Significant Turnaround? Two Fearful Histories - Weekly Blog # 614

Mike Lipper’s Monday Morning Musings

Significant Turnaround? Two Fearful Histories

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

Current Pictures 
All three popular US stock market indices have price charts indicating a top of some magnitude. Market analysts view these tops as a sign of a reversal of a major trend. The questions facing investors today:

1. Is this a correction of perhaps 10% and an opportunity to buy a favored cheap stock?
2. Is it a cyclical top with a potential decline in order of magnitude of about 25%?
3. Is it a less frequent structural change that might cause a displacement of 50% or more?

2020 is still very young, but current markets as reflected through mutual fund performance are showing dramatic trend divergences. Year-to-date through last Thursday, the only mutual fund investment averages above 4% were: Global Science & Tech +4.86%, Large Cap Growth +4.09%, and the more domestically oriented Science & Tech +4.07%. Declining Equity Mutual funds were Natural Resources -8.38% and Basic Materials -5.15%. Commodities declined even more: Energy -11.35%, Basic Metals -7.18%, and Agriculture -5.02%.

After generating net sales earlier in the year, High Yield mutual funds and ETFs suffered significant redemptions this week, while higher credit bond funds continued to draw positive net flows. The Wall Street Journal' s weekly chart of 72 securities indices, currencies, ETFs, and commodities, only saw 24% of them registering gains. The spread between the price of gold and gold mining stocks also narrowed. These data points are  not encouraging for those looking for higher stock prices.

The task for professional analysts and portfolio managers is to examine the current data and look at possible alternative future directions. Most bright futures take care of themselves and the job is simply trying to optimize the rate of return. The less frequent downsides need to be reviewed more carefully, because for professionals there is much greater career risk.  The owners of capital need to blame someone other than themselves for major declines, but often take all the credit on the upside! I therefore periodically examine the chances of cyclical and structural declines, without excessively focusing on when they will occur.

What's Wrong? 
A top followed by a significant decline is usually identified with an event that focuses people's attention, although it often has little to do with the underlying cause. How the underlying cause for most wars is explained is a classic example. For example, school children are taught that WWI began because of the shooting death of Austria's Archduke by a lone anarchist. The truth is, the balance of power keeping competing nations in check after the Napoleonic era was breaking down. The growing strength of Germany, combined with weaknesses in France and Russia, led to them creating self-defense alliances with weaker states. Note, hostilities did not begin until six months after the tragic murder. It was the movement of Serbian troops threatening Austria that brought Germany and Russia into military conflict.

Somewhat like the US entry into WWII being caused by a single attack on Pearl Harbor, resulting in a Declaration of War by the US against both Japan and Germany, plus Italy. The Coronavirus is similarly be blamed for the decline in most stock markets around the world. The virus has led to one hundred or more deaths of the thousands infected. Unfortunately, there will be more, but it will eventually be contained and cease to be a problem. What it has done is to dramatize the importance of China to World Trade. Although China has contributed about half of global GDP growth, it still represents a relatively small number. The markets were showing weakness for some time before the advent of the virus and many industrial stocks and commodities were flat or declining in the latter part of 2019, if not before.

The 1929 peak in October marks the begin date of the Great Depression, but few realize that by December 1929 the Dow Jones Industrial Average had fully recovered. (Perhaps, there is still hope for stock traders this year.) There are always a number of factors that contribute to making a top and its subsequent decline. The current ballooning expansion of credit is one of the conditions shared by events leading up to the 1929 crash. "Bubble or Nothing" is the title of a study by The Jerome Levy Forecasting Center LLC, which makes the following observations:

1. The last three US recessions were ended by ever larger inputs by the federal government.
2. Economic recoveries were successively smaller after each recession.
3. Private credit has expanded at a faster rate of operating assets and operating income.
4. Most national governments are already operating with a deficit.

I would add that astute bond investors are already conscious of these conditions and are shifting their purchases to the highest quality non­-government issues, reducing their immediate commitment to high yield. Also, I find it very interesting that the performance spread between the price of gold and the price of gold mining shares has narrowed. In the modern world, other than when currencies become worthless, the main reason to buy gold is in anticipation of inflation. However, there is none in the government published data.

What to Do?

1. History has favored buying high quality and holding it for long periods of time, if it remains high quality. 
2. For US individual investors, the step-up at death is one of the best ways to pass wealth on. (That may not always be the case!)·
3. It does not mean we all abandon buy and hold strategies and become traders. However, it does force investors to focus on the timing of planned cash expenditures. 
4. The size and composition of the payments reserve needs attention, recognizing that guessing the future is fraught with mistakes. Based on present conditions, I suggest that payment reserves for the next five years be invested only in high quality paper, with up to 50% in maturities under one year. 

What about Long-Term Money? 
The history of greed and fear cycles indicate we cannot avoid periodic tops and declines. I suggest that intermediate length accounts be prudent and hold reserves of at least 25%, with maturities of five to seven years as a limit.

For those investments meant to be long-term or legacies, recognizing that within a generation you are likely to experience a structural top. As long as there are sufficient payment reserves, I would not add any additional reserves, except for those who can use opportunity reserves effectively. Many fiduciaries can't or won't.



Congratulations to Clark Hunt for his team winning the Superbowl, demonstrating the value of teamwork.



Question of the Week: What is your sense of timing as to the market and how is it expressed in your portfolio?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/01/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/01/is-it-always-brains-over-flexible.html

https://mikelipper.blogspot.com/2020/01/architectural-sway-points-and-current.html



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