Selectivity over Factors - Weekly Blog # 551

Mike Lipper’s Monday Morning Musings

Selectivity over Factors

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

We are entering a new phase where successful investing will be different than successful litigation and gatekeeper buying. The classic way to judge the strength of a civil law case is to follow past precedents. The same reliance on history carries the day with most institutional gate keepers and investment advisers. Their standard phrase is “Past Performance does Not Guaranty Future Results”. Nevertheless, soon after delivering this dictum they mouth such and such factor or manager has the following good record compared to other records, except when things change.

I believe that underneath the volatility we have seen in 2018 we are seeing greater dispersion in the returns of factors and mutual fund classifications. This ranges from pseudo mathematical certainty to the art form of selectivity. Increasingly the differences in performance are more important than the similarities. Another way to look at it is that instead of looking at any giving picture two dimensionally, we search for a third or perhaps other dimensions. This leads to different views being developed by different observers. The more successful observers will be much more valued than those who are just model makers until the next changes in the investment picture.

POSIBLY BIGGEST CHANGE IN 100 YEARS
Practically all of those who have been schooled in Liberal Arts courses believe that it is the government’s function to stimulate the economy out of a recession. From this requirement it follows that it is the government’s responsibility to control the economy. Modern governments, whether elected or command controlled, translate that into job creation. Increasingly, leaders are becoming frustrated with their inability to get their economies (people) to comply with their desires. Part of their problem is that their favorite handmaiden, the central bank, has not been as effective as desired. The institution that studies the central banks with the most detail is perhaps The Bank for International Settlements (BIS). The head of the BIS’s Economics-Research Department is quoted as saying “politicians have come to rely on central banks to stimulate growth since the (financial) crisis.” Yet, with very rare exception, constituent economies have produced below normal historic results. Central banks/governments have kept short-term interest rates below the levels needed to cover  non-paying loans, whose interest rates are too low. A still greater penalty has been levied on economies by the misallocation of resources during recessions. Far too many people continued to be employed by failing organizations kept alive during the recession, instead of transferring that human capital to sustainable activities. In the face of these challenges some governments have reduced administrative burdens and tax levels, but this will probably only have a modest impact. The more people and businesses recognize that central powers are attempting to manipulate them, the lower their confidence in their own ability to build their own futures.

As is often the case, I am fulfilling the function of the prudent analyst gazing at the various futures ahead. Clearly I am ahead of the current thinking of those in power and most of their opposition. Nevertheless, I am beginning to ponder the impact of an appropriate investment strategy in response to the relative ineffectiveness of the top/down thinking of the central powers. The following topics should be explored by those charged with the responsibility to make payments to multi-generational beneficiaries:

1. Will the coming recession be largely caused by cyclical or structural causes? If largely cyclical, we have been there before. We know how to play that game, which is mostly based on sell/hold/buy decisions in the same securities. If structural problems are the main cause of the recession, the decision process centers around which areas and instruments should be employed and which should be abandoned.
2. What is the probable length of the recession? Typically, a cyclical recession is quicker because prices can adapt quickly. A structural recession involves the transfer of productive resources from one sector and location to another. This raises the question as to how quickly critical employees can be found and trained, not only in manufacturing but also in sales and service roles.
3. What will be the new measure of success in the post-recession recovery period?
4. How much of our economic and personal lives will be disrupted by technology applications? There are some that have concerns about the world of Big Data and its impact on individuals. Due to internal security concerns China will be the leader in that world, even more so than Saudi Arabia was in a world run on oil.
5. In a recession, particularly one caused by structural factors, corporate and personal defaults will likely be higher for credit instruments than for underwritten bonds. However, with the shrinkage of the number of brokerage firms and commercial banks, who will do the underwriting? It may be easier to distribute credit instruments directly to pockets of wealth rather than through a syndicated underwriting of bonds. (In the latest week, focusing only on financial organizations, two  yields tightened and six widened.)

SHORT-TERM POSITIVE
As mentioned in past blogs, market analysts believe that significant price moves are unlikely if there are price gaps between trades, particularly when comparing price ranges day to day. Gaps in price charts need to be filled before a sustained move is likely. Of the three main stock market indices, two had price gaps filled by declining prices this week. There are only six weeks left in this calendar year to avoid breaking a fifty-year rule, that bonds and the S&P 500 do not decline in the same year. Bonds are off this year. The only fixed income funds positive on the taxable side are Ultra Short Obligations, Short Investment Grade Bonds, High Yields, Short US Governments and Money Market Funds. With only the US Diversified Equity Funds macro group being positive, the only way to avoid breaking the fifty-year rule is for there to be a pretty broad stock price increase in the next six weeks. Because no one expects it, there is a chance that we could even reach record levels by year-end.

A MAJOR WORRY FOR GRANDCHILDREN
In the weekend edition of the Financial Times there is a three-page article about the opening-up of some of the secrecy surrounding the long-term outlook for the US military. What becomes very clear in the article is that the current administration is worried about the growing technological skill of the Chinese. It is quite conceivable that at some point in the future the Chinese military establishment could surpass the US capability to an extent that could be extremely upsetting to the US. (I firmly believe that this is a more important concern for this administration than the loss of manufacturing jobs in the US.)


Question of the week: 
What actions are you contemplating based on the changes you foresee?


Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2018/11/history-guide-not-map-or-trap-weekly.html

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


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