Mike
Lipper’s Monday Morning Musings
Retro, Forward, & Cycles
Editors: Frank Harrison 1997-2018, Hylton
Phillips-Page 2018
Managing Money Motivations
There are two very different parties in a professionally managed investment
account. The first is the owner of the capital who is primarily interested in
investment performance, usually using current performance as representative of future
performance.
The second participant is the manager of the account who wishes to
maintain the relationship for a long time. The fully loaded cost of acquiring
the account is usually not earned back immediately. Thus, the first rule for
the manager is not losing the account. This is somewhat different than the
motivation of the owner of the account.
Best Defense is to Keep the Account
Managers assemble a number of different securities into a portfolio so
that not all of them decline by the same amount in most down periods, hopefully
some will rise. One of the standard ways of accomplishing this task is diversifying
the investment characteristics of the securities. The most important
characteristic of a security is deemed to be its risk of declining.
The money management profession in many cases believes stocks and bonds
have separate levels of risk of decline. The way this is expressed and managed
is through a ratio of stocks and bonds, for example 60/40. This means 60% in
stocks and 40% in bonds. The investment media has declared the 60/40 strategy dead
following approximately 40 gainful years for bonds and 3 years of decline. The
average performance of 107 mutual fund sectors over the last three years
through Thursday, 41% have lost ground. All but one of the declining sectors
were fixed-income oriented. The one
exception was Chinese Regional funds. (This confirms my view that we have been
in a period of stagflation for some. We will be dealing with Chinese oriented
funds in a subsequent blog.)
Understanding the Use of Numbers
The purpose of the ratios was to manage risk. Today there are many
stocks that are less risky than some bonds or other credit instruments. A better
name for this diversification function would be low risk, or high quality/high
risk, or low quality. One should recognize that like almost everything else in
life, risks move in cycles. Some Scottish Trusts started life owning only British
gilts, and over time introduced stocks. Today, some of these trusts are almost
exclusively invested in stocks, while maintaining their historic names.
In the US, trust accounts have gone from 100% bonds to a 50/50 split. Trusts
then moved to 60/40, with some advocating for 70/30 and even 80/20. What brings
this concept of cycles to mind is in 1957, or there about, discussion I had with
the venerable Professor David Dodd, who was teaching Securities Analysis at
Columbia. He emphasized the use of balance sheet related data in securities selection.
With the arrogance of a student, I suggested growth had become more important since
the Depression, when he and Ben Graham wrote their seminal textbook on
Securities Analysis.
He closed the discussion by explaining that the fund he was involved
with had made lots of money buying discounted value securities. However, ten
years later growth stocks led the market. Perhaps the good professor was right
for professionals. Many growth stocks fell, including from the ’73 peak, whereas
his value stocks held up much better. This experience convinced me that the appropriate
diversification schedule is a cyclical pattern.
Are We Near a Change in Valuations?
There is some evidence that it is possible, if not likely, we are near a
change in valuation. Fixed income yields have been inverted without a marked
recession for over a year. Last week the US Treasury yield-spread between the two-year
(4.93%) and thirty year (4.03%) was a remarkably narrow 0.9%. This suggests the
long-term future is not as attractive as the current period, with potential
recessions in the next thirty years.
This appears to be at variance with current estimates for S&P 500
stocks. Net income changes in the second and third quarter of 2023 are expected
to be -8.6% and +1.7%, respectively. (These are net income changes, EPS estimates
are expected to be -6.4% and +1.7%, respectively. This shows the benefit of firms
buying back their common stock. Buy backs potentially help managements with their
stock options, but possibly not in the long-term improvement of the value of
the company.)
The “bulls” in the market are possibly relying on one of the oldest
market forecasting devices, The Dow Theory, which requires both the DJIA and
the Transportation Index to move in the same direction. In the latest week only
two of the 30 DJIA stocks rose, with thirteen of the 20 transportation stocks rising.
At this time of year seasonal inventory is moving toward the stores, but many stores
are closing or hiring inexperienced staff.
With services and non-durables growing while durables are not, there is
a long-term structural problem for the economy.
Conclusion:
Changes are coming and we need to manage them, or they will manage us.
Did you miss my blog last
week? Click here to read.
Mike
Lipper's Blog: Gravitational Waves & Investing - Weekly Blog # 791
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Lipper's Blog: Manageable Risk - Weekly Blog # 790
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Lipper's Blog: Predictions Suffered Last Week - Weekly Blog # 789
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