst friends describes his current portfolio as a 1950s one. As many of the relatively newly minted investment advisors don’t have the historic perspective for the type of market we appear to be entering, they will disappoint some of their customers leading to a positive surge in equity mutual fund sales. (As an owner of a number of domestic and international mutual fund management company stocks both in my private financial services fund and personally, I hope so.)

Question of the Week:

For your own account how are you defining risk?  

__________

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A. Michael Lipper, CFA

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Contact author for limited redistribution permission.