LONG-TERM TRENDS MAY NOT BE A FRIEND - Weekly Blog # 568

Mike Lipper’s Monday Morning Musings

LONG-TERM TRENDS MAY NOT BE A FRIEND

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

                     
     

“Big Mo” in the political world, “The Trend is your Friend” in the commodities world, and momentum investing are beliefs in continuing that which is into the future. Certainly, various media pundits stress current trends. Salespeople of all stripes find it is easy to sell their wares by highlighting current conditions. As a contrarian investor I am delighted to see great levels of enthusiasm for the currently popular, because it leads to significant mispricing of both rewards and risks, creating opportunities for the careful investor. For those swept up in what is currently popular, it should be a well-earned learning experience.

Faulty Long-Term Predictions

This week there were two very relevant notices in the press. The first was a statement by Ajay Sing Kapoor, an analyst at Bank of America/Merrill Lynch. The statement said “There is really no permanent trend just lazy intellectuals confusing a long cycle for a perpetual-motion machine.” This is a useful insight in the climate change debate. One of the best market analysts I know grew up on a farm which he has owned for 30 years. He mentioned the feast and famine cycles experienced while living there, much like the biblical seven fat years followed by seven lean years. 

The belief in long-term trends is present in today’s investment selection, which focuses of selected factors based on selected histories. The strongest of these is the belief that changes in earnings per share will dictate the price of the shares. This was true even when I was a junior analyst at a trust bank, where investment leaders used the change in reported earnings per share to make investment decisions. Even then I was suspicious, feeling that reported earnings were the result of both controllable and uncontrollable forces. It is only later that I became more conscious of the changes in Generally Accepted Accounting Practices (GAAP). Today, earnings report releases emphasize “adjusted earnings, adjusted operating margins, adjusted profit margins and even adjusted revenues”. The SEC has mandated that these reports must also show the results according to GAAP, but they don’t  highlight the fact that almost every year AICPA makes changes to GAAP. Corporate data complements government produced data as critical inputs to thinking on the economy according to Jim O’Neill, the former Goldman Sachs partner and global economist who coined the “BRICS” term for the rapidly developing emerging markets countries. He writes, “Though economics aspires to the rigor of the natural sciences, at the end of the day it is still a social science.” Thus, the specific numbers produced by economists are kidding us with their precision, particularly when they are expressed with decimals.

An Improved Fan Dance

If the base data is questionable, its use as the foundation for future prediction is extremely questionable. Consequently, The Bank of England and some of the US regional Federal Reserve Banks are showing charts using the most current or corrected datapoints, then adding a fan like wedge showing the range of future predictions.  My natural skepticism questions if the wedge is too narrow. I can accept that a narrow fan probably includes most of the probabilities utilizing a single up and down standard deviation. However, as an investor I like most others feel much worse after a decline than a pre-tax gain. I would much prefer a wider wedge that includes the reasonable possibility of two or three standard deviations. (I believe that both long-shots win and racing accidents happen on occasion, depriving the best horse from winning.)

Jason Zweig on the Wrong Long-Term

The second important item in this week’s press is a column by my friend Jason Zweig. He cautions against investing in companies that are building for the long-term, properly concerned that the focus on long-term investing can lead to the mistaken allocation of resources. Tech companies spend substantial capital on new facilities and equipment for future markets that might not evolve. Think of the engineering and construction geniuses responsible for the construction of the Egyptian Pyramids. The pyramids were monuments to the rulers while living, as well as in their after-life. I am much more interested in the long-term development and acquisition of talent, including the building of multiple generations of leadership at all significant levels. 

Investing for the Long-Term

I have devoted most of my investments to the long-term and where appropriate for my clients I have done the same. While this on average generally means a low turnover of securities and funds, it is not a lock-step process of holding regardless of current input. It requires careful examination of current information versus long term perspectives, both of the specific investment and its place in the portfolio, as well as any changes in the needs of the beneficiaries. I accept the cyclicality of both the markets and my ability to correctly analyze the inputs. I often expect to be premature and less often to be wrong. My long-term attitudes are derived from the study of some of the best investors as far back as I have information. In general, these attitudes have been good for my accounts and family over time.

Mid-Term Platform or Lid?

Each week I look at the investment performance of mutual funds around the world as a good representation of the results of managed money. This week I paid attention to the average returns of US Diversified Equity funds for the five years ended this week. The period included the final years of the past administration and the first couple years of the present one. The importance of politics is questionable. The twenty-investment averages for the five years generated an annualized compound growth rate of +5.69%. This included some extremes on the upside: large-cap growth funds +12.13%, S&P 500 index funds +10.72% and multi-cap growth funds +10.16%. On the down side there were dedicated short bias funds -19.35% and alternative equity market neutral funds -0.74%. These results suggest that large-cap tech companies produced a disproportionate portion of the gain and that being out of equities was a loser. 

Five years is a little longer than the average US stock market cycle and roughly equates to the presidential cycle. Being a contrarian I would not expect the two extremes to repeat over the next five years. The extreme contrarian would examine the funds that produced negative results feeling they could be the leaders at some point. In that vein I would be scanning for any indication that things are changing for the better for commodities funds, particularly those involved with different aspects of energy and agriculture. I don’t currently see a catalyst, but I can afford to be late as I suspect that most of the selling in these sectors is over.

Short-Term = Confusion

As is often the case the future direction from current conditions is not clear to me. Banks do not appear to need deposits to make loans as the interest rate offered on average is 0.59%, down from 0.61% the week before and its recent cycle high of 0.63%. Lack of new loan demand is not encouraging. The latest survey sample of the American Association of Individual Investors (AAII), a very volatile measure, shows the three alternative predictions for the next six months are all between 31% and 36.5 %. On a more positive note, the roster of price moves in the Weekend WSJ showed 64 out of 72 being positive. Of the 25 best performing funds for the week, 14 were growth funds and 3 were health-oriented funds.

The one certainty after a period of level market performance is that there will be a breakout on the upside or a breakdown, possibly both, based on  higher volume and enthusiasm.

Another Favored Myth Destroyed

For many years during a US recession Americans talked about moving to Australia with their US acquired skills. Very few did, but it was in the back of their minds as an economic escape. In the nuclear age several Americans thought that the safest place to live with their families was the South Island of New Zealand. The tragic events of this week have shown that there is no practical place to escape. We are going to be forced to deal with present and future problems where we are. The destruction of myths often leads to the recognition of the benefits of where we are and focuses our attention on making our lives and investments better.          

  

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

https://mikelipper.blogspot.com/2019/03/the-top-before-big-top-weekly-blog-567.html

https://mikelipper.blogspot.com/2019/03/2-speed-vs-2-directions-old-better-than.html

https://mikelipper.blogspot.com/2019/02/lessons-from-warren-buffett-and-italian.html

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Be Aware of History

Introduction

My basic belief is that you can scratch an analyst and a historian will bleed. The good professors and scientists at Caltech tell me that our memories are a critical decision-making part of our brain. Thus each of us are to some extent historians. On this weekend before the historic Brexit referendum I thought it would be useful to selectively search history for clues as to future wise investment moves.

Lowest Interest Rates in 5000 Years

In Mesopotamia about the first recorded interest rate was 20%. That was the same rate charged in Babylon in 1772 BC as well in Italian cities about 1150 AD. The highest recorded rate was in 539 BC of 40+% at the time of King Cyrus taking Babylon. What may have been a spur to colonization of the US, English interest rates were 9.92% in the 1700s. To show the volatility in the US, our rates were about 1.85% during WWII. By the 1980s rates rose to 15.84% compared to the 0.25-.50% the Fed is using currently. The sources for this and other similar data are the Bank of England, Global Financial Data and a book by Homer and Sylla entitled “A History of Interest Rates.” Dick Sylla an NYU professor for many years has been the chair of the Museum of American Finance whose board I served on. The purpose of showing the historic swings in rates is to alert investors that a future surge in rates may not peak in the mid single digit range.

One of the very best chart readers I know suggested to me that the continuously offered 30 year US Treasury Bond has possibly reached a thirty-five year peak in a move that began in 1981. I am conscious that Treasury officials, the SEC, and various hedge fund operators are concerned about the illiquidity in portions of the Treasury market. This may well be the reason that the Treasury is not materially expanding the duration of the US Government Debt structure. As investor for clients and my family in equity funds I find that any potential disruption in the most senior market can be unnerving. The modern theory of equity investing is based on the floor created by the risk free interest rate on US Treasuries. Perhaps it could be suggesting that we should be looking for a sub-basement below the floor!

Historic Perspective on Brexit

I do not know which way the vote will go, but the way I look at the polls as of now the “leaves” appear to be winning. Regardless on the outcome unless there is at a least ten point spread, it is my belief there will be other elections in the UK and Europe both for leaving and joining. From a historic point of view one can see that Common Market is just another attempt at European unity which goes back to the time of Julius Caesar. All of these have failed in the end for two intertwined reasons, (1) lack of confidence in the leadership particularly and (2) the provision of defense of the life of the homeland. During the Spanish Civil War there was great fear of the “fifth column” of enemies in civilian clothes creating great damage. Today throughout the world this fear is again present in the inability to properly screen immigrants or perhaps their children.

In the developed world these fears (along with concerns about the future economic outlook) are leading to a decline in the rate of marriage as well as fertility. Demographic trends take a long time to develop and change slowly. In time these trends play a political role and the referendum and the coming US elections could be influenced beyond the political leadership’s expectations.

Risk Management

On a recent trip to Europe one of my good analytical friends who is now a US citizen but was born elsewhere was anxious to return to the US, a land of risk-takers. By implication he was decrying that most of the Europeans that he was talking with were not attuned to taking risks. I believe that the US has benefited from the fact that many of our ancestors had to take big risks to get here. But we are not as much gamblers as other people are. What we risk is our hard labor against long-term goals.

One liberal arts university whose board I sat on recognized the need to offer business related courses to keep its attendance up to the level that they could afford the professors and staff. The would-be business professors came to the board and were outlining what they wanted to teach. In one case they wished to teach risk avoidance. I demurred. To me they should teach risk assumption and therefore risk management. Our whole private and public equity culture is based on wisely seeking risk assumption at the right price and conditions. To an important degree this drive is missing in many countries, but not others -  particularly in Asia.

Getting Bullish

The essence of risk management is to take on risk when others shed it as much as possible or are reluctant to commit to a future. While both Brexit and the high quality bond market may prove to be hurdles, they are not absolute impregnable walls. When too many are in their foxholes or trenches, this could be the time to advance. Clearly if bad things happen there could be cheaper entry points if one is not too petrified to move. Thus, I would urge long-term oriented investors to begin or increase their equity investing. If they are having trouble finding the appropriate funds to use, I will be glad to help for awhile.

Question of the week: Will the outcome of Brexit change your equity allocation by more than 20%? 

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Copyright © 2008 - 2016

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All Rights Reserved.
Contact author for limited redistribution permission.

Risk Controls Hurt Investment Profits

Investors are giving up too much on the upside

The financial world is being buffeted by credit risks. To protect investors from large unexpected credit failures, various risk control approaches are being used. A look at financial history suggests that hiding a problem only makes it worse when it is revealed. In the meantime, by hedging the risks, money is taken away from more productive investing at today’s low prices. Those that are doing the hiding, hedging and manipulating of the markets are concerned about career risk for themselves or their leaders.  I believe we should deal with the present unpleasant problems,  re-set our levels, and unencumber the potential upside.   

Questions for Jamie Dimon

I was one of the analysts and portfolio managers that attended the early morning analyst meeting masterfully presided over by JPMorgan Chase* CEO Jamie Dimon. Both in his presentation and the two accompanying presentations, attention as well as most of the analysts’ questions were focused on the CIO (Chief Investment Office) and the “London Whale” losses. Many who know me either directly or through reading this blog may recognize that when all or almost all attention is focused narrowly on one topic, I try to explore other areas that I believe can be more fruitful. Thus I asked two somewhat related questions about derivative exposure. The first was, “With some $86 billion in derivative assets and $76 billion in liabilities, how much was netted with the same counterparty?" The second question was how much of the June 30 statement included the CIO debacle?  The answer to my first question was that the subject was covered in a previous presentation to analysts as to the complexities of its management of derivatives. My second question was answered with the statement “very little.” The answers delivered were not satisfying.

What was the JPM CIO designed to do?

 

Purportedly the office, among other tasks, was meant to hedge some of the loans made by the bank. These loans of various maturities were with governments, central banks, commercial customers, and other banks. A bank can only stay in business by accepting some of the risks of making loans. JP Morgan does some of the best credit work of any large bank, thus it had to have some inkling as to the type of credit losses it was exposed to through its loan portfolio. Considering what has been going on in Europe for the last year, one would assume that JPM had some worries as to its loans to various European financial institutions. (Reportedly the large loss was in a derivative that tracked the credit of large US commercial entities. However this does not totally eliminate a concern about some large European Banks.) I do not know whether there were additional concerns about prompt payment from certain derivative counterparties, particularly if the originating derivative transaction was not executed through an exchange with a strong clearing house behind it.

*For many years I have owned shares in JP Morgan, but they are not currently owned in the private financial services fund that I manage.

JPM and Libor

Somewhat more understandable was Jamie’s ducking questions as to the ongoing Libor investigations. (Wouldn’t it have been interesting to hear his views from his place on the board of the New York Fed?) Some may not see the connection to the two probes, but I believe that they are getting to the crux of the overriding problem facing investors and financial consumers.

Too much fudge can make one sick 

As kids we all liked sweet things, I was particularly enthralled with brown sugar fudge. After a while it became clear to me that eating too much fudge made me sick.  As an adult, I find the “fudging” of data makes me equally unwell.

  

Since probably sometime in 2007 there was an attempt by some to manipulate the Libor rate. One of the repeated mistakes of the financial community is to use a particular metric designed for a specific purpose for other uses. (My favorite misapplication is the use of price/earnings ratios to identify cheap or expensive, growth or value stocks.) The original purpose for the daily setting of a US dollar Libor rate, was to estimate the rate that banks would pay for US dollar loans from other banks  on days when there were no known transactions. The methodology used was for sixteen specified banks with operations in London to indicate what it would pay for money. Reuters, now Thomson Reuters**, would collect the data, then drop the four highest and the four lowest samples and take the inter-quartile mean of the eight central results and report that calculation to the British Banking Association which authorized its publication as an estimate. 

The rate was never designed to be an interest rate arbiter for non-banking loans. When floating rate paper was being developed first at the wholesale level and then on the retail level, some “bright person” at a law firm or an investment bank grabbed Libor as a well-known daily fluctuating interest rate that the London market controlled rather than a US Treasury rate. Starting in 2008 some in the marketplace were getting concerned that the interest rate estimates were being influenced by traders for the benefit of their trading positions. At any rate the British government used its knowledge of the individual bank submissions as a possible indicator that a bank with a high rate needed to use the high rate to attract capital, for it was perceived to be having problems. It is alleged that the Bank of England, the central bank, did not want to have to rescue another failing bank, suggested to at least one bank that it need not always be the highest bidder for money. No one is publicly discussing that banks that submitted lower rates did not expect to get additional loans or equity through the marketplace and thus following a US Marine Corps tradition, “kept off the skyline.”  The rumors of these concerns probably entered the hedging practices in JP Morgan’s CIO as well as others who were in the business of making loans to banks. (Confirming this assumption would have helped in understanding what the CIO was doing in its proper hedging activities.)

** In 1998 Reuters bought the operating assets of my old firm, Lipper Analytical Services for cash. While currently a user of the firm’s data and an occasional columnist for Reuters, I have no contractual relationship with the company. Both the fund I supervise and personally I own shares in Thomson Reuters.

The Third Aberration To Sound Investing

In addition to the CIO errors and Libor manipulation, the very same concern for the safety and soundness of banks in major countries of the world has led to various central banks rescuing specific banks and banks in general by flooding their economies with cash as well as driving down interest rates. These low interest rates do not recognize the credit risks in the marketplace which has two impacts:  the first is to dry up the lenders’ willingness to lend to the borrowers, which slows the economy. The second and more insidious is that individual and institutional investors that we serve cannot meet their ongoing income needs in high quality investments. Thus they seek other investments with enlarged credit risks so that they can pay for people’s retirements, pay reasonable wages to those devoted to the non-profit areas and provide capital for future expansion of facilities and employment. 

What do you think?

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The Next Big One - FX

The Madoff scandal and other similar grand thefts come as a complete surprise to people, but they shouldn’t. Why? Bad behavior is part of the human condition. Large scandals happen because they can happen. Investors believe first in people, and second in their own understanding of the perpetrator’s personality. In the back of these investors’ minds is a belief that there are effective, long-established controls that would prevent any large frauds to take place. Often the mind of an outright criminal, or more likely someone who “temporarily borrows money” from the unsuspecting, is smarter than the best of the designers of financial/trading controls. Most of the large losses experienced over the last ten years grew because the perpetrator(s) understood “the back office” systems better than those in charge of various compliance functions. Some may have actually been motivated by the battle of man vs. machine, where the lone mind can beat the machines and their watchdogs. I will let the lawyers and the forensic accountants supply the blueprints to the Madoff scandal, if they can. I am attempting to spot the next big, unexpected fraud.

One of the attributes of securities fraud is that the ultimate size of the transfer of wealth is usually large. In most cases of embezzlement, the initial transfer is small and is designed to cover an error or unauthorized trading loss. However, once the person learns how easy it is to cover the tracks, the need to fill an ever larger hole or desire often prompts a continuation of the transfers. Until conditions and compliance functions change, these activities will continue. Most of these frauds “go with the flow” of enthusiasm in rising markets.

Showing both my age and my experience as an aerospace analyst, I was attracted to the competition to build the next experimental fighter aircraft, which led to a procurement of thousands of aircraft, translating into tens of billions of dollars. Another, larger weapon system is also labeled “FX,” and has a similar order of magnitude cost. This second FX is Foreign Exchange transactions, not a weapon that can travel the world in supersonic speed, but one that can span the globe in milliseconds.

Even in today’s world of expanding global trades, and the need to pay for goods and services in different currencies, the share of the FX market needed to settle these transactions is believed to be a small part of the total FX market.

The bulk of the FX market is made up of two components. The first is the exchange of currencies required to settle securities trades, e.g. the American buyer of a German bank share. The second component is those transactions that are undertaken to make a profit. In the most recent weekend edition of the Financial Times there is a long interview with George Soros, who I knew years ago as a struggling defense/aerospace analyst. The article includes a brief description of his $10 billion trade against the pound sterling. As a result, he and his funds made $ 1 billion, and received the title, “The man who broke the Bank of England.” The bank was on the other side of the trade, trying to support the pound. What is not publicly known is how much of the position was equity, and how much was borrowed. In those days and today, one can borrow up to 99% against currency collateral.

Numerous advertisements on financial cable channels point out that the FX market trades more each day than any other financial market, and is never closed. These purveyors will make their money by loaning capital to the retail investor who wants to take the relatively small daily changes in currencies and multiply it by the use of margin. The ads focus on the lack of regulation. In the scheme of things these activities can be described as small potatoes.

The big enchilada is the trades with and among the banks. To gain some insight into this size, we can learn from the fourth quarter statement of 3 trust banks that have large custodian business and whose foreign exchange earnings were in the hundreds of millions of dollars (one of the few earnings plusses for the quarter). The unknown players in this market are the investment banks’ FICC Groups (Fixed Income, Currency and Commodities), dealing through their proprietary desks and other hedge funds. Some or all of these use various derivatives including currency forwards.

My bottom line is that the FX markets are huge, largely unregulated, with complex compliance procedures which may not be fully water-proofed, and fueled by the prospect of large gains and oversized bonuses. As with my aerospace days, FX can be a major weapon of destruction. Don’t say that you weren’t warned.