Mike Lipper’s Monday Morning Musings
Repeat Past History Probable or Just Possible?
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
Like most professional investors my first tool in dealing with an uncertain future is my knowledge of history. I pay particular attention to military history and horse race betting. The growing enthusiasm for the US economy and stock market is leading many other markets higher. An almost universal belief persists that 2020 will not see a recession. One sign of a top is excess enthusiasm and we appear to be marching quick-time along that path. Military history warns of the dangers of a sneak attack.
Many historians studying the last two World Wars point to the underlying causes and the immediate events preceding them. The underlying cause of both wars was the presumed weakness of the US, both economically and militarily. It lacked the ability to maintain the global balance of power when presented with increasingly aggressive drives by Germany and Japan. The initiating causes presented to the public were the assignation of the Archduke, heir, to the Austrian Throne and the sneak attack on Pearl Harbor. These events gave political cover to the leaders who sought to defend their countries by going to war.
I am not predicting these types of events, but I am aware that they can happen. Consequently, I’m examining possible triggers for a meaningful reversal of the current enthusiasm, which could cause chaos in both the stock market and greater economy. The resulting chaos would not be so bad, except to investor egos and confidence. Sun Tzu, the earliest great military/political strategist is quoted as saying "In the midst of chaos, there is also opportunity."
Contrarian Signs
1. In the US the fixed income market is much larger than the market for stocks, a reality not captured by the media. The owners of fixed income securities expect to either own them through maturity or play price peaks and valleys, adding or subtracting price movements to their total returns. As the terminal value at maturity is known when these securities are issued, investors become much more aware of anything that could reduce their value. Most issuers are directly or indirectly influenced by the movement of interest rates and are therefore much more sensitive to economic conditions than most stock buyers focused on corporate prospects. Fixed income securities prices often move six to eighteen months before the stock market reaches a peak or trough.
Adjustable mortgage base rates have started to rise, although they are well below the rates of a year ago. The yield curve for US treasuries is rising, especially for maturities that are five years or longer. The year-to-date average total return for the 43 General US Treasury mutual funds is a way above average +10.69%, but has declined -2.01% in the fourth quarter through last Thursday, suggesting the deterioration is relatively new.
"Bond Risk Seen in Leverage Loans" was the headline in the weekend edition of the WSJ. The article focused on the ratio of credit rating downgrades to upgrades, with 3 times the number of downgrades to upgrades on traded loans. The Financial Stability Board also noted the weakened documentation of loan agreements, i.e. weakened covenants.
2. One of the more common places to hide from expected market, currency, or economic declines is precious metals. Currently, there are 65 pure stock fund investment objectives tracked by my old firm. Of these, only 7 are up over 30% for the year through Thursday. In third place are the 76 Precious Metals Funds which have averaged +37.41 % year-to-date, with 16 being among the top funds for this week. Interestingly, the price of physical gold is not higher than it was this summer, suggesting stocks of gold and other precious metals mining companies are viewed as having better prospects than the price of the metals. This may be true, as their earnings will benefit from both their debt structure and their high fixed-cost operations.
3. In December, corporate insiders sold an unusual amount of their own shares. It could be that they need cash to exercise some options coming due, or that they fear capital gains tax rates will rise materially.
4. In the latest week, half of the 20 stocks in the Dow Jones Transportation Index declined. As passenger traffic is good, I suspect sellers are expecting lower than forecasted freight revenues, which aligns with the lower expectations of their industrial customers.
5. There is not much difference in the five-year total return performances of the following four investment objectives:
Domestic Sector +5.79%
World Sector +5.89%
World Equity +5.93%
Mixed Asset +5.82%
All had hoped to beat the leading equity investment objective, US Diversified (USDE) +8.99%. It appears that on average, being diversified produced a roughly 3% advantage over more narrowly constructed funds. It is worth noting that the five-year returns were roughly equal to the progression of earnings and returns on equity, although those observations should not apply to a portfolio of funds gaining 20% or more.
While each of the following investment objectives generated way above average gains for the past fifty two weeks, they did not outperform the USDE funds return of +29.93%.
Domestic Sector +25.54%
World Sector +26.70%
World Equity +24.26%
Mixed Asset +19.71%
The last category was hurt by the inclusion of poorer performing fixed income and international holdings.
6. Of the 17 non-leveraged peer groups of funds within the USDE classification, seven performed within the range of the above-mentioned groups of funds. Offsetting these slower performing funds were four growth fund peer groups and S&P 500 Index Funds. However, as stated in earlier blogs, one should look deeper. You should recognize that the NASDAQ Composite has been the leader of the popular stock indices for some time. This composite added 1000 points in 176 trading days. Nearly one third of the gain was attributable to the five stocks shown below. The table displays their gains and weight in the NASDAQ Composite:
Weight in
Stock Name Wtd Gain NASDAQ Composite
Microsoft +56% 8.8%
Apple +83% 8.4%
Amazon +23% 7.1%
Facebook +58% 3.6%
Alphabet "C" +31% 3.5%
Many stocks in smaller market-cap peer groups also benefited as suppliers to the five stocks mentioned above. The key observation is that the gains in the averages are not representative of many stocks. Thus, some of the enthusiasm for the market and the economy may prove to be misplaced.
Investment Conclusions
For many long-term accounts, this is not the time to be adding additional risk. Because we are late in the investment cycle, disappointments could trigger sales. Particularly large gains have unbalanced many accounts and should gradually be re-adjusted.
Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/12/mike-lippers-monday-morning-musings.html
https://mikelipper.blogspot.com/2019/12/faulty-decision-processes-at-change.html
https://mikelipper.blogspot.com/2019/12/investors-are-worrying-about-wrong.html
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A. Michael Lipper, CFA
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