Architectural Sway Points and Current US Stock Market - Weekly Blog # 611

Mike Lipper’s Monday Morning Musings

Architectural Sway Points and Current US Stock Market

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

Most of the time very tall buildings and highly valued stock prices don’t fall, but history shows that it is smart to worry about the possibility of it happening.

Buildings that are over 100 floors are largely a U.S. phenomenon. During the early days of New York’s World Trade Center, I was asked to join a luncheon club on the top floor of one of the towers. In the ride up to the club the elevator noticeably swayed. Upon arriving at the top, I could see for many miles out of the windows. I watched planes flying up the Hudson River that were below where I was standing. When pressed to join the club I commented that international clients were important to me and my business. I felt that these clients would be nervous due to the lateral movements of the elevator and the thought that they were above planes in flight. I was told not to worry as the lateral movements in the elevators would be dampened, and they were.  As the planes could clearly see the World Trade Center Towers, they wouldn’t fly too close. The increase in wind velocity from ground level to the 100th floor was anticipated by the architects, who allowed the building to sway in order to absorb the energy of the winds.

Unfortunately, as with many assurances, they did not address all risks that could befall those in the higher floors of the WTC. I had neglected to consider the landlord being the Port Authority. As its own governing body, the Port Authority did not need to abide by the stricter rules of the New York Fire Department regarding the width of the stair wells and some other fire precautions. Nor did I contemplate Boeing developing commercial aircraft capable of carrying more fuel than other airliners. Most importantly, I did not consider those planes being used as guided missiles. Nor did anyone else.

This is not the first time a structure tilted measurably. The leaning Tower of Pisa has become a teaching site in terms of soil movement, foundations, and architecture. We are now assured that tall buildings constructed after the tragedy of 9/11 will have a far lower death count and will probably remain upright.

Can we compare the attack on tall buildings and their ultimate collapse to the current US stock market? I clearly don’t know, but the life-altering experience of 9/11 causes me to wonder. Which assurances given will be proven to be somewhat faulty due to unexpected changes in conditions? As a professional investor for others, I feel compelled to consider the fall from high stock prices.

Being a numbers guy and learning from the great educational institution of the racetrack, the first thing I do is look at the long-term odds. From 1928 through 2019 there have been 92 years of data. Breaking the data into performance slices, the 30% gain for the S&P 500 Index in 2019 ranks in the top 21% for all periods. To expect similar results for 2020, or any subsequent year, is like betting on favorites at the track. It is generally not consistently a rewarding approach.

For the last decade S&P 500 Index Funds have grown at a 12.98% annualized rate. Mutual funds that did well during this period were growth oriented and had substantial investments in technology and consumer services. The worst performing funds were invested in natural resources. These trends appear to be continuing in 2020. Through Thursday, 13 of the top 25 mutual funds for the week were growth focused and 6 were technology oriented.

One of the lessons learned from the track is that good near-term performance brings more money, a bet on the continuation of the trend. At the track, the weight of money lowers the pay-off odds, which must be split among more bettors. In the investment races popularity attracts competition, as well as more scrutiny from governments and others who seek to share in the gains of investors.

One way to avoid some of the risks inherent in today’s large-cap growth stocks and funds is to re-examine small-caps and emerging markets. You could also examine a group like natural resources which has not had positive performance for a decade, with a particular focus on energy.

Question for the week: If you made a list of your fundamental investment beliefs and were forced to rank them, which of your top five could prove to be harmful due to changing of conditions?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/01/how-much-will-markets-decline-10-25-or.html

https://mikelipper.blogspot.com/2019/12/repeat-past-history-probable-or-just.html

https://mikelipper.blogspot.com/2019/12/mike-lippers-monday-morning-musings.html



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"Things are Seldom what they Seem" - Weekly Blog # 599

Mike Lipper’s Monday Morning Musings

"Things are Seldom what they Seem"

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

Premise 
Things are seldom what they seem is an appropriate maxim for military reconnaissance, home buyers, merger & acquisition specialists, political and security analysts, and most importantly long-term surviving investors. When surface observations prove to be accurate, popular rewards tend to be small and when they are wrong the penalties can be large. This week I share three instances where a deeper understanding of what is popularly "known" are examined more broadly.

"Informed Prices" 
On Friday the Dow Jones Industrial average fell 255 points, with 67 of those points in the last half hour. Before using these "knowns", one should examine the makeup of the numbers and their implications. First, almost two-thirds of the decline was caused by just two stocks, Boeing and Johnson & Johnson. Boeing's fall is particularly significant because the DJIA is a price weighted average and it’s fall disproportionately impacted the result, as it is the highest price stock in the index.

As an analyst/portfolio manager, the larger implication lies in reviewing the investment selection criteria. Statistically oriented pundits and marketers generally want to sum up the company's results using factors such as changes in earnings, returns on equity or capital, revenues, or book values etc.

Both the price declines of Boeing and J&J were responses to internal disclosures. In Boeing's case it was a reaction to emails from the chief pilot expressing doubts on the Max 737. In J&J's case it was the discovery of a single batch of contaminated product. Neither of these disclosures were or could have been captured by any known factors. Ever since investors have compared investments and managers they have utilized screens to highlight and understand differences. Rarely was success the result of one management being smarter than others, it was often due to comprehending what was not captured in the statics, i.e. patents, customers, locations etc.

In the following market factors for the week I found issues of future importance, which I would be happy to discuss further with subscribers:

1. There were price gaps from earlier in October in all three major stock indices.
2. There were differences in the patterns of the high/low ratios for stocks on the two stock exchanges - NYSE 303/101 and NASDAQ 197/230
3. On the NYSE the volume of shares going up was very close to the number of shares going down.

"Plain English" can be Plain Wrong 
Jason Zweig, in an always interesting column in The Wall Street Journal, described attempts by a member of Congress and the SEC to force mutual funds to issue a new four-page document in "Plain English". Ironically, this is an effort to correct errors of judgement by both the Congress and the SEC. A generation or two ago there used to be an active retail market for investments in most cities and towns in ground floor stock brokerage offices. Their longevity was a testament to the value they were providing. They existed because busy people who recognized their lack investment knowledge needed help, the situation is no different today. In many cases the customers', man or woman, provided good service to the investing public and many of their recommendations proved to be profitable for both the investors and the brokerage firms. I believe the average retail investor's returns were superior to those of today, in part due to lower interest rates. Perhaps unconsciously, the SEC destroyed this setup by removing fixed commission rates. (That is not to say that there weren’t some abuses and bad judgments made.)

The SEC has faith in the disclosure of "facts", and numbers are even better. For a while it considered requiring funds to publish their beta numbers, urged on by the late and sometimes great Jack Bogel. Luckily, the requirement was dropped after being ignored and considered something of questionable utility. (It could have had some value as an annual or market phase measures.) Digital representation are an attempt to capture reality. While most critical decisions are reached through analog searches and comparisons, JP Morgan himself said that he did not lend based on collateral, but on character. The new document cannot correct for a poor education. Many successful investors learned early about budgeting their time and resources, without which no four pager or four thousand pager will produce on average, winnings.

When someone asks for my help with their investments, the first thing I should ask is how much time they intend to devote to investing. For those devoting "twenty minutes or less", I suggest that they either find someone they trust to manage their money or just accept one or more fixed rate investments. For the remaining few, I would be happy to introduce you to the multi-level set of investments arts.

"Follow the Leader" is Chasing one's Tail or Worse
As someone, with the help of a great staff, who probably created more lists of leaders and laggards than perhaps any other person, I can appreciate the media and spectators knowing who are at the "tops of the pops". Unfortunately, people don’t evaluate all the short to long-term time periods, or how quickly a name rotates from the leaders lists to the laggard roster. That is a mistake, but it is even worse to not notice the change in market conditions.

As an outsourced chief investment officer and a member of non-profit investment committees, I have seen a growing share of assets devoted to private equity and debt. In a recent article in FT WEALTH devoted to Family offices, a survey showed that over 80% are using private equity investments through funds or fund of funds. They are following the lead of certain Ivy League universities which have been investing in private equity for two generations. In the early years these schools produced results superior to the public market. At one of these investment committee meetings the members were presented with a book authored by one of the in-house chief investment officers, highlighting his success in investing in privates. That was then, today most of the former leaders have completed a year where in aggregate they underperformed the public market measures. What happened? The structure of the market was changed dramatically by the SEC’s efforts to make investing easier.

The way investments are taught in most places focuses almost entirely or totally on the issuer of the securities. However, the company is only one of five forces on the price and utility of investing in the security. The others are the needs of the customer, the compensation for marketing, the profitability of the firms that provide investment management, investment banking and trading, the changing nature of the exchanges, and the attitudes of the reviewers/critics.

The combination of generally declining profitability caused by the SEC’s elimination of fixed rate commissions and the long-term decline in real interest rates altered the commercial needs of the players other than the issuer and dramatically changed the market for privates. For over two generations brokerage firm equity/agency commissions were unprofitable. Their profits came from net interest on margin loans, dealing spreads, underwriting, financial advisory activities and investing for their own accounts.

This led the institutional sales force and eventually the retail sales force to shift to the sale of private securities, either individually or in packaged products of funds. In order to supply their sales forces, many firms got into the business of underwriting or offering private securities. They were often directly or indirectly paid in shares of the products they were selling. While a couple generations ago there were only a few in these markets, now almost all the firms that have survived are there.

At the same time successful managers of private venture funds were regularly coming to market with new merchandise. Owners of private companies therefore had many underwriters and investors competing for an interest in their companies, leading to higher prices. That was sustainable if these companies went public at sufficiently high prices to create profits for all who participated in the build up to the sale. It all worked as long as the IPOs rose in price long enough for all the willing restricted stock to be sold. In 2019 we have seen some IPOs break below the offer price and some have been withdrawn.

I have witnessed first-hand the success that Caltech's investment staff and appropriate consultants have generally had with their privates. They have worked long, hard and smart. I am convinced that there are few groups that have a similar dedication to this effort.

One of the general lessons in investing is that it is difficult to make meaningful gains in crowded trades and they can be very unprofitable if the crowd attempts to stampede out.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/10/mike-lippers-monday-morning-musings.html

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



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 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

After Selling Short-Term, You Should Buy Long-Term

Two weeks ago I suggested that on a trading and cyclical basis one should sell on the Wednesday after the 2012 US election. My thinking was based on the premise that the election would not provide a meaningful answer to the economic future of the US or to the rest of the world. Since the election, on average six out of eight market sessions have recorded losses. This continues the trend for the last four weeks since the probabilities that the president would be elected rose, and the market average declined 5.66%.

What did the US election signify?

As this blog is increasingly being read by those who are not Americans, I should share with you my analysis of the election.  (Readers from over 40 countries have joined our blog community.)  In general, Americans have had a fear of government actions unless they are directly helped, and often vote by selecting the least objectionable candidate. This election was decided upon the basis of perceived personalities. There was no real focus on a perceived future. Despite the victor’s view, there was no policy mandate given, as only a little over half of the potential voters voted and the spread in the popular vote was less than 3%. However, there were at least two clear implications that will affect the next election cycle that began on November 7^th. The first is that the Chicago machine is well trained in urban get out the vote campaigns and produced a much better result than the Boston-oriented management consultants who thought they were dealing with a corporate turnaround. The significance of this disparity is that winning politics is not just policy, but performance. The second implication for the Republicans is that they need to select better candidates for the House and Senate. (Interesting enough, the Republicans were more successful in terms of races for governors, other state officers and state legislatures.)

Fiscal cliff or barrier mountains?

Those who want short and complete answers to complex problems speak in terms of a single fiscal cliff.  I see the challenge as a series of difficult to solve barriers to a free floating economy. The basic problem (which is not being discussed in the US and most other major countries) is that the governments are providing services to a population that is unwilling to commit to pay the bill. This is not a new phenomenon in the US. Alexander Hamilton, the first Secretary of the Treasury bemoaned this very same condition. In Hamilton’s 1795 report to the Congress, he described the public’s desire for services, and their unwillingness to pay for them through higher taxes. The answer was to borrow the shortfall. However, as much as he tried, at the time Congress was unwilling to establish a specific plan to extinguish the debt. Today we have the same problem. We are facing the threat of sequestration, which will automatically raise tax rates and cut both military and discretionary spending. In addition to sequestration there is the self-imposed debt limit, which will likely result in a credit rating drop. On Friday there was a happy talk session at the White House where the congressional leadership appeared in public to accept some broad but not defined principles of cooperation.  Believing that “God is in the details,” I have my doubts that we will see any meaningful solutions until we get a final House-Senate conference committee proposal. The earliest that I expect any sort of practical compromise will be in March and maybe not even then. The timing may be ironic, as in March the new leadership of China will be in command to somewhat more aggressively manage the world’s second largest economy.

Disclosure:  Not only did Hamilton and I graduate from the same college, he founded the bank where I gained my first fulltime employment on Wall Street.

As much as the politicians might want to be able to act in their own time, there may well be external pressures that will change the picture of cooperation substantially. The first pressure will be the probable need to restock the Cabinet with replacements that will have to go through what could be rough interrogations from the Senate minority party. The second force, dear readers are you, the investors. The bond market can no longer play its traditional role as bond vigilantes because of the manipulation of the credit markets by various governments. Replacing the bond market in its role as protector will be the stock market. If both individual and corporate leaders sell because they feel that their taxes will go up too much for them, there will be a negative “wealth effect.” If the general population feels that they will be poorer due to higher taxes, they may seriously restrict their spending. This could deepen the recession that the Congressional Budget Office (CBO) expects in the first half of 2013. International actions and other surprises could also change the arduous progress to various agreements. Moody’s is predicting that corporate default rates will rise from their abnormally low levels, moving back to their historically more normal ranges. Let us hope that a relatively minor increase in defaults won’t lead to a rise in unemployment, which could impact any congressional compromise.

Secular bulls:  your time is coming

As an optimist, (as is everyone who gets out of bed in the morning), I am concerned about the relative lack of other optimists; as a contrarian this absence makes me bullish. If one believes in secular trends as I do, you may see that we are setting up one of the great bull markets of our lifetimes, not in magnitude, but in length. PIMCO, the world’s largest bond manager believes that stocks will outperform bonds in the future, but the average rate of gain will be more like 5% than the historic 10%. While they may be correct in terms of the aggregate growth of operating earnings, I see a good chance that stock prices will be higher than earnings projections due to valuation adjustments. Beyond that, I believe that there are a number of opportunities to do materially better than the market. There are two very different examples as to how this can happen.

The global label

Even if the US solves its fiscal problem, the odds are that its standard of living will decline relative to other parts of the world. Work ethic, education and demographics trends are moving against the US. In recognition of this, I believe that US investors need to invest their equity in a portfolio that has at least 50% of its underlying earnings power from non-US sources. This can be accomplished by investing 60% of the equity portfolio in US multinational companies. These companies have at least 40% of their own earnings from overseas sources. They can accomplish this by having overseas production sites selling into local markets; e.g., Coca Cola, Colgate, etc., or by exports (net of imports) like Boeing and Deere or a hybrid like Apple,  whose annuity-like future I believe is in making and selling products in China. (Though I have used large company names, there are any number of mid-sized or smaller companies that would qualify particularly in terms of exports and royalties.)  The multinational portion of the equity portfolio would have foreign earnings of approximately 24% (60% x 40%  = 24%).  In addition to the 60% in US multinationals, an additional 21% of the equity portfolio should be invested in local companies overseas, particularly those that do not have much of their sales in the US.  Thus 60% + 21% = 81%, which will leave 19% for purely domestic investments. I have presumed that you or your adviser has the requisite knowledge not only to do the detailed analysis of foreign vs. US content, but to also pick winning stocks. If your level of comfort in these abilities is not high, then perhaps some or all of this strategy can be well executed through the use of mutual funds or similar vehicles.

Disruptive Opportunities

I search for companies that perceive opportunities differently than others. Everyone’s favorite example of this is Apple, but this was not a good example years ago when I got some shares. Allow me to use a very narrow example from my particular area of focus, the financial services industry. In a private fund that I manage for a few clients and my family, we own 22 financial services company stocks. Since I learned securities analysis initially under Professor David Dodd, of Graham and Dodd fame, I believe that any and all companies can be acquired. Currently the brokerage/investment banking business is having difficulties. In the last couple of weeks KBW (Keefe, Bruyette & Woods), a dominant financial services broker, is being acquired by a larger more diversified firm. This week ICAP, a UK interdealer firm has closed its New York floor operation and announced significantly down earnings. The general perception is that these businesses are having a rough time and could be terminally sick. This week there was the announced disruptive acquisition of Jefferies, a position in our portfolio, by Leucadia National. In the future, the combined company will be managed by the senior people from Jefferies and they will be able to use both Leucadia’s capital and net operating loss carry forward. What is significant to me about this deal is that as a result of this merger, the new company will be managed for the growth in its book value not its quarterly earnings. This approach is similar to two of our other holdings, Berkshire Hathaway and Alleghany Corp. Actually what has me excited is that I perceive this deal as creating the US equivalent of the very successful (for awhile), UK Merchant Banks. While the US rules are now different than the set of rules that operated in the UK, some of the activities could be similar. To the extent that all of the perceived advantages of this combination come to be, it will change the acquisition of turnarounds in terms of competition with private equity groups.

I am reasonably confident that these types of transformational deals will occur in many sectors of the economy and will create highly focused special opportunities.

It’s your turn

Now it’s your turn to share with me how you are structuring your portfolio.

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