Is it Always Brains over Flexible Policy in Investing? - Weekly Blog # 612

Mike Lipper’s Monday Morning Musings

Is it Always Brains over Flexible Policy in Investing?

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

Two questions:

1. Why don’t smart people always make money with their investment responsibilities?
2. When is the time to fix a leak in the roof, when it’s sunny or when it starts to rain?

The answer to the second question is obvious, when it is sunny. Why then do so many smart people fail to adjust their investment portfolios when the market is fairly, if not fully priced? Could it be that selecting good investments is emotionally more rewarding than focusing on policies that could direct future movements within the portfolio?

None of us knows for sure what the future will bring in the periods ahead. A characteristic most of us share in the developed world is the necessity to compete. We measure our results against perceived peers, or in their absence against artificial indicators that were not necessarily designed to replicate our real-world tasks.

For most investors, their responsibility is to convert the assets they manage into a series of known and unknown payments for various future periods e.g. paying bills. In order to accomplish this, they must make some difficult guesses as to the size of the bills due. Whether they like it or not they should be thinking in terms of investment survival. However, they also need to grow capital in the account to pay more bills than would be possible with current assets. This introduces a difficult and unknown risk/reward equation.

Far too many investors focus on competing with peers or indices and not on the risk/reward equation. Some professional investors also add career risk into the calculation. If they fail to please the owners of the capital, they risk losing the client and account or jobs. Unfortunately, most owners of capital and many investment executives don’t know how to evaluate their managers, except statistically or by comparison. I know of one very successful sector analyst that kept his fund from investing in it. His timing was excellent and when that sector collapsed, he was rewarded with a partnership. He eventually became the managing partner of a successful fund management firm. Charlie Munger and Warren Buffett have often said that individual investors can make better investment decisions than many institutional managers because they are not facing career risks.

Now we come to that leaky roof. The best time to fix the roof is when it is not raining or snowing. On Friday the three main US stock market indices reached a new high, as they have many times over the last three years. Stocks go up in price because more buyers than sellers believe the future will be better. They may currently be correct, but at some point in the future they won’t be. There is an old saying from the floor of the Stock Exchange that bulls and bears make money, but pigs get slaughtered. (Maybe they will be shipped to China where there is a pork shortage.)

Will the US market continue to go up? I hope so. However, in thinking about leaks in the roof I’m seeing some dark clouds that might carry rain. While the world will need more goods and services in the future, they might be in short supply at current prices. Because of geo-political fears in the US and much of Europe, the capital expenditures necessary to build additional capacity has been slim. Another capacity constraint is the working age population, which is already declining due to the falling birth rate. (It is possible that Southeast Asia and Africa will be the source of additional physical and human capacity, which is why we’ve invested some capital there.)

Should we be paying so much attention to geo-political events? I recently saw a study that looked at 21 such events, from Pearl Harbor through the killing of the Iranian general. Only 4 sent the S&P 500 Index down 10% (which is normally called a correction). Pearl Harbor was the worst both in terms of the 19.8% decline and the 307 calendar-day recovery. The average historic decline of 5% is interesting because it falls within the 3%-7% collection of 2020 institutional expectations for the S&P 500 Index. With the indices at a record high, the general’s death did not appear to affect the market. For long-term investing, JP Morgan believes you should be guided by long-term trends and not events.

What clouds are we seeing other than long-term capacity constraints? Conditions are becoming more speculative, with the NASDAQ continuing to lead the other markets. The growth of alternative styles and different trading instruments is also a concern. Furthermore, we are seeing many “conservative” institutions shift from 60% in equities and 40% in fixed income to 70/30 allocations. In the first two weeks of the year we have seen growth and tech-oriented funds gain over 4%, which translates to approximately doubling over a year if continued.

Another unsound extrapolation is that over $40 billion went into bond-like funds during the first 16 days.  This extrapolates to annual rate of $1 trillion. We are already seeing intermediate interest rates moving up. Intellectually, I suggested that it would make sense to short the 30-year US Treasury. (The trend of universities issuing 100-year bonds is spreading overseas. Caltech has now done it 3 times and I believe Cambridge is considering it too. With the average US government debt maturity under 10 years and the UK’s under 14 years, we would like to see a lengthening of maturities.) With gains in many cases over 10%, 2019 was an outstanding year for bond holders. I suspect it will not be wise to own bonds for quite awhile.

Sir Isaac Newton is an example of someone considered to be among the smartest of people. He was a young Cambridge Professor who first conceived the three laws of motion and in so doing formed the basic principals of modern of Physics. He was so respected that he was knighted, very unusual for a scientist. He became the master of the Mint, a high honor. At that time in England the government had not yet set aside money to pay its debts, so they created a lottery. The lottery involved the newly formed South Sea Company, which had dubious prospects, but the potential odds were attractive. Sir Isaac recognized the fallacy of the issue and sold his shares. However, he got seduced by the skyrocketing prices and went back in. He is thought to have lost his investment, which may have been 22,000 pounds in 1722. After the Bubble popped, he was quoted as saying “I can calculate the movement of the stars, but not the madness of men.” Clearly a very bright person who made a big investment mistake.

Subscribers, please help me and yourselves from getting sucked into the concluding whirlpool when the current enthusiasm subsides.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/01/architectural-sway-points-and-current.html

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



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A. Michael Lipper, CFA

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Is There Enough Left on the Upside?

Introduction

One of the many necessary elements for a peak to occur is the belief that the current market rise will continue. This belief is nurtured by cheerleaders and there were two highly respected ones sharing their views with us this week. The first was in Mark Hulbert’s column, where Sam Eisenstadt, the former statistical genius of Value Line stated that he believes in the next six months the stock market will rise 8% as the leadership will shift to higher quality companies rather than the lower ones which have been the leaders. 

The second was an observation from U.S. Global Investors’ Investor Alert which quoted a study by BCA Research which examined the 30 years since 1870 when the market was up 25% or more. They found that in 23 years following the big gain that the market had an average gain of 12%. A number of Wall Street types are now hoping to split the difference and are looking for a 10% gain.

Is 8, 10, or 12% good enough?

On the one hand (as the economist would say) these gains are 2-4x the recovery high on the US Treasury 10 year note at just over the 3% yield achieved this Friday. On the other hand someone trained on using the odds of meaningful success would start to get cautious. Just five years ago the percentage decline in the market offered a potential recovery to the prior peak of 2-3x what is now being offered. This is not counting on going on to new highs. The question now is, are we about to enter Sir Isaac Newton’s “greater fool theory” trap? Remember he participated early in the run up of the infamous South Sea Bubble. He got out early, but got sucked back in when his friends were making more money faster than he did. When the bubble did break he lost all of his gains and more. What we have learned from the recent studies at Caltech is that some people don’t retreat when they sense danger, but stay involved believing that their sense of timing will take them out of danger. As I mentioned in prior posts, I learned about this as a junior analyst and it was called the greater fool theory. To believe that future big gains are possible after large gains are achieved does not show the level of caution that many successful long-term investors use.

I used to question why we researched bonds when I was studying Security Analysis at Columbia with Professor David Dodd.  The name of the class was the same as the title of the book that he co-wrote with Ben Graham. What became clear to them and reinforced in the recent mortgage market collapse beginning in 2005 and culminating in 2008, that at times the fixed-income markets are much more sensitive to credit conditions and therefore the eventual health of the economy than my fellow stock jockeys.

As mentioned above on Friday the ten year US Treasury bond’s yield rose to a psychologically important 3% from a low of 1.63%. This in turn caused bond prices to decline in absolute terms. I look at historic 10-year yields the following way:

• I view the normal yield for the ten year to be about 4%. 
• During abnormal times rates would be in the 6-8% range, which should meet the relatively few defined benefit pension funds' actuarial requirements.
• Under economically stressed periods one could see yields in the 9-12% range if not higher. 

The higher current yields would occur when there is greater demand for capital than what is immediately available, usually with both the private and public sectors needing money to meet their immediate and longer-term needs. We are currently far from these conditions now, but sound equity investors should be alert to credit conditions as both the private and public sectors are short of capital for long-term productive investments.

Is there too much asset allocation?

For far too long investment pundits and those who direct the construction of long-term portfolios have found comfort in diversification into many different asset classes; e.g., domestic stocks, international stocks, emerging market stocks and bonds and now stocks from frontier countries as well as similar fixed-income asset classes going from the most to the least secure. To these lists add private equity, commodities of different types, real estate, timber, and elements from the art worlds plus intellectual property. While not a separate asset class, hedge funds owning one or multiples of these classes are included in the array for diversified investing. Many of these types of investments have badly trailed the simple stock market and some for 2013 are likely to show negative results, such as commodities and volatility measures. I would suggest there are three lessons one should consider before deploying asset allocation.

The first is that in declining markets and particularly sharply declining markets, correlations will increase. Wherever there are pools of liquidity they will be drawn down. Assets that can be sold quickly will be. Second, when there are choices to be made and particularly in the early phases of a rally, selectivity will be important. Along with the skills of the selector it is important to understand the relative sizes of compensation of the intermediaries. Isn’t it strange the highly compensated products and intermediaries get the first mover advantage? The third clue (the most difficult one for those of us who are trained in complexity) is to keep the strategy simple where most of the time is spent on selectivity.  In his weekend column in The Wall Street Journal, Brent Arends quoted a study by Andrew Smithers, a well-known and highly respected British investment thinker, who in a study for the investment committee of a college at Cambridge University recommended that it should have only two asset classes, stocks and cash. Stocks could range from 60% to 100% based on the level of the market, utilizing some long-term ratios. In today’s world this simple but effective approach is making a lot of sense, at least until reset approaches coming off the next major bottom.

What is increasingly missing from our command structure?

As a US Marine Corps officer, we never really retire, we just change uniforms. Over the weekend I enjoyed an interview with Camille Paglia  where she is quoted as saying. “The entire elite class, now in finance, in politics and so on, none of them have military service, hardly anyone. These people don’t think in military ways. The politicians lack practical skills of analysis and construction.” She finds “no models of manhood except on Sports Radio.” (My friends at the National Football League and the NFL Players’ Association will be glad to hear that they are her models of manhood.) However, they are not alone seeing the benefits of military thinking, conditioning, focus, and street smarts for returning service men and women. Prudential Insurance and JP Morgan Chase are among the leaders in seeking out these returning heroes and heroines with job opportunities. I am guessing some of these people will rise to the top of our leading organizations. On a global basis the benefits of a well-spent military life could, and I believe should, give the US an advantage in our international competition. This alone may be a reason to be long-term bullish on America.

What are your thoughts?

Drop me a line.

I hope all of the members of this community will have a Healthy , Happy, and Prosperous 2014.     

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