Preparing for a Recession - Weekly Blog # 843

 

         

 

Mike Lipper’s Monday Morning Musings

 

Preparing for a Recession

 

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

 

             

 

Learning from Wartime

When US Marines embark on a troop ship, they are instructed to wear less than comfortable life jackets. This sense of preparedness was one of the things I learned as a Combat Cargo Officer training fellow Marines for potential conflict. This preparation for the probability of danger to our economy, including client and personal investment portfolios, is what I hope to highlight in this blog.

 

Recessions are inevitable because humans prefer optimism to pessimism, expanding debt to leverage the oncoming good times. Politicians have learned that it is not a good vote-generating strategy to disappoint voters with actions. This has been the strategy for a large number of US Administrations from both parties, where they increase private and public debt without building up reserves. Consequently, history suggests we have not repealed recessions, we just don’t know when they will occur. Furthermore, we don’t know if the oncoming recession will be cyclical and largely a correction in prices, or a more painful structural recession with significant businesses collapses requiring lifestyle changes.

 

Don’t Abandon Ship by Massive Selling, But Get Your Lifejacket Ready

As a midshipman in training on the Battleship New Jersey, I was assigned to serve watch as the sole crew member in the crow’s nest, the very highest point on the ship. I was to report anything I saw as dangerous by phone. At one point I saw some round metal objects that looked like tin cans through my binoculars and excitedly reported it to the deck officer. This caused some commotion. Luckily, the old Salt of the deck officer recognized me as a landlubber and didn’t put the ship in an emergency condition. He understood that it probably was a tin can and not an unidentified destroyer known to Ship sailors as tin cans. In viewing what may be ahead for markets and economies, I will remember my midshipman experience and be careful with my language.

 

This is What I See for You to Evaluate

• The Conference Board reported that the University of Michigan survey showed a large drop in its measure of Consumer Confidence. It came close to the low of 2020.
• Perhaps as a preparatory move, 100,000 tech workers have been laid off year-to-date. (I don’t know how many are still unemployed.)
• New capital goods orders (non-defense except aircraft), were expected to gain +0.1% but actually declined -0.6%.
• A number of large public companies are cutting employment by selling products or divisions. The interesting thing is the breadth of companies taking these steps: AIG, Morningstar, Interpublic.
• Several mutual funds that performed well in the first quarter have cut back holdings weighted over 5%. Some of the stocks cut back were Berkshire Hathaway, TSMC, and AIG. (All held in personal accounts.)
• In the latest week, 55% of the stocks on the NYSE rose vs only 49% on NASDAQ. Remember, the NASDAQ is considered more speculative than the “Big Board”. Only 38% rose in the latest Saturday WSJ list of weekly prices for market indices, currencies, commodities, and ETFs.
• Two well-established mutual fund management companies with long-term orientations are expecting dramatic changes. Capital Group expects to see a meaningful rise in price volatility. (If this happens, there will likely be a rise in direct trading between major institutions.)  The other group is Marathon, who is concerned about the expected growth prospects of all aspects of “AI”. There is not enough planned construction for all elements of AI and what is required for the rest of the economy/society. There is a need for innovation and increased efficiency.
• Year-to-date through June 27th, there were four investment sectors that produced average returns exceeding the +15.51% earned by the average S&P 500 Index fund. (You may be able to get the one day that is missing, which didn’t have much impact.)

 

Investment Peer Groups Performing Better than S&P 500

Large-Cap Growth    +20.42%

Science & Tech      +17.91%

Energy MLP          +17.69%

Equity Leverage     +16.29%

 

There were 1222 funds in these four groups.

 

Question: How are you going to recognize the next recession?

 

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Leadership Change Late in the Game

Regular readers of these posts already know that I have been prematurely speculating about the risks of a top of the market. Most securities analysts date the last important bottom as of March 9^th, 2009. Almost exactly four years later, the Standard & Poor’s 500 Index (S&P500) reached a new high on the last trading day in March, 2013. Market cycles vary in length from bottom to peak, but generally they are in the 40 month range. (One of the sounder investment management organizations uses a rolling four year period as the shortest benchmark for its internal incentive compensation.)  Each market cycle is a bit different than those of the past, but they have many of the same characteristics. Most often on the rise up, the sectors that lead make sense as they come from deeply discounted price levels. In this particular case the second best performing group from the market cycle bottom was the financials, a group that is of particular interest to me. (I believe that a market boom needs to excite the owners of financial shares. With that thought in mind, I manage a private financial services fund that has been enjoying this rise because among the financial leaders within the S&P500 were Discover Financial, McGraw Hill, American Express and AIG. All of these, I have owned for many years.) 

Buyers need a quantity of sellers before they can push stock prices higher. The coming week or weeks will likely supply some sellers and some will say the doubling off the bottom is enough. Others may feel that after low double digit gains in the first quarter, the time would be right to lighten up on their positions. They would be urged to do so by those who insist that there should be a tight correlation between the prices in the market and their generalized view on the domestic and global economy. (As long as there are numerous economic pundits that are somewhere between wary to negative on the market, I can take a relatively relaxed view of the future for long-term investment accounts similar to what we manage.) 

The drivers so far

Arranged by the leading central banks, the best thing driving the stock market higher is the impact of the banks’ experimental policies to force interest rates to confiscatory levels. These efforts have done much to the maligned credit ratings which have proven on balance to be correct in the long run. Recognizing that it is almost impossible for a credit rater to speculatively lower credit ratings, they do provide a useful purpose of confirming current opinions as to the chances of timely payment of principal and interest. At the top of the credit rating pyramid is the Nine-AAA league composed of the sovereign debts rated AAA by S&P, Moody’s, and Fitch. According to the Financial Times the size of this pool has shrunk by 60% from $11 trillion to $4 trillion since the beginning of 2007. (US, UK, and France are no longer AAA rated.) The size of the drop is first a measure of the scale of the combined fiscal and monetary overreach by governments and the sharp reduction of the size of the pool of so called totally risk-free assets from a credit standpoint. The message delivered to investors is that there is relatively little in risk-free assets available, so if you want to earn a somewhat reasonable rate of return you must assume other risks in the bond and stock markets. 

As many of you probably already know, I spend a great amount of time analyzing mutual fund data. I do not pay much attention to the net flow data that combines the dollar totals of sales and redemptions, since I believe that the motivations behind each stem from very different needs. I do pay attention to gross redemptions. According to the Investment Company Institute (ICI), gross redemptions of equity funds in the first two months of 2013 declined $12.7 billion to $224 billion whereas gross redemptions of fixed income funds rose $21.6 billion to $ 141.9 billion. Strategic Income funds rose $12.8 billion in redemptions for the year to $65.7 billion, followed by increased redemptions in high yield and government funds. The Strategic Income fund bucket includes those fixed-income funds that can move from one type of fixed-income market to others. I believe that the shareholders are concerned that they were not exiting governments and high yield fast enough. My guess is that these figures are just showing a bit of nervousness on the part of some mutual fund holders; the largest single category of redeemer was institutional investors who redeemed $158 billion up $29 billion from the first two months of 2012. These numbers do not support the much-heralded great rotation out of bonds into stocks. I believe that thus far the biggest single contributor to the increased gross sales of equity funds is coming from a $121.8 billion increase in money market redemptions to a total of $2.4 trillion. Thus there is a reasonable chance that when individuals and their managers recognize that for the moment they shouldn’t fight the Federal Reserve, they could commit their assets that may well drive the stock market higher. Or they could decide that the risks are too high already in stocks. 

Need for new leadership

On the rise from the 2009 bottom, the leading large portfolio funds have been managed by value-oriented managers. They have bought and owned stocks of companies that were statistically cheap using the company’s financial statements as a guide. This is one of the reasons that the financials appealed to these portfolio managers globally. Many of these stocks were yielding an above stipulated inflation rate or would if permitted by the central banks. Other stocks that were found in these portfolios had rising operating and before tax margins. This was mostly achieved by capital and labor efficiencies in spite of limited sales growth. Without a global pickup in sales many of these companies will not be able to show earnings growth. This is exactly the problem facing those who need the stock market to move higher between now and the next Congressional elections. 

Possible new leadership

With fewer and fewer high quality bargains available the value-oriented investor is finding it is difficult to identify new large names. At the same time a growth-focused investor is being limited by the expected lack of volume growth. One possible area for future strength is broadening the concept of value beyond statistical value based largely on reported financial statements. I am suggesting an old merger & acquisition gambit of searching for strategic value.  Strategic value rests on a well-researched view of significant change. In an oversimplification, one could look at these opportunities through the eyes on the cash flow statements or a materially different earnings structure.

One of the key questions is: are there significant opportunities for the company and its peers to materially reduce their capital expenditures? As a relatively young analyst I spent time with an older leading analyst of aluminum producers. He became bullish on these stocks when the companies were shutting down the hot lines and factories. His bullishness was based on the idea that with less available competitive capacity, demand would force prices up until the next wave of expansion would take place a few years in the future. Airlines have followed a similar strategy through their mergers to reduce excess capacity. In a minor way we have seen a similar thought pattern in the financials, with the waves of expanding and contracting fixed-income trading and branch building. The final objective of these strategies is to use cash flow to pay off debt, pay dividends and shrink the number of shares outstanding. Some practitioners of these art forms have produced brilliant results. To some degree the asset allocation skills of Warren Buffett and Charlie Munger at Berkshire Hathaway^* and those of Leucadia^* fit into this model.  

Currently on offer are two very different investments with dramatic change elements. The first, alphabetically, is Dell. The question here is whether a change to a more patient capital structure and/or change in management can produce good long-term results. While it is possible, I personally have my doubts, as the original driver of these discussions was an embarrassed (or should have been embarrassed) shareholder. Those involved are more financial engineers than sustainable company builders. I could be wrong and this type of shareholder action could become a model for the new leadership. There are lots of candidates for this kind of operation, but not without risk.

The other stock on offer and somewhat a competitor to the first is Hewlett Packard which likewise has been gravely wounded by the computer wars and unfortunate acquisitions. The difference is that the current CEO is in an announced five year turnaround plan. She has solid marketing and management experience. I believe that it is clear that the future company will not be producing the same products if at all or in the same way.   

While less attractive to me is what I have called “the three M” Strategy. The three “M”s stand for McKinsey, (a consultant with a dubious track record of success; e.g., Enron), Merrill Lynch and Morgan Stanley^*. The two financials have used the consultant to provide cover for what their managements wanted to do and have hired former McKinsey partners. Both of the two operating companies are trying to improve their balance sheet by selling off elements of their empires to improve their balance sheet ratios. They are doing this rather than materially improving their products and delivery systems. Nevertheless, they may well succeed; I hope so, as they have a number of talented people on board.

Each of the three alternatives to build increased strategic value could be part of a new market leadership which I think is needed to go from the newly established highs to materially higher stock prices. 

^*Owned in both my financial services fund and personal portfolios

What Do You Think?

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Investment Lessons of the Week

Previously I have written about the eventual trap of arrogance. Most politicians, and many investors will not admit to making critical mistakes. I try to be different. The only thing I promise each of our accounts is that I might make mistakes that hopefully I correct before there is too much pain. My main defense against arrogance is that I try to learn something new every single day. I have suggested this pattern to my children and grandchildren. The power of the new idea, new view, and new approach is that it forces one to relate the new with the old - and that becomes a challenge to many of our beliefs. Just this week, I have knowingly been exposed to at least five new elements to my thinking. All of these have a global context.

Logistics lead, but need to be interpreted

Last week I commented in my blog about what I learned from our visit to Mount Vernon. First, that steamship volume was increasing and that I saw many trucks from logistics companies going south on the Interstate Highway. This week a friend of mine noted that in September, the Baltic Dry Index moved from 662 to 778. What was even more encouraging is that the spot rate for the largest-sized vehicles carrying dry cargo (for example, iron ore) skyrocketed from around 2000 to 7600 this week. I believe the surge noted in iron ore shipments is due to the announced efforts to build many subway systems throughout Chinese cities. (As someone who for most of my life lived in and around New York City, the idea of relieving the roads of the clogging, expensive, and pollution generating car traffic seems to be a great idea.) To me the materially-increased infrastructure investment in China is a very practical stimulus that will use imported iron ore to make steel in local Chinese mills, a very intelligent way to address its economic slowdown.

A careful searcher for truth will almost always find some contradictory evidence. One of the oldest of all technical (market) indicators is the belief that the Dow Jones Industrial Average cannot make and hold new high levels if the Dow Jones Transportation  Average (which used to be composed of just railroads) does not confirm by making its own new high. The belief is that if the two indexes diverge they will have to find a bottom before there can be a successful sustained new high. This week the Norfolk Southern Corp. lowered its expectation for the current year’s earnings. The Dow Jones Transports declined on this news. The decline’s impact on the industrials needs to be put into perspective. The railroad is one of the largest shippers of coal in the country. Just as governments can attempt to make companies grow; e.g., solar and wind power, it can force lower sales of others. The Obama administration, along with much lower natural gas prices, is making coal an unattractive fuel for our electric utilities. Fuel for the electric utilities is not being delivered by train, but by pipelines, barges and other vehicles. Thus, as of this week I believe that we are seeing some resurgence in industrial activity, which the stock market is already discounting.

Cash to stock is becoming an easier switch

Last week I attended two investment focused meetings. In the first a large regional bank gathered some of its best potential and actual investment clients to a private lunch to hear my views on investing. They would not have taken time from their busy day if they were not already investing in equities or considering it. In our conversations they recognized that long-term they needed to be significantly exposed to the world of stocks, perhaps through funds. Everyone at the lunch could recite, in detail, their concerns about the stock market, but they still came and stayed for two hours.  One evening last week I was at a post-meeting dinner for a board on which I sit. At one point during the long dinner, a very successful second generation Wall Streeter leaned over to me to tell me he had not bought a common stock for his own account for over two years and now he was ready to buy. I suggested that he call a mutual friend of ours with whom he had successful business dealings, to help him reenter the market. He noted on his pocket pad to call our friend in the morning. These two instances suggest to me that the historic pattern of people coming into the stock market as it goes up is holding. While some of the easy money has already been made in the low volume markets, there will be opportunities at higher prices.

‘Tis the season to be “Vixed”

Many commentators have spent much time noting that there appears to be a low level of fear expressed in the options on the S&P 500 as captured in a traded index with the symbol of VIX, (CBOE Market Volatility Index). If one reads Randy Forsyth’s article in Barron’s Friday September 21, we should be prepared for problematic markets. I have lived through the October “crashes” in 1978, 1979, 1987, and 1989 but not the big one of 1929. What I had not compiled were the other autumn events that were dangerous to one’s capital base. As today’s global stock markets are reacting to government manipulated fixed income markets, recognition of the following Autumn occurrences is important:

1.    September 24^th 1869: the US government sold gold  to break the “corner” that was attempted by Jay Gould and Jim Fisk.

2.    September 20, 1873: the New York Stock Exchange closed due to a panic.

3.    September 21, 1931: Great Britain’s suspension of the pound’s link to gold.

4.    September 21, 1985: the so-called Plaza Accord broke the ascent of the US dollar. (Too bad to bring that wonderful grand hotel into another round of government manipulation.)

5.    September 16, 1992: The withdrawal of Sterling from the European Exchange Rate Mechanism and reportedly a huge winning bet by George Soros.

6.    September 23, 1998: the culmination of the Asian currency crisis which began in July 1997.

7.    September 11^th, 2001: the attack on the World Trade Center in NYC.

8.    September 15^th 2008: the collapse of Lehman Brothers followed the next day by the near collapse of AIG.(These were much more significant in the global fixed-income markets than in the stock markets.)

Long-term fears and where you hold your investments

Ray Dalio, the founder and co-CIO of Bridgewater Associates in an interview with CNBC  had some dark thoughts. His fear is that after a ten to fifteen year managed depression (austerity without growth), that the social tensions between various economic and ethnic classes in southern Europe may produce an appeal to some strongman/woman to take over and solve the problem; e.g. the appeal that brought Hitler to power. Much closer to home, a savvy investor shared her concerns with me. She is worried that in the US (and by some extent in other Western countries and Japan) that the medical and related costs of keeping the elderly will be too much for the younger tax paying generations to tolerate. A financial class war is what she is predicting.

I asked this smart, experienced lady how she was preparing for this with her portfolio today. In general she had foreign investments for 30-40% of her portfolio. But the bulk of the rest was in multinational companies. She uses Coca Cola as an example, which gets most of its earnings from outside the US. I am not sure that her strategy will deliver against her fears or those of Mr. Dalio.

For many years I have complained to various fund managers that displayed their portfolios on the basis of the statements they receive from their custodians. The custodians list securities on the basis as to where the entity is legally domiciled. From an analytical standpoint, I am interested where the company is making most of its operating profit. That is the country or region which will have, in general, the biggest impact on sales and operating earnings. For regulatory reasons I will probably won’t win this argument with published reports but with careful analysis I can probably guess the key sites of operating earnings power which should help in determining the strategic value of the investment. However, the concerns expressed by the lady and Mr. Dalio raise another issue.

If our current fears turn us into a refugee mentality, it is not where an entity makes its money that is important, but where are the assets and where can they be traded in a period of distress. If these fears become somewhat more widespread, we may see wealthy US investors move to vehicles that are beyond the problem areas.

Which comes first: weak currency or weak military will?

A study of history suggests that a weak military will eventually invite others to seize our assets and possibly our lives. Often the decline in military willingness to aggressively defend its homeland comes from a policy of weak currency management as it attempts to take market share away from trade counterparties by having lower prices than they do. For a generation we have seen that many Europeans will not support a strong military; e.g. in the Balkans, and we also see that the value of their currencies decline. While much has been written about Quantitative Easing Infinity,  in terms of US stimulation, on a longer-term basis the decline in the value of our currency is in effect a weak dollar policy. Combining our planned Asian withdrawals and defense expenditure cutbacks, a weak dollar policy is going to invite more trouble. As much as we don’t like to be negative, maybe we need to pay more attention to our worriers.

The bottom line: be careful and stage your money into equity vehicles with some concern as to where your assets are being housed.

What Do You Think?

In London

I will be conducting interviews and investment manager meetings in London during the week of October 8 - 12.  If you would like to meet to discuss investments, client strategies or one of my blog topics, please email me at aml@lipperadvising.com .

Blog email        

Email deliveries of my blog last week contained only the post’s title with a hyperlink to the complete blog, requiring readers to make an additional click. Unfortunately, Google changed its procedures without notifying us.

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Round Peg in Square Hole Produces Splinters

After a shocked weekend dealing with what the French will call “The Madoff Affair,” Sunday night finds me thinking about the lessons that have been forgotten. First and foremost, is the lesson that unbelievably good results do not overcome the need for due diligence. The appropriate outlook is the one that cautious investors have relied on since the beginning of handing one’s own money to another: Unbelievably good results ARE unbelievable. Part of the unquenchable belief is imbedded in the alchemy of academics, confusing volatility with risk. In my book MONEY WISE, I try to focus readers’ attention on the real meaning of risk. The real meaning of risk is the large, permanent loss of assets that can change one’s ability to meet life’s goals. In the Madoff case, investors experienced few fluctuations in their consistently high monthly returns. With little or no volatility, the resulting returns produced unbelievably high risk-adjusted returns. We have seen this action occur previously, right before the last Act’s denouement.

Diversification is a basic lesson for all investors, but overlooked in the Madoff affair. No regulated insurance company, and almost no mutual fund could tolerate such little diversification. Many investors (either directly or in funds) concentrated a substantial part of their liquid wealth with these funds. Perhaps more distressing, some used fiduciary responsibilities to direct their charities to do the same. A portion of these same people were moving out of checking accounts this past summer to produce diversification and to get their balances below FDIC insurance levels, as we did. Otherwise intelligent and sophisticated investors were so greedy to capture all of the good returns that they forgot about the discipline of diversification.

The unexpected results of the bankruptcy of Lehman Brothers and the de facto collapse of AIG were not from the size of their debt loads, but from the counter-party risks which froze the assets upon which others had primary claims. The brilliance of the Madoff affair was in not charging a performance fee for superlative investment returns as an adviser, but rather conducting these as brokerage accounts for which they were the exclusive custodian or sub-custodian. Thus all of the risk (and all of the disclosing information) was located in just one place. Thus every investment account had one huge, unrecognized, counter-party risk. The absence of a known auditor sealed the unreliability of the information.

With the exception of this single or small group of perpetrators, all the rest were victims in the Madoff affair - particularly the recipients of the various investing charities. Throughout history we have other examples of “Ponzi Schemes.” Let us hope that in the future people will take more care in turning over their money to unbelievably good results.

P.S.: We feel especially sorry for those investors who entered the Madoff world through an international bank or through another brokerage firm and believed that the stable returns were analogous to fixed income, therefore suggesting that this investment could be done with the benefit of margin. I have heard that in some cases the margin may have been as high as two to three times the original investment. The big lesson here remains that rates of return do not describe the risks of ultimate loss.