Expectations Changing? - Weekly Blog # 930

 

 

 

Mike Lipper’s Monday Morning Musings

 

Expectations Changing?

  

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

 

 

 

The Main Motivator They Don’t Teach

Fear is the main motivator they don’t teach you about in pre-kindergarten through Ph. D studies. Primarily, this list is comprised of what can go wrong and what will hurt you, such as going broke, losing a job, or being defrauded. Discussions are informative but not particularly action oriented. What would be useful is a list of expectations, and of prime importance how to recognize them and what to do. These are life lessons which we all need but are not taught.

 

Each of us has our own level of awareness of critical expectations and we are aware of the changes in them. While all aspects of human life are open to change, I am going to focus on the expectations which impact our investment realities. These expectations are easier because they deal in large part with numbers. Numbers, like prices or earnings per share, are precise but mean different things to different people at different times.

 

The difficult part of dealing with expectations is identifying when they change and by how much. For example, a stock price expectation between $103 and $98, or an earnings per share expectation between $0.67 and $0.70. The critical issue is how early, or late investor expectations begin to evolve compared to others. Being early or late is often more impactful than being right or wrong?

 

Are We Changing Expectations?

A recent January survey of institutional investors had 50% expecting stock prices to rise, 39% expecting prices to be stable and 10% expecting prices to fall. An American Association of Individual Investors (AAII) six-month sample survey of investor expectations found 33.2% bullish and 32.9% bearish. Three weeks ago, both groups were about equally sure at 38%.

 

For the week ended Friday, more stocks fell on the NYSE and NASDAQ than rose (NYSE 56% and NASDAQ 53%, respectively). Normally slow-moving industrial commodity prices rose to123.06% from 121.92% the week before.

 

Most important of all, the US and Israel bombed Iran on Friday night. (The timing of the attack was a surprise to most, although the US has been building up its military and Naval forces in the Middle East recently.)

 

For some time, large companies in the US have not replaced retiring workers with new hires. We will see in the coming week if there is a large change in market expectations and whether that change in expectations is long-lasting.

 

 

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

Mike Lipper's Blog: Diversification - Weekly Blog # 929

Mike Lipper's Blog: To Win Long-Term, Learn From Great Presidents - Weekly Blog # 928

Mike Lipper's Blog: Strategically, Time to Think Differently - Weekly Blog # 927

 

 

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Data Driven Reactions Dangerous - Weekly Blog # 633

Mike Lipper’s Monday Morning Musings

Data Driven Reactions Dangerous

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

Starting with the unemployment statistics published on the next to last Friday of the month, we have experienced whipsaws for the seven trading days since then, impacting stock prices by approx. 10% from top to bottom. Both the extreme highs and lows were “gut” reactions to the perception of what the numbers signified.

Employment Surge
Each month the federal government announces the level of employment and unemployment based on the week closest to the middle of the month. In this case it was released before the Friday morning opening the week ended May12th. What surprised many people, particularly those who were bearish, was that the number of people employed actually rose instead of declined.

US stocks prices surged and if investors understood when and how these numbers were constructed they should not have been surprised. First, throughout the month of May and into June, various business in largely non-coastal states were reopening, bringing back some of their workers. (The number continued to grow, at least through this last week.) Second, there was a relatively slight change in the classification adjustment as to which people were reported as employed.

The announcement came on a Friday morning, often a low volume trading day during warmer weather. It was probably exaggerated by many of the active traders sheltering at home or beginning a three-day weekend. Furthermore, since March 23rd many stock prices have risen materially. Bank of America (Merrill Lynch) published the Farrell Sentiment Indicator, named after their former great market analyst, showing this rise being the most “hated” rise in history. (The indicator is based on surveyed six month market projections over the prior ten weeks by the American Association of Individual Investors.) Consequently, it was not surprising to believe there were a lot of short sellers. Opening prices jumped and we suspect many purchases were made to close short sales and limit loses, either voluntarily or involuntarily.

Spike in COVID-19 Numbers
On the following Monday, higher numbers of victims of the Coronavirus were announced. The number of tests jumped as did the overall number within hospitals, although few noticed. Furthermore, as various communities open-up from lockdowns, one suspects more people will be tested and quite possibly contract the plague.

Appropriate Investment, Not Trading Reactions
Careful analysis of both announcements should have led one to conclude that first was positive and the second negative, but not to the extremes the market took each impulse. More importantly, the history of market investing for long-term investors is that they are not swayed from their focus on meeting their long-term goals. Unfortunately, a reverse in market direction is often an excuse to plow reserves back into the very investments that created prior losses, doubling down on the prior mistake instead of shifting into sounder investments. Before accepting the results of various statistics you should understand how and why they are constructed the way they are.

We find the same needs beyond investing, as illustrated by the following:

1. In most communities the entry age to grammar schools is calendar based, often with September 30th being the cut off. (Some parents, believing their youngsters are not as mature as they should be to enter school, keep them out and place them in school the following year, giving them a competitive advantage academically, socially, or athletically.)
2. COVID-19 reports end on Saturday, as some communities view the Sunday data as being unreliable. (Interesting, I found the same unreliability when I started to collect and measure mutual fund performance in the 1960s. We could not call back a number of east coast funds on Friday and question their net asset values and dividend data. Thus, we ended our week on Thursday, which is still the practice.
3. For marketing purposes, all thoroughbred horses officially have their birthday on January 1st. One of the elements used to help pick winners in the most difficult maiden races of two-year old’s, was to attempt to find out when they were actually born. In absence of that data the size of the colts and fillies was a clue, as young horses grow bigger with age.  

What is the Market doing?
In the table below you can see that we are going through three somewhat different markets, as captured by various indices. One could assign labels to the three indices in an oversimplification, based on the primary drivers of each: NASDAQ (Seasoned Speculators), S&P 500 (Large investors, particularly with limited research staff), Dow Jones Industrial Average (Media, retail investors, and active traders)

         Date of    % Change   % Change
Index  2020 High   to 6/13    for Week   2020
DJIA     Feb 12     -13.35%     -5.55%   -10.28
S&P500   Feb 19     -10.18%     -4.78%    -5.86
NASDAQ   June 10     -4.31%     -2.30%    +6.87

By losing less the NASDAQ beats the DJIA, although at some point the gap may close.

Another set of year to date data through Thursday is the performance of the three leading mutual fund sector averages:  Global Tech +9.48%, Domestic Tech (largely domestic) +6.66%, and Precious Metals +6.37%.  Large Cap Growth funds +4.42% and Convertible Securities funds +4.26% were also leaders.

An Unheralded Way to look at National Data
As evident to all our readers that I pour over all sorts of data to help me think through the investment problems of our clients. The ensuing discussion looks at our economy in a very different way for analytical purposes, not to begin a discussion as to individual and national priorities. The data quoted is from Wikipedia and covers federal data through 2019 and state/local data through 2015. If the combination of federal, state, and local government data provided to and for our people was done by private enterprises, economists would label it as services activity. There is probably no single recipient of these services that approves of how the combined expenditures of federal, state, and local governments are spent. Nevertheless, out politicians believe that enough people approve of each item, although for the most part we have not been asked.

The math includes not only those items paid for by income taxes, but also sales and use fees. (Thus, the cost of your drivers’ license, registrations, admissions to parks, and utility fees are included.) In fiscal 2019 the Federal government reportedly spent $7.3 trillion (34% of GDP). States spent $3.7 trillion and local authorities $1.9 trillion, for a combined total of $12.9 trillion out of a GDP of $21.4 trillion, suggesting the combined governments are spending about $39 thousand per person in this country. You can dispute the accuracy of the numbers and adjust for the very likely increase in governments spending in this year of lockdowns without meaningful government lay-offs. Any number between $20,000 and $50,000 per person is a large number, assuming the working poor brings in $20,000. The average working person has become middle class. Those with children and other non-workers are not doing badly either, compared to people all over the world. This is not to say we have developed an efficient system to provide critical services to all our inhabitants.

These issues will only become more binding in the future and have been with us for a long time. Since 1990 the Federal portion of total spending has grown at a rate of 4.6% per annum and taxes at 4.3%. I suspect State and local spending has grown faster, but taxes and fees have probably risen close to the same level.

The growing gap of spending vs. revenue generation cannot continue forever. As a corporate stock owner, I wonder whether these concerns will lead to lower profit margins and dividend growth.

We need to get some of our best minds to work on this.

 

Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/06/caltech-data-heretics-go-to-track-for.html

https://mikelipper.blogspot.com/2020/05/mike-lippers-monday-morning-musings_24.html

https://mikelipper.blogspot.com/2020/05/time-to-review-investments-weekly-blog.html



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A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.

Investment Losses Can Be Profits - Weekly Blog # 616

Mike Lipper’s Monday Morning Musings

Investment Losses Can Be Profits 

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

Losses from investments can, and often should be, counted as profits. This is not from my normal contrarian side, but from my lifelong attempt to learn something from most occasions, every day. Losses materialize when our portfolios are out of sync with the markets. In terms of results, there is no difference in being premature or being wrong.

Why Now? 
One should rarely delay in acting on a mistake. This may be a particularly appropriate time to accept the “wisdom” of the market. This week we witnessed the S&P 500 and the NASDAQ Composite going to new highs, with the Dow Jones Industrial Average close behind. The American Association of Individual Investors sample survey rose to an often unsustainable level of 41% bullish. Depending on one’s historical measure, the US stock market has been rising for over one or ten years. In this latest week WSJ chart 85% of the weekly prices rose, of 72 stock price indices, currencies, commodities, and ETFs. This is the highest percentage gain I have seen for the 72 elements and I therefore don’t expected it to continue.

During this period of generally higher stock and high-quality bond prices, it is a good time to review one’s portfolio. Any stocks that are currently being held at double-digit, absolute percentage losses or are selling at significant losses relative to their benchmarks, should be considered candidates for “capital liberation” or complete/partial disposal.

One should be aware of the following statement by the market analysis  group of Bank of America’s brokerage affiliate, Merrill Lynch “We stay irrationally bullish....We expect peak positioning along with peak liquidity(need) in the second quarter, triggering a “Big Top” in risk assets.” Why accept market prices that could be wrong?

Considering general stock market prices have risen beyond being fairly-priced (having as much upside as downside) to being fully-priced (having more risk of a decline than upside). If a position’s price has not risen with the market or it’s appropriate benchmark, it is a serious candidate for sale.

What is the Benefit of Selling Now? 
All of life should be treated as a learning experience. Outside of purchases used as part of a hedge strategy, investment losses are not additive to accomplishing one’s investment goals. (Often in a hedging strategy, one leg will produce an actual or relative loss while the other produces gains. In assessing whether the strategy is succeeding, the entire hedged investment must be reviewed to see if they are doing their job.) Almost everything life follows some cyclical pattern, such as investment opportunities in the present often being similar to those in the past. This is because people usually follow similar patterns when exposed to similar situations. Hopefully, after recognizing a losing situation, we can identify some of its characteristics. Remember the old market saying, fool me once and it is your gain, fool me twice and it is my loss. Winning the investment game calls for escaping avoidable losses. 

One of the benefits of selling a loser is to redeploy the money into other investments or leave it in cash for future deployment, either at lower prices or when better opportunities arise. For the taxable investor, the loss can be used to shield gains. It is not unusual to have long-term gains as well as losses. Some of the gains are quite large and are in securities that are not performing to expectations. Some investors make the mistake of letting “the taxman” be their portfolio manager and avoid taking profits. Losses can be used to offset some of these gains. Thus, the size of the capital available for redeployment doubles when an equal amount of the loss is used to free up some mothballed gains.

For Americans, this is a Good Weekend to Think About Losses 
On Monday, the nation celebrates Presidents Day, a combined vacation and shopping day replacing the birthday celebration of our two greatest presidents, George Washington and Abraham Lincoln. You could spend a lifetime studying these two great men. Of interest to me is that both Presidents started their position of power with significant military losses, based on poor strategy and key leadership gaps. In each case they learned from their mistakes and found the better leaders that were needed. Washington stopped attacking the British in New England and the Mid-Atlantic States, as did Lincoln in Virginia.

Washington opted for better training in his winter camps in New Jersey and Pennsylvania. He also had good leadership in the South with the local militia. Lincoln finally found the right generals and shifted the campaign to the Midwest, recognizing the strategic value of the east-west railroads after Lee had almost accomplished his mission of disrupting the east-west railroad through Pennsylvania. Grant and Sherman captured the east-west railroad through Atlanta, logistically crippling the South. While there are many reasons to celebrate these two Presidents, their ability to learn from mistakes were traits few others demonstrated. For us as investors, I hope we all learn from our mistakes.

Applying the Lessons 
I am undecided when to recognize the only loss vs purchase in one account. It is a fund management company that used to have some noteworthy performance and an unusual distribution pattern. While it could recover its former glory, that would take both time and talent. Based on history, the obvious solution is for it to merge into a larger and hopefully stronger investment group. This has been true for a couple of years, but it hasn’t happened yet. This may be because management wants to stay in control and has convinced the funds’ boards of directors and the key distribution people that they can rebuild the company. Possibly, the existing management wants too high a price. This stalemate has gone on for too long and I should probably recognize my relatively small loss. On occasion, something new happens. This week my old firm, now a part of Refinitiv, calculated that the mutual funds and ETFs included in the Lipper Financial Services Funds segment are attracting sizable net inflows. These positive net flows followed substantial net redemptions in the last two years, which about equaled the net inflows in the 2013-2017 period.

My quandary is, should I show a little more patience and see whether the new flows result in a terminal price high enough to get management to sell out? Any thoughts?   



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/02/the-art-of-portfolio-construction.html

https://mikelipper.blogspot.com/2020/02/significant-turnaround-two-fearful.html

https://mikelipper.blogspot.com/2020/01/mike-lippers-monday-morning-musings.html



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Copyright © 2008 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

Where is the Stock Market Going? ESG Might Learn from Columbus - Weekly Blog # 598

Mike Lipper’s Monday Morning Musings

Where is the Stock Market Going? ESG Might Learn from Columbus

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

CORRECT CONTRARIAN CALL SETS UP WARNING
In last week’s blog we expressed our contrarian view that the next move of the US stock market was up. On Friday afternoon the market shot up and was able to keep most of its gains by the close. Even when flipping coins, the odds of a trend continuing or reversing does not change. However, as a contrarian I am worried about being successively right. (In the early 1960s I was right in choosing specific stocks six times in a row; it ruined me in terms of the only real product of the stock market = humility. Hopefully, I have fully recovered.)

In addition to not trusting in a continuation of a trend, there are two signs that should sound some caution. The first deals with the difference in outlook of investors vs. speculators. In an over-simplification one could suggest that the bulk of the money invested in New York Stock Exchange stocks is for investment, while the bulk of the money invested in NASDAQ stocks is more speculative short-term. In the week ended Friday, the number of new lows on the NYSE was 147 vs. 302 for the NASDAQ.  Part of the reason for this dichotomy is that the focus of investment leadership may have changed. Using mutual fund performance averages for the week ended Thursday, before the sharp gain on Friday, the best category average return was achieved by World Equity funds +0.81%, which beat the return of +0.52% for US Diversified Equity funds. The average sector funds declined slightly -0.04%. Expanding the performance lens to the month of September, I looked selectively at the performance of some T. Rowe Price funds (*) to get a clue as to the future direction from the following list:

                            September 
Fund                       Performance
Financial Services            +3.36%
New Asia                      +3.15
New Era                       +2.66
Emerging Market Stock         +2.25
Growth Stock                  –0.99

The two leading sectors in the Financial Services fund were banks and insurance, both of which trailed earlier in the year. New Asia is heavily invested in China and India. New Era was a fund designed by Mr. Price himself, to serve as an inflation protected portfolio invested in energy and other commodity related issues. The Growth Stock fund is led by FAANG stocks and a small position in pre-IPO investments. I have hedged our larger positions in Growth Stock and similar funds with international funds, inflation sensitive funds, financial service funds and some stocks. The purpose of hedging is to have some relative winners when long-term, attractive growth stock investments, are experiencing difficulties in the short-term.

(*) Owned in our private Financial Services Fund and in personal accounts.

The second short-term factor is that the overall US stock market, as currently priced, is clearly in the middle of its valuation range. The following statistics are in general flat with a year ago:

                        Current     Year Ago
Indicator               Reading     Reading
DJIA Yield               2.20%       2.19%
S&P 500 Yield            2.00%       1.99%
Market/Book - DJIA       4.12x       4.09x
Market/Book - S&P 500    3.49x       3.35x
Consumer Prices         +1.74%      +1.74%
Inflation               +1.70%      +1.70%

Perhaps the most reassuring indicator is a contrarian one. The current American Association of Individual Investor's weekly sample survey has a bearish reading of 44%. As noted in prior blogs, readings over 40% are extremely rare. Three weeks ago this number was 33%, demonstrating its volatility.

SHORT-TERM WARNING
We may create an important barrier to future higher prices if within a reasonably short period we do not see record price levels with expanding volume.

• Some may view multiple attempts to achieve new highs as a sign of a market top after rising for more than ten years. 
• Many stock holders disappointed with the lack of progress in their particular selections may see the current price level as a good exiting opportunity. 
• From an analytical viewpoint, if the seller’s volume is larger than the buyer’s appetite, near-term prices will decline. I emphasize near-term because sellers are often sold out bulls, who feel compelled to re-enter the market regardless of price for fear of missing out (FOMO).

COLUMBUS DAY LESSONS FOR ESG INVESTMENTS BY INSTITUTIONS
Most Americans have been brought up to celebrate Columbus Day, “the discovery of America”. They are familiar with the story of Christopher Columbus who convinced the Queen of Spain to use her jewels to pay for his three ships. These ships set off to find a new route to India and found an island in the Caribbean instead. He is celebrated for his persistence and courage to go where nobody had reportedly gone before. Instead of this tale being taught in elementary schools, the real story should be taught in business schools, particularly in advanced investment and marketing classes. (The latter has to do with one of America’s great resources, the ability to sell myths.) The real story is very different than the one presented to children.

THE REAL STORY
Spain’s main competitor and neighbor was Portugal. The king of Portugal was known as Henry, The Navigator.  He funded a series of voyages along the African coast and eventually had one of his ships round the Cape of Good Hope at the southern tip of the continent. Later, his ships landed in India and he was able to set up the spice trade. In the time of no refrigeration spices were extremely valuable in Europe. They had learned from Marco Polo that the addition of spices preserved the taste of meat.

When Columbus was attempting to raise money for his venture, Spain was in the midst of the forced conversion or expulsion of Jews. Not only was the Inquisition expensive, but it wiped out much of the merchant class in the country. The Queen, recognizing the need to divert attention from the expulsion and poor state of its economy, found in Columbus a “pigeon”, or a willing accomplice.

Columbus today would be called a skilled marketer with a smattering of scientific knowledge. Most other explorative voyages were done with a single ship, not three. So, like most marketeers, Columbus overspent. He was not a good manager or leader, suffering a mutiny and the loss of one of his ships. When he landed he did not know where and what he brought back was of little economic value. But like a good marketer, he was able to raise funding for two additional voyages.

In one respect Spain got very little from its investment in the spice trade. However, Spain got a great deal from its discovery of gold and silver, in countries with weak militaries. Spain, along with Portugal, seized Latin America and parts of what is now the US. (Interesting enough, the smaller of the two occupiers got the biggest piece of South America, Brazil.) In some respects, the rest of Europe paid for Spain’s success. The gold from Latin America created two hundred years of inflation and shifted the political power bases within Europe. Perhaps due to inflation, other European countries avoided funding exploration and development directly, licensing private companies to do it for them instead. The Dutch and English were particularly successful, their effort lasting longer than that of the Spanish.

COLUMBUS AND ESG INVESTING BY INSTITUTIONS
ESG is a series of views for the protection and improvement of the world. ESG stands for Environmental, Social and Governance, which some investment institutions impose on businesses, not governments. They hope to shame, or through the use of proxies, force businesses to improve their conduct. These improvements include how companies treat the environment, how they interact with their communities and workers, and the composition their boards and management. They do not appear to be concerned with the cost of their actions, which will be felt by shareholders and customers. One example is the use of tax subsidies to lower the initial cost of electric cars. There is no concern that the electricity used, particularly in China, comes from burning coal to generate electricity, or that these vehicles will require fewer workers to build or maintain. This is not to say that ESG issues should not be addressed, but the total cost for all stakeholders needs to be understood and managed.

For proponents of ESG they should consider a possible parallel with the lessons of Columbus. Both Spain in its time and the boards of various fiduciary institutions today have looked for things that do not exist in reality:

• Both have spent other people’s money without the direct authorization of the beneficiaries 
• Both were exposed to some very successful marketing
• Both needed to focus attention away from a world of low returns
• Neither wanted to turn over development to private enterprise, with their history of frequent and periodic measurement, and audits
• Both appear to have been unconcerned with the consequences of their effect on others

This is not to downplay the need for answers to society’s problems, but there is a concern about the instruments being used.



Question: 
What are your thoughts about the short-term outlook for the market or the Columbus Day lessons?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/10/contrarian-bets-and-other-risks-weekly.html

https://mikelipper.blogspot.com/2019/09/mixed-near-term-after-recession.html

https://mikelipper.blogspot.com/2019/09/capital-cycles-changing-weekly-blog-595.html



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Copyright © 2008 - 2019
A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

News Focus May Drive Investment Success - Weekly Blog # 555

Mike Lipper’s Monday Morning Musings

News Focus May Drive Investment Success 

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

                                   

We are bombarded with hundreds if not thousands of bits of “news” and observations each day. Separating those that are important enough to impact our investment actions is one of the keys to long-term investment success. One useful filter is to separate the incoming into time buckets. The first is a cause for immediate action, before too many others do. The second are those significantly impactful inputs that are likely to change extended periods of investment results. Of course, the biggest bucket is for discards due to lack of value and/or integrity.

The sorting mechanism that I use can be described mathematically. The first can be described as the prime derivative. It contains factors that are slow to change most of the time and are likely to shape the results at the end of the investment period.  Demographics is an example which encompasses all those alive today and their inter-relationships. Other examples include the number of consumer units vs. the number of producing units, the interactions between productivity and income, the interactions of health and wealth, the size of the agricultural community to the quantity and quality of food produced, etc. These factors tend to move slowly.

The second bucket deals with the rate of change in the factors impacting the items in the first bucket. These factors are more driven by psychographics or how people feel at a moment. They are volatile and can change rapidly, as well as reverse direction. The content of the second bucket can be described as the second derivative of the first. Apparently, we have entered a period where the track of the second derivative is getting much more attention than the first. Liz Ann Sonders of Charles Schwab (*) is quoted in Barrons as saying “better or worse matters more than good or bad”. Someone else has said “after driving 70 miles per hour, no one likes driving at 55 mph”.

Second Derivative Hot Spots
For portfolio managers who are generating much worse returns in 2018 than 2017 and are thus dealing with career risks, the following are some of the hot spots currently causing concerns:

• Cash is likely to perform better than stocks or bonds in 2018.
• This week there was a record net inflow into money market funds.
• Small business optimism has become weaker.
• Growth is declining in both China and Europe.

A contrarian might focus on the following items:

• The very volatile and often wrong American Association of Individual Investors sample survey which showed 21% to be bullish and 49% bearish.
• The size of the short positions in the SPDR S&P 500 and iShares China Large-Cap both represented 17% of their assets. These shorts will be covered eventually and often at losses, as these ETFs move up in price.
• Stock valuations using forward P/E estimates are the lowest in five years.
• More hedge funds closed in the third quarter than started, implying less competition.
• The most recent survey of US bridges showed that 9.1 % were deficient 2 years ago.

LONG-TERM INVESTORS USE A TELESCOPE NOT A MICROSCOPE
Looking through the current malaise and all but certain recession, followed by a certain recovery, I focus on fulfilling the reasonable needs of future beneficiaries. The list of items from the first bucket or first derivative are as follows:

• While most of the developed world’s population is stagnant, with an aging population that will need to find some retirement support, the developing world is producing both workers and consumers.
• In the developing world the levels of schooling and healthcare is improving.
• Technological developments will produce more value and at lower prices.
• There will be a shift of savings from the developing world to the developed world to help meet retirement purchases.
• Because interest rates have been constrained, valuations are acceptable for long-term investing.  

Question of the week: 
Which of the three lists most represent your thinking and why?


(*) A long position is held in a financial services fund that I manage or in a personal account or both.


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

https://mikelipper.blogspot.com/2018/12/investment-memory-friend-or-foe-answer.html

https://mikelipper.blogspot.com/2018/12/worries-2nd-derivative-3rd-degree-and.html

https://mikelipper.blogspot.com/2018/11/on-road-to-capitulation-and-recoveries.html


Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

Three Concerns: EPS/Golden Calf, the Next Dip, Indexing is Faulting - Weekly Blog Post # 489

Introduction

Most individual and institutional investors are in essence outer directed. Either consciously or not they follow what others do and have a fundamental belief in “smart money.” For extended periods of time this philosophy has worked. Perhaps, it was my brother’s experience in the US Marine Corps Reconnaissance as the leading point for wartime patrols to avoid walking into an ambush. Or my experiences at the racetrack where betting favorites won only about one-third of the time. I look for instances where the “crowd” is wrong. Not to be just a contrarian, but looking at the profit opportunities when the generally unexpected occurs. Some of these opportunities are just plain random, others can be perceived ahead of time. Each of this week’s concerns has some evidence backing up the views as to future changes. Whether you agree or disagree let me know.

Is EPS our Golden Calf?

Throughout my investment career I have heard earnings, actually reported earnings per share, drives the market. In the 1960s I was told all one needed to know was the growth rate of earnings to determine the appropriate price/earnings ratio. Recently I heard a very well known and respected Portfolio Manager explain in a long cable news interview that “earnings drive the market.” The first thing he said about each of his five buy recommendations was their earnings per share. The analyst in me rebels at this kind of over simplification.

In a period where much of senior managements’ compensation is based on in order, EPS, sales, and market price - do you think that they attempt to show the best possible record? I don’t want to proclaim that they are totally manipulated or are the equivalent of “fake news” but it makes you wonder whether it is a true reflection of the value and future potential of the company. One of the first lessons from my Professor David Dodd, who wrote the five editions of Securities Analysis with Ben Graham, was to reconstruct the financial statements of the company under study. We laboriously went through each line in the income statement and balance sheet adjusting for removal of non-recurring elements and questioned the accounting techniques that produced each item. We were quickly taught that in various cases the results in the press release or Management’s letter did not give a totally accurate picture.

When professionals discuss the valuation of various Merger & Acquisition deals today, comparing them to others, the metric that they use is EBITDA. This stands for Earnings before Interest (net), Taxes (paid or accrued), Depreciation (based on what schedule), and Amortization (what were the write offs?). The drive here is to understand what was the operating earnings of the company. Net Interest is the result of the financial condition  and policies of the company and might not be followed by a new owner. One of the simplest techniques that I learned at a trust bank was to put all the steel companies held in trust accounts on the same tax rate. This deprived some of the companies of their tax management skills, which were often transitory, but would be different under different ownership.

Depreciation charged is a function of the weighted ages of the plant and equipment with no adjustment for critical future expenditures. Amortization could be an orderly way to recognize the deteriorating value of intellectual property purchased and/or other write downs. To some degree I think all of these items plus debt service obligations are more important than reported earnings and so do the “M&A” troops.

Notice that a good portion of some companies “earnings improvement” comes from profit margin expansion. What this really means is that reported earnings are growing faster than sales. This is favorable when the company is increasingly earning more over its fixed cost base. However, it may mean that it is not spending enough on plant and equipment and/or research and development. These considerations are important in an increasingly competing world of relatively slow growth.

In history, when the ancient people felt that the Golden Calf  did not answer their needs, not only did they destroy the statue, there was a period of turmoil and violence until new, and in some cases, better beliefs were established.

The Dangers of Buying the Next Dip

This past week there was an extremely sharp jump in the portion of the American Association of Individual Investors views on the market. In one week 41% are bullish, a gain of 12 percentage point from the week before with a concomitant decline in bearish beliefs and neutral holding about even. Both the Dow Jones Industrial Average and the S&P 500 went to new highs, not immediately echoed by the NASDAQ Composite. It is quite possible that the two senior averages need to catch up with the NASDAQ. The year to date performance shows the performance gaps, DJIA +12.68%, S&P500 +16.88% and NASDAQ + 22.96%.

Could this be the key missing element to a race to the top? While a number of highly respected market analysts expect a minor pull back, as there are a few price gaps that should be filled in before a major new top is reached. This could be accomplished by a 5 to10% correction. The Goldman Sachs^* view is that there won’t be a dip as too many people are expecting it. (Remember the humility production function of the market.) This focus on sentiment over financials is a concern of Professor Robert Shiller as expressed in The Sunday New York Times when he refers to John Maynard Keynes’ belief that market participants were not making their own investment decisions, but were guessing what others were doing, in other words, trying to follow “smart money.”

^*Held in the private financial services fund I manage

My concern is that this trading attitude may actually succeed. The risk is that the successful traders and later their acolytes will have faith that it is a repeatable result, and they are truly skilled. My concern is that when the next “Big One” occurs it will be quite different than managing through normal drops and even minor corrections. The difference is the size of the trading capital in the marketplace having to provide liquidity to non-price sensitive ETFs and margin-called players. There is little to no capital on the floor of the exchanges. Dealers have capital constraints and banks are limited by various regulations in a global marketplace connected in less than nano-seconds.

I don’t worry about trading losses, they come within the territory of investing. What I do worry about is the potential of future revulsions to investing and a generation that will decide “never again.” This will be tragic for themselves and their families. But also the rest of us taxpayers who are likely going to have to pick up some of their missing retirement capital.

More Evidence Indexing is Faulting

You have to excuse me for looking at the world with lenses that start with mutual funds which I have been following for more than fifty years.

Each week I look at the funds’ performance for varying time periods. For the week ending last Thursday I saw an interesting pattern evolving. My old firm, now part of Thomson Reuters, tracks close to 100 different fund peer groups. The largest equity group is the $ 1.2 Trillion S&P 500 Index funds. I compared its results for three periods and counted the number of peer groups that beat the large Index funds as shown below:

Type of Fund	# of Fund Types Surpassing Index Funds
	YTD	52 Weeks	5 Years
US Diversified funds	4	3	2
Sector funds	12	7	5

There were four fund types that beat the index in all three periods, 2 diversified and two sector fund types. The key point is more active managers are beating the Index. It is not because they switched from dumb pills to smart pills. It is due to greater variability of performance within the 500. Mathematically this splitting is called less correlation and greater dispersion. Within the Index there are some big winners and a few big losers which is meat to active managers, and in theory to long/short managers (hedge funds and the like).

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A. Michael Lipper, CFA

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Is the “Two Step” the Last Dance of the Bull Market? - Weekly Blog # 487

Introduction

Many years ago when people actually held each other there a very energetic fast dance called the “two step” which exhausted the dancers and often at the end left them clinging to each other. I am wondering whether there is a reasonable chance that we are setting up a “two step” dance before we have the “big one,” a once in a generation major decline.

A Contrarian View of Current Sentiment

A basic belief derived from history is that the only attribute that market survivors share is a well earned sense of humility. A study of history through the ages, cultures, and fields of endeavor shows that at critical points most people are wrong, but not always. Viewing the current stock market through that lens raises the possibility that we can be on the edge of a meaningful market advance.

A number of good market analysts pay more attention to sentiments and shifts in sentiments than economic and financial ratios. There are a number of sentiment readings, some published in Barron’s each week. One that has caught my eye is the weekly readings from the American Association of Individual Investors which also parallels my sense of institutional investors thinking as indicated by changes in transaction volume. In the last three weeks the percentage of bullish individuals has dropped from 34.2% to 25.0% with only a minor increase in neutral views going from 33.0% to 35.1% with a major rise in the bearish column from 32.8% to 39.9%. One can understand that the current political and military events are matters of concern, but in theory investors should have longer term time horizons than day traders. Both my study of history in general and the learned analysis from the racetrack, suggests to me that the odds, not the certainty, is that the dramatic switch in sentiment is wrong.

Interesting to me is that market volume has not picked up. This indicates to me that while people are generally worried about conditions they are not now acting to preserve their wealth or that of their clients.

Stock Market Analysis

What is more interesting to me, particularly as an investor in some smaller cap funds, is that the NASDAQ index has gone to a new high. The older and broader indices both in the US and a number of other markets are in striking range of new highs. While the NASDAQ index did hit a new high on a light volume Friday, it did not go up to qualify as a clean breakout of a past trading range and could reverse and create a top. Recognizing I am intrigued with the possibility that the index will achieve a breakout velocity.

The tactical importance of a breakout, particularly if followed by others, is that the prior reversal patterns, called “head and shoulders” becomes a base for a material advance. The base will show a rather large volume of past sellers who may feel the need to get back into the market to participate in future gains. Often the past sellers left large relatively high quality stocks and now may feel the need to quickly catch up through more than normal (for them) speculative investing.

Thus a vigorous “two step” dance could be in our future.

Fears of “The Big One”

One way I attempt to keep up with investing globally is when possible to read English language foreign media both for their local and global views. Recently I read an article in The Star Online from Malaysia where Tan Sri Andrew Sheng who writes on global issues from an Asian perspective. While enjoying the 24.7% gain in the MSCI Emerging Market Index, he is concerned that we may be heading for a major drop. In this light he as we all should re-read Charles Kindleberger’s “Mania, Panics and Crashes” (Macmillan, 1996). He identifies the following steps to the collapse labeled the South Sea Company Bubble of 1720:

•           Displacement
•          Credit/ Monetary Expansion
•           Over Trading
•           Financial Distress
•           Fraud, Swindles, and Malfeasance
•           Revulsion, mistrust of shady products and intermediaries
•           Panic selling

We have seen similar risks attached to a number of other panics before and after the South Sea Company Bubble panic. His bullish view is that he does not see enough similarities to today’s markets to fear  a repeat  panic.

The odds are that he is correct that the next decline will be one of the more normal falls. In the US context when we had floor specialists and other well capitalized broker/dealer trading desks this meant declines in and around 25%, not the once in a generation collapse of 50%.

However, as the job of a prudent analyst is to think the impossible thoughts. I look at the above itinerary to panic and feel we may be on a similar somewhat predictive path. One might suggest that either the internet or bitcoin qualifies as displacement. The key concern with displacement is that it is an excuse at least temporarily in believing old rules of prudence no longer apply. The growing lists of unicorn valuations for private companies that have little or no profits but with perceived great futures. It makes me nervous that some very good mutual funds are currently profitably benefiting from their private equity investments. Some less sound funds may follow and could have liquidity problems.

Our friendly central banks and deficit spending by governments and the growing number of new credit funds are certainly expanding money supply to the market systems. The mere hint of a “tapper” can cause both bond and stock markets to shudder.

At the moment most of the remaining sign points are not flashing great concern which is why I have not built reserves up in our long-term oriented mutual fund managed accounts. However, I am very concerned about the item of revulsion and mistrust of intermediaries. Some in the media are perfectly looking to shout “fire” in a crowded space. In addition, numerous politicians may act against all the intermediaries and their favored products. Their math is not based on dollars or other currencies, but on numbers of potential swing votes. As a critical element of self protection those of us who are professionals in the market need to have our clients and their beneficiaries understand that while we undoubtedly make mistakes, we are essentially honest and place them ahead of our own short-term financial interests.

It is a mistake to rest our relationships primarily on performance, particularly short-term performance.

With appropriate level of concern and caution I am still a believer that the process of prudent investing can generate longer lasting wealth than most activities, as long as it is based on our best efforts.

Momentary Input

On an intermittent rainy Sunday on the Labor Day weekend, the crowd at one of the glitzy shopping malls, The Mall at Short Hills, crowds approached the Christmas season levels. The big difference that I noted is that more men were in attendance, not just as bag carriers. They were actually shopping and often not in the company of female companions. At numerous stores there was a major effort to divert credit card sales to their home or co-sponsored brands. Retailers are also looking to capture long-term relations not just current sales. This is a necessary effort, hopefully it is not too late to keep any of the stores open for business in the malls.

Question: How quickly will your humility permit you to reverse some of your investment choices?                                

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

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Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.