Independence Day + 3 Investor Lenses - Weekly Blog # 688

 

Mike Lipper’s Monday Morning Musings

Independence Day + 3 Investor Lenses

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

Lessons From the Patient Genius of The Founders

Before the founding of the United States there were a number of democracies of free men. All these largely city-states failed to become large powerful nations because they did not carefully protect the rights of their minorities, leading to the collapse of their military and cultural defenses. The Founders struggled with this historic fact, leading to a thirteen-year period between The Declaration of Independence and the enactment of The Constitution. The Founders knew their history and presumed the new nation would have similar problems in the future. That is exactly why they created a government which protected the rights of its minorities, albeit imperfectly, with laws applied by an independent judiciary. Furthermore, they assumed future wars for independence would be fought by citizens, not a large professional military/naval force.

Most Americans invest in providing for themselves, their heirs, and specific institutions for which they care. Conceptually, when thinking about their responsibilities to themselves and others, they use one or more lenses to make investment decisions. The lenses are a telescope for the long-term, a magnifier to enlarge the picture, and a microscope to look closely at the details. To some degree the Founders were familiar with all three instruments. I look at the current investment challenges through the same instruments. However, I have given myself an easily available advantage in segmenting my thinking into sub-portfolios. These are largely based on the duration of future expected deliverables. Most subscribers to these blogs have not exercised the same option, but think about their bundle of talents, financial assets, and responsibilities as a single unit. My comments will address those united conditions.

The Current Picture

As is often the case, the current picture contains positives, negatives, uncertainties, and unknowns. I will briefly list some I currently believe are important and urge readers to share their views of other critical issues facing them, either in private or through discussion within our blog community.

1. Stock market prices are at or near record levels in the US and are rising elsewhere, including in Canada and Europe, but not yet in the Southern Hemisphere. However, close to half the listed equities are not really participating in the enthusiasm pushing US stock indices higher.
2. Overall market transaction volume is low and a good bit of the volume is from a new class of speculators lacking experience or business knowledge. An important portion of these transactions are being executed with borrowed money (margin) or options. While I am not too concerned about the future losses to these speculators, I am concerned that some sound stocks, brokers, and banks could be damaged.
3. A large group of the public and politicians have been schooled, not educated, at institutions with singular courses in top-down macroeconomics. Far fewer have sufficient knowledge of bottom-up microeconomics, starting with the family or a small business. (Remember, small businesses which are largely privately owned, employ half the working population. We all rely on them to provide relatively inexpensive goods and services.)
4. Government bond prices are expected to continue to decline, along with many high-credit-quality corporate bonds. (Traditionally, weak bond prices do not foretell strong future stock prices.)
5. One of the consistent conditions of life and prices is their cyclicality. Almost all activities are transitory, with different and difficult to predict longevity. The current bout of reported inflation is beyond supply chain issues. I suspect most readers hope the current rise in the valuation of their real estate won’t reverse quickly and hope recently hired restaurant and entertainment workers will receive lower wages soon. Most supply chain shortages are due to a multi-year period of unattractive future expectations profiting from capital expenditures. This has led to insufficient capacity expansion and high prices for existing production. The JOC-ECRI Industrial Price Index captures some of this phenomenon, rising +1.71% this week and +94.32% year-to-date. (While the index level has been dropping, perhaps due to lumber, I don’t expect it to go negative until there is a recession.)
6. For those mostly growth investors that use the telescopic lens, the biggest long-term risk is the growing autocratic attitude of the US and China, assuming no major political change. Governments choosing which companies should prosper and which should be curtailed has not produced good results for investors or customers, except during war periods. Competition, with its acknowledged faults, does better. The recent rearming of the Federal Trade Commission to perform anti-trust regulation should frighten all customers and investors. They should look at the prices paid and quality received for many goods during the Clinton/Obama terms. (Excluding the price of oil, which is now rising due to the Biden administration curtailing supply.)
7. The Founders and their early descendants wisely initiated judicial actions in the Justice Department and argued them in court. Today, almost every administrative department, SEC, IRS, and FTC have department judges reporting to Presidential appointed commissioners. This blatant abuse of administrative power has resulted in the formation of a new non-partisan, non-profit, civil liberties group, the New Civil Liberties Alliance.
8. The naivete of the Administration is a gift to the legal profession and other countries, as indicated below. 
• There is no definition of “fair share”, other than perhaps a flat tax, like a sales tax. 
• The hiring of thousands of new IRS employees is unlikely to bring significant net new revenue to the government, as taxpayers regularly hire the best and brightest tax accountants and lawyers.
• In terms of the global minimum corporate tax, when has the US won any negotiation with foreign governments? I suspect it will lead to less exports from the US and more companies moving their “headquarters” to selected “tax havens”.
9. China, which has its own internal problems, appears to generally be meeting the challenges thrown at it by the US. In March, China accounted for 16% of world exports. The last time the US reached that level was in the 1970s.

Portfolio Approaches

1. Don’t expect your big winners to continue producing similar returns. For example, our private financial services fund materially outperformed the major diversified market indices for the first six months of the year. However, after the current round of dividend increases and buy backs in the US, the portfolio will probably underperform. Why not sell? Using the telescope approach, I believe the collected talents within the industry, including the fintech segment, will be critically needed to build the new environment for managing risks and opportunities in the distant future.
2. Buying “cheap” stocks can continue to make sense if one uses a microscope, not a magnifying glass. The pundits and administrators believe that every stock with a low price/earnings ratio, or a low absolute price is a “value” stock. I recognize, due to the flow of buyers and sellers, that every stock enjoys a burst of activity related to large owners meeting their own needs rather than a change in valuation. The elements that make a stock of interest to buy are:

a. Imbalance between buyers and sellers

b. Specific economic trends

c. Change in management 

d. Share of market changes

e. New products or services  

Rarely does a company have more than one of these characteristics and few have all. Thus, most stocks labeled as value don’t perform, their period of attraction is shorter than the more expensive growth stocks.

 3. Don’t confuse trading positions and investment holdings. A trading position should be sold or bought because of a very current price move, with a small initial investment. A larger position should be added when one feels comfortable with the company’s communications. From time to time prices decline for good investments. Most stocks move down at least 50% from their annual high during a year. Don’t try to bottom fish, the relatively small gain, if successful, will probably be small compared to the long-term gain if you’d bought at the average price for the latest 12 months.

4. Expect unfavorable news to be published. If you understand the implications, it could represent an opportunity.

What other suggestions should I share with subscribers and/or use?

        

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

https://mikelipper.blogspot.com/2021/06/what-did-fridays-market-political.html

https://mikelipper.blogspot.com/2021/06/mike-lippers-monday-morning-musings-50.html

https://mikelipper.blogspot.com/2021/06/to-benefit-long-term-investors-invert.html

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July 4th Lesson: Need to Hire Wise, not Just Smart People - Weekly Blog # 636

Mike Lipper’s Monday Morning Musings

July 4th Lesson: Need to Hire Wise, not Just Smart People

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

Bear in mind, many smart people are taught lots of valuable lessons in schools and search for answers that look like test questions in terms of simple (straight line) answers. Wise people are educated through their own experiences and the experiences of others. This is the main reason many smart people do not achieve lasting success in various activities, including investing.

Current Dilemma 
Almost the entire globe is being worn down by the Coronavirus plague. We will probably only exit the current economic and political conditions and enter the “New Normal” when either effective medical treatments or vaccines are in large supply. This is a smart, but not a wise view based on history. The fatality rate currently reported (including the estimate of undiagnosed Covid-19 cases) is undeniably tragic, but is low compared to historic experiences.  Conversely, public reaction has been unprecedented in size and scope.

What are the differences causing all this turmoil? 

1. The rampant fear of the unknown and the uncertainty of the depth and duration of the impact of the pandemic.
2. The stress of the “lockdowns” caused by the shrinking of the economy and changing political conditions.
3. The speed at which it has happened and its continued acceleration. 

In the desperate search for a “New Normal”, people do not remember a quote attributed to Lenin “There are decades where nothing happens; and there are weeks where decades happen.” The revolutions Lenin instigated may have impacted more than half the world at one point.

American Revolution
This blog is being written on the day after the US celebration of July 4th, Declaration of Independence. I believe this 18th century revolution, supported by a fraction of those living in the country at the time, is still impacting the world to an extent even bigger extent than Lenin’s efforts. To a large degree the American Revolution began the New Normal for most of the world. While it is still evolving, a new normal may be entering the globe, potentially impacting commerce and consequently the political sphere. Thus, it makes some sense to grasp how much time it took to complete the first phase of its new normal.

The Boston Massacre and Boston Tea Party were the first skirmishes in 1773. These were reactions to perceived unsuitable taxes and were followed by the first Continental Congress in 1774, leading to a somewhat unpopular war which ended with very appropriate march music by the surrendering British soldiers “The World Turned Upside Down”. The real revolution came to the political sphere in 1781 when the Articles of Confederation were passed, giving an unsatisfying structure to the 13 independent states. To address its deficiencies and to create a central government, the US Constitution was passed in 1788. Perhaps, more important in today’s environment is the  Bill of Rights, passed in 1791. The first major test of the American experiment came in 1797 when George Washington’s second term ended in the peaceful succession to Massachusetts lawyer, John Adams. (George III, and many elsewhere in Europe predicted Washington would be crowned King, or would be replaced by a “strongman”. Similar to what has happened recently in Russia, China, and parts of Africa.)

Thus, the functioning “New Normal” took 24 years before it was viewed as secure and essentially lasted until the Civil War broke out. Most current history written about the Civil War lists slavery as being the cause of the War. This was the same issue that occupied much of the wrangling by the members of Congress in producing both the Declaration of Independence and the US Constitution. In both cases the Members concluded that they could not agree on perfect documents and accepted a compromise. What really broke the impasse was economics in the form of import tariffs, something generally not credited and one of many failures to teach accurate history.

The main source of tax revenue for the US Government until the 20th Century, excluding the federal income tax during the Civil War, was money from tariffs. These were quite favorably supported in the North, as they gave price protection to Northern manufactured goods. Those in the South saw tariffs as hurting the export of their cash crop, cotton. The southerners were already being squeezed by the declining economics of slavery. As is often the case when economics is important, it is hidden under more acceptable social causes.

Translating to Our Search for a New Normal

1. I believe the various medical solutions for COVID-19 and its aftermath will take longer than expected to reach a reasonably affordable conclusion. 
2. The trend to work at home will evolve, but we will not see the same number of people working every day in large offices.
3. There will be continued growth in shopping over the internet.
4. Education will increasingly be delivered over the internet, with some necessary exceptions. Furthermore, schooling will be focused on current and particularly future employment needs.
5. The military will be focused on a combination of raids and electronic warfare.
6. Supply chains will be rationalized, both for security and economic advantages.
7. Travel will be streamlined and made medically safer.
8. Politics will revert to the former House Speaker Tip O’Neill’s view, that all politics is local.
9. We will live longer and more expensively.
10. My strongest view of all is that I will both be wrong and surprised.

What to Do?
What is taught in most business, finance, management, and economics classes, success is based on formulated planning. I have been both a reasonably successful private company entrepreneur and an investor in competitive fields. It is my belief that success is based on finding the right people and having them evolve in the right jobs.

In terms of picking successful funds to invest in over long periods of time, the skills and culture of management has been crucial to the result. One of the better ways to guess whether management will make the profitable decision is to look at how they handle the myriad of short-term details that surround any activity. Most companies have reasonably good management in particular portions of their business; however, going beyond the borders of that expertise adds to risk without the addition of new talent.

As fund investors we are believers in well-diversified portfolios of concentrated funds, when they can be found. When they cannot be found we invest in low cost broadly invested portfolios.

Where are We Now?
Short-term, until at least the election or longer if there are meaningful changes. One should recognize that in terms of stocks and stock funds the attention of the market has become more speculative, as shown below:

1. In the first half of 2020, mostly in the second quarter, there have been 64 IPOs on the NASDAQ raising $19.11 billion and 33 on the NYSE raising $15.44 billion.
2. While both the DJIA and S&P 500 are still below their former highs, the NASDAQ Composite has gained +13.76% year to date, including dividends.
3. Precious Metals funds for the first half are up +21.76%, Global Tech funds +19.74%, Tech funds +15.56%, and Large-Cap Growth funds +11.92%. There are 21 peer groups positive for the year.
4. As a contrarian indicator, this last week was the third week in a row that the AAII sample survey had a bearish reading over 40%.

Fixed Income Funds

1. Europeans expect mid-term inflation.
2. Mortgage applications are at their highest level since 2008.
3. The default rate for speculative issues is 12.5%. Credit defaults are expected to rise in a prolonged recession.
4. The Big Fear – a trifecta of Democratic victories. Based on history it is unlikely. If it happens, except in the case of the current administration, when has a politician delivered on campaign promises?

Conclusion
Long-term investors should maintain equity holdings and look to add selectively overseas. Shorten up durations on fixed income.

 

Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/06/mike-lippers-monday-morning-musings-new.html

https://mikelipper.blogspot.com/2020/06/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/06/data-driven-reactions-dangerous-weekly.html



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Copyright © 2008 - 2018

A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.

1776 Can Make Us Independent Again

Historical Introduction

Most Americans believe the single most significant act of 1776 was the signing of the Declaration of Independence. I suggest that when facing today’s economic problems we consider a still more important event that occurred  in 1776, the publication of Adam Smith’s The Wealth of Nations.  (Not to be confused with the very insightful contemporary author and television personality who uses Adam Smith as a pseudonym.)

The two events are very much related. Our Declaration of Independence was driven by the colonists’ abhorrence to the Navigation Acts and other laws of Great Britain that raised the costs of imports into America and restricted the transportation of our exports. Remember the famous Boston Tea Party was caused by the tax on imported tea.

These laws were an outgrowth of the mercantilist philosophy of European governments to promote their own exports and restrict imports into their lands. This governing philosophy reigned between about 1500 and 1800, and was based on the need to get trading partners to ship gold to those countries where they had an unfavorable balance of trade. The importance of gold was not primarily economic, but rather to pay for their constant wars. In the minds of the European leaders, particularly the British and French, this was a matter of survival.

What Adam Smith advocated was that nations should specialize in their production of items to be exported and import those items where they did not have a cost advantage. Over the succeeding generations his ideas were finally accepted.

Today and for some time American Presidents have announced policies that would make the US independent of foreign oil. In response to questions and comments from a number of regular blog readers, I will attempt, in a small way, to play an Adam Smith role.

My biases

I have never seen a totally unbiased report. Most of the authors are not fully conscious of their own biases, particularly those that were inculcated into them at their universities. As we are all captives of our experience, biases cannot be completely avoided. The best we should do is to identify either the biases or the sources of our biases. Mine starts with a college course in Middle-Eastern history, geology and geo-politics. I learned that in Saudi Arabia, the direct lifting cost of a barrel of oil was approximately four dollars and did not change much over the years. From time to time I have invested directly into domestic gas producers to make money or energy-focused mutual funds as an inflation defensive move. When I was lucky enough to become a trustee of Caltech I was exposed to numerous professors who were focusing advanced scientific approaches to find energy and use it more efficiently. These inputs allow me to think about a problem from different viewpoints, and therefore biases. 

Parsing the search for energy solutions

The three main fuel sources of energy are oil, gas, and coal. (For the purposes of this search I am ignoring nuclear, solar, wind, hydro, and geothermal with the belief they will play an expanding role, but won’t provide sufficient power in the short to intermediate future.) I believe that each of the age-old big three should be addressed individually.

Oil

This is where I put my hat on as a modern Adam Smith. The popular view of Americans from the White House to Main Street is that it is dangerous for us to rely on the importation of oil from those nations that  “don’t like us.”  The fear is that in time of military conflict those that supply us with oil will cut off flow, or at least hold it up for ransom. There are many counter arguments to this fear. First, our military has developed lots of means to defeat an enemy without the need for the quantities of petroleum products required in World War II and subsequent engagements. Second, we have built a strategic oil reserve which is intended for military emergencies. (Not to be used as a politically-inspired price mechanism.) Third, if needed, government agencies believe that there is more oil underlying US government-owned land than has been discovered in the rest of the world.

There is another set of economic arguments which update Smith, the canny Scotsman. If oil is a scarce resource and cannot be easily replaced, we should deplete other countries’ reserves and political power by buying all that they will sell to us. Further, a rise in the international price of oil, while somewhat painful to the US in the short-term, dramatically changes our competitive position in the world. The US is less dependent on foreign oil than Western Europe, Japan and China. If petroleum manufacturing costs for the rest of the globe goes up and we have competitive products at a lower price, the US share of market will go up which can aid our job growth. Based on what we have already seen, the threat of higher priced oil will trigger greater conservation efforts and the development of more efficient uses of energy.

Gas

There are reasons to believe that the US and certainly Canada can be net exporters of natural gas. Other countries are also developing their gas properties. From a strategic viewpoint, I might be reluctant to become too reliant on imported gas except from Canada. Over time I would expect the bulk of our heating requirements will be filled by natural gas. We are likely to see both the military and large trucking fleets switching to hybrid or fully dependent upon “nat. gas.” The environmentalists will need to prove that fracking is dangerous to the neighborhoods of gas extraction and then our technologists will probably find solutions.

Coal

Some politicians have proclaimed that there is no such thing as clean coal. Considering the US has a reported 250 year supply of coal, I hope they are wrong.

If the price of energy goes up, I believe that there will be enough room in the final price of coal for both steel-making and heating to cover the costs of technological fixes that are underway.

Conclusions

Just as 1776 brought forth thoughts and actions that changed the world, I think we are at the point of achieving meaningful economic energy independence in the near-term future as we modernize our thinking.

As is my wont turning to investments, I would suggest investments in stocks of companies that are devoting some of their efforts to new ways to make our search and use of energy more efficient. These areas could be mining and extracting efforts, transportation efficiencies, and battery producers among many other beneficiaries of the application of new and improved technologies. These could include some, but not all, of the major oil, gas and coal companies.

Are you ready to be independent in the new world?  Let me know.

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The Declaration of Independence and Your Investments

Introspection is not one of the listed activities for usual July 4th celebrations though perhaps it should be, at least this year, in terms of your investments. Let’s start with the Declaration itself. The assertion of independence, among other elements, was to sever dependence on Great Britain with its laws and its world dominating Navy and Army. In the future these United States would be governed by our own laws and natural, perhaps God given, principles. In a much less dramatic way, the recent reactions to the global financial problems are similar to the yearning for freedom which was sweeping the world in the 18th century.

Changes going forward

There is a good chance that going forward the investment world will be as different as were the changes in the political world as a result of the first successful revolution to create a new country. In a small way the enactments of the “Dodd-Frank Wall Street Reform and Consumer Protection Act,” “Obamacare,” and the European and the Chinese austerity programs plus the investor reactions to these moves will change the investment world going forward in a similar way as did the American Revolution.

Two important aspects of the Declaration

There are two aspects of the Declaration of Independence which do not get enough attention. The first is the framers belief in “natural law.” They recognized the limitations of appropriate government authority. They looked primarily to our citizens to follow the recognized natural law of seeking the pursuit of happiness among other rights. Putting this natural law into perspective today, we need to recognize how people operate within markets not only for securities but also for a full array of goods and services. There will always be more and less popular items. The congregation of popularity can be handled in most markets. When popularity becomes extreme, the market structure will force a higher or lower price. As prices gyrate so does the temptation to take advantage of driven transactors. There are other natural laws, e.g. nine women can’t have a baby in one month.

The second aspect the Declaration I would like to emphasize is the 56 signers. They were all risk takers, not just 11 merchants but also the 24 lawyers or judges. They paid for taking the risk of rebelling against the most powerful nation in the world. Five of the signers were captured, tortured and killed as traitors. Twelve had their homes ransacked and burned. A number died destitute or bankrupt.

The important things to remember from our founding are that from the beginning we were risk takers and we would look to new laws. As a group we are used to unimaginable changes. (I believe this attitude should be incorporated in our portfolio thinking.)

Entitlements

However, the saga of the Declaration shows we are only willing to move ahead so far until proverbially, we kick the can down the road. In today’s terms, the issue that our Founders could not settle was an entitlement. We properly recognize it as slavery. For many it was a moral issue and for others an economic entitlement. With the coming austerity programs, I believe we are on a collision course with entitlements. Just as the issue of slavery in the US was settled with much loss of life in the Civil War (unlike the UK, where the issue was settled bloodlessly), I fear there will be high social costs to a cutback in entitlements. Some of these costs will be borne by investors.

Portfolio implications

With all of this as background, what should we do to prepare our portfolios for the post revolutionary phase? I would suggest the following as a general outline that needs to be adjusted for each investment account:

1. A large liquid tactical reserve.
   
2. Equities of companies that can adapt to change.
   
3. Investments in countries of savers who also have rising productivity.
   
4. I would avoid those “go anywhere” funds, not that the concept is faulty. The practice unfortunately is that these portfolio managers go back to the securities they are accustomed to. Very few of them learn new things.
   

Please share with me how you are preparing for the post regulatory revolution.

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