Did Friday Begin a New Up Cycle?

Introduction

Market and economic historians like to date the beginnings and ends of various phases. They usually pick the ultimate peaks and bottoms of a statistical array. When possible I find it more useful to pick a date or a range of dates when attitudes change. If the financial markets are performing their function they should be discounting the future path not purely reacting to late reports of the economy. The problem is to define how far out in the future the markets are discounting. Most of the time markets look to different futures based on their needs for duration and safety of their segments.

Friday could have been such a turnaround in market sentiment. The surprisingly strong markets could have been a function of realizing that in the long-term, Brexit could produce some positive results that the “experts” who were wrong in their referendum forecast were similarly wrong in their completely one sided forecasts as to the consequences of a vote to “leave” the EU.

On Friday, July 8^th , two price movements contrary to each other were reached. (This was not in celebration of two birthdays, The Wall Street Journal and my own.)  The S&P 500 came within one point of its all time high price reading a bullish sign. On Friday the yield on the ten year US Treasury hit an all time low. Normally a low high quality bond yield is a sign that investors will accept a very low yield for safety because they fear that the worst is forthcoming. These twin occurrences on the very same day suggest to me two things. First, that different segments of the market are discounting very different futures. Second, that past valuation approaches are no longer working. (In future posts I will raise  questions as to the relevance of unadjusted financial statements.)

Fund Performance Numbers Reveal

On Friday the Dow Jones Industrial Average gained +1.4% and the S&P 500 was up +1.53%. Since the indices are not burdened with either low returning cash or expenses including commissions they often perform better than managed funds. Despite having cash redemption reserves and tactical reserves plus expenses, average Large Capitalization Core Equity funds as well as Large Cap Growth funds equaled the S&P 500 daily performance with the average Large Cap Value funds performing 10 basis points better at 1.63%. My old firm, Lipper, Inc.,  did not provide to The Wall Street Journal an analysis as to the performance of the ETF universe broken down by investment objectives, but it is my impression that the bulk of the ETF assets are in passive Large Cap vehicles who probably did not equal the average performance of the active Large Caps. For those of us who manage portfolios of funds we were pleased to see Mid and Multi-Cap funds on average rise between +1.96% and +1.65%. The big winners of the General Diversified funds on Friday were the Small Caps on average up over 2% led by the Small Cap Value Equity funds +2.25%.

If these relatively better results can be maintained they will answer the rather dour forecasts for the fund industry by Barron’s and McKinsey and some others. Like the Brexit Leave experts they do not study the fund and asset businesses very well. They focus on net redemptions which is the net result of an aging fund ownership population needing more income and perhaps less volatility. These negative reports also highlight poor sales due to the higher profit sales of competing products who over the long-term on average haven’t produced good results.

As someone that invests both in mutual funds and fund management companies, I am delighted to find negative indicators. As I have said in the past, negative indicators tend to be more consistently wrong than positive ones. However, to be fair and balanced I need to remind my readers I could be guilty of confirmation bias which only sees things that favor my point of view.

Brexit Updates

Fitch is reporting that beneath the surface, pre-negotiations are already going on across the channel. Whitehall is already reaching out within the UK government circles and the commercial world to look for experienced analysts and negotiators. We suspect many of the old countries of the Commonwealth are already seeing an opportunity to increase their trade with the U.K. on more favorable terms with the elimination of various EU rules on British trades.

I believe too many people see the local reactions as anti-globalization. I suggest when you again look at the data, one can see a fundamental reaction to expensive governments who impose their social expenditures  on to the commercial world which pass on their costs to the consumers in higher prices. For instance, in the US we are currently seeing wage and benefits rising faster than sales which is causing profit margins to decline. I believe all over the world the costs of big government are depriving consumers money which could help them in addressing both their education and retirement needs which are growing faster than their economy.

Modern Lessons from Europe

As readers may know, I have drawn the parallel between Brexit and the 1848 disruptions. The one person that played the most successful role for the next forty years was Otto von Bismarck, the consolidator of Germany who successfully played on each political side from time to time and maneuvered the other nations brilliantly. He has many great quotes and lessons attached to him. The first is the basis of my continuing analysis of good and bad performance. “Only a fool learns from his own mistakes. The wise man learns from the mistakes of others.” Hopefully these blog posts aid in that effort. The second quote is very useful for most of the world which will go through contested elections from now through the end of 2017: “ People never lie so much as after a hunt, during a war or before an election.”

The third lesson is the failing attempt to unify Europe from the time of Julius Caesar to the present. We should be able to relate to this problem when we look at how many large mergers actually work. Takeovers initially have a better chance but only if in the end they enlist the taken over into the new structure and leadership.

Working Conclusions

Brexit will lead to vital changes in trade, politics, technology and most importantly of all, consumption. From an investment view point we should try to spot as many winners as possible because only some will be long-term winners. Thus an active portfolio management strategy has the best chances of reasonable rewards and relative safety.

Question of the Week:

What are the questions you would like to ask me? 

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How to Send Your Investment Dollars Overseas

More and more money is leaving home. The flight is caused by unhappiness at what is happening in this country, if not outright fear as to the long term value of our hard earned capital. What many Americans fail to realize is that there is hardly a truly popular government any place. To some this desire to obtain capital escape is a new urge, but the truth is that wealthy individuals and families have been exporting their investment capital for centuries. The earliest investors to send their money across borders were the wealthy from small, often but not always, wealthy countries. The two leading countries that were slow to export an important part of their wealth were the Americans and the Japanese. In our case there was some foreign investment in the late 19th and early 20th centuries, (I believe that my grandfather’s brokerage firm had not only foreign customers, but some US investors investing overseas through his facilities). From the time I was a trainee in the vault of a New York bank counting foreign stock certificates that backed the American Depository Receipts some 50 years ago, I was interested in investing in foreign securities. While I have owned individual foreign stocks in the UK, Canada, Australia, Netherlands, and France, I found a sounder way to invest. With total bias, the better way to invest is through internationally-oriented mutual funds.

GLOBAL FUNDS OR INTERNATIONAL FUNDS?

For those who are novice investors the best choices are global funds that mix at their discretion, US and foreign holdings. In truth, today most large capitalization funds almost anywhere in the world are global funds. In many cases at least half of the earnings growth driving their performance is generated by foreign-based affiliates or exports. But for those of us who believe that we have the right mix of investment managers, a dedicated international fund is the right tool. For those of us who are more demanding, a number of different international funds are needed.

FOUR APPROACHES TO OVERSEAS INVESTING

Recently I was present when a large domestic investor was hearing the seductive call to invest overseas. Sitting through three presentations of separate account international managers, I realized that the analysis leading to their decision should have been similar as to what I do in selecting international funds for portfolios of largely domestic funds.

PARTICIPATE IN THE MARKET

The first approach entails asking the question, “What does the international investment bring to the account?" The simplest desire, and the one that can not be assured, is better performance than the existing portfolio. To me the first step is how the new investment integrates with the existing investments. Some portfolios are essentially participators in the general economic conditions. Most of the satisfactory investments for this need are index huggers, or if you prefer, closet indexers. Some prefer actual index funds trading off potentially advantageous stock selection for lower fees. In truth, the portfolio manager of this product can be located anyplace where there is electricity for his/her index modeling computer.

TILTING THE ALLOCATION

A second approach is a country and/or sector allocator. In this case there is a willingness to move away from the central tendency of the index. As practiced by the activists, there may be a willingness to eliminate some countries or sectors. Others have an operating rule to underweight or overweight a country or a sector by 50%. For the most part these managers use publicly known trends. Their skills of mixing and matching can be practiced from any location where air travel can easily bring in foreign salesman or commentators.

PICKING STYLE

The third approach is to have a global point of view. Often this is described in terms of growth (of earnings) or value (a discount from intrinsic value). Various studies show that from time to time either growth or value produce better results. As the investment game is now global, it is my point of view that growth or value leadership (or for that matter most sector leadership) follows a similar path in the domestic market as it does in various international markets. Therefore, we try to match the style inclinations of the international portfolio managers with those that dominate the domestic portfolio. As international investing is inherently more expensive, I reserve the domestic portfolios for minor style changes if I do not have the ability to meaningfully shift cash flows. In this third approach one is counting on the allocation skills of the portfolio manager. If one wants to participate in the leading edge and willing to be part of the “bleeding edge,” then the activist should be located in the flow of information. While today we can do a lot from a central location like my intergalactic world headquarters in Summit, New Jersey, there is a belief particularly by clients and some consultants, that closer to the action listening posts are better. (Notice that most of these are in cities with good restaurants.) There is some risk that the listeners are primarily getting their inputs from these restaurants, golf clubs, and in certain places, the American Clubs. The listeners may not have their ear really to the local ground. For example, in none of the recent manager presentations or six month reports did I hear anything about wide scale loss of faith in the European Union. On August 27, in my previously mentioned global world headquarters, I read that only 42% of Europeans say they trust the European Union, and this is down 6% in the last six months. In addition, “fewer than half of Europe’s citizens see their country’s membership in the EU as a positive thing….” as reported in EurActiv. I do not find this poll as a positive indicator unless I want to put on my contrarian hat. If I do this hat trick my investors should be warned.

STOCK SELECTION

The fourth approach and the one that I generally favor is one where individual stock selection is the critical talent of the portfolio manager. To my mind they have to know as much about the companies they invest in as the leaders in the various local communities. These managers should regularly attend important weddings and funerals; speak and understand the local dialects as well as be able to prepare local foods. In other words, they should have gone, or are, local. Having a string of offices around the world would help if they are offering investments beyond a single market. These should be primarily research offices not sales offices. There is a risk to this marriage with the locals similar to the risk of working with industry analysts. While from time to time they may advocate a sale, rarely will they advocate complete retreat and closing the office. Thus in this fourth approach there is a purchase bias which must be recognized.

We use all four approaches depending upon the needs of the account. Notice in no case did we focus on performance. My approach is that performance is at best an introduction to a manager and may well be poorly timed after a period of good performance.

As this blog is an instrument of a global community, I am curious whether you will share your thoughts on international fund and manager selection.

I hope next week to devote this blog to a view as to the direction of the domestic market that appears to be wallowing in fear and unhappiness. Any thoughts would be most welcome.

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