Anticipating Topping US Stock Market for Portfolio Managers vs. Stock Pickers - Weekly Blog # 662

 

Mike Lipper’s Monday Morning Musings

Anticipating Topping US Stock Market

for Portfolio Managers vs. Stock Pickers

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

                           

                   

                           

Warning: How Markets Approach Tops

Perhaps fittingly, markets reach tops in a similar fashion to countries going to military wars. There are two phases. The first can go on for a lengthy period of a year or more, with the slow destruction of the ability to successfully fight back. The second is an immediate event, which galvanizes the opposing forces into military action. The assassination of the Archduke in WWI and the Attack on Pearl Harbor in WWII are two examples. In both cases the general population was not paying attention to the deteriorating conditions and they were truly surprised by the triggering events. Those in power were not surprised that an event could trigger hostilities and there were premature warnings if one looked for them.

With the US stock market nearer a probable peak than a bottom, I sense an oncoming peak followed by a meaningful decline. I just don’t know when, although I have a pretty good idea who will be blamed for it.

Topping Signs

The first sign is the public’s wish for a better year than the last, often expressed as a bigger gain in the US stock market. The raw gains for the Standard & Poor’s 500, with dividends reinvested, was +18.40% for 2020. A level roughly twice the long-term average of +9% to +10%. The average S&P 500 index fund, with $1.9 trillion entrusted to them, gained +17.91% with dividends reinvested and management, administrative, and transaction expenses deducted. As good as these results were, they were below the average return for US Diversified Equity Funds, a gain of +19.14% on $10.3 trillion in assets. Even with the history of a strong November and December being followed by a year producing returns of +10% or more, one should be cautious in expecting the 2021 return to be better than 2020. 

Excessive speculation with increased leverage weakens all but the strongest financial structures.  Excessive speculation is often an open invitation for enemies to embark on bold adventures (Pearl Harbor). There is no doubt we are experiencing rampart speculation, 2020 had the fastest bear market and included a record level of IPOs and an equal number of SPACs (Special Purpose Acquisition Company). In addition, 2020 saw a record level of margin debt and a new generation of inexperienced investors rapidly trading on home computers, somewhat like the “roaring twenties”. 

Accelerating inflation also weakens the defense mechanism of a society. The JOC-ECRI Industrial Price Index ended the year at +24.44%, with 81% of the weekly prices rising in the weekend edition of the WSJ. Other cracks are also visible in the economy, with landlords and their banks speculating on when and if their tenants will pay their rent. One also hears of some officially unemployed workers only willing to work off the books. Integrity is often forgone in periods of speculation and inflation.

We should not attempt to remove all speculation from the markets, as we would be killing opportunities to take risks that have paid off very well in 2020, shown in the performance of the following mutual fund averages:

Alternative Energy Funds     +92.89%

Global Science & Tech        +65.00% (C)

Science & Technology         +52.21%

Multi-Class Growth Equity    +42.89% 

(C) Canadian Information Technology stocks +80.65%

Typical Stock Pickers Play Differently

Picking stocks is an old art form encompassing both short-term gambling and long-term investing. One of the main mental attitude differences between an almost exclusive focus on picking stocks and portfolio management, is that stock pickers focus almost exclusively on the performance of individual holdings, whereas professional portfolio managers focus on the performance of the entire portfolio. This usually leads to a stock picker having a more limited number of holdings, with many driven by the same market dynamics. Many newer stock pickers are entertained by the frequent examination of price volatility, intending to hold if his/her stock prices rise relative to other immediate alternatives. The focus is often on what is happening in the market and/or in the headlines, not on the fundamentals of the company which happens to have the same name as the stock. If the stock disappoints, the player sells and either buys something else or totally withdraws from the market, until a new wave of speculation gets his/her attention. In viewing the history of stock-pickers, one is reminded of what is said about pilots “There are old and bold pilots, but there are no old bold pilots.” 

That speculation burns out many inexperienced traders is unfortunate, not only for them but also for the nation. We have reached a point where the number of new companies equals the number retiring, either voluntarily or involuntarily. Among the reasons are demographics, labor and other capital productivity, regulation at various levels, and tax rates. One of the reasons US productivity was a world leader was the birth rate of new ventures and the success of some. Among the biggest advantages a stock picker has is that he/she does not have to play and record of results is not known. If the record is self-disclosed, it may not be believed. 

The Professional Portfolio Manager Plays a Different Game

The biggest risk for most professional managers is career risk, either losing employment or reputation. Furthermore, the portfolio manager is constantly being measured against supposed peers and externally identified time periods. At times absolute and relative investment performance are paramount and at others presumed risks is critical, whereas for some accounts cash generation is most important. For example, in 2020 the same account could be a relative leader or laggard and finish the year with very acceptable results, depending on the period selected. In some cases, when an institution borrows money during a period of economic strain, cash generation or volatility is critical to making payments or maintaining credit ratings. Because of COVID and a disruptive economy, some institutions have become much more sensitive to short-term results, whereas others look at the same characteristics through a longer-term lens and see new opportunities and risks.

In contrast to the stock picker, a portfolio manager looks at each investment not only in terms of its investment merit, but also its role in creating the appropriate balance in an account in terms of risk and reward. While a stock picker would ordinarily be delighted to have every one of his/her holdings do well, a professional portfolio manager would be concerned, fearing a change in the impetus driving the market could make the portfolio a very risky vehicle. In income-oriented portfolios, the timing of flows is critical to meet payment obligations and that can put constraints on the structure of the portfolio.

Unlike the private investor, most professional portfolio managers can’t afford to be out of the market, as most outstanding performance requires ownership on key turnaround days. The best a manager can do if the market is moving differently than what is perceived to be correct long-term, is shift the relative volatility of the portfolio, with a willingness to move quickly into higher volatility when the trend is what it should be.

How are You Protecting Against Unwarranted Speculation?

• Ignore?
• Raise Cash/Short-term vehicles?
• Change Volatility?
• Prune holdings which don’t help?
• Or something Better?   

I like quoting Ben Graham, not only because of his well-earned knowledge but because of the New York Society of Securities Analysts gave me an award named after him. He is quoted as saying “the essence of investment management is the management of risk, not the management of returns.”

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

https://mikelipper.blogspot.com/2020/12/stud-poker-new-swamp-game-weekly-blog.html

https://mikelipper.blogspot.com/2020/12/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/12/searching-for-surprises-weekly-blog-659.html

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

Searching for Bottom, Understanding, and Select Futures - Weekly Blog # 620

Mike Lipper’s Monday Morning Musings

Searching for Bottom, Understanding, and Select Futures

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

“The Bottom”
Even before the end of hostilities, survivors begin to determine how bad is bad when someone is attacked. Is this the bottom? For those in and around the stock market there is lots of history to provide clues. At 9:26 AM on the 13th, Larry Goldstein, a very successful micro-cap fund manager and a junior analyst in the same shop with me years ago, wrote the following:

The factors that make a bottom in the US stock market include a combination of climatic selling with an intraday reversal, combined with a breakthrough announcement on testing and treatment for the Coronavirus...This will turn, it always does.

On Monday he was generally right. There was a sizable price gap opening in the DJIA compared to the previous day’s close. The low for the day (21,159 vs 21,200 Thursday close). The close on Friday, which may be close enough to fill the gap, was 9% higher than Thursday’s close.

A Largely Predictable US Stock Market Fall
What was not predictable is the size of the decline in one month’s time. A student of history could have predicted two out of the three causes for the decline. I know of no way to predict the rapid spread of Covid-19, although it’s clearly possible that some in the medical sphere had knowledge of Chinese conditions. The rapid spread of the Coronavirus was a convenient time for Russia to attempt to grab a much larger share of the oil market from US shale frackers and “swing” producer, Saudi Arabia. A student of 19th century world trade history would not have been surprised.

In the 19th century a great German military strategist proclaimed that war was just another way to execute national policy. In the 21st century one could easily substitute trade wars for military wars. Some may even suggest that Germany provided the muscle for WWI due to that country’s late economic development. Germany needed more global markets but found themselves blocked by the trading strengths of the US, Great Britain and others. One could also point to the Japanese attempt to build a “Co-Prosperity Sphere” as being a contributor to the Pearl Harbor attack.

In the current era, China’s contribution of at least one quarter of the growth in world trade was dramatically changing. Under their command economy they needed to create both employment and a rising standard of living. They were evolving from being an export driven economy to having greater reliance on internal market development. Thus, the growth rate of their exports declined, so too would the rate of import growth. The trade issues with the US added to these contractions, Europe lost some exports to China and they received lower price imports diverted from the US.

Europe’s general economy had slowed and in some cases was approaching stall speed, while Russia and Saudi Arabia attempted to catch up with the more developed world through massive capital projects. Both are critically dependent on oil exports to generate the capital needed to hold off the global drive of popularism. Thus, the Russian move to capture greater market share makes sense, it came with much lower prices, contrary to the Saudi’s own needs.

Remember, most large expansions by industry and government are debt financed. The equity market is often slower to react to economic trends than the fixed income market. That is exactly why the following quote from BlackRock’s CIO of Global Fixed Income was so unnerving.

“If you don’t know where the safest asset in the world is, it becomes impossible to figure out (where) everything else is.” 

This uncertainty for the week ended Wednesday led to net redemptions in corporate investment grade bond funds of $7.3 Billion and $5.1 Billion from high yield bond funds. (More on the threat of the bond bomb later.)

Going Forward
The odds are favorite that we have seen the bottom of the major US stock market indices for some time. (I am guessing there is a 60%-75% chance that this is a correct assumption.) I assume any top or bottom will be tested before investors accept a major turn in the cycle. The test can be above or below the bottom, but it will have less sustained force behind it. I have reasonable confidence in the turnaround as a result of measuring the price differences of our closely followed roster of financial services stocks, between Wednesday and Friday closing prices were within 0.3% of being equal.

The reliance on reported earnings per share is a worry for equities. It is a much-manipulated figure due to changes in accounting standards, federal/state tax rates and rules, plus buy backs. Utilizing I/B/E/S data from REFINITIV, analysts estimated that fourth quarter reported S&P 500 earnings would be +10.2%, but net income only +8.2%. That spread widened from 2% in their first quarter 2020 estimate to 2.4 % (+14.3% earnings and +11.9% net income). Since mid-February, or even earlier, no one is holding to 2020 earnings estimates.

The reason for showing the spread is that analyst and perhaps corporate management believe others will accept the reported per share numbers. I always look at any equity in terms of what a knowledgeable person in that or an affiliated business would pay for the entire company. I believe most acquirers would start with net income in building their price bid, or 20% lower before adding premiums and discounts. Thus, many stocks were priced too high, historically they normally are priced at a discount to what an occasional acquirer would pay.

The problem of valuing fixed income paper is more fundamental. There is far too much reliance on debt in our society. Starting with most governments running a deficit, businesses issuing debt to meet current needs, and individuals use debt through credit cards and other devices to cover living needs.

Too many in the population are not using debt to leverage their equity in the purchase of investment producing assets. Those that properly use debt, their underlying equity assures the lender is not taking the first or possibly the largest long-term risk. These days, most debt issues are largely for refinancing existing debts, not increasing earnings generation. (Most of the time, long-term gold owners use their gold positions to hedge against the valuation of other assets. However, after an extended price rise, such as now, they use some of their gold to meet current cash needs or payoff their debt.)

Opportunities 
In many respects we have involuntarily entered a new era. Because Coronavirus it is now critically important that most families be connected electronically. Instead of traditional European style food shopping where one goes to the food market daily, we will attempt to regularly store essential food needs for two weeks or more. We may change our entertainment mix so that more is delivered electronically and less in theaters and stadiums. Universities and other schools may have to learn how to educate differently, rather than putting on classes and giving exams on paper. Perhaps we will need to reconfigure the structure and size of campuses and student housing.

To me, as both an analyst and entrepreneur, I believe we have this year a unique opportunity to build soundly without paying too much attention to the impact on the record. We have involuntarily entered a “gap year” and the track handicapper can throw out one or more races as long as the horse, jockey and trainer are building skills.

As an investor and portfolio manager for others, I am going to be searching for what will be different after these crises are over. Covid-19 and similar problems will be addressed with increasing success throughout the year. Near-term energy prices will settle as market forces find equilibrium points. The “debt bomb” will take much longer, perhaps a generation of both write offs and long-lasting penalties.


Discussion for the week: I am happy to chat with subscribers and explore the opportunities they did not see as we finished 2019.         



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/03/searching-for-bottom-and-plan-weekly.html

https://mikelipper.blogspot.com/2020/03/should-changes-in-markets-change-your.html

https://mikelipper.blogspot.com/2020/02/hate-doesnt-work-for-investors-weekly.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.