Momentum is Slowing under Too Many Cross-Trends - Weekly Blog # 651

 

Mike Lipper’s Monday Morning Musings

Momentum is Slowing under Too Many Cross-Trends

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

The human mind prefers simple actions leading to success in order to address present issues. As a professional investor with fiduciary responsibilities, that is what I want. However, the discipline of preparing a weekly blog does not often lead to straight-forward conclusions. This is such a week and the best I can do is to briefly outline the various cross-trends that I perceived. I ask subscribers to select the options that direct them to an investment conclusion, which hopefully they’ll share.

The following is a list of the trends in no order:

1. Seeing signs of smart professional bottom fishing buyers in Energy, particularly natural gas related and an array of financial services-banks, funds, brokers, and service providers.
2. A minority of professionals appear to be bullish and a sizable minority of the public are bearish. The rest are confused and waiting for direction, with more than normal cash reserves.
3. Myopically cheap securities can be value traps due to outmoded statistical measures and/or inappropriate timing.
4. Alibaba, Ant Group, and Tencent’s securities are being found in  institutional portfolios. These groups are becoming more global rather than focusing on Chinese holdings. (Almost all companies are influenced by trends beyond their headquarters’ locations, some more than others.)
5. In the weekend WSJ, only 42% of price aggregations rose this week.
6. “More than 40% of total US equity trading volume now takes place outside of public stock exchanges”, according to the Chicago Board Options Exchange.
7. The NASDAQ Composite gained +0.79% and the NYSE Composite declined -0.63% this week. As there is less passive trading in the NASDAQ relative to the NYSE, I believe it is a better indicator of professional investors thinking.
8. The JOC-ECRI Industrial Price Index is up +6.69% from a year ago, signaling inflation.
9. For the week, the average Large-Cap Growth Equity Fund was up +1.81%, S&P 500 index funds were up +1.07% and Value funds were down -0.29%. Not the expected change in momentum pundits were expecting.
10. According to the National Bureau of Economic Research, most stimulus payments were saved or applied to reducing debt. Hedge fund performance fees do not protect investors from paying for poor performance.
11. PwC’s view of the World in 2050 is based on the following points: 
• World GDP will double by 2037 and almost triple by 2050.
• China is already the largest based on currency purchasing power(CPP) on market exchange rates (MER) and will be number 1 in 2028. 
• India will be the 2nd largest in 2050 (CPP) and 3rd in (MER).
• Mexico and Indonesia will replace the UK and France by 2030.
• Nigeria and Vietnam will be the fastest growing by 2050.
• There will be a significant gap between the top three: China, India, and the US vs the rest.
• The US will remain the wealthiest.

Working Conclusion:

Some of these observations may prove to be useful to long-term investors, but probably not all. The timing of their value is also uncertain. I therefore suggest you have a global orientation with a reasonable amount of liquidity (cash or highly liquid stocks). Any high-quality fixed income holdings beyond a 2-year maturity could be a burden. The appropriate investment objective is to first avoid losing purchasing power, with an additional reserve for being wrong. The second objective is to build capital opportunities in a number of places and different vehicles when possible.

Questions for the week:

1. What do you think of the list?
2. Will anything mentioned cause you to make any changes?
3. What are the other trends we should be tracking?

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

https://mikelipper.blogspot.com/2020/10/mike-lippers-monday-morning-musings-are.html

https://mikelipper.blogspot.com/2020/10/what-is-nasdaq-saying-to-whom-weekly.html

https://mikelipper.blogspot.com/2020/09/there-is-incredible-shortage-weekly.html

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A. Michael Lipper, CFA

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Chinese Disruption Around the World - Weekly Blog # 524

Introduction

Most of those who think about the future of the Global economy believe that China at some point will probably replace the US as the global leader, until perhaps after a generation it is replaced with India. Based on current population trends,  Nigeria will have more mouths to feed in the future than India.

China Influences all Markets

Size, in and of itself does not guarantee a good place to invest. At this point investors, no matter what they invest in or where they invest, need to understand the ability of China to heavily influence, if not disrupt, almost all investing in stocks, bonds, commodities, real estate, art, and racehorses. While I intuitively agree with Charlie Munger that there are more investment opportunities in China than in the US, I lack sufficient confidence in my understanding as to how the winning game is played.  Nevertheless, I feel compelled to invest in China and Asia. The way I do it for my clients and myself is through selected Asian specialty funds.

The inclusion of some of the “A” shares in the MSCI indices is in response to demand from institutional investors to put money to work into China very quickly. There is more than the normal amount of risk being created, for the list of included stocks is based on size, not quality or other investment factors. This is particularly significant to what is likely to be a rash of China ETFs. When the financial reports become available there could be a positive fleshing out of how business is done in China.

Racetrack Influences

On Saturday the South China Morning Post, which is now essentially a vehicle for the Mainland government, published an entire section devoted to Horse Racing, with the kind of statistics we used to see in the US in the popular press and specific publications for racing fans. What is impressive to me is that the paper had extensive records of the leading jockeys and trainers. What is notable is that neither the leading jockeys nor trainers win over 20% of the time. This highlights my reluctance to embrace the most popular stocks most of the time.

The Chinese interest in both racing and more important breeding future champions, was again highlighted on a sloppy track Saturday afternoon when Justify won The Preakness. This is the second title to the Triple Crown after Justify won The Kentucky Derby for its largely Chinese syndicate owners. Competitors are labeling Justify as a “super horse.”

The newspaper has the same type of mutual fund price (NAV) listings one sees in London. These are paid placements which often represent the key profit item for the paper. Recently I co-chaired a panel at the International Stock Exchange Executives Emeritus conference in Hong Kong. In our lead off session with the Chair of Value Partners, I was somewhat surprised to see a good sized list of Value Partners funds and their classes in the newspaper. They even had some funds quoted in New Zealand’s currency. Most of their competitors are UK and Swiss groups. For historic and cultural reasons, only a few funds appear to be offered in the US.

Xi Jinping Cites People’s Liberation Army “Principles”

On Thursday the same paper had a front page article with a headline “President calls for stronger military science studies.” In the article Xi Jinping, as chairman of the Central Military Commission said, “Innovation has to be practical and closely based on warfare and combat issues to create advanced military doctrine suitable for modern warfare and embodying the PLA’s unique characteristics.” (Bear in mind the People’s Liberation Army has not been at war in a generation. During that period the US has almost constantly been in small wars.) Notice there is no particular emphasis on defense, which suggests offense is important and could be in the President’s plans.

The leading economic thinkers viewing China internally as well as externally are very conscious of developing economies running middle income growth to the limit. There is a fear that they become old before they become rich, as on balance China has an aging population. Japan and most of Europe  are laboring under demographics that reduce the proportion of productive human labor and an increase in the portion of the nation’s wealth spent on healthcare. (With US fertility rate at an all time low, we hope that US leaders see a similar long-term risks that needs to be addressed quickly.)

A number of funds investing in China have been shifting their emphasis away from exporters and basic industries, investing instead in consumer-oriented stocks and services. Many global and international portfolios cover their China bet with one or two stocks, such as Alibaba and/or Tencent. From a stock price standpoint, most of the time their prices parallel the so-called “FAANG” stocks, not China-focused developments.

Balance Sheets More Useful than  Income Statements

My old Securities Analysis professor David Dodd might have enjoyed my late conversion to paying initial attention to balance sheets rather than income statements. In the class (taught by the co-author of our text book) we had discussions on the proper methods of security analysis. I had the temerity to argue with him in favor of the primacy of income statement analysis. He shut me off once when we were discussing a specific security, which just happened to be in Graham and Dodd’s portfolios. He ended the discussion by informing the class and this doubter, how much money they had made on that position. Thus, it is ironic that I bring up balance sheet and related cash flow concerns in dealing with Chinese investments.

The very successful export drive that led to China being the fastest growing large economy for a number of years was based on exporting industrial goods and consumer products. On my visit to Hong Kong and Shenzhen* I was very impressed with the new infrastructure that has been put in place in under a generation. At the same time the US and most developed countries experienced deteriorating infrastructure, Hong Kong is expected to require an additional airport in 2019. (Our returning flight was slightly delayed in leaving as it had to coordinate with flights from nearby Chinese airports.)

*I would be happy to share by email the field notes of my visit to the fascinating BYD headquarters in Shenzhen.

China Experiencing Downsides to its Growth

However, there are a couple of downsides to the growth in the Chinese economy. After the farmers flocked to the cities, they used their savings to buy apartments, quickly followed by a cars, resulting in crowing and auto pollution. For this reason, the government is heavily subsidizing the production and sale of electric and hybrid cars. Thus China is the manufacturer of half of the world’s electric vehicles. This led to BYD leveraging its flows and balance sheet to a point where liabilities equaled or exceed assets. BYD is not worried however, as its loans are from state controlled banks.

One Belt, One Road Linkages

A further extension of debt was used to finance infrastructure in Africa and along the promoted “One Belt, One Road” connections from China to neighbors on the way to European markets, which will probably make use of the excess steel and cement capacity that is not being used internally in China. I am not predicting the future but rather asking prudent investors to study the history of debt-driven expansions in railroads in North and South America, and the financial history of the car business.

I will be happy to learn from subscribers about prudent ways to invest in China.

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

Two Worries: “Happy Talk” Stocks + Fixed Income Leverage

Introduction

Now that the “feel good”  US election is over, investors around the world have only two main worries. The first is the released enthusiasm will be found dissipated by the time a budget is signed at the White House, assuming that Valerie Jarrett approves. However, what could be worse is that the enthusiasm leads to a surge of buying, creating a parabolic price chart. The second worry is one that few are watching: the unidentified growth in leveraged fixed income transactions.

 “Happy Talk” for Stocks

While the Chair of the Federal Reserve is publicly worried about potential volatility when interest rates begin their inevitable rise, I am worried by the volatility on the upside. There is very little in the popular press about upside volatility. When stock prices go up the pundits claim that it is due to some economic statistic, they don’t attribute the gains to market structure imbalance. Because academics want their students to be aware that prices can go down as well as up, they label the gains as rewards and declines as risks; which fundamentally misinterpret the nature of risk. 

For those that have the responsibility of managing other people’s money, risk is the permanent loss of large enough amounts of capital that threaten long-term goals for the use of the money. The academics wanted (and many still do) a mathematical formula for risks and adopted standard deviation of returns which has led to far too many counting risk as volatility of returns, not impacts on outcomes. To solve the need to be able to define the volatility of “the market” our friends in Chicago created the Volatility Index on the S&P500 which then could be traded with the moniker of VIX.

VIX can miss

We have just finished a four month period when the VIX index doubled off a historically low base and then returned to low levels. However, this move to be did not capture the true saw-tooth movement in the market place. My firm has been charged with managing a series of portfolios largely invested in mutual funds for different needs. In this four month period we are tracking 51 separate funds and separately managed accounts for this client. While most of these portfolios invest in stocks, a number invest in fixed income. The movement of the VIX did not really capture the price movements. In July, 39 out of the 51 declined which was echoed in September when 49 were flat or declined. Our client should have been pleased that in October 43 out of the 51 rose. Perhaps, much more significantly over the four month stretch 32 rose. At no point was the ability of these accounts to meet future funding needs ever in question. Thus, there was no real risk to their goals.

Good news, bad news

In a recent investment committee there was a discussion as to moderately changing asset allocation in favor of domestic equities. There was an expressed belief that we are entering a period of increased upside volatility. This view makes sense to me in the short run. In previous posts I referred to the media’s use of “handles” to describe surpassing round number levels. S&P 500 at 2000, Berkshire Hathaway^* at $200,000, Apple^* at $100 and now we could add Alibaba at $100. It will be interesting to see whether Moody’s^* can rise to $100. The stock appears to have stalled out at $99. Also can Goldman Sachs^* go over $200?   If investors, both institutions and individuals, translate these handles as rungs in a ladder reaching materially higher levels we could see a wall of money coming out of cash instruments and into the stock market. (One investment banking firm is predicting a 3000 handle for the S&P.)

^* Securities owned personally or in our private financial services fund.

If this wall of money enters the global stock markets without discipline, stock prices could gyrate upward in a speculative frenzy. If that would happen, it would fill the main remaining element needed to identify a major top.

Fixed income leverage

Most stock investors don’t realize that the fixed income markets are much larger in size than stock markets.  Historically price movements in these markets are less than those in stock prices. In addition, almost all fixed income investments have a maturity date thus banks, brokerage firms, and governments have felt comfortable allowing borrowers to borrow up to 99% in the case of currencies and somewhat less for other types of issues. In modern times it is not unusual to borrow money in a low interest currency and buy a lot in a higher (more risky) currency. Often the supplier of the leverage is a bank or brokerage firm who will be the recipient of the trading flow of the borrower. That has worked well, in the past. Today each of the banks or brokerage firms for regulatory purposes has had to reduce the amount of capital than can be used by their trading desks to provide liquidity to those fixed income accounts that need rapid liquidity. (In part this was one of the major contributing causes for the Lehman bankruptcy.)

The fundamental fallacy of governments bailing out financial and industrial companies is actually boomeranging and could make future collapses worse.  Collapses occur because a large number of people make rapid, poor judgments. One can not force sound decisions by law. (We probably would not have the political leaders that are present today if we could mandate sound decisions.) Governments don’t want to capitalize bailouts, so through regulation and legislation they are attempting to reduce the size of their exposure by limiting the size of the participants. The Fed has now decreed that no financial company can have capital in excess of 10% of the combined liabilities of all the other banking institutions. 

This has the effect that the US will have ten or more large banks. Other nations have a much more concentrated financial community. With the US institutions being limited in the global markets, their foreign competitors will increase their share of the loans. In time they will have to deal with large global failures which will impact US institutions and put our investors at substantial risk. One of the problems facing all governments is that they can influence, but not rule the global financial community effectively. The attempts to do so is creating a false sense of security which when their balloon is popped could lead to massive movements in the market places.

I would like to learn how big is the potential problem. There is no global tally as to the amount of money that is being provided to fixed income investors and these include important currency players.

When there is a major dislocation in the bond market the institutions involved or fear that they may get involved will reduce their support for all markets as they husband their capital before an eventual redeployment. Thus, one of the major risks to the stock markets is a sudden major contraction in the fixed income markets. This is called contagion and we saw it happen to the Latin American markets when Russia defaulted.

Question of the week:

What are you worried about? Let me know.

__________    

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Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2014

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.