Mike Lipper’s Monday Morning Musings
Faulty Comparisons
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
Judgement Traps
When asked how his wife was an old comic replied, compared to whom? While that generated a laugh, it highlighted that some important considerations are not well decided by quick comparisons. Unfortunately, far too many investment decisions are made largely by comparison, with extreme performance judged to be better.
As someone who has largely devoted his career to making and using statistical comparisons, I am the first to suggest that historical comparisons are not good “divining rods” for making investment decisions. When dealing with the public the SEC requires that a warning be included indicating past performance is not indicative of future results. Unfortunately, this warning is not attached to all comparisons. For example, size, yield, book value, return on asset, equity, sales, operating earnings etc. All that these measures tell us is what happened, not why they happened or even the conditions that may have contributed to the results.
The main reasons there are betting favorites at the racetrack, political campaigns and possibly at the entertainment awards, is that there is a belief that the “smart money” knows something and therefore is worth following. I was recently in contact with some very bright student investors who used a lot of statistical measures to make investment decisions. One of their newer tools was the size of mutual fund holdings and possibly transactions in a stock. I felt this was an oversimplification in their search for the “smart money”. I suggested they separate the fund universe into three buckets:
- Passive/index funds
- Funds with net inflows
- Funds with net outflows
I would totally disregard the passive funds because they are not making considered judgements on individual securities. They should pay only partial attention to funds growing through net inflows and pay particular attention to funds in net redemption.
Portfolio managers of funds with net inflows generally use the money to either buy more of what they own or begin a position in a new name. If the new name attracts additional future dollars of inflows, that could be of interest. The job of the portfolio manager experiencing net redemptions is quite different. He/she may love all their holdings but must still raise cash. Consequently, it is likely securities with the worst near term prospects will be sold. That could be the most interesting factoid of the exercise. For further insights, I have found it worth following specific funds, particularly when they invest in a new name. (This is exactly the type of SEC warning that would be appropriate, past performance does not predict future results.)
Part of the fallacy of comparisons is a misperception of the appropriateness of the index used to compare a particular stock, fund, or investor. Currently, the largest number of investment accounts hold 10 to 30 stocks and have less than $5 million invested. In these cases, performance comparisons with the major indices are inappropriate. Indices, in terms of the number of securities, represent a small percentage of the number of available securities. Additionally, unlike mutual funds, most stock accounts do not face daily liquidity needs. Most pension funds have limited need to make unplanned sales, thus liquidity is not paramount in their decision process also.
As a young junior security analyst, I thought comparing a steel company in Chicago with those in Pennsylvania was not useful. The Chicago producer mainly sold to nearby customers and had a transportation cost advantage, which they used to get higher prices. Similarly, the degree of internal production of critical auto parts was a major differentiation between auto companies. Thus, I at an early questioner of comparisons without adjustments.
Applying Comparisons to Future Market Direction
As is often the case, intelligent analysts and portfolio managers see the US stock market going in one of three directions:
- A major economic expansion
- At half time in a continuing bull market
- At a pause before a market storm
In each case, their primary argument is based on a comparison with an indicator. I have listed their views and indicators below, allowing subscribers to make up their own mind.
“Mother of All Recoveries”
This is an economic forecast based largely on a combination of government stimulus and recovery from the lockdown.
Half Time
“Half Time” in a long-term bull market trend, with an occasional correction and a change in market leadership, supported by market analysis.
A Rounding Top that Could Lead to a Bear Market
Through Thursday, the Dow Jones Industrial Average (DJIA) -1.64% and the S&P 500 -1.81% are down from their peaks on May 7th. The NASDAQ is down -4.77% from its peak on April 26th. While the first quarter was quite positive, it is possible the second quarter will be flat to down, with earnings per share gaining the most in the second quarter this year. In the latest week, Precious Metals Funds were up +7.16%, with 118 new lows on NYSE and 230 new lows on the NASDAQ. In the week tax payments were due, Money Market Funds attracted $25.2 Billion.
What Are the Odds of a Top in the Next Six Months?
Mother of All Recoveries 25%
Half Time 35%
Rounding-Top 40%
Based on these projections, I would prepare to trade portions of the account and be prepared to raise 50% in cash. For accounts with a five-year time horizon, a cash holding of 20% to be redeployed once the market has moved beyond a 10% decline, makes sense. For accounts looking beyond five years, no additional cash is suggested.
Please share what you think?
Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2021/05/extreme-views-can-be-good-lessons.html
https://mikelipper.blogspot.com/2021/05/where-is-stock-market-going-next-weekly.html
https://mikelipper.blogspot.com/2021/05/mike-lippers-monday-morning-musings.html
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A. Michael Lipper, CFA
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