ON the ROAD to CAPITULATION and RECOVERIES - Weekly Blog # 552

Mike Lipper’s Monday Morning Musings

ON the ROAD to CAPITULATION and RECOVERIES

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

                                         

Every connection to life has its own ups and downs. One of the major translation errors from the singular precision of mathematics to the real world in which we live and invest is the implication that the shortest distance between two points is a straight line. Not that it is incorrect, but in the real world of dealing with people and their money, straight lines are a fantasy. As sure as days follow nights, we deal with changing observations based on changing conditions. Thus, we should educate ourselves and others about cycles. In the two-dimensional world these are linked in time by plotting ups and downs, or if you prefer the mathematical term, their representation is sinusoidal. Actually, even that picture of reality is incorrect, cycles travel in multiple dimensions. Meaning that we cannot totally rely on past cycles being repeated exactly in the future. Thus, in planning for our investments we cannot rely solely on history. We need to be aware of the differences between past cycles and current conditions. Even more difficult is guessing the differences in future cycles.

As an investment manager for long-term institutional and individual investment accounts I am now focusing on identifying the coming bottom for stock prices and more importantly the nature of the recovery from the bottom. The answers to the second question are to an important degree a function of whether we will be hitting a cyclical or structural low point. There will be elements of both types of declines in the bottom, but one usually is more predominant.

CYCLICAL BOTTOM 
Most cyclical bottoms are created by dramatic change in sentiments based on very current stock price changes. One example is the (AAII) weekly sample survey. Three weeks ago the American Association of Individual Investors reported the percentage of respondents that were bullish was 41% and bearish 31%. This week AAII reported 25% being bullish and 47% being bearish. Barron’s produces a confidence index based on the difference between high quality and intermediate quality bond yields. Unlike the AAII statics this index usually moves less than one percent from week to week and has only moved 2% over the last year. It moved 2% this week compared to the prior week, in a direction that demonstrates there is concern in the bond market. (While the AAII numbers are highly volatile and are often negative indicators for future stock price moves, history suggests concerns in the bond market precede those in the stock market) Another indication of concern is that 14 of the 25 best-performing mutual funds for the week were Precious Metals Funds, a rarity. A sudden surge in gold mining stocks and funds after a long period of poor relative performance indicates worry rather than hedging.

Most of the time recommendations from transaction focused brokers and fee paid investment advisers are similar. However, brokers are currently recommending the building of cash positions (To build future buying power), whereas advisers are continuing to recommend holding on to stock positions. This dichotomy may reflect the “growth/value” dilemma. “Value” stocks, which are often significant dividend payers, usually fall less in down markets and underperform in up markets. “Growth” stocks tend do better in up markets and did quite well into the third quarter, led by the FAANG + BAT stocks, although they have given a lot of that back in the less than two months since then. Investors traditionally feel that the loss of a dollar is twice as painful as the pleasure of a dollar of gain. Thus, while some more mature investors are concerned about the size of their money pile, those that have cash flow needs are more focused on the expected terminal value of their accounts. (As an investment manager it is our job to work with accounts to achieve the proper balance.)

As Yogi Berra said, you can see a lot by observing. My wife Ruth and I did our usual “Black Friday” investment research visit to the glitzy Mall at Short Hills. Our overall observations were:

• Mostly women shoppers, often in groups consisting of three generations
• Good but unobtrusive security
• Shoppers very selective, with some quite empty stores. Specifically:
• Apple(*) - Quite full, but no outside lines
• Verizon - Better than normal, but not crowded
• AT&T - Actually had a few people there
• T Mobile - Some traffic, possibly due to being opposite Apple
• Starbucks - Jammed
• William Sonoma - Very busy
• Canada Goose - Lines outside, with limit access
• Tiffany - OK
• Hermes, Gucci, and Chanel - All busy

Relative to prior years I would give it a solid B, perhaps a B+. (I wonder whether the strength of the women’s’ shopping can be tied to changing demographics, economics, and shifting voting patterns and are these cyclical or structural?)

Market analysts might consider that this week the DJIA, S&P 500, and NASDAQ composite reached prior lows. This could represent a double bottom from which a price recovery could take place. If it were to happen, we would have experienced a cyclical decline with the relatively gentle capitulation that occurred this week.

STRUCTURAL DECLINE
While most of the time the stock market anticipates a recession, it doesn’t happen every time. The 22% one day decline in 1987 was unrelated to an economic recession, whereas The Great Depression of the 1930s combined an overpriced stock market with an out of balance economy and government errors. Historically, investors without trading skills are better off within a year or two after a cyclical fall, if they stay invested in their reasonably diverse stock portfolio or funds. On the other hand, a structural decline can take much longer to recover from and some companies and sectors won’t come back. Thus, out of prudence, I look for signs of a future structural decline and there are a few that need to be watched.

1. The Bank for International Settlements (BIS), the bank for central banks, is pointing to the rise of “Zombie” companies. These are companies whose return on invested capital is below their cost of capital. If these conditions continue the companies will not be able to generate the money to grow and will eventually consume their own capital and commit suicide. BIS sees the number of these types of companies growing. An expected rise in interest rates without an increase in return on invested capital will have them trapped.
2. Several young people entering the financial services business have asked me where they should start. I have suggested that if they can get exposure to past mistakes in workout situations and/or bankruptcies, it is much better than focusing on the successes of the firm. Thus, I try to learn what I can when one of these surfaces. David’s Bridal, a chain of stores selling wedding gowns and related materials announced it was going bankrupt. The press chalked up the problem to a change in young people getting married and wanting less flamboyant weddings, which may be true. However, I think there were other problems that an outsider could see. For example, too much inventory, slow cash conversion, sloppy credit extensions, and their second set of private equity owners over-leveraging their relatively high purchase price. (I cannot comment on the critical issue of management)  The over-leveraging of a high acquisition price is far from unique in today’s world. Years of interest rates not high enough to absorb credit loses combined with a sharp increase in relatively inexperienced people at non-bank credit institutions making loans is a prescription for trouble, although it does not parallel the sub-prime credit expansion that contributed to the last financial crisis. Interestingly, we are seeing some non-bank mortgage companies withdrawing from their market.
3. I believe the financial services sector is critical to the workings of the global economy. As an investor in this segment I know that at times one can make money in these stocks, but not always. Nevertheless, I study it because of their centrality to the system. I am seeing activities that suggest some career investors in this segment are concerned about growing concentration. Merger and Acquisition activity is increasing to improve revenues and reduce overhead (people). Suggesting that this is a drive is to maintain or improve profit margins and returns on invested capital, rather than growing the business. 
4. Two of the sharpest minds in our business see this as both an opportunity and a challenge. The first is the very well known, often contrarian, chairman of Berkshire Hathaway*), who was working down an excessive amount of the $120 Billion in cash by buying and additional $13 Billion in financial services stocks, including $4 Billion in JP Morgan Chase* stock.  He and Charlie Munger are still maintaining $100 billion for big opportunity investments at attractive prices. Less well known in the US is Paul Myners from the UK. Paul has had success in the investment management business in UK, US, and Hong Kong. Besides his investment management work he has also led the financial industry both in the UK Government and import industry bodies. His latest role is chair at Autonomous Research, a very good in-depth research firm covering Europe, the UK, and US companies. He is selling the firm to Alliance Bernstein which is partially owned by Axa (*), in part due to the shrinkage of research commissions, particularly in Europe.

(*) A long position is held in these securities either in a financial-services fund I manage or in personal accounts, if not both.

I always look for changes in the structure of the market that can disrupt how investors react. There are two aspects worth watching. The first is the large and still growing amount of money being invested away from publicly traded markets. Pensions & Investments magazine has published an article on foundations. It tabulated how the fifty largest foundations allocated their assets between stocks, bonds, and other investments. Other investments, which included private equity, hedge and venture capital funds, real estate, and direct investments, represented 60% of their total of $230 billion. Fourteen of the fifty largest foundations have more money invested out of the market than in it. I have seen the pull of these investments in endowments and foundations whose investment committees I sit or sat on. For a number of years as a group they have underperformed, even before fees are deducted and certainly afterward. This is in spite of a limited number of quite spectacular results from individual funds or properties. If the flows away from the market slow down or reverse there will be less leverage available to private and public companies, which could lead to structurally lower returns.

All too many investment results are phrased in terms of risk-free returns, which is translated as superiority relative to US Treasuries. One of the more successful fixed income mutual fund managers, Michael Hasenstab of Franklin Resources, has a view that US treasuries are due for a perfect storm. His three reasons are:

1. The US fiscal deficit will rise (This may be particularly true with the House Ways & Means committee in the hands of spenders who will want to match defense spending increases.)
2. A decline in bond buying by the Fed.
3. Inflation will rise.

If “risk-free” rates of return decline, it may materially impact asset allocation and overall rates of return.

Conclusion:
As of the moment, because of a lack of enormous enthusiasm at the prior peak, my current guess is that we are dealing with a cyclical decline and good holdings should not be disturbed. However, I will keep looking for increases in the list of structural issues that need to be addressed before we have a structure driven fall.

What do you think?


Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2018/11/selectivity-over-factors-weekly-blog-551.html

https://mikelipper.blogspot.com/2018/11/history-guide-not-map-or-trap-weekly.html

https://mikelipper.blogspot.com/2018/11/things-are-seldom-what-they-seem-weekly.html


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When the Stock Market Sleeps - I Get Nervous

Not only have the popular US stock market averages been flat for a period of twelve years, the recorded volume this summer has been scant. The so-called fear index, the VIX measure, is producing returns significantly below averages. 

In another sign of lack of concern, the decision was made at a recent investment committee I attended that a specific inflation defensive fund was not needed. (If you believe the US government’s statistics, the latest available all items count would be a minus -0.16% for the month of May and a core rate of 0.01%).

Somewhat more ominously there was praise for our committee’s market index fund selection, with the question as to why we should pay the high fees for hedge funds that are not producing better-than-market results. In another investment committee meeting it was suggested that many institutions are buying hedge funds directly and redeeming funds of hedge funds. (If the latter approach gains momentum it can hurt the expansion plans for the number two profit contributor to Legg Mason, a holding in our private financial services fund.)

What makes me nervous is that there are lots of facts and opinions that are crying out for significant changes in portfolios.

Start with the negatives

A recent piece by Moody’s* chief economist, John Lonski entitled “Global Slowdown Menaces Ratings,” focused on the recent plurality of downgrades as opposed to upgrades both for High Yield and Investment Grade bonds. As reported in my previous blogs, the appetite for yield at the moment appears to be insatiable. In the current quarter there have been 43 downgrades and 20 upgrades of high yields, and a 13 to 3 ratio for investment grade paper. Remember that one of the criticisms of the credit rating agencies (for understandable reasons) is that their findings are late relative to the market. The sellers and buyers of bond funds, particularly of high yields, do not appear to be following the changes in ratings. As an equity analyst I have been trained to think that the bond market senses trends before the stock market. The ultimate payoff with bonds is the return of principal with interest, as distinct from the equity market’s hope of future capital appreciation.

*Moody’s is another holding in my private financial services fund.

In one of John Mauldin’s well-written weekly letters he suggests that we may be approaching a Minsky moment. Hyman Minsky, a well-known European economist stated that stability leads to instability. After a period where the normal is flat, there will be a violent change. The key to this thinking is that something will dramatically change people’s views as to when the current supply and demand mix will abruptly change, which is easy to believe in our 24 hour news cycle world.   

In another letter John Mauldin mentions that the real problem for the euro long-term is France, which I have felt to be the case even before the last unfortunate election

One of the advantages to investors of the flat performance of the VIX futures, particularly if we do experience a Minsky moment, is that hopefully both the academics and the marketers will stop using volatility as a measure of risk. To me, risk is the inability to meet future payment goals for an investment or portfolio, not whether the return is calm or fluctuates. This belief can be a problem for the sleep patterns of trustees.

The positives that no one believes

If you ask most people about the progress of the market in 2012, they will say they don’t believe that we are up low double digit returns by mid-August. These returns would more than fulfill the annual requirements of most institutional funds; as a matter of fact the returns are close to double the needed returns for the more sensible institutions.

Richard Bernstein, now independent from a career at Merrill Lynch suggests that Bull Markets begin out of a malaise of fear. Investors are fearful of facing an unpopular election in the US as well other unpopular and unknown changes in governments for over half of the world’s GDP. In addition, the so-called “fiscal cliff” comes due to challenge the US at the end of 2012.

There are no apparent signs of valuations which are historically too high. (I would suggest that the excesses are in the bond market where the manipulating central banks are depressing interest rates. As we know, eventually even the manipulators run out of money.)

One of the more bullish pieces that I have read is by Seth Masters of Alliance Bernstein. In his view of a normal market expansion he sees a Dow Jones Industrial Average of 20,000 in five years. Even on a lower multiple basis, Masters predicts the market will reach this level in ten years. What is significant about this piece is first that it is coming out now in a period of malaise, second it is not from a promoter, or a Dow at 38,000 proponent,  etc., and third, if true a move from here to a 20,000 DJIA would fulfill lots of investment requirements. (As long as inflation remains tame.)

Perhaps the single most bullish piece that came out this weekend was the disclosure of the portfolios of Paul Ryan and his wife Janna. I do not know who selected the list of well-known and generally sound mutual funds. What is significant to me is that the potential “second family” of the US has been well advised and has a spread of funds that are appropriate for the current world. If Mr. Ryan becomes the Vice President or stays as chair of the House Budget Committee, we will have someone in a high place that has a sound outlook for his and hopefully the country’s investments.

Sleep well, but not too well.

Corrections
 In last week’s blog I mentioned a recent study of one account that we manage and said that there was not a single decline in 2012 through July, in the list of 47 funds. The actual number was 37. My apologies for the error. 

Second, for an unexplained reason some of our email readers received a version with the initial letters of some words doubled. If that happens again please let me know and we will send out a corrected copy. 

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