Two Critical Questions: - Weekly Blog # 717

 

Mike Lipper’s Monday Morning Musings

Two Critical Questions:

I.  Can Performance Replace Diversification and Create Too Much Risk?  

II.  Is January 2022 the Beginning of the Bear Market?

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

Are the Answers Linked?

The youth of today, with all their expensive schooling, are at a distinct disadvantage. They have not studied ancient history or the leaders and common people living through those periods. In their limited time, if they could study just two periods, they might find relevant answers to questions with implications for today. The development and collapse of the Roman Empire and some of the structural causes of WWI. 

As this is an investment blog, I won’t teach history in detail. The following is a list of historical topics with significant implications for today. They may help answer the two questions asked:

1. The tension between a divided Roman Senate and the leadership of the strongest state in the world.
2. The most technological roads and viaducts also helped weaken defenses.
3. The rising costs of “gifts to the people” became necessary bribes, reducing military spending.
4. While a lose collection of German tribes eventually ran over Rome, they could not agree on how to govern their conquest.
5. Compared to the cohesion of other European countries, Germany was late in unifying and did not have nearby land to grow.
6. The Holy Roman Empire, based in Vienna, was structurally weak.
7. France lost 25% of their young men in the Franco-German War, the most productive people in their country.
8. Making the loser pay for the winners’ costs through reparations failed, and in so doing ignited global inflation, leading to many autocratic governments, including the US.

The Positive and Destructive Power of Performance

(Historical Notes: In the mid-1960s, I was one of the very few securities analysts focused on what were called conglomerates. As an analyst, my research I sold to financial institutions, largely in the US, but also in the UK, Continental Europe, and Canada. Consequently, I became conscious of multi-industry companies in their countries too. My early analysis focused mostly on US auto parts and bicycle parts manufacturing companies, then gravitated to electronics companies, particularly those with defense and aircraft applications.)

From the beginning of recorded history, the danger of relying on a single or a few similar clients was clear. (Shakespeare’s “The Merchant of Venice” demonstrates the risk of a merchant’s wealth being tied up in a single voyage.) To avoid such risks, the more enterprising merchants evolved into merchant banks, with multiple clients in multiple trades. Famous Scottish trusts developed investment vehicles for the wealthy and lower classes, investing not only in voyages, but also in a wide array of stocks and bonds. They paid attention not just to investment performance, but also to the longevity of their businesses.

A handful of Boston Law firms began as custodians for the wealth of ship captains on their Asian voyages. They developed documents hoping to limit the risk of total disaster by minimizing the risk in stocks, investing the remaining assets in supposedly super-safe bonds. It was out of this colonial heritage that Boston based firms developed the first US mutual funds, utilizing their successful Balanced Funds business.

The Boston law firms had their own security analysts and portfolio managers until at least the 1960s. Their legal documents proscribed diversification rules to lower the risk of total loss during hard times. Thus, the need for diversification came into usage in the institutional asset management business and appealed to insurance companies who had similar rules.

The Problem with Two Asset Type Diversification

If the two asset types were totally uniform, one could control the risk of large losses. Losses were significantly reduced by requiring the investment of 60% in stocks and 40% in bonds, at cost. While this worked for the lawyers and their naïve clients, security selection remained a risk. Including the selection from among so-called “high-grade” stocks and bonds of different maturities and liquidity. 

Asset managers whose customers were primary interested in upside performance found the restraints too limiting, particularly during periods of inflation. To get a more appropriate measure of fund risk, I tried to group funds taking similar risks. By the end of the 1980s my firm had created over 100 separate peer groups for performance measurement purposes. There are probably an unknown number of new peer groups that would be useful today.

When I privately compare funds, I go beyond just security selection. Among the things I look for are:

• Portfolio turnover
• Whether the portfolio is collegially managed or has a single decision maker
• The size of the firm’s research effort
• Tax management
• The historical recognition of losses
• The availability of back-up people
• Trading and administrative skills available within the group

All these measures are useful in reducing investor risk. However, better relative performance in one segment can diminish the power of diversification in limiting risk.

Where Are We in 2022?

While we have only experienced three weeks of the new year, we have been confronted with a very different market and performance environment. With a lot to identify and interpret, I am using fund performance as an intermediate filter to examine what is happening. I’ve observed meaningful changes, raising questions about the normal desire to extrapolate past performance trends. I find the following significant:

1. Through Thursday, with Friday having an additional significant loss, most fund peer groups experienced single digit losses. The sole double digit loss was the e-commerce business.
2. The very few US registered mutual fund gainers have been international funds, with strength in emerging markets, commodity funds, and global energy vehicles.
3. Large-Caps have fallen less than the smaller-caps, suggesting larger-caps have earned a liquidity premium.
4. The average stock in the broad indices is down considerably more than the relevant cap-weighted index.
5. JP Morgan released a study of thematic fund performance, which was no better than the general market measures.

What Does the “Tech” Correction Mean for the Future?

(Remembering that the sole function of fluctuating markets is to produce humility in the survivors, and my assertion that I can and will be wrong, there are reasons to be concerned.) The history of peaks and bubbles shows good performance in a small minority of traded issues at the top. The good performers, in this case a limited number of large-cap tech stocks, have drained dollars out of the rest of the market.

As readers know, I view moves in the NASDAQ Composite as leadership in the entire US market. From its all-time high, the index is down 14.5%, clearly a correction. I believe the Russell 2000 is in correction as well. At some point, I guess the more senior measures will close the gap with the NASDAQ. The interesting thing is the size “off” volume at the NYSE and NASDAQ are about the same.

I have been concerned about the underlying economy showing some disturbing signs:

1. The lowest interest rates in 5000 years, until the Fed’s future small moves. The adjustable mortgage interest rate is showing some contrary trends e.g., the 3-year rate rose 12 bps this week, vs 3 bps for the 20-year.
2. Capital expenditures are being spent on supply issues rather than “greenfield” expenditures. This is indictive of a lack of confidence in the longer-term future.
3. China is having problems with a peaking workforce, although its currency is rising against the dollar.
4. The US stock market is being driven by shorter-term players, with more volume in ETFs than the more retirement oriented conventional mutual funds.
5. There is a significant trend of bank branch closures. I expect to see more retail mergers and growth in crypto-currency vehicles. The average young person has much less cash than we did at a similar age.
6. A focus-group of independents who each voted for both Biden/Obama and Trump, are concerned about crime and the way the current economy is being managed. With worries about the future, these concerns could lead to a consumer-based recession. (With rare exception, there is not a popular political leader globally, although the opposition currently lacks much support.)
7. The National Science Foundation published a report on the state of US Science & Engineering. the report shows the US losing leadership to Asia (China, Japan, and South Korea), measured in dollars expended. Considering wages are less in Asia than in the US, the Asians may be getting more for their money.

Working Conclusions

If the correction in capital-intensive Tech and Health companies accelerates, it could cause an overall decline in the stock market. Much like in the run-up to The Depression, it could cause some consumers to cut back their spending, leading to a consumer recession. It doesn’t have to happen, and the timing may be uncertain, but based on the subjects not being taught, the odds favor it. 

  

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

https://mikelipper.blogspot.com/2022/01/current-causes-of-concern-weekly-blog.html

https://mikelipper.blogspot.com/2022/01/deeper-thoughts-weekly-blog-715.html

https://mikelipper.blogspot.com/2022/01/mike-lippers-monday-morning-musings.html

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