Some Past Errors Create Future Problems - Weekly Blog # 798

 

Mike Lipper’s Monday Morning Musings

Some Past Errors Create Future Problems

 

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

 

 

 

Employers can't find suitable candidates to hire due to both faulty education and attitudes toward work. This is one of the reasons the US is losing the productivity of labor battle. In at least 16 states a large percentage of students are failing third grade reading tests e.g., 60% failed in Tennessee. (In our machine era, if you can't read instructions, you can't operate various machines.) I suspect that teachers are taught to teach to the test, test scores are used for hiring, and schools are retaining teachers in union jobs.

 

Teachers should be teaching students how to use information to gain knowledge. This is not what is happening today. (A classic example is a problem I had with my late daughter. She drove me crazy with her disability, which caused her to have problems adding a simple column of numbers correctly. So, I changed focus and concentrated instead on how she kept track of spending money. She always had money in the bank and her bills were always paid. In explaining it to me, she said that was easy. She said she was conserving the money by keeping it intact at the bank, while we paid her credit card bill. Thus, she was the best money manager in the family. The key was that she figured out what none of her teachers or aids did. The teachers need to learn to teach life lessons.)

 

The biggest problem with what is being taught is the integrity of our history, which pivots on one word: Tariffs. People don't like paying taxes. Politicians throughout history have given popular reasons why people should make these payments, without focusing on the real reasons. Three examples in US history still hurt us today.

 

The “Boston Tea Party”, staged by American Colonists dressed as Indians, threw the first shipment of taxed British tea into Boston Harbor. The Colonists were protesting the payment of a tax without being represented in the British government. The truth of the matter was that Lord North, an unpopular British Prime Minister, needed to pay for a six-year war with the French to protect the American colonies during “The French-American War”. Lord North and many in England thought that America was costing too much. It was being totally financed by revenues derived from goods purchased from “The Mother Country”. The Tea Party thus became one of the initial political events leading to the American Revolution.

 

The second misappropriation embedded in our history is the Civil War. In this weekend’s Wall Street Journal there is an opinion piece by Jim Webb, a US Marine Officer who served in Vietnam and a Secretary of the Navy. He was also an independent director of a respected Mutual Fund. In the article he commented that there were very few confederates who owned slaves. He also noted that more slave owners fought for the North than the South. Yet it remains a popular belief today that the war was about slavery. In truth, the war was about tariffs. The North wanted high tariffs to protect its manufacturing, while the South wanted low tariffs to aid the British who were major buyers of their’ cotton and were suppliers of cash to the Confederacy.

 

Post Civil War through the Wilson administration, Americans were fed a political diet about slavery. For about the fifty years this was happening, the German General Staff made many trips to study American war battles, particularly battles in the Shenandoah Valley with Stonewall Jackson. The study of these battles played a critical role in both WWI and WWII, particularly in their attacks of the ”low countries”.

 

I also believe the German underground political movements in the US led to delays in the US entering both world wars, despite British efforts. (The US recognized the importance of the war and placed its War College in Pennsylvania, hoping to understand both battles and the infrastructure challenges.)

 

The third misappropriation is still taking place today, with the last two administrations selectively using tariffs for domestic political purposes. These tariffs caused inflation that was importantly paid by low-income people. The current administration is attempting to hurt Republicans by damaging corporate earnings through the restriction of sales, while at the same time trying to raise labor union wages and their contributions.

 

With All This Good News-How to Invest?

Like Ronald Regan, “I won't exploit my opponent’s youth and inexperience”.  Neither party is serving up a long-term leader or a set of policies. Most people can see through their own accounts that there is no great future for them. Around the world young people have lost confidence in the "system".

 

With most equities around the world declining in real terms, one should consider a careful plan to dollar cost average into the markets. The more China suffers, the more attractive long-term investment in China becomes. Foreign car companies will benefit compared to ‘the big 3”, as the UAW forces prices higher.

 

Recognizing my COVID Brain does any of this makes sense.

 

 

 

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Mike Lipper's Blog: Inputs to Implications - Weekly Blog # 797

Mike Lipper's Blog: Markets Are Time Frame Exchanges - Weekly Blog # 796

Mike Lipper's Blog: Possible Investment Lessons - Weekly Blog # 795

 

 

 

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Managing Mistakes - Weekly Blog # 652

 

Mike Lipper’s Monday Morning Musings

Managing Mistakes

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

Mistakes are common in all endeavors. That is why we should learn from them and raise the fundamental question as to why we don’t. In the US we have entered a two-month period where almost all the candidates make mistakes due to oversimplification, incomplete statements, over-worked staffs, inexperienced candidates, etc. Some of these unforced errors will cause a few candidates to change their preferences.

The political world should learn from the experiences of both the sports and military worlds. Most of the time the declared winners are the side that makes fewer mistakes at crucial points. On a win-loss ratio, General George Washington lost more battles in the American Revolution than he won, particularly in the earlier years. He won at Yorktown because he benefited from battles won in the South by other generals using fewer European tactics. Additionally, weather in the Atlantic allowed the Allied French fleet to depart from New England and kept the British fleet harbor bound while British politicians in London grew tired of an expensive war.

How does this focus on historic mistakes apply to portfolios? Like most American election choices which are already made up, most portfolio owners are sticking with their plans. Modified only after the election as a result of foreign political changes. 

The Crux of the Problem: Unrealistic Plans

Some individual and institutional investors are unhappy with their portfolio results and are seeking to make small adjustments. There is rarely an almost perfect portfolio than can be converted to complete satisfaction by the change of a single security or fund. The crux of the problem is addressing multiple needs with a single solution. Most often investors have a diversified portfolio in mind, but due to an emotional need to be with the crowd their investment performance is closer to that of the popular indices.

True diversity can only be accomplished long-term by a collection of winners and losers at different points in time. In our everyday lives we are both self-insurers and hedgers, taking on physical risks at home and at work. While we may have fire and auto insurance policies, they are unlikely to pay off enough to totally substitute the new for the old. In effect we accept the shortfall as part of the bargain embedded in the contract. In other words, we chose to tolerate less than complete perfection. Yet in our portfolios we wish to avoid any deficits in actual or relative returns. Understanding how the markets and life rotate disappointments and mistakes hopefully gives us the opportunity to own winners where the gains are much larger than the mistakes.

The so-called mistakes may quite possibly be insurance premiums to be activated in future periods. I therefore favor dividing a single portfolio into parts, first in terms of risks and second in terms of desired delivery time. If one has only a single portfolio then any “mistake” is a negative, whereas a portfolio that addresses different levels of risks or different time periods provides some insurance. Today’s risks include changing tax rates, materially higher inflation, fall of purchasing power due to currency changes, technological changes, management changes, political changes, medical and health conditions, and the unknowns.

Could This Be the Time to Change?

One of the disadvantages in pouring over current data is that whatever occurred recently has little to do with what will occur subsequently. Nevertheless, the performance of equity oriented mutual funds for the week ended last Thursday could be indicative of future directions. In contrast to the slight decline of -0.85% for the average S&P 500 Index fund, 87 fund peer groups did better. The five peer groups averages that did best included: Base Metals Commodity Funds +2.49%, Latin American Funds +2.46%, Financial Services Funds +1.87%, Utilities Funds +1.58%, and Agricultural Funds +1.38%. I know of not a single portfolio that holds all five weekly leaders. The only common denominator is that these groups underperformed the S&P 500 for a considerable period of time, as did most of the other 82 peer groups. 

This is not only a US phenomenon, of 44 markets in local currencies only 15 Ex US markets gained, including 2 European markets (Moscow and Spain). In contrast to many of the pro-inflationary funds groups, the average 6-month money market deposit account interest rate declined to 0.19%, down from 0.22% the prior week and a three year high of 0.72%, signaling that many banks cannot find secure borrowers to lend to.

One additional symptom of a speculative market producing a lot of gains for some nervous holders is the change in trading volume on a year over year basis. NYSE listed stocks +7.84%, DJIA stocks +46.09%, NASDAQ +84.86% and Dow Jones Transport stocks +186.19%. Traders of volatile stocks are likely to look for future volatility.

Working Conclusions:

Clear investment answers are not likely to be revealed immediately after the US elections. I suspect we will be in for a period of excess volatility that will attract more cash off the sidelines. This uneasy period is not likely to end until most if not all the cash has been consumed. While this frenetic period continues, there will be time to transform a single portfolio into a collection of portfolios based on different needs and risk appetites. All portfolios should have sufficient reserves to absorb the mistakes that will occur without hurting the investment objectives too much.

Question of the Week? Are your ready for Changes?     

 

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

https://mikelipper.blogspot.com/2020/10/momentum-is-slowing-under-too-many.html

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

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July 4th Lesson: Need to Hire Wise, not Just Smart People - Weekly Blog # 636

Mike Lipper’s Monday Morning Musings

July 4th Lesson: Need to Hire Wise, not Just Smart People

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

Bear in mind, many smart people are taught lots of valuable lessons in schools and search for answers that look like test questions in terms of simple (straight line) answers. Wise people are educated through their own experiences and the experiences of others. This is the main reason many smart people do not achieve lasting success in various activities, including investing.

Current Dilemma 
Almost the entire globe is being worn down by the Coronavirus plague. We will probably only exit the current economic and political conditions and enter the “New Normal” when either effective medical treatments or vaccines are in large supply. This is a smart, but not a wise view based on history. The fatality rate currently reported (including the estimate of undiagnosed Covid-19 cases) is undeniably tragic, but is low compared to historic experiences.  Conversely, public reaction has been unprecedented in size and scope.

What are the differences causing all this turmoil? 

1. The rampant fear of the unknown and the uncertainty of the depth and duration of the impact of the pandemic.
2. The stress of the “lockdowns” caused by the shrinking of the economy and changing political conditions.
3. The speed at which it has happened and its continued acceleration. 

In the desperate search for a “New Normal”, people do not remember a quote attributed to Lenin “There are decades where nothing happens; and there are weeks where decades happen.” The revolutions Lenin instigated may have impacted more than half the world at one point.

American Revolution
This blog is being written on the day after the US celebration of July 4th, Declaration of Independence. I believe this 18th century revolution, supported by a fraction of those living in the country at the time, is still impacting the world to an extent even bigger extent than Lenin’s efforts. To a large degree the American Revolution began the New Normal for most of the world. While it is still evolving, a new normal may be entering the globe, potentially impacting commerce and consequently the political sphere. Thus, it makes some sense to grasp how much time it took to complete the first phase of its new normal.

The Boston Massacre and Boston Tea Party were the first skirmishes in 1773. These were reactions to perceived unsuitable taxes and were followed by the first Continental Congress in 1774, leading to a somewhat unpopular war which ended with very appropriate march music by the surrendering British soldiers “The World Turned Upside Down”. The real revolution came to the political sphere in 1781 when the Articles of Confederation were passed, giving an unsatisfying structure to the 13 independent states. To address its deficiencies and to create a central government, the US Constitution was passed in 1788. Perhaps, more important in today’s environment is the  Bill of Rights, passed in 1791. The first major test of the American experiment came in 1797 when George Washington’s second term ended in the peaceful succession to Massachusetts lawyer, John Adams. (George III, and many elsewhere in Europe predicted Washington would be crowned King, or would be replaced by a “strongman”. Similar to what has happened recently in Russia, China, and parts of Africa.)

Thus, the functioning “New Normal” took 24 years before it was viewed as secure and essentially lasted until the Civil War broke out. Most current history written about the Civil War lists slavery as being the cause of the War. This was the same issue that occupied much of the wrangling by the members of Congress in producing both the Declaration of Independence and the US Constitution. In both cases the Members concluded that they could not agree on perfect documents and accepted a compromise. What really broke the impasse was economics in the form of import tariffs, something generally not credited and one of many failures to teach accurate history.

The main source of tax revenue for the US Government until the 20th Century, excluding the federal income tax during the Civil War, was money from tariffs. These were quite favorably supported in the North, as they gave price protection to Northern manufactured goods. Those in the South saw tariffs as hurting the export of their cash crop, cotton. The southerners were already being squeezed by the declining economics of slavery. As is often the case when economics is important, it is hidden under more acceptable social causes.

Translating to Our Search for a New Normal

1. I believe the various medical solutions for COVID-19 and its aftermath will take longer than expected to reach a reasonably affordable conclusion. 
2. The trend to work at home will evolve, but we will not see the same number of people working every day in large offices.
3. There will be continued growth in shopping over the internet.
4. Education will increasingly be delivered over the internet, with some necessary exceptions. Furthermore, schooling will be focused on current and particularly future employment needs.
5. The military will be focused on a combination of raids and electronic warfare.
6. Supply chains will be rationalized, both for security and economic advantages.
7. Travel will be streamlined and made medically safer.
8. Politics will revert to the former House Speaker Tip O’Neill’s view, that all politics is local.
9. We will live longer and more expensively.
10. My strongest view of all is that I will both be wrong and surprised.

What to Do?
What is taught in most business, finance, management, and economics classes, success is based on formulated planning. I have been both a reasonably successful private company entrepreneur and an investor in competitive fields. It is my belief that success is based on finding the right people and having them evolve in the right jobs.

In terms of picking successful funds to invest in over long periods of time, the skills and culture of management has been crucial to the result. One of the better ways to guess whether management will make the profitable decision is to look at how they handle the myriad of short-term details that surround any activity. Most companies have reasonably good management in particular portions of their business; however, going beyond the borders of that expertise adds to risk without the addition of new talent.

As fund investors we are believers in well-diversified portfolios of concentrated funds, when they can be found. When they cannot be found we invest in low cost broadly invested portfolios.

Where are We Now?
Short-term, until at least the election or longer if there are meaningful changes. One should recognize that in terms of stocks and stock funds the attention of the market has become more speculative, as shown below:

1. In the first half of 2020, mostly in the second quarter, there have been 64 IPOs on the NASDAQ raising $19.11 billion and 33 on the NYSE raising $15.44 billion.
2. While both the DJIA and S&P 500 are still below their former highs, the NASDAQ Composite has gained +13.76% year to date, including dividends.
3. Precious Metals funds for the first half are up +21.76%, Global Tech funds +19.74%, Tech funds +15.56%, and Large-Cap Growth funds +11.92%. There are 21 peer groups positive for the year.
4. As a contrarian indicator, this last week was the third week in a row that the AAII sample survey had a bearish reading over 40%.

Fixed Income Funds

1. Europeans expect mid-term inflation.
2. Mortgage applications are at their highest level since 2008.
3. The default rate for speculative issues is 12.5%. Credit defaults are expected to rise in a prolonged recession.
4. The Big Fear – a trifecta of Democratic victories. Based on history it is unlikely. If it happens, except in the case of the current administration, when has a politician delivered on campaign promises?

Conclusion
Long-term investors should maintain equity holdings and look to add selectively overseas. Shorten up durations on fixed income.

 

Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/06/mike-lippers-monday-morning-musings-new.html

https://mikelipper.blogspot.com/2020/06/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/06/data-driven-reactions-dangerous-weekly.html



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

Independence Day: A Chance to Re-think Our Portfolio Structure

• Independence
  
• Interdependence and Insights
  
• Items of Interest

In the United States we celebrate July 4th as Independence Day. Many countries celebrate a Nation Day, observing the date when they became independent from an occupying power. The US appears to be an exception. We celebrate the date we published our Declaration of Independence (actually agreed to on July the 2nd). Thus, we are celebrating a document of principles that we hoped would separate us from what was our Mother country. At the time in 1776, the wish would not have been considered a good bet. The British had the best army and navy in the world, and we had thirteen colonies of very different backgrounds and policies. In at least three states the delegations to the Continental Congress were split and many of our people remained loyal to the Crown, fearing the disruption that would be caused by this new form of government. They were right to be afraid. A number of those successful men who signed the Declaration, who survived capture, torture and death in battle, died bankrupt because of their loss of property during the war. They could not agree among themselves how to govern, even if their independence was won. After twelve long years of debate, a compromised Constitution was passed. Viewing this arduous procedure from today’s vantage point, one of the key political decisions was to create a currency union by assuming all of the outstanding debts of the individual states, and agreeing to make payments in the discredited national currency of the US dollar. I am particularly proud that the driving force behind this and the other financial matters of the new government went to the same college as I did. Alexander Hamilton attended what is today Columbia University. (I need to assure the young in my family that we were not classmates.)

The currency union rested on the ability of the federal government both to raise taxes (largely through tariffs), and to muster a standing army that was under the President’s command. The current problem with the fiscal conditions in Greece, Portugal, Spain, Ireland and Italy are subject to the weak currency union of the Euro. One of the lessons from the American Revolution is that while ideals can flow across borders well, commands do not. I am not suggesting that our various mother countries follow the American experience, but they should use it as a base for their thinking as moderated by local conditions. We also need to apply some introspection to our own activities and thinking, including our investment portfolios, which is the focus of this blog.

Interdependence and Insights

While some early Americans may have thought that they could be independent of the “Old World,” we now know that our very existence and markets are dependent on what is happening both in the Old World of Europe, but even more importantly, China and other countries that we label, somewhat incorrectly, as “emerging.” Perhaps it is my intellectual inheritance from Alexander Hamilton, but I view the world through the prisms of financial lenses. Hamilton, first as the Secretary of Treasury, was very concerned in paying off the war debt of both the country and the assumed debt of the states. He was aided by the development of an active bond market. Only after he left the government did he become involved with the stock market, in part by founding the Bank of New York. (BONY was my first employer after leaving active duty with the US Marine Corps.) Even today investors should first be conscious as to what is happening with the various fixed income (debt) markets. These markets are much more sensitive to changes within the economy than the longer-term focused stock market. Too many stock investors today are not paying attention to the signals from the bond market which can be highlighted as follows:

1. The interest rate spread between US Treasury securities and Treasury Inflation Protected Securities (TIPS) is widening to 2.7%, indicating that market participants over the next ten years expect inflation to be 2.7% or possibly higher.
   
   
2. A number of the bond dealing desks of banks are shedding both people and capital invested in making markets. This is causing some lack of liquidity with prices becoming more volatile with reduced volume. A similar pattern is expected on the stock side of these dealers. To some degree the use of Exchange Traded Funds (ETFs) is providing additional liquidity for the stock market, on both the long and short sides of trades. Lack of liquidity, at times can lead to sudden, large price movements.
   
   
3. High Current Yield bonds and their bond funds are marching to a different drummer/different direction. While we do not just yet have the final numbers for the second quarter fixed income performance, my friends at Lipper, Inc., to which I am no longer connected, estimate that High Current Yield funds will show the only declines in the fixed income averages. These small declines should have been expected. Again, as estimated, these funds had net redemptions of $1.3 billion for the second quarter. The enthusiasm for these “junk bonds” reached a peak in March, when close to $16 billion was purchased at the time of significant issuance by corporations taking advantage of low interest rates. By May the gross flows into this category of funds had dropped to $6.4 billion, which was lower than 14 out of the last 16 months. One of the reasons for the enthusiasm for these bond funds is that in May, Moody’s* estimated that no more than 2.7% of rated bonds defaulted, and they expect by year end this number could be lower than 2%. I have two reactions to the above elements. First, I view high current yield paper as essentially equity with interest payments due and are really a form of stock investing. When these become less popular, I am concerned that stock investing in time will become less popular (which we may be seeing now). Stock markets have difficulty sustaining a big rise without increased volume. My second reaction is that I believe most things follow a cycle pattern. While Moody’s may be correct that we will be in an era of low bond defaults, I have my long-term doubts and would expect as interest rates rise and there are more high-priced deal financings, that the level of defaults, will unfortunately also rise.
   

*Moody’s is a position in our private financial services fund.

Items of Interest

One of the benefits of serving on important tax exempt institutions’ boards of directors/trustees is sharing different points of view. Recently, one particular board was asked about the outlook of the various organizations represented. The concerns of the management were first, that during poor times the needs for its services will rise. Second, fund raising is more difficult when the economy, particularly the local economy, is not expanding. Third, could the endowment be expected to raise its contribution to the operating funds? Much of the answers could be expected if one read the local newspaper. However, there were two expressed views that were interesting. The first was from an accounting firm that was increasing its hiring at the entry level. (Considering the training cycle for the firm, this was a bet that business was expected to be expanding in 2012 and beyond.) The other view held by a number of financial types, excluding me, was a bit dour focusing on this country’s debt problems. One could say that the view from these elements of the financial community was already expressed above, in the drying up of liquidity and smaller staffs on trading desks.

Those who know me would not be at all surprised that I had a different point of view. I expected that the near-term would be a period of increased volatility filled with opportunities. Some companies will do unexpected things that they never considered doing in the past. I believe that there is more proven executive talent available now than at any other time. I saw sufficient long-term growth ahead to warrant investment of reserves above the level of contingencies. A few days after the above-mentioned board meeting, I read a survey conducted for Chase Bank (JP Morgan Chase) indicating that 72% of the companies polled expected higher revenues, 62% expected higher earnings, and 50% said they would be hiring. The difference between the Chase survey and my board’s comments was that Chase’s was a national survey and the board was New York centric. The Chase survey did show some elements of concern. First, with revenues expected to grow but less than earnings, raises questions as to a margin squeeze. Second, with revenues expanding, the expansion of employment is less robust.

Two inside baseball statistics hit me as perhaps significant regarding the changing structure of the fund marketplace. First the net sales, (sales vs. redemptions) in the institutional channel was, in aggregate, greater than the combined net sales in the first five months of the direct marketing, sales force, and variable annuity channels. Most of the money recorded in the institutional channel comes from the institutional shares used by salary savings plans, e.g., 401k, 457, 403b, etc. The second and somewhat related statistic was that US Diversified Equity mutual funds had net redemptions of an estimated $4.9 billion in the first half vs. net sales by similar ETFs of $7.8 billion. The impression I draw from these factors, mirrored by slow volume at retail brokerage firms, is that the investing public is disengaged from the stock market, and is only investing involuntarily through employers’ savings plans. While this is very understandable in view of investors’ experiences over the last ten years and what they read/hear from the media, in ten or more years from now they will look back regretfully at what they could have bought.

With the second half beginning Tuesday what are your views?
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