Mike Lipper’s Monday Morning Musings
Guessing What Too Quiet Stock Markets Signify?
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
“The Dog Didn’t Bark” This Week
In one of the Sherlock Holmes detective stories, he solved the mystery when he observed that the dog didn’t bark. I am wondering whether the global stock markets are sending us a message we are not hearing. There was nothing that happened this week to restore confidence in global political leadership. However, markets meant to discount future prices, never-the-less drifted up on below average transaction volume. Market analysts view relatively low volume as a sign of lack of conviction. Perhaps another view, at least temporarily, is a growing lack of conviction in our own ability to manage our way through uncharted waters. We seem to lack the conviction of a Christopher Columbus who set out on a journey into unknown waters with heavily leveraged vehicles, searching for a faster route to the theoretical riches of Asia. (Even after three attempts, all he accomplished was a failed experiment. At the time it was not recognized that his so-called failure led to the richest discovery of all - The Americas. Spain benefited from Latin American gold for the next 200 years.)
Are the Financial Stocks Showing the Way?
This week several leading US financial stocks reported their third quarter earnings, including JP Morgan Chase, Goldman Sachs, and Morgan Stanley. (All three are owned in accounts I manage/own). All three reported significantly larger than expected earnings gains using GAAP (Generally Accepted Accounting Principles). While their stock prices rose, gains were modest relative to predictions. Thus, the small price gains relative to announced earnings had the immediate impact of lowering their price/earnings ratios. Why?
The market saw through the GAAP numbers and instead focused on the recurring earnings power of the three firms. Participants in the market were not willing to pay for released loan credit reserves and tax settlements. For example, JP Morgan’s GAAP earnings per share in the third quarter was $3.74. Later in the press release it was revealed that the combination of credit releases and more favorable tax settlements amounted to $0.71 per share. This meant the per share earnings that should be used for valuation purposes was $3.03 vs. $3.00 per share in the second quarter. Hardly an encouraging sign of growth and unsurprisingly the share price did not rise. I believe the reasons to own JP Morgan are their “fortress sized” balance sheet, their dominance in various financial sectors, and a growing commitment to increasingly use financial technology likely to change the nature of banking.
Goldman Sachs announced that their nine months earnings were higher than any of their full record earnings years. This result was achieved during a period of significant restructuring to impact the future earnings power of the leading investment bank. No other firm so perfectly captures the favorable elements of the period, which included a record of assisting clients with Mergers & Acquisitions and record financial advisory revenues. Underwriting earnings were also strong, due to private placements, convertibles, and IPOs. Third quarter earnings in Asset Management were good, but less than the second quarter’s large “harvesting” of private equity. During the quarter, GS continued to invest in broadening its capital raising in Consumer and Wealth activities, as well as increasing its technology spending.
Morgan Stanley had similar results, but because of its business line mix, did not have as big a price increase as Goldman Sachs. MS has a larger and more retail oriented wealth management group. It also benefitted from popular IPOs.
None of the three stock prices gained as much as third quarter earnings. Mathematically, this means their current p/e ratios contracted a bit and could be an unrecognized warning that future earnings gains may be more difficult to achieve. When one analyzes the sources of the gains they appear to be historically more speculative and cyclical than the firms’ other businesses. {Warning #1}
Are Universities Leading the Wrong Way?
This week, the investment performance of various university endowments was published for the June 30 year. The leading gains were in an astonishing 40% to 60%+ range. This is a group of investors that historically had difficulty beating the S&P 500. (Few followed the strategy of going to cash for the rest of the year when their equity performance produced a 20% rate of return. Additionally, they held bonds in an inflationary environment.) This year’s juice was a substantial investment in alternatives. Most of the dollars in this category were invested in private capital, mostly equity and less in hedge funds.
As a student of investing, I have noticed that market peaks result from many more buyers than sellers trying to participate in the latest capital appreciation trend. Today it is rare for a financial institution or financial distribution system to not offer participation in private equities, which have multiple transaction and other fees compared to publicly traded products. The private equity culture offers participation in size limited, private fund vehicles. Once the vehicle is fully funded the sponsor, believing there is still more money wanting the privilege of investing with them, offers additional funds. The very success of fund raising encourages new entrants from existing fund groups, often built around mid to lower-level people. This has many economic impacts:
- A valued employee resigning from a manager wants a significant compensation increase compared to their present employer.
- The old employer may in time find compensation for new talent, but also wants to earn more.
- The private equity industry grows rapidly, and thus with higher expenses and a need to perform quickly, they bring out the next fund.
- The bargaining power of attractive investment owners recognizes that there are more buyers than sellers for the opportunities to invest in their companies/ideas. This produces higher entry prices.
- Lower returns for private equity funds will come from increased acquisition prices.
- To corral investors for future new funds sponsors attempt to discipline their investors into investing in future offerings, promoting the fear of not being eligible for new investments if they fail to do so.
This head long growth of investing in popular alternatives appears to be a race to the top without a useable parachute. {Warning #2]
Timing ?
If I could regularly time price movements, I would be able to buy a big yacht and invite you to regularly come with me. Don’t pack your bags because I can’t deliver. What I can offer are two different tools.
The fist is a partial examination of the current picture, including the two warnings already labeled. As many of you know, I feel the actions by savvy investors in the NASDAQ are more useful than those on the NYSE. The latter are clouded by passive funds driven by some users to hedge their long positions. Furthermore, since many former brokerage commission salespeople have converted to being “wealth managers”, they feel they must do things to continue to earn their fees. Their clients look at the market through the Dow Jones Industrial Average (DJIA) lens. Consequently, these managers make their moves on the NYSE. There are also numerous institutions with large asset bases and small investment staffs who find comfort in big names and liquid markets. The following table illustrates the difference between the investors in the two markets:
Market New Highs New Lows Issues Traded
NYSE 345 134 3,570
NASDAQ 305 336 4,990
NYSE investors don’t seem to be worried, NASDAQ investors are!!
The other insight I can offer are the periods immediately preceding WWI and WWII. For the aware investor it was increasingly clear that hostilities would not be avoided, but the exact timing was difficult:
WWI - It was about six months after the assassination of the Archduke and his wife that War was declared. During this period there were considerable troop movements. Both alliances discussed their likely actions and considered the industrial power of the US being under the control of an isolationist, pacifist, ex-college president. Economic conditions were worsening in central and eastern Europe. Frequent political and military moves were in the direction of armed conflict, only the timing and specifics were not clear.
WWII - From the American point of view, Europe was already at war. It had little impact, but generated some sympathies in the US. A US president was running for the first third term election, as an isolationist. Once elected he cut off US oil to Japan, which was involved in a land war with China. The US economy was also deteriorating due in part to federal government actions and policies. (A war would bring the US out of a long recession.) This was the first time in US naval history when they moved all the Navy Aircraft Carriers out to sea from their Pearl Harbor port, leaving the old Battleships behind. The week before there was smoke coming from the Japanese embassy in Washington as they destroyed their critical papers. (The US later provided temporary living quarters for the members of the Japanese embassy at a luxury hotel with a golf course, while they awaited their exchanged Tokyo personnel.) There was not much reaction from my mother’s guests that Sunday afternoon on December 7th when I burst into the living room, announcing the attack on Pearl Harbor. Not many people quickly grasped the meaning of the raid. I sensed something bad had just happened and worse would come.
What Does it Matter?
All too often people don’t grasp the significance of events. What would happen if some large private equity firm or a major private equity fund financially disappeared, leaving lots of debt outstanding? I don’t know, but I do have a bad model.
On August 17th, 1997 Russia announced a restructuring of their debt, in effect defaulting. The so-called Smartest Hedge Fund in America, with Nobel Prize partners on board, was heavily invested in leveraged Russian paper. Initially, most people were not particularly disturbed. They were as nonplused as those on that Sunday evening in1941, who had not contemplated how interconnected the global financial world was. The first thing that happened the following morning was Latin American investments being dumped at any available prices. Long-Term Capital Management (LTCM) and other hedge funds and traders were desperate to fill their reduced liquidity. The situation got worse as it became clear that major trading firms on Wall Street had similar positions to LTCM or had loaned them money. The potential size of the problem got so big that the Federal Reserve Bank of New York convened a meeting of the major capital players at the offices of Bear Stearns. Resurrecting what Mr. Morgan did in 1907 to force the community to bailout a Trust company borrower whose unpaid debts could trigger other defaults and bring the system down. The Fed, with the help of the US Treasury, was able to assemble both the capital and liquidation procedures to prevent more of the “street” and numerous banks from failing. These saving functions had an interesting aftermath. Years later, the Treasury found it could bailout Bear Stearns but could not do the same for Lehman Brothers, the only firm that did not participate in the bailout.
I don’t know when any of the histories I have outlined will be repeated, but they should be studied because of the odds similar situations will appear.
I appreciate any views from any of our valued subscribers.
Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2021/10/what-is-problem-weekly-blog-702.html
https://mikelipper.blogspot.com/2021/10/the-confidence-game-weekly-blog-701.html
https://mikelipper.blogspot.com/2021/09/two-confessions-weekly-blog-700.html
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