Dead Cat Bounce > Last Chance - Weekly Blog # 952

 

 

 

Mike Lipper’s Monday Morning Musings

 

 Dead Cat Bounce > Last Chance

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

 

          

 

We appear to be in a normal trendless summer, with relatively low volume on hints of fall upsurges and declines. This poses a big risk for

investors with large gains in their portfolios who could be subjected to major moves from stampeding investors selling for fear of a big decline or speculative surge.

 

I am therefore suggesting that this is the time to build cash reserves so that you are in a position to take advantage of large future declines. The trick is to have a reserve large enough to shelter the portfolio from meaningful losses, but small enough to protect against being out of the game following the next rise. The next decline could be major and last for a long time, which might encourage those who have too much cash to stay out of the game. That is the real risk facing careful investors.

 

My suggestion is to treat your account as a long-term pension or endowment account with annual flows of about 10%. This would require a two-year buildup of short-term cash reserves under normal investing conditions. This suggests a target equity commitment of 70%, with a short-term reserve of 20% and an emergency reserve of 10%. The key to this strategy is avoiding a down market that reduces the equity commitment below 50%. One way to accomplished this is to begin an orderly reinvestment program in the declining market.

 

Reasons for Concern this Week

• The Consumer Confidence survey fell to 50.8% vs the expected 52.4%.
• Estimated GDP for the second quarter came in at +1.5%, below the estimate of +1.8%.
• Chinese tech stocks fell -8.6% in July. On Friday, Apple (personally owned) fell -7.4% on rising earnings.
• Barron's 10-year high grade bond yields slipped -0.03% while yields on 10-year mid-quality bonds rose +0.04%. (The bond market is more concerned about the future of the US Government and the currency than commercial credits.)
• There were 286 new highs and 189 new lows on the NYSE, versus 468 new highs and 692 new lows on the NASDAQ*. Suggesting there is presently more opportunity in industrial and financial stocks on the "Big Board" than tech-driven stocks on the NASDAQ. (*NASDAQ stock owned in managed accounts and personal portfolios)
• Warren Buffett is quoted as thinking the market is gambling, not investing. (In the past his general warnings have proven accurate.)

 

What Do You Think?

 

 

 

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Mike Lipper's Blog: Long-Term Money Via Telescope, Not Microscope - Weekly Blog # 951

Mike Lipper's Blog: Before Focusing on Shorter-Term Reactions - Weekly Blog # 950

Mike Lipper's Blog: Little Occurred During the Trading Week - Weekly Blog # 949

 

 

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The Inevitable Recession - Weekly Blog # 914

 

 

 

Mike Lipper’s Monday Morning Musings

 

The Inevitable Recession

 

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

 

 

 

Loses Are Needed

Securities analysts, portfolio managers, investors, politicians, and others, need the fear and reality of recessions. Both written and geological history record meaningful and painful declines. Since they happen with some regularity there must be a repetitive set of reasons, with the lure of a gain sucking us into overexpansion and other error-making decisions.

 

Humans evolved from hunters and/or gathers, who periodically generated supplies beyond their immediate need, beyond a limited reserve for emergencies. When they gathered too much, costs grew and quality suffered. In the financial world we hoard and or borrow too much in the way of financial assets. This became increasingly clear as conditions changed.

 

These adverse conditions are clear in recorded history, in Babylon, China, and other places. Thus, the history of weather, business, and political cycles were written, becoming critical drivers of financial markets.

 

The Rise of Financial Analysis

Trading markets began soon after communities were established. Over time, it became clear that some successful traders achieved periodic, large returns on their use of trading capital. A number of these people gained reputations as good traders and found other people who recognized they did not have the same skills, contacts, and capital. These traders could borrow money at attractive rates and could charge fees to manage portfolios for selected outsiders. A number of these traders evolved into investment banks, who had both skilled traders and statisticians, some of whom became analysts.

 

US and UK Governments vs. Fraud

When markets fall, investors don't blame themselves for the losses they sustain. They claim fraud on the part of the "system", which includes issuers, exchanges, underwriters, and salespeople. Generally, the public investor does not understand business and financial cycles or chooses to forget the warnings that were given before they placed purchase orders. To protect the "public", disclosure and other laws were passed. While no law or regulation can prevent bad judgement, disclosures can ensure investors receive what is required to be transmitted to them. Unfortunately, accounting and legal disclosures use terms that the public does not understand.

 

As a result of large losses sustained by US public investors in the 1930s, there were seven reform laws passed, including the Securities & Exchange Act and a similar set of regulations in the UK.

 

The Development of Securities Analysis

While there were numerous books written about investing prior to the 1929 crash, they were not read by many investors. In the early 1930s Benjamin Graham and David Dodd wrote a Securities Analysis textbook for a Columbia University course. (Ben was a portfolio manager and Dave Dodd was a professor, who was still teaching in the late 1950s when I took the course from him.) Their main lesson was how to think about investing in securities while minimizing losing money. The course was taught as a supplement to a number of accounting and business law courses. They largely used the reconstruction of financial statements to assist patient investors. (While useful in minimizing investment losses, creating language to allow people to understand the thinking of others and the politics of an industry or client would have been more valuable.)

 

Recession Analysis

I believe most of those in the market are assessing the probability of an oncoming recession by focusing on published economic data. The stock market is focused on the future, not the past, and in that way it’s ahead of the economics releases. For example, the election results of last Tuesday suggest Louis XIV’s building of Versailles, even though no one else is saying it. The King was always at war, usually with England, and ran up big debts. He destroyed the local power of the nobility and insisted they spend most of their time attending to him in the Palace. (Is the reaction to larger than expected Democratic margins of victory in New Jersey and Virginia and the destruction of part of the White House for a big ballroom similar to what Louis XIV set in motion before the French Revolution and Napolean?)

 

Other market indicators last week included decliners on both the NYSE and NASDAQ being larger than gainers, with the NASDAQ losing twice as much as the gainers. NASDAQ's volume over the last year increased 38.21% vs the NYSE volume gaining 22.98%. (One of the clues to identifying a peak and then a decline is a decline in "quality", which is better evidenced on the balance sheet than through earnings.)

 

On Friday, the best performing mutual fund categories in rank order were Currency funds, Precious Metals Funds, Real Estate Funds, Natural Resource Funds, and Materials Producers. All are not heavily held by funds and other institutional holders. On a year-to-date basis, the only fund categories that beat the S&P 500 Funds Index category were Science & Tech, Precious Metals, Global Science & Tech, and Large-Cap Growth. (There is considerable overlap in the names in their portfolios). Barron's weekly list of foreign market indices showed 5 Asian markets up, with only 1 rising in Europe.

 

Identifying the date when a recession begins is officially only determined after it ends. As a practical matter you might use the purchasing managers' index, which has been in contraction for the last 8 months and is now showing only 42.3% rising. While it is foolish- to name both a market direction and a date, it may be useful to be aware that the market generally rises at least 80% of the time. Considering the 5-year average length of time CEOs remain in their chair, it suggests a market decline once every five years, which somewhat parallels the 4-year length of a US President's term. (I don't know how to adjust the number for the current President but possibly averaging all Presidents it may be around five years.)

 

Working Conclusion:

The odds of a recession before the next Presidential election is probably 67%, with a depression at 50%. (The latter would require some mismanagement during the recession to raise the odds of a depression above 50%.)

 

 

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Mike Lipper's Blog: Biggest Investment Hurdle: Complexity - Weekly Blog # 913

Mike Lipper's Blog: Signals of Change in Historic Patterns - Weekly Blog # 912

Mike Lipper's Blog: Where Are US Stock Prices Going? - Weekly Blog # 911

 

 

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A Good Time to Sell? - Weekly Blog # 910

 

 

 

Mike Lipper’s Monday Morning Musings

 

A Good Time to Sell?

 

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

 

 Selling is More Important

When an investor, distinct from a trader, asks me if they should sell some portion or all of their holdings, I first try to determine the critical time period in judging the results of the action. If one is persuaded by media voices the answer will usually be tomorrow or at the end of the calendar year. For me, it is when the money is expected to be needed. For example, for my newborn great grandchildren's retirement or the replacement of the new university dorm, it could be a 100-years. Another matrix could be the future low price point needed to protect future funding of a desired goal.

 

Regarding a future low price point, it is important to recognize that prices move in cycles. The important cycles can be labeled as seasonal, cyclical, secular, and structural. It is how I think of the latter part of last week’s drop in prices, where what I follow fell -15% to gains of +7%. To conserve your time and the blog's space I will comment on the year-to-date period for those impressed with media voices and include some other screens as well.

 

The first thing that hit me was the largest average gain of +15.94% in non-leveraged, diversified large growth mutual funds. These gains were driven by the biggest positions in technology stocks. However, they missed out by focusing on securities registered with the Securities Exchange Commission. After many years of SEC registered stocks performing very well, there were some foreign markets that generated much better performance multiples. The leading countries were Ghana +130.25%, Cyprus +94.75%, Luxembourg +74.8%, Greece +71.45%, Columbia +70.05%, Nigeria +65.1%, Korea +61.1%, South Africa +48.02%, China +32.85% and Chile +31.02%. Weekly Barron's performance charts showing 14 European and 7 Asian countries had 7 Asian and 4 European indices gaining. (As an analyst that has followed non-US stocks and invested in some, I believe this is a good time to examine these opportunities.)

 

Most Analysts Focus on Rising Stocks

I glanced at those stock prices not doing so well. For example, the Dow Jones Industrials (DJIA) and Dow Jones Transportation (DJTA) stocks fell -2.739 and -4.88% respectively for the week. Perhaps more importantly, their year-to-date performance results were +6.90% and -5.21% respectively. (This suggests the US goods economy is not doing well. Tariffs could be a problem. Freight movement is down for both the rail and truck business and may forecast Halloween and Christmas sales being behind earlier expectations.)

 

Down Prices = Opportunities

Three industry sectors are showing small declines on a year-to-date basis: Banks -4.26%, Insurance -1.64% and small companies -1.1%. Restrictions on all companies are the same, but small companies may be impacted more due to their staff size. To the extent the current administration reduces some of the regulatory overhead, it cou1d restore a competitive advantage to smaller companies. However, many restrictions on smaller financial and insurance companies appear to make it easier for new entrants.

 

AI, An Unrecognized National Problem

Some are beginning to comment on the absence of large profits from Artificial Intelligence companies due to lack of public discovery of relevant financial disclosure, so I will not. At a recent meeting hosted by the London Stock Exchange Group, one of their headline speakers noted that the challenge for the AI industry was to produce "more with less". It is well recognized that AI is taking over an unidentified number of job functions, reducing the need for human labor. Great! Where are these laid off people going to get jobs anywhere near similar wages? This could be a concern for future Administrations. 

 

The 4th Activist President

Just like Andrew Jackson and the two Roosevelts, President Trump is trying to solve various national problems by changing how they are handled. Some of these attempts will survive the Courts. What I am not seeing is how the restructuring of the economy will work. Looking at the aftereffects of prior activist Presidents, I suspect it will materially change the outlook for investments, something people are not currently focusing on.

 

I would like to know if anyone has any thoughts on what restructuring will mean to their investment orientation.

  

 

 

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Mike Lipper's Blog: Tactical Headlines Show Strategic Clues - Weekly Blog # 908

Mike Lipper's Blog: Anticipation Pays; Deliveries May Not - Weekly Blog # 907

Mike Lipper's Blog: Selected and Casual Road Notes - Weekly Blog # 906

 

 

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“The Archduke Lives For Awhile,” As Speculative Excesses Build Up

• Speculative excesses
  
• The gathering evidence
  
• More evidence from theWall Street Journal
  
• The Enthusiasm is Growing
  
• Trying to focus on the longer-term
  
• When will the Archduke be shot?

I suspect that in the colleges and universities as well as our “better” high schools there is little or no attention being paid to why the First World War was inevitable. The process started many years before with the disastrous results from the French side of the Franco-Prussian War, where the French lost 25% of their young men to a newly united Germany, inducing fears on the part of the French of German militarism. Queen Victoria's vast family united the crowns of tsarist Russia, Germany (Prussia) and the British Empire during her reign. Her death weakened those ties. The completion of the first phase of the European carve-up of Africa to secure raw materials, added to the wariness. The intensive study by the German general staff of the US Civil War and the development of the war of maneuver laid the foundations to the way the German Army would fight in the next two wars. Poor economic conditions in Russia, in part due to high taxes and lowered farm yields, pushed the government into many unpopular moves. The Russians were recovering from the expenses of their defeat in the Russo-Japanese war with a smaller, but better equipped and led Japanese. Peace between these two combatants was designed conceptually by the US President, Teddy Roosevelt at his home on Long Island. For his efforts he won a Nobel Prize. (As a trustee of Caltech, the home to so many Nobel laureates, I highly value these awards.)

When the Archduke and his wife were assassinated, the Austrians felt that this was the beginning of an attack on their sovereignty by the local Slavs, egged on by the Russians and/or the French. The Austrians cashed-in their guaranty agreement with the Germans to protect their country. Quickly the French felt that they would be under attack by the superior German forces. The Russians were by treaty required to support the French if they were attacked, and in turn this brought the British into the war. All of these actions were predictable and became inevitable once a spark was fired in the tinderbox of Europe. One could see it coming.

Speculative excesses

In a similar fashion the history of stock market collapses rests on the building of speculative excesses. These excesses suck in many people who should not have put their relatively meager life savings into markets that appear to offer great wealth opportunities, but in reality are based on permanently higher prices. In a recent CFA Digest article, as noted by Frank Holmes of US Global Investors, three ingredients of asset bubbles were identified. Financial innovation, investor exuberance and speculative leverage contributed meaningfully to the bubble. I would suggest that we are in the early stages of again building such a bubble. While it may be the early days of the pieces falling into place, one must be aware of the risk from the unexpected (the assassination of the Archduke.)

The gathering evidence

Some of the elements that are visible to me from the financial press this week cause my long term concerns. Alan Abelson, the heart and soul of Barron’s, in this week’s column bemoans the sharp increase in the level of bullishness being expressed by investment market letter writers. He compares the data from Investment Intelligence, which shows that we have not seen this level of optimism since 2007. Many people treat this as a contrary indicator: the greater the optimism the more wary some get. I think there is more room for higher levels of optimism as we are now stacking the cards in favor of speculators.

The next two items are only linked in my mind through excessive leverage, speculation, and resulting fraud. In this week’s Barron’s, there is an article on one of two publicly traded companies that are serving the retail urge to play in the foreign exchange (FX) game. The article points out that over 70% of the accounts lose money; many of those initiated their accounts with a credit card. Some of the regulators are concerned about the leverage used by these retail accounts and have cut the permissible leverage in half to fifty times (50X) in the US and 25X in Japan. Elsewhere there are no limits and some leverage reaches 200X. (A portion of the record breaking first quarter volume on the CME is also likely to be highly leveraged by so-called professional/institutional traders.) When there is that much leverage being used there will be significant losses, which in some cases will be “temporarily” hidden by “borrowing” from accounts to speculate more successfully. To a degree this is the theme of the extensive interview with Bernie Madoff in the weekend edition of the Financial Times. The promises of riches returned becomes the driver that cannot be denied by some.

More Evidence from the Wall Street Journal

In a recent article the WSJ noted that the SEC is considering relaxing the reporting rules on private companies. Currently only those companies with 500 or more shareholders need report. The current restriction caused an investment bank to withdraw an offer of Facebook shares to its selected private clients. Assuming that this change comes to pass, the firms that we used to call bucket shops here and overseas can claim that their market has expanded (to the detriment of the gullible public). I recognize that many regulators are pretty desperate to shrink their responsibilities in an era of tightening budgets. However, over the next several years the number of inexperienced players that regulators will have to review is going to increase. (As a manager of a private financial services fund and a member of a number investment committees, I am offered the chance to be an early investor in lightly regulated banks, trust companies, and real estate-oriented finance companies run by people who have limited experience in this new world.)

And now the herds are building up. In a March 31st article in the WSJ, it was noted that Merrill Lynch (Bank of America) Wells Fargo (A G Edwards) and Edward Jones were dramatically increasing the size of their broker training classes. Some believe that the cost to train these recruits over a two to three year period is on the order of $300,000 per trainee. Only about 1/3 of these rookies are likely to be employed by the house that brought them into the party. Some will be cut because they don’t make the required production levels and others will voluntarily leave for higher payouts or object to the products being sold. One expert believes that from the houses’ standpoint the firms will only earn a 10% return on the capital spent. My concern is almost the opposite. In order to fulfill the capital generation requirements, these relatively inexperienced brokers will sell complex products that have high profits for the firm and/or encourage margin purchases. They are not going to be happy with agency-only trades, e.g. buy 100 shares of Ford every month for three years.

The enthusiasm is growing

My old firm, Lipper Inc., noted in its first quarter report: “Breaking a two-year trend, equity mutual fund investors injected more net new money into equity funds for the quarter than into fixed income funds.” Interestingly the reported volume on the stock exchanges, unlike the commodity exchanges, is not perking up. (With a portfolio heavily weighted toward mutual fund management companies and brokerage firms, these are trends that I follow closely.) However, I am concerned that few of these investors paid attention to another article in the WSJ. This article focused on measurements that mislead. Included is the point of view that the statistics from the recently completed NFL(*) Scouting Combine are not great predictors of the future playing records of the player. However, the stats probably do track the sizes of the initial signing bonuses. This is similar to SAT scores which do not predict college graduation rates, 4 year grades or success after college. They are somewhat useful in guessing freshman year results. In effect, these statistics which drive lots of actions, are not particularly useful in making long term judgments. I feel the same about the use of mutual fund performance numbers. My guess is that the majority of the flows are going into funds that have shown the best near term results which may mean that they have an oversized position in Apple (*).

Trying to focus on the longer-term

At this particular moment one of the keys to the future is guessing as to future inflation expectations. The Federal Reserve, by its actions, is inducing inflation into the global economy and lowering the value of the dollar at a time when many others do see the threat of inflation. John Mauldin and others see capacity utilization rising, which can only lead to higher prices until new fields, mines, and plants come into production. Many other central banks are attuned to this risk, and those in both Europe and Asia are raising interest rates that will slow their economies a bit. Our own bond market senses inflation is real and growing. One measure I use is to compare the ten year yields of US Treasury Bonds with the Treasury Inflation Protected Securities (TIPS) of approximately the same maturity date. Currently the spread is 289 basis points or 2.89%. Thus the market is predicting inflation at the high end of its “normal” range of 2-3%. My fear is that it may go into the 4%+ range if we do not get better control of our deficits.

When will the Archduke be shot?

Not only do I hope it doesn’t happen and if it does that it is long in the future. Nevertheless, I feel we must be prepared for a sharp market break. I do not yet see enough speculative excess to make a premature move to raise cash, but I am watching for it. One of my three sons is an investment professional with a CFA. This weekend he expressed the hope that we have ten years of good markets ahead of us. I hope he is correct, but history suggests to me that the next five years could be difficult for some.

What do you think? Please let me know.

(*) Disclosures:
1. We are lucky enough to manage a number of defined contribution plans for the NFL and the NFL Players Association.

2. For many years I have personally owned shares in Apple that was a spinoff of a closed end fund that I owned many years ago. Foolishly, I sold some years ago in a tax balancing move. One should never make an investment decision based on tax impacts alone.

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