Europeans Win, Experts Lose, Trading Opportunity vs.1848

Introduction

The essential difference between market followers and sound analysts is the former follow short-term momentum and the latter long-term directional changes. I embrace the second responsibility. Brexit, in my opinion, is the beginning milestone on the march to an era of more freedom of consumption and investment which will lead to better lives for many Europeans. Note I am focusing on people not present political countries.

The Perils of Over-Confidence

The focus on the needs and desires of most people is exactly what the expert class was not doing. They did not see or hear what the working class and much of the middle class were saying. The colossal surprise of the upset is only a surprise in that the expert classes of economists, political scientists, politicians, portfolio managers, senior investment people and media pundits had never considered that they were wrong. They had no plan “B.” In the US Marine Corps young officers are instructed you will only be judged on what you execute which will largely be plans “B,C,D, E, or F.”

This tendency of overconfidence will be part of a panel discussion this week at the New York Society of Securities Analysts celebrating the work of Benjamin Graham, the father of value investing. At the meeting I will be focusing on mistakes investors make keying off some of the mistakes that Berkshire Hathaway has made over the years. I have been asked about the single biggest cause of professional investment mistakes. I will discuss the overconfidence which has led to sizable losses. A similar pattern was in evidence in the London approach to Brexit. 

What Actually Happened: A tale of Three Countries

In Great Britain the London-centric experts thought the campaign would be won focusing on the fear of economic disruption. They were not listening to the people of the North of England and Wales who were primarily concerned with the loss of national sovereignty in terms of immigration and Brussels’ determined justice and procedures. These working classes and much of the middle class were fed up with what they perceived was likely to happen to them.  

One of the signs of this great division with those who wished to remain is the number of voting districts where the winning side polled more than 60%. We are used to seeing a split in many voting areas similar to the final 52/48%. The wider spread indicates to me that both sides were effectively only talking to their own and not engaging with the sizable undecided or opposed. The London-centric people initially bet over 90% of the money with the book makers that they would win only in the last few hours of the referendum, bet 90% on Brexit. (Too bad the Londoners didn’t know their history. More on that later.) Since the bulk of the more active institutional and trading money is intellectually based in London, over the preceding days they were heavily buying securities and sending similar thoughts to other markets. Interesting when the shock of the results became clear, the UK stock market declined one of the smaller falls in the world in part because only 35.5% of the indices’ revenues were domestic to the UK.

German investors suffered a 12% decline in part because 72.4% of their revenues are international in scope. One corollary measure is in the US, the Vanguard Europe ETF fell 11.3% as noted by my friend Jason Zweig.

In the US with approximately 70% of our revenues produced domestically, the main stock averages fell in the neighborhood of 3%.

This needs to be put into perspective. First, the decline essentially corrected the last several days’ rise based on our trading fraternity believing what they were hearing from London as well as significant short covering by hedge funds and similar traders. I believe the over 600 point fall in the Dow Jones Industrial Average was caused by the absence of short covering and algorithm-driven quant funds that sold as various price levels were violated. People at JP Morgan believe that from this source some $25 billion dollars were thrown on the market. If there is a continuation of the sharp decline they are looking for up to $300 billion more to be added to the market.

For those of a trading mentality I suggest at some point a near-term bottom will be reached, possibly on Monday. Current prices for many securities are back down to the bottom of their recent trading ranges which could well hold. If these trading bottoms do not hold further, declines will find other bottoms. Whenever the bottoms are found, subsequent rises could be dramatic because of the absence of positioning capital on trading desks.

While I recognize a potential trading opportunity, at the moment I do not see a substantial reason to change fundamental investment strategy. In terms of our four chamber TIMESPAN L PORTFOLIOS^® I might adjust the second chamber or the Replenishment Portfolio’s equity trading account to either take advantage of some cheaper merchandise or reducing risk if there are more violations of support levels. I would not change either the Endowment or Legacy Portfolios.

Londoners Had the Answer

The intelligentsia in London had the answer if they knew where to look. I do not know whether or not the restaurant that was in the downstairs floor of the residence of Karl Marx is still functioning. One evening my wife Ruth and I climbed the rickety stairs to his apartment which still had no electricity. At the request of the German Communist Party, Karl Marx authored the Communist Manifesto in early 1848. (A side note: because of his subversive activities in Europe he was never allowed to become an English citizen even though he was buried there.) He believed that it was in England that the revolution of the proletariat would begin because of its class structure.

1848

The main reason to focus on Karl Marx is the year 1848. This was the year of some 50 revolts by the working and middle classes throughout Europe and Latin America. These brought down a number of governments including in France. There was widespread dissatisfaction with the political leadership. Nationalism was on the rise in France, Germany, Netherlands, Denmark and Italy among other places. The violence of the revolts and the desperation of the people led to massive migration into “the new world” which in one generation proved to be a major brain drain. Lenin summed up what happened. “There are decades when nothing happens and there are weeks when decades happen.” (Courtesy of John Mauldin)

Perhaps the bureaucrats in Brussels and the current political leaders on the Continent are now seeing the risk to their structure. As is natural their first instinct is to punish the interloper, the second is to become defensive and the third hopefully to negotiate and evolve. Possibly Dr. Brendan Brown of Mitsubishi UFJ Securities is correct when he says. “The referendum result marks the start of A European journey out of a failed EU.  Britain is in the lead…There are serious grounds for hope (for) greater economic and political freedoms, prosperity and European harmony.” Greater Europe has for centuries developed official and more informal trade patterns that has produced satisfactory results both in peace and war and I would expect that to continue. In that light I believe that Europeans need the British as much if not more than the British need various European elected and non-elected states.

What to Do?

Many of the better US managed international funds have significant portions of their portfolios invested in Europe. I suspect over time these will be good investments and could find places within sound Endowment and Legacy Portfolios. For those whose preference is individual financial services securities, on a long-term basis they may wish to examine INVESCO, Franklin Resources, and Goldman Sachs all three are long term positions in our private financial services funds and have been under pressure recently. There are similar long-term attractive non-US domiciled financial service companies that I will be happy to discuss with our readers.

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What Have We Learned...if Anything?

Personal Perspective

I see the world somewhat differently than most. Perhaps I was always destined to be a securities analyst. Or learning basic analysis at the race track where betting on favorites for every race was a losing proposition. Or being trained the elements of leadership from the US Marine Corps. Regardless of the source of my learning, I tend to examine popular beliefs with a somewhat jaundiced eye. In reading my posts readers would be wise to remember how my thought process works. 

Introduction

Too much has been written about the causes of the late August declines in global stock and bond markets. The focus has been  almost exclusively on the various financial instruments and economic data. Almost nothing has been written or spoken about the key determinator of market prices. Did a significant number of people all of a sudden get a new insight as to how they should manage institutional or individual portfolios?  In general, the answer is ‘no’ and more importantly, they did not take away any lessons that they should use in terms of structuring their portfolios to be winners over time.

The Current Picture

Going from the most negative to the most positive, comments that I have seen are as follows:

1.      JPMorgan's leading mathematically driven analyst believes "half selling is done." Since much of the selling started with various derivatives it is worth noting that in August the CME reported a 60%+ increase in the volume of index trades. Further while the S&P500 market weighted index declined -6.03%, a version  whose components are equally weighted declined -5.39%. This suggests that large sales of market weighted ETFs (Exchange Traded Funds) contributed to the decline. (This in turn leads me to believe that the August market turmoil was a trading event rather than a fundamentally-driven move.) Put volume exceeded call volume which is also a bullish sign.

2.      A market analyst from Morgan Stanley has commented that the size of earnings estimate revisions have been declining for almost fifty years.

3.      At this time of year Byron Wien regularly reports in his series of exclusive lunch meetings for visitors to the Hamptons. His conclusion is that no one is expecting a recession. (Caution: one of his more perceptive guests commented that the consensus is usually wrong.) 

4.      It is worth noting that according to The Economist there are three local markets that have risen in US dollar terms more than ten percent this year: Hungary +18.8%, Denmark +14.7%, and Argentina +14.5%. I don't remember seeing any of these stocks in emerging market stock portfolios which shows that there are still opportunities for hard working analysts. 


Looking Forward

The second largest California State Pension Plan is electing to reduce its stock investments to 43% from 55%. It is somewhat following its larger neighbor which is pulling out of investing in hedge funds. I view both of these as good news. 

We all search for good indicators to follow. After many years of watching the record of the best positive indicators I have concluded that they are correct only 2/3rd of the time. The inverse of some negative indictors has a greater accuracy level. Thus I view the actions of the two California pension plans as positive.

A somewhat more positive view is expressed by actuaries which are recommending to their clients a 6.4% actuarial rate for pension plans. First, one needs to remember how conservative they are. Second the rate is for the entire pension plan. Assuming a "normal 60/40" split between stocks and bonds and a 4% total return on the bond portfolio would suggest an 8% return for the stock portfolio and a so called risk premium of 4%. The risk premium would drop if bonds were assumed to earn 5% and the actuarial rate remained constant.

One of the guests at Byron's lunches was a CEO of a tech company who addressed the concern that the tech world will run out of big new products or services within thirty years. With what he saw on the horizon if anything he thought technology would be accelerating its progress. 

Perhaps the most bullish and soundest piece of analysis was done by the good people at Charles Schwab. They looked at annual returns of the S&P500 from 1926 to last year to determine the performance extremes for one, five, ten, and twenty year periods.  

Time Period	Extreme High	Extreme Low
One year	+54 %	-43.3 %
Five years	+28.6 %	-12.5 %
Ten years	+20.1 %	- 1.4 %
Twenty years	+14.8 %	+ 3.1 %

These periods can be utilized in our Timespan L Portfolio^TM construct.

The longer the time period the smaller the extreme loss, with no loss for the twenty year period. These periods would be appropriate for operational, replenishment, endowment, legacy and custom portfolios. In custom making these portfolios one has at least five different attributes for his or her portfolios which include aggressive, conservative, middle of the road, rigid, and idiosyncratic. These attitudes can be exercised by the selection and combination of stocks, bonds, mutual funds, ETFs, and separate accounts.

What should have we learned?

There is a significant difference between our intellectual financial risk tolerance and our emotional risk tolerance. If we are using an operating portfolio and possibly a replenishment portfolio, we should have been reducing our risk in the first and starting to nibble at the second. As a practical matter (as one of our readers indicated) that procrastination was the mode of the day. This means that for most managers of their own or other people's wealth they have not thus far reached their emotional risk tolerance action point.

There is a good reason for this inaction. They do not believe all the focus on interest rate setting by the Fed and or the latest pronouncements of GDP. Without knowing it they may be practicing Goodhart's Law, introduced to me by David Kotok of Cumberland Advisors. The law states "When a measure becomes a target it ceases to be a good measure." In these two cases (over-utilizing GDP and interest rate data) the poor forecasting ability of the Federal Reserve Board and many of its banks makes one wonder why anyone thinks they could get monetary policy right. The calculation of GDP is not only suspect in China but also in the US as reported recently by John Mauldin. I suspect that many of us are giving additional credence to the fact that we are seeing more people being hired and more jobs that are going unfilled.

The current geopolitical picture is also an element of worry with a Chinese Naval fleet operating off shore in US waters near Alaska, the migration from the Mid-East, and the appeal to populism in many countries, including this week in the UK when the new Labor party leader is elected.

Bottom Line

For those who lack sufficient trading skills and are long-term oriented: stay the course.

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Losing Short-term Confidence? Selling Out is not the Answer

Every action we take is based on our confidence that the action will produce a result, hopefully the desired result. Often we are not overwhelmed with confidence, but believe that we must do something, remembering that doing nothing is in itself an action.

In last week’s blog about my stock selection training vs. using passive ETFs, I indicated that it was rare that macro considerations impacted my investment selection decisions. Macro elements are what is happening to the world as a whole, whereas micro elements are what is happening to a single or a small group of potential investments. One of the reasons to focus on micro elements is that they have proven to be easier to identify. After any review of what various political, economic and investment gurus prognosticate, one has the feeling that there is a high error rate. Often the more clever pundits get some things right, but not enough to be truly helpful for those of us who have to make investment decisions for others.

While I think throughout the previous week what I am going to say in Monday Morning’s blog, I pay particular attention over the weekend. Often I search for confirmations or challenges of my beliefs online, frequently focusing on what is probably the largest data bank of computerized investment company data in the world as put together by my old firm, Lipper, Inc. This weekend I am coming up empty for relevant micro insights, as the range of potential outcomes on the macro side is too great and my confidence in the short run of the market is waning.  (I do not have to be right, I just need to not be really wrong.)

The Macro Factors that can go either way:

The debate as to the final constellation of the euro

My frustration is that I cannot add anything to the debate. Worse, I do not see any progress to a permanent solution to the deficit production of governments and central banks supported by the general populations who in aggregate want more in government services than they are willing to pay. Having no responsibility to solve the currency problem, I can perhaps too easily come up with a grand solution.  At the currency level, Finland, Denmark, Holland, and possibly Austria should lead Germany to a hard euro with responsible governments. France and Italy should lead the peripheral countries into a softer euro with one or more devaluations and probably some form of centrist government eventually. I hope the solution evolves quickly; then all of Europe as well as Russia and China can turn to a much more serious problem in their midst which is the growing population of Islamists that fundamentally hold different cultural norms, particularly in the rule of law.

China: can the government continue to get it right?

For at least the last decade, which is the Chinese Party’s time frame, no government has done a better job of controlling its economy in both a huge expansion and a slowing contraction. Power has devolved from the central control of a headquarters-based party to lower levels of government, including getting down to the village and city levels. Actually it is at the lowest level where the biggest monetary contribution is made to the general population’s benefit. From the study of large organizations be they political, military, corporate, religious, or sporting activities, we recognize how difficult it is for good orders from the top, (and they are not always good orders), to be carried out effectively at the lowest level. Recently China has experienced a significant problem on the political level and another at the industrial (railway) level. I am sure that there have been other malfunctions. At the speed that the society must find reasonably well-paying jobs for the population, the Party may not have sufficient control factors in place. An uncorrected mistake could spark the feared social tensions that could derail the growth plans. I will not have high confidence in this arena until I see what the new political leaders will do.

The US election may not be decisive

I do not know many potential voters that are happy with their particular favorite for President or for Senator, when one is running in their state. They vociferously favor their choice over the opposition, but are still not totally thrilled with their candidate. Perhaps this is a good thing, for many political leaders that came into office with a large wave of enthusiasm have disappointed. My real concerns are that unless things change dramatically, getting effective fiscal legislation through the Senate will be difficult. Along with the rest of the world there does not appear to be any groundswell in the US to drastically cut the costs of the things it enjoys and little delight in paying more taxes. Perhaps out of this morass some true statesmen or women will arise and lead the US onto a prudent growth path.

US exceptionalism comes with a price that it cannot deny

The exceptional results of the US are not solely, and may not be mainly, due to its population. The two ocean borders and the abundance of arable land and other natural resources should not be dismissed or discounted. At the moment the US has a large number of the leading universities of the world;  I speak with a bias as a trustee of Caltech. In many fields such as software and biotechnology (including the Human Genome Project) the US is the leading developer of technology. With the gifts that have been given to the United States, the country has a responsibility to others less fortunate. If it shirks these responsibilities as it is now doing, other nations will surpass and could even suppress it. My meetings with the brightest young Americans I know does give me confidence, but not when I see many existing political and corporate leaders.

Investment Implications

My short term confidence and those of others may recover very suddenly. Markets can move extremely rapidly from the present level. I would rather be a worried investor reasonably fully invested in equities than trying to time a re-entry move. Where possible I would have a significant investment in technology companies that have a practice of being leaders in disrupting the status quo. The world has progressed to such a point that all of my investments must address a global world to prosper. Sleep may be overrated as a priority in this pursuit.

Do you have confidence in your portfolio?  In which securities and why?

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