Mike Lipper’s Monday Morning Musings
Sentiments Approaching Reversal Points
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
In the near future US stock market sentiment will approaching a reversal point.
Handicapping the US Stock Market
The art of picking winning bets at the racetrack is called handicapping. The betting goal is the same for long-term investors, to have more money at the end than when you started. Note, unlike baseball it is not the number of wins vs. loses. Both handicappers and investors recognize they will be wrong a percentage of the time, but in both cases success is measured by the number of dollars remaining at the end of the game, suggesting that in order to cover the losses gains will need to be larger. As the portion of the wins must be bigger than the average win, most successful investing involves a streak of contrarian thinking. With that in mind I’ve laid out my view of the current level of the stock market.
As of August 9th, the three major stock market indices have declined modestly from their recent record levels. (S&P 500 -3.54%, DJIA -3.92% and NASDAQ -4.45%) None of these are even near a -10% correction, a -20% bear market, or a generational decline of -50%. Even including the worst week of the year, the three indices are up between +15.87% and +23.14% from the lows generated on January 3rd. However, the weekly survey of sample members of the American Association of Individual Investors (AAII) shows that only 22% are bullish for the next six months, with 48% being bearish. These percentages are historically extreme. A somewhat more nuanced view is expressed by bond and bond fund investors that also indicates caution. For the week ended Friday, yields on a Barron’s list of high-grade corporate bonds yields fell 11 basis points vs. only 4 bps for a similar list of intermediate credits. (Remember, a fall in yield means prices rose, indicating increasing demand.) During the trading week ended Thursday, General US Treasury Bond funds rose +2.25%, while the average High Yield fund declined -0.48%. It’s interesting that in a week where the Fed lowered interest rates by 25bps, the flight to safety pushed US Treasuries higher.
Like Charlie Munger and Warren Buffett I am not a big fan of book value as a measure of operating success, although it is somewhat useful as a gross comparative measure. Comparing last week’s market to book value with those of a year ago, the DJIA declined very slightly, while the S&P 500 is the same as a year ago. Thus, the market is not grossly overpriced despite second quarter earnings being flat. According to analysts, the current quarter is expected to show a 1-2% decline that will be made up in the fourth quarter.
However, there is still reason to be concerned. On a year to date basis mutual funds have gained 2-3 times their average rate of gain for the last five years. Additionally, they are producing gains that are higher than their very long-term rates of return. Funds limited to the largest stocks, both within the US and abroad, have gained +14.47% year-to-date on average, compared to their five-year average return of +5.77%. Multi-cap Funds, a group of funds without a size limit which often has some large caps, were up +13.74% year-to-date and +5.32% for the past five years. Funds focused mostly on US holdings did somewhat better than those invested abroad due to having more tech holdings and the long-term rise in the dollar.
Short-Term Investment Thinking
Just as the betting results on the most favored racehorses is not great because they rarely produce enough betting winners to cover losses, I am betting against both the AAII crowd and the buyers of US Treasuries. I would also not be surprised if 2019 ends with high single-digit equity gains. In most of our managed accounts I would not disturb the highly selected funds in our portfolios.
Caution: Healthcare Could Look Like Financial Services in the Future
Over my professional investment life the Financial Services business has been quite good to me and my family. However, the average rates of return have not been as good as they were in prior decades. Looking at the structure of these businesses today, while the numbers are larger the number of people and firms have shrunk. The number of publicly traded firms has been cut in half. The rates of return are also smaller than what they were years ago. Perhaps the single best measure of the decline is that fewer sons and daughters of successful professionals and successful investors want to enter these businesses. In sum, I believe the percentage returns are smaller than those of past decades for most investors. There is a very real risk that the same trend will govern the Healthcare Industry.
As with the Financial Services business, the Healthcare business is already highly regulated by the government and it is likely to become more so. In both cases the purpose of government regulation is to make care available, better, and cheaper for the public. I have twin fears that it won’t happen. The first is a story in Sunday’s New York Times about an individual who went to Mexico for a knee operation paid for by a generous employer funded insurance plan. This is just another example of what is now called medical tourism, in this case to lower costs. Non-US citizens, both the very wealthy and the very poor, are entering the US for healthcare services they can’t get at home. For many years US residents have been traveling to other countries to get medical treatments not been approved here. These trips, along with the number of Canadians in our hospitals, demonstrate that patients will travel to get what they believe to be better or cheaper medical care. They may or may not get it.
What has likely caused the increase in medical tourism is the combination of increased regulation and the limiting of profit making of doctors, hospitals, insurance companies, pharmaceutical companies and all their suppliers and servicers. As an investor, as well as portfolio consultant to a hospital, I have looked at their financials. The good ones are reasonably profitable, but increasingly many are not and therefore one needs to look beyond the dollars of profit. The first ratio to consider is profit relative to investment. Perhaps more important, is their perceived ability to pay dividends to their owners. For the most part these organizations feel compelled to reinvest their so-called profit into their activities. In many ways I do not consider retained earnings as current profits, because as an outside investor I can’t spend it.
As someone who has a large family dependent upon me to pay some or all their medical bills, including insurance, I would appreciate lower medical costs. It is important to understand that insurance is temporary risk shifting, favoring long periods of paying premiums directly or through the workspace. In the end my real desire is for others to have the lowest costs, but I want the best care for my family and the best often includes the new best drug or procedure. My fear is that as we restrict profitability in the healthcare system we won’t get the lifesaving or life betterment new drug or procedure quickly enough.
Just as we are well served in the financial services businesses by an appropriate level of profit, we need to ensure that the healthcare system can do its job of making our lives better.
Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/08/is-last-week-significant-weekly-blog-588.html
https://mikelipper.blogspot.com/2019/07/chinese-emperors-learn-all-roads-lead.html
https://mikelipper.blogspot.com/2019/07/us-stock-markets-new-highs-misleading.html
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