Mike Lipper’s Monday Morning Musings
Beware of Balloons:
" Things Are Seldom What They Seem"
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
Thanksgiving
In the US, as in many historically agricultural countries, we celebrate a harvest festival. Its origin was the celebration of the first hard earned harvest in the new world. In the 400 years since the first Thanksgiving in Massachusetts, a second fundamental drive of the American culture became prominent in the holiday celebration. As a society we worship shopping in the cathedrals of commerce, either physically or over the internet.
I celebrate the freedoms earned by those hardy Pilgrims, the freedom of thought and the freedom of expression that followed. That is why I present some controversial ideas below. These ideas are not necessarily more important than conventional views, although I firmly believe they should be reviewed. Not just because they may be correct, but because they may strengthen more popular views.
Picking Winners or Making Money
As regular subscribers have learned, I believe many of my skills as a securities and mutual fund investor come from my studies at the New York racetracks. One of our regular and prized subscribers called to my attention an article by the former editor of The Racing Form this week. The Racing Form is the equivalent of The Wall Street Journal (WSJ) for handicappers and the editor stresses that it’s not primarily for picking winners, but for the sound handling of money. Translating this to investing, it is the difference between picking well known winners or sound portfolio management. In the latter case long-term investors do very well by avoiding big losers. Thus, the most productive portfolio managers weigh their choices first in terms of the risk of large losses.
Balloons Lead to Bubbles, Then to Big Losses
Losses are sustained when there are more items for sale than buyers. At turning points, the more popular issues are more volatile than most other securities, as the more popular securities have numerous cheerleaders (pundits). Investors crowd into these expected opportunities while sellers temporarily withhold their merchandise to get higher prices. The increased intensity creates a balloon and while some balloons deflate peacefully, others expand to a breaking point. While a few talented traders can dart into crowded trades and escape in time, it is not a sound game plan for most long-term investors and should be avoided.
Short-Term Implications
Post-Election Balloon - Possible Bubble Building
After election day many stock markets rose and many who supported the victors treated it as a celebration. However, there are other explanations.
- A top is rarely established with a lot of cash on the sidelines, as a movement to a higher level is achieved by bringing in new money. This appears to be happening, with cash from private and institutional accounts. These latecomers are favoring stocks from the Dow Jones Industrial Average (DJIA) rather than the savvier NASDAQ.
- Immediately after the election there was a sharp diversion between the Citi Inflation Short and Long Indices. The long index gained 20% after the election while the short index remained flat.
- Foreign currencies have been rising relative to the US dollar. Some believe that interest rates on global governmental debt are being lowered by Central Banks controlled by their governments. Thus, investors denied one of their usual reserve elements are using currencies and perhaps Bitcoin to express their long-term fears of the declining purchasing power of the US Dollar. This may have contributed to the rise of many currencies and the prices of ADRs (American Depository Receipts), particularly in Asia.
Escaping domestic problems and losses through switching currencies has been executed by investors since the creation of borders between currency blocks. Many years ago, large Japanese institutional investors bought US assets at what seemed to be inflated prices, including Rockefeller Center and California Golf Courses. Many Americans thought that they were foolishly taken, but they missed the point! The Japanese were switching partially out of an inflated Yen denominated asset and into a less inflated US dollar asset, whose value could grow over many years and recover from inflation. Is it possible that this is what American investors did post-election?
Longer-Term Implications
Foreign exchange fluctuations occur daily and their relative movements tend to be important primarily in the short run. However, there are other factors at work that have longer-term implications and perhaps greater impact.
Commodities are Calling
While many commodities trade daily, their daily price fluctuations tend to rotate on near-term changes in demand. Commodity prices long-term however, often move in long cycles caused by changes in supply. Changes in supply move slowly, as capacity building is expensive and often takes years to come on-line. The daily prices of most commodities have not had sustained high prices for some time and additions to capacity have been limited, creating a long-term supply-demand imbalance leading to higher prices. Even at current prices, relatively little capacity is being added. Goldman Sachs, owned in our private financial services fund, believes that a long positive cycle is ahead for commodities. If accurate, this expectation is unlikely to be held in check by the central banks’ lid on interest rates. Rising commodity prices will impact the prices of many other goods and services.
The following is a brief list of commodities that are out of balance for longer-term consumption:
- Global energy demand is expected to grow 50% in the present decade, according to Wood Mackenzie.
- Demand for copper used to produce renewable energy is expected to double in the next decade.
- Rare Earths use 1 electric vehicle for every 1000 Smart Phones.
- The present shortage of Palm Oil is forcing processed food prices higher.
Market Considerations – Mutual Funds
Total net assets in mutual funds are at record levels, although the number of individual funds is dropping due to consolidations and liquidations. This mirrors the decline in the number of publicly traded issues and the number of brokerage firms, which has reduced both the number of opportunities and the number of independent decision makers and is likely to lead to more volatility and some bubbles.
The market for US securities is becoming more concentrated. In 2006 there were 3,738 funds invested in domestic equities and at the end of October there were 3,015. Investments in mutual funds are used primarily for retirement and with an aging population only 50% of fund assets are invested in equities. After a decade of high investment performance greater than the growth of GDP, this number should have been higher. Both professional investors and individuals have followed the historic trend of the wealthy, investing beyond the borders of their government when possible. Twenty five percent of equity fund assets are currently labeled world equity funds and this number understates the foreign exposure, as most money is invested in large funds with significant exposure to multinational companies. While many companies of all sizes export our goods and services, multinationals own operating facilities overseas to serve both local and global demand. I suspect that if I could find the geographic sources of most large equity portfolios, foreign operating earnings would be substantially higher than 25% and could be in the 50% range. Thus, with the value of the US dollar in secular decline under the increasing weight of restrictive regulations and rising taxes, some investors are in a reasonably good position.
Current Portfolio Management Strategy
In the past I have been an advocate for dividing investments into sub-portfolios based on specific large needs. Although I continue to believe this is a sound strategy, I increasingly believe it would be useful to have overlays over the sub-portfolios. I have come to this view after talking with people expressing great anxiety about the future and it has led to a realization that we are not managing securities and funds, but uncertainty and expectations.
The early days of a new administration and continued changes in the world order resulting from the pandemic and technological changes have most investors worried, with many feeling frozen in place. My outlook comes from my experience at the racetrack and is like Charlie Munger and Warren Buffett’s third desk box of “too hard”. I deal with those things I can in terms of my actions and don’t stress those I can’t.
This sets up two overlays to be applied over the needs-based sub-portfolios.
- The first overlay follows long-term successful investors who invest for the long-term. In the case of multi-generational families and institutions, that can go on forever. History and progress are the two guide rails for these portfolio decisions.
- The second overlay is for those who have never gotten over their childish needs “to do something” and places vulnerable portions of the portfolio in trading modes dictated by price action. Each security/fund is set on a price schedule of future transactions as to when to sell and buy. For mutual fund owners, consider using passively managed ETFs as a substitute for uncertain mutual fund holdings. (This is one reason some investment advisors are heavy users of ETFs for fresh cash in accounts, as it is easy to initiate limit price orders for all accounts and adjust when the market moves unexpectedly.) As a fundamentally long-term tax aware investor and portfolio manager, I have yet to execute the second overlay, although it is regularly under consideration.
Critical Question: How are you handling current uncertainty?
Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/11/approaching-multiple-turning-points.html
https://mikelipper.blogspot.com/2020/11/mike-lippers-monday-morning-musings_15.html
https://mikelipper.blogspot.com/2020/11/mike-lippers-monday-morning-musings.html
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A. Michael Lipper, CFA
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