Is it Always Brains over Flexible Policy in Investing? - Weekly Blog # 612

Mike Lipper’s Monday Morning Musings

Is it Always Brains over Flexible Policy in Investing?

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

Two questions:

1. Why don’t smart people always make money with their investment responsibilities?
2. When is the time to fix a leak in the roof, when it’s sunny or when it starts to rain?

The answer to the second question is obvious, when it is sunny. Why then do so many smart people fail to adjust their investment portfolios when the market is fairly, if not fully priced? Could it be that selecting good investments is emotionally more rewarding than focusing on policies that could direct future movements within the portfolio?

None of us knows for sure what the future will bring in the periods ahead. A characteristic most of us share in the developed world is the necessity to compete. We measure our results against perceived peers, or in their absence against artificial indicators that were not necessarily designed to replicate our real-world tasks.

For most investors, their responsibility is to convert the assets they manage into a series of known and unknown payments for various future periods e.g. paying bills. In order to accomplish this, they must make some difficult guesses as to the size of the bills due. Whether they like it or not they should be thinking in terms of investment survival. However, they also need to grow capital in the account to pay more bills than would be possible with current assets. This introduces a difficult and unknown risk/reward equation.

Far too many investors focus on competing with peers or indices and not on the risk/reward equation. Some professional investors also add career risk into the calculation. If they fail to please the owners of the capital, they risk losing the client and account or jobs. Unfortunately, most owners of capital and many investment executives don’t know how to evaluate their managers, except statistically or by comparison. I know of one very successful sector analyst that kept his fund from investing in it. His timing was excellent and when that sector collapsed, he was rewarded with a partnership. He eventually became the managing partner of a successful fund management firm. Charlie Munger and Warren Buffett have often said that individual investors can make better investment decisions than many institutional managers because they are not facing career risks.

Now we come to that leaky roof. The best time to fix the roof is when it is not raining or snowing. On Friday the three main US stock market indices reached a new high, as they have many times over the last three years. Stocks go up in price because more buyers than sellers believe the future will be better. They may currently be correct, but at some point in the future they won’t be. There is an old saying from the floor of the Stock Exchange that bulls and bears make money, but pigs get slaughtered. (Maybe they will be shipped to China where there is a pork shortage.)

Will the US market continue to go up? I hope so. However, in thinking about leaks in the roof I’m seeing some dark clouds that might carry rain. While the world will need more goods and services in the future, they might be in short supply at current prices. Because of geo-political fears in the US and much of Europe, the capital expenditures necessary to build additional capacity has been slim. Another capacity constraint is the working age population, which is already declining due to the falling birth rate. (It is possible that Southeast Asia and Africa will be the source of additional physical and human capacity, which is why we’ve invested some capital there.)

Should we be paying so much attention to geo-political events? I recently saw a study that looked at 21 such events, from Pearl Harbor through the killing of the Iranian general. Only 4 sent the S&P 500 Index down 10% (which is normally called a correction). Pearl Harbor was the worst both in terms of the 19.8% decline and the 307 calendar-day recovery. The average historic decline of 5% is interesting because it falls within the 3%-7% collection of 2020 institutional expectations for the S&P 500 Index. With the indices at a record high, the general’s death did not appear to affect the market. For long-term investing, JP Morgan believes you should be guided by long-term trends and not events.

What clouds are we seeing other than long-term capacity constraints? Conditions are becoming more speculative, with the NASDAQ continuing to lead the other markets. The growth of alternative styles and different trading instruments is also a concern. Furthermore, we are seeing many “conservative” institutions shift from 60% in equities and 40% in fixed income to 70/30 allocations. In the first two weeks of the year we have seen growth and tech-oriented funds gain over 4%, which translates to approximately doubling over a year if continued.

Another unsound extrapolation is that over $40 billion went into bond-like funds during the first 16 days.  This extrapolates to annual rate of $1 trillion. We are already seeing intermediate interest rates moving up. Intellectually, I suggested that it would make sense to short the 30-year US Treasury. (The trend of universities issuing 100-year bonds is spreading overseas. Caltech has now done it 3 times and I believe Cambridge is considering it too. With the average US government debt maturity under 10 years and the UK’s under 14 years, we would like to see a lengthening of maturities.) With gains in many cases over 10%, 2019 was an outstanding year for bond holders. I suspect it will not be wise to own bonds for quite awhile.

Sir Isaac Newton is an example of someone considered to be among the smartest of people. He was a young Cambridge Professor who first conceived the three laws of motion and in so doing formed the basic principals of modern of Physics. He was so respected that he was knighted, very unusual for a scientist. He became the master of the Mint, a high honor. At that time in England the government had not yet set aside money to pay its debts, so they created a lottery. The lottery involved the newly formed South Sea Company, which had dubious prospects, but the potential odds were attractive. Sir Isaac recognized the fallacy of the issue and sold his shares. However, he got seduced by the skyrocketing prices and went back in. He is thought to have lost his investment, which may have been 22,000 pounds in 1722. After the Bubble popped, he was quoted as saying “I can calculate the movement of the stars, but not the madness of men.” Clearly a very bright person who made a big investment mistake.

Subscribers, please help me and yourselves from getting sucked into the concluding whirlpool when the current enthusiasm subsides.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/01/architectural-sway-points-and-current.html

https://mikelipper.blogspot.com/2020/01/how-much-will-markets-decline-10-25-or.html

https://mikelipper.blogspot.com/2019/12/repeat-past-history-probable-or-just.html



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