Anticipating Topping US Stock Market for Portfolio Managers vs. Stock Pickers - Weekly Blog # 662

 

Mike Lipper’s Monday Morning Musings

Anticipating Topping US Stock Market

for Portfolio Managers vs. Stock Pickers

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

                           

                   

                           

Warning: How Markets Approach Tops

Perhaps fittingly, markets reach tops in a similar fashion to countries going to military wars. There are two phases. The first can go on for a lengthy period of a year or more, with the slow destruction of the ability to successfully fight back. The second is an immediate event, which galvanizes the opposing forces into military action. The assassination of the Archduke in WWI and the Attack on Pearl Harbor in WWII are two examples. In both cases the general population was not paying attention to the deteriorating conditions and they were truly surprised by the triggering events. Those in power were not surprised that an event could trigger hostilities and there were premature warnings if one looked for them.

With the US stock market nearer a probable peak than a bottom, I sense an oncoming peak followed by a meaningful decline. I just don’t know when, although I have a pretty good idea who will be blamed for it.

Topping Signs

The first sign is the public’s wish for a better year than the last, often expressed as a bigger gain in the US stock market. The raw gains for the Standard & Poor’s 500, with dividends reinvested, was +18.40% for 2020. A level roughly twice the long-term average of +9% to +10%. The average S&P 500 index fund, with $1.9 trillion entrusted to them, gained +17.91% with dividends reinvested and management, administrative, and transaction expenses deducted. As good as these results were, they were below the average return for US Diversified Equity Funds, a gain of +19.14% on $10.3 trillion in assets. Even with the history of a strong November and December being followed by a year producing returns of +10% or more, one should be cautious in expecting the 2021 return to be better than 2020. 

Excessive speculation with increased leverage weakens all but the strongest financial structures.  Excessive speculation is often an open invitation for enemies to embark on bold adventures (Pearl Harbor). There is no doubt we are experiencing rampart speculation, 2020 had the fastest bear market and included a record level of IPOs and an equal number of SPACs (Special Purpose Acquisition Company). In addition, 2020 saw a record level of margin debt and a new generation of inexperienced investors rapidly trading on home computers, somewhat like the “roaring twenties”. 

Accelerating inflation also weakens the defense mechanism of a society. The JOC-ECRI Industrial Price Index ended the year at +24.44%, with 81% of the weekly prices rising in the weekend edition of the WSJ. Other cracks are also visible in the economy, with landlords and their banks speculating on when and if their tenants will pay their rent. One also hears of some officially unemployed workers only willing to work off the books. Integrity is often forgone in periods of speculation and inflation.

We should not attempt to remove all speculation from the markets, as we would be killing opportunities to take risks that have paid off very well in 2020, shown in the performance of the following mutual fund averages:

Alternative Energy Funds     +92.89%

Global Science & Tech        +65.00% (C)

Science & Technology         +52.21%

Multi-Class Growth Equity    +42.89% 

(C) Canadian Information Technology stocks +80.65%

Typical Stock Pickers Play Differently

Picking stocks is an old art form encompassing both short-term gambling and long-term investing. One of the main mental attitude differences between an almost exclusive focus on picking stocks and portfolio management, is that stock pickers focus almost exclusively on the performance of individual holdings, whereas professional portfolio managers focus on the performance of the entire portfolio. This usually leads to a stock picker having a more limited number of holdings, with many driven by the same market dynamics. Many newer stock pickers are entertained by the frequent examination of price volatility, intending to hold if his/her stock prices rise relative to other immediate alternatives. The focus is often on what is happening in the market and/or in the headlines, not on the fundamentals of the company which happens to have the same name as the stock. If the stock disappoints, the player sells and either buys something else or totally withdraws from the market, until a new wave of speculation gets his/her attention. In viewing the history of stock-pickers, one is reminded of what is said about pilots “There are old and bold pilots, but there are no old bold pilots.” 

That speculation burns out many inexperienced traders is unfortunate, not only for them but also for the nation. We have reached a point where the number of new companies equals the number retiring, either voluntarily or involuntarily. Among the reasons are demographics, labor and other capital productivity, regulation at various levels, and tax rates. One of the reasons US productivity was a world leader was the birth rate of new ventures and the success of some. Among the biggest advantages a stock picker has is that he/she does not have to play and record of results is not known. If the record is self-disclosed, it may not be believed. 

The Professional Portfolio Manager Plays a Different Game

The biggest risk for most professional managers is career risk, either losing employment or reputation. Furthermore, the portfolio manager is constantly being measured against supposed peers and externally identified time periods. At times absolute and relative investment performance are paramount and at others presumed risks is critical, whereas for some accounts cash generation is most important. For example, in 2020 the same account could be a relative leader or laggard and finish the year with very acceptable results, depending on the period selected. In some cases, when an institution borrows money during a period of economic strain, cash generation or volatility is critical to making payments or maintaining credit ratings. Because of COVID and a disruptive economy, some institutions have become much more sensitive to short-term results, whereas others look at the same characteristics through a longer-term lens and see new opportunities and risks.

In contrast to the stock picker, a portfolio manager looks at each investment not only in terms of its investment merit, but also its role in creating the appropriate balance in an account in terms of risk and reward. While a stock picker would ordinarily be delighted to have every one of his/her holdings do well, a professional portfolio manager would be concerned, fearing a change in the impetus driving the market could make the portfolio a very risky vehicle. In income-oriented portfolios, the timing of flows is critical to meet payment obligations and that can put constraints on the structure of the portfolio.

Unlike the private investor, most professional portfolio managers can’t afford to be out of the market, as most outstanding performance requires ownership on key turnaround days. The best a manager can do if the market is moving differently than what is perceived to be correct long-term, is shift the relative volatility of the portfolio, with a willingness to move quickly into higher volatility when the trend is what it should be.

How are You Protecting Against Unwarranted Speculation?

• Ignore?
• Raise Cash/Short-term vehicles?
• Change Volatility?
• Prune holdings which don’t help?
• Or something Better?   

I like quoting Ben Graham, not only because of his well-earned knowledge but because of the New York Society of Securities Analysts gave me an award named after him. He is quoted as saying “the essence of investment management is the management of risk, not the management of returns.”

Did you miss my blog last week? Click here to read.

https://mikelipper.blogspot.com/2020/12/stud-poker-new-swamp-game-weekly-blog.html

https://mikelipper.blogspot.com/2020/12/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/12/searching-for-surprises-weekly-blog-659.html

Did someone forward you this blog? 

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.