Time to Get out of the “Foxhole”? - Weekly Blog # 623

Mike Lipper’s Monday Morning Musings

Time to Get out of the “Foxhole”?

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

Quite possibly the biggest mistake in the world is not recognizing that some critical fundamentals are changing. This mistake rests on strongly held views of the future, that it will seamlessly extrapolate from the immediate past or quickly be governed by a new order that will make sense of it all. Good luck to all who believe this.

I start from the assertion that I don’t know what the future holds, either for us or our investment responsibilities. Nevertheless, we know that we cannot stay still in our present condition. Now is the time to recognize that there have been some small changes in the last two weeks that could be meaningful. They have already rewarded some double-digit returns.

In the weekly ranking of traded price changes, a minority of 24% are going up. Not surprisingly, the biggest gains were for those related to oil, which had a relief rally of 25%. However, several unrelated prices also rose somewhat. (Consumer Staples +3.46%, Copper +1.63%, TIPS +0.90%, 7-10 Year US Treasuries +0.79%, Gold +0.54%, +20 Year Treasuries +0.48%, and the Yuan +0.06%). I find the rise of both copper and the yuan hopefully significant. The commodity market players and economists often refer to copper as “Dr Copper”, because it is often an indicator of early demand. The minuscule rise in the Chinese yuan is another indicator that some things in China are improving.

Fixed Income Quandaries 
All too often people group investments with a specified maturity and expected interest rate into the same category, such as government bonds and other bonds with a high credit rating. This can be quite misleading, as evidenced in this week’s Barron’s. The Best Credit Bond Yield average dropped by 37 basis points, while the yield on intermediate credits rose by four basis points. (Remember, bond prices go in opposite direction of yields). The market was therefore pricing the safety of credit more than it was higher yield.

I was at a meeting recently where a money manager included the high yield portion of the portfolio with other bonds. I suggested that high yield paper normally travels parallel to stocks, not bonds, and he agreed.  With interest rates currently at historic lows, high quality bonds should not be counted on for income. They should be recognized as a source of capital to be reinvested into bonds at higher rates (lower prices). This is particularly true now as the yields on longer maturities are rising. (One of the reasons that retail investors with high yield mutual funds underperform total returns is that they spend the distributions rather than electing to reinvest them.) Many disagree with my view in last week’s blog that rising deficits around the world will drive inflation and interest rates higher, and in time a lot higher.

Market Structure Changes
There is some inconclusive evidence the US stock market has hit a bottom. Market analysts suggest that some time must pass for the market to establish a large base before a successful assault on prior record levels can be made. One reason this makes some sense to me is that recessions are meant to correct the excesses of a prior bull market. Perhaps the reason the previous long expansion did not go higher was too many old zombie companies not earning their cost of capital. If this was the case, the next expansion will likely be shorter.

There is plenty of “dry powder” that could fuel a big expansion. One metric Wall Street focuses on are the portfolios of individual investors and for years they looked to Merrill Lynch to provide this view. This now comes from Merrill’s new owner, the Bank of America. They have indicated that the amount of cash in their client’s accounts are at a ten-year high, with the amount in bonds at a seven-year high. Additionally, the large amount of uncommitted funds in private equity is blocking them from raising new funds. The recent market decline has brought the S&P 500 ratio of market price to book value to below 3 times, a level at which M&A deals are often considered.

Covid-19
The public, media, and politicians are looking forward to the “flattening of the curve”.  This may be occurring in Italy, Spain, and New York state in terms of death, not number of new cases. Much more important to me are the vast majority of those who died in both Italy and China having other medical problems. What I don’t know is what killed them, the virus and its complications or their other problems. The following table, provided by US authorities, lists the proportion of patients that had other medical conditions:

Chronic Renal Disease     74.8%
Cardiovascular Disease    61.0%
Diabetes                  54.7%
Former Smoker             49.4%
Immunocompromised         42.4%
Chronic Lung Disease      40.4%
No Underlying Condition    9.7%

Perhaps a positive spin on this tragedy is that it is causing us to rethink, not only our healthcare systems and personal relationships, but also the structures of business and educational organizations.

Hylton and I wish you and your love ones good health. We hope you are practicing good procedures to protect yourself, your loved ones, and the people you are in contact with. We will get through this together.

Question: From where we are today, how should we organize to make us all better?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/03/where-we-are-depends-on-where-we-have.html

https://mikelipper.blogspot.com/2020/03/stealth-bottom-and-other-considerations.html

https://mikelipper.blogspot.com/2020/03/searching-for-bottom-understanding-and.html



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A. Michael Lipper, CFA

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An Awkward Moment with Frustration not Exhaustion - Weekly Blog # 591

Mike Lipper’s Monday Morning Musings

An Awkward Moment with Frustration not Exhaustion

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

Trying to develop a sound long-term investment strategy at any time is difficult, as most of the time we are clearly not at a top or bottom of a significant market move. We wander along an uncertain path to an eventual turning point, but each day, or in my case week, I must read the current sign posts to decide whether or not to change direction on the path I am traveling. Currently, there are three difficult choices to select from:

1. Stay reasonably fully invested in the upward sloping secular trend, accepting that there will be periodic cyclical movements.
2. As the opportunities and risks in today’s world are not the same as in the past. We should become increasingly defensive by building meaningful cash reserves.
3. Prepare for global policy mistakes that causes devastation.

I put the chances of being correct for each of these choices at 65%, 30% and 5%, respectively. On an overall basis I would improve my odds by sub-dividing the portfolio into timespan segments and periodically re-weight the commitments to the segments based on both perceived future conditions and the changing needs of the beneficiaries.

These three working conclusions are based on the following inputs:

Secular Continuation with Bouts of Cyclicality

• Most of the current volume is being generated by those that have a short-term time horizon. They are being whip-sawed by politically oriented news which is generating a lot of frustration. However, it is not generating the quantity of transactions representative of final exhaustion, or a complete retreat from participation.
• Nevertheless, traders are making decisions based on liquidity e.g. compare the ratios of advances to declines on the NASDAQ 211/314 vs. NYSE 411/229. (In general stocks on the NYSE trade in greater volume than on the NASDAQ) 
• Net flows into and out of ETFs shows short-term withdrawals this week. The two largest withdrawals totaled $4.6 Billion and the two largest net purchases totaled $1.2 Billion. The S&P 500 and MSCI Emerging Markets were sold and Consumer Staples and Gold were bought. 
• Even after Friday’s drop of 3% for the NASDAQ it is till up +16.63%, whereas the DJIA is up only +9.87%. Both gains will probably be larger than the total earnings gains for 2019, suggesting the market is looking for a good 2020.

Game Changers

• Lower interest rates and less binding loan covenants are likely to cause more bad loans.
• Only 42% of weekly prices are rising. Could we have deflation in goods and inflation in services and imported goods?
• Last week the interest rate offered to depositors went from 0.65% to 0.73%, suggesting that banks are increasing lending in face of slowing demand for products and services.

Global Mistakes

• The battle for dominance is essentially driven by defensive needs, not land or market dominance.
• The Chinese have been thinking in these terms for more than a thousand years. The earliest example of their well-developed thinking is in the writings of Sun Tzu entitled “The Art of War”. Jessica Hagy has produced a book that visualizes Sun Tzu’s thoughts. These should be understood by other world leaders and are shown below:
• Hold out baits to entice the enemy
• Feign disorder and crush them
• If your enemy is secure at all points, be prepared for him. If he is in superior strength, evade him.
• If your opponent is temperamental, seek to irritate him. Pretend to be weak, that he may grow arrogant.
• If he is taking his ease, give him no rest. If his forces are united, separate them.
• Attack him where he is unprepared, appear where you are not expected.
• These military devices, leading to victory, must not be divulged beforehand.
• The general who wins battles makes many calculations before a battle is fought.
• The general who loses a battle make but few calculations before-hand.

The Asia Times has an article entitled “China now has edge in Indio-Pacific”. It is based on a think tank report from an Australian group named United States Studies Centre. The study raises the question “Could the era of US military primacy in the Pacific be over? Their view is that internal conditions within the US suggests that it will not fully fund the needs of its National Defense Strategy. At the same time China is building a capability which in a surprise attack would destroy or cripple some or all of the US’s Western Pacific main installations in Guam and Japan. (Interesting that the report did not name our forces on Iwo Jima and in the Indian Ocean.)

My Point of View
As a former electronics, aerospace, broadcasting and conglomerates analyst, I have seen the power of small electronic components change massive companies and markets. The current “trade war” was designed to protect the primacy of our semiconductor technology, which is critical to both US and Chinese defense efforts. To paraphrase Admiral Alfred Thayer Mahan’s statement of Who controls the Seas, controls the world. I believe the two Emperors of China and the US are acting as Who controls (leads) semiconductors and related technology controls the defense of their countries.

An Important Question
Considering how long value focused managers have suffered, can we build portfolios that are able to survive a similar period, regardless of our investment strategy? Any thoughts?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/08/short-term-recognitions-plus-longer.html

https://mikelipper.blogspot.com/2019/08/sentiments-approaching-reversal-points.html

https://mikelipper.blogspot.com/2019/08/is-last-week-significant-weekly-blog-588.html



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Announcement + Misplaced Focus Hurts Results

Announcement for Timespan L Portfolios^®

I am very pleased to announce that our affiliate, Whitridge LLC has been awarded Registration No. 4,837,713 by the United States Patent and Trademark Office for the designation of Timespan L Portfolios^®.  Timespan L Portfolios is a unique strategy designed to address the multi-faceted needs of significant investors within an idea of creating a structure that can be used for many decades into the future.

Information for competent investment advisors and other financial institutions wishing license information for this service is available.

For more information, email me at: aml@lipperadvising.com

------------------------------

Misplaced Focus Hurts Results

Introduction

In sports, wars, politics, and investments why do smarter opponents with more resources lose to more agile competitors with less resources? In selecting funds for long-term investing we make a practice to analyze the successful and unsuccessful managers. History is replete with examples of seemingly smarter, bigger forces with substantially more resources losing critical battles. Often the losers believe in their own superiority and that they will produce a never-ending series of victories. Napoleon said that "God is on the side of the bigger battalions," then went on to be defeated at his Waterloo by smaller forces he had beaten previously.  In addition Napoleon did not use his battle trained reserves well. Today we are seeing the rise of "populist" political leaders globally, either on the Right, the Left or even by established political parties and their leaders. This phenomenon is little different than the fall of various “Investment Kings” to different managers who are practicing the game dissimilarly and often much more narrowly.

One of the first clues that a manager will not succeed long-term is the amount of space he/she devotes to the economy and current politics in views and writings. Few future winners start their investment pitch with a discussion of GDP (Gross Domestic Product). I agree with the current number two in China who suggested some time ago he did not trust the numbers produced by his government staff as they were “man made,” which suggested that they could be either inaccurate or corrupt for political purposes. He preferred to rely on industry statistics produced in the private sector; e.g., electricity, freight car loadings, and bank loans (to private companies and individuals) .

The error of focusing initially on the economy is that it starts the thinking process of viewing things from the top down. This is a useful exercise for those that use, or perhaps abuse, the media to pontificate to unsuspecting audiences. It also is a prepaid mechanism when something doesn't work, (“The economy or the government did not do what was expected.”)

Many years ago I was exposed to a much more successful way of thinking which is bottoms up. Often, after a busy day of visiting many portfolio managers in his city, I had a private dinner with at that time was the leader of the single most successful fund group in the world. I thought our dinner table conversation would be about broad fund industry topics and politics which was dispatched quickly. What really turned him on was analysis of individual stocks that weren't well followed. The discussion often focused on what was the critical analytical approach to various companies and most importantly, about the relative strengths and weaknesses of different managers. Occasionally I would come up with new thoughts for him. With only some success I tried to apply this approach with him on some of his various leading funds. Ultimately these insights were of great use to me and eventually my investment clients on the likelihood of the continuation of various "hot hands" who were doing extraordinarily well exploiting various inefficiencies in the market. I recognized many of these aspects for I had travelled with a number of his analysts and portfolio managers.

Today when either an associate or I visits funds we zero in on bottoms up details from portfolio managers and spend as little time as possible following top down chatter. The same approach leads to more fruitful conversations with CEOs of public and private companies. Apply the same approach to how you live your life. The details of what you have to do today is much more important than the top down topics called upon in today's media.

Bottoms Up Factoids

The job of an analyst is to review an enormous amount of bottom up type of details that when combined with previous knowledge or beliefs lead to areas of future analysis (or for the moment to be added to the discard pile). The following are from my readings of this week.

1. Emerging Markets Local Currency Debt funds was far and away the best performing fund classification for the month to Thursday, +4.36% to bring its year to date loss to ­-9.70%. This class of funds that earlier in the year was being heavily pushed as an extra income provider was quite volatile and produced equity type performance as distinct from acting like a high yield bond fund.

2. According to The Economist most equity markets were strong, 37 out of 43 showed gains with half equaling or performing better than our Dow Jones Industrial Average. However, only 15 were positive for the year. This suggests that with selectivity one can beat US results. In our Timespan L Portfolios^® there can be roles for international funds and stocks in both the Endowment and Legacy Portfolios.

3. For those who believe in sector rotation, using FactSet data, three out of ten S&P 500 sectors, Health Care, Industrials, and Consumer Staples are nine years from their prior peaks. If one combines a contrarian streak and some bottoms up knowledge of removing capacity from production, there could be surprisingly selective good performance within the next year. As this is more of a cyclical play as far as the Timespan L Portfolios is concerned, the most logical space for these kinds of investments would be in the Replenishment Portfolio.

4.  An article by Matt Ridley in The Wall Street Journal proclaimed, "Most technological break-throughs come from technologists tinkering, not from researchers chasing hypotheses." I believe a well managed research program that can recognize commercial opportunities is worthwhile in companies that have large enough operating earnings to afford long-term research and development. However, I am much more interested in companies that have a  history of sound development. The Endowment Portfolio should have some representation of well managed research and development companies. The Legacy portfolio could hold the "wild card" type of investment.

In reply to Questions of the Week

I read and think about your questions and replies. This week is in part an answer to DB and his thoughts on GDP. He will get a more complete reply directly.

_________   

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.