Anticipation Pays; Deliveries May Not - Weekly Blog # 907

 

 

 

Mike Lipper’s Monday Morning Musings

 

Anticipation Pays; Deliveries May Not

 

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

 

 

Since last December the bulls have been calling for a drop in the Fed interest rate. Some anticipated an interim pay-off near the close on Thursday when the last print on the 10-year yield failed to maintain its announcement high, fulfilling the dictum of selling on the news. The number of Friday’s declines on both the NYSE and NASDAQ were above the number of rising prices.

 

With the much-expected rate cut I found it interesting that the sample surveys of the American Association of Individual Investors (AAII) were bearish for the last three weeks. The six-month projections stayed in the 40% range for all three weeks (42.4%, 49.5%, and 43.4% respectively). In the latest week, which probably did not benefit from Thursday’s rate cut, the bullish estimate of 41.7% was slightly below the bearish call.

 

The explanation for the three main market indices rising to record levels from their April lows this week was the familiar “FOMO”, fear of missing out. I suspect traders sharing that impulse were largely housed in retail-oriented wealth management arms of brokerage firms and non-trust departments of banks.

 

The battle for investment survival is being waged by armies marching under the “FOMO” banner, as well as others withholding their purchase orders upon reading the economic data. There are two ammunition arsenals safeguarding the non-buyers, the declining number of job-openings and the rise of non-US traded equities benefiting from the fall of the US dollar. In April there were 158,000 jobs added, which fell to 22,000 in August. Barron’s shows the investment performance of 14 local markets in Europe and Asia each week. This week Europe had 4 risers and Asia 8. Asian and Emerging Market funds were most prominent among the better performing mutual funds this week.

 

On a longer-term basis there are a number of worries about investing in US markets:

1. The US market is becoming more speculative, with year-over-year NYSE share volume rising 16.24% and NASDAQ 68.97%.
2.  The current administration appears to want to reduce the independence of the Federal Reserve.
3. The President and SEC are floating the idea of switching from quarterly reporting to semiannual. Both ideas will make foreign-traded issues more attractive than they are now.
4. The drive to include non-publicly traded securities in retail accounts, particularly retirement portfolios, is expected to increase the risk of losses.
5. The London edition of the Financial Times devoted a full page to the headline “A new era of McCarthyism?”, showing a picture of President Trump and the late Senator McCarthy. This reminds me of sibling rivalry between an older brother and a successful younger brother. With a number of listed London exchange stocks moving to the US there is risk to a portion of the London market.

  

With the US stock market indices but not the average shares at record levels and the economy open to question, please be careful.

 

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Mike Lipper's Blog: Appeals Court Rules (7vs4) Against Trump, but Life Goes On - Weekly Blog # 904

 

 

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Four Letter Words to Sounder Investing - Weekly Blog # 678

 

Mike Lipper’s Monday Morning Musings

Four Letter Words to Sounder Investing

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

When I was growing up I was admonished not to blurt out various four-letter emotionally driven words, which had the effect of me not using four-letter words at all.  I rarely focused on words such as love or nice. When I now think about communicating sound useful concepts to long-term investing, it strikes me that there are at least five four-letter words that shine a light on critical concepts. These are briefly discussed below in alphabetical order.

Debt

Debt is the temporary transfer of capital from lender to borrower in exchange for periodic interest payments. Both sides benefit from the exchange, the lender receives payment for delaying current spending and the borrower from using someone else’s capital. In a world where debt is growing faster than the growth of the economy, the question arises, is this a wise temporary transfer of capital?

From the borrowers’ viewpoint it should be about the amount of benefit received, be they individuals, businesses, or governments acting as an intermediary for taxpayers. Such as borrowing to invest in long term assets that will produce a stream of income larger than the interest and related costs. A mortgage on a business building is a good example.

Unfortunately, we are seeing more borrowing by both governments and individuals for consumption. One can look at much of the stimulus spending, which politicians hope will benefit them at the next election. Some may call these bribes, like the “bread and circuses” of ancient Rome, which at least built roads and bridges that produced a stream of increased traffic. 

When viewing any transaction one can often identify at least one winner, although this is not the case for high-grade debt today. The lender is receiving interest payments that will not fully compensate for the future decline in purchasing power, both in the national and international markets. (The JOC Industrial Price Index is up +108.81% and producer prices are up 12% year over year.) This may be why large commercial bank loans fell in the first quarter, even as deposits grew.

There is currently another problem with debt, the fastest debt growth is being financed outside of regulated banking institutions. The source being brokerage/investment banking firms and other financial companies. Margin loans to support securities transactions have grown 70% year over year. In well-managed brokerage firms, utilizing listed stocks and bonds as collateral is reasonably safe for the lender, who can recover from some of their clients going broke. However, there has recently been a surge of borrowing to leverage non-listed derivatives tied to relatively illiquid stocks listed globally. The question facing the market is, are we approaching a crisis like the Morgan Library Panic of 1907 where the banking community was forced through locked doors to contribute to endangered competitors? The problem would likely be socialized with government bailouts today, adding to the growing deficit by partially financing it with more debt. Bottom-line for most institutions and individuals, debt is not currently priced for the long-term inherent risks.

Risk

Sir Isaac Newton came up with a critical rule, “There is an opposite and equal reaction to every action”. Too bad he did not offer an investment rule for his own considerable fortune, suggesting every investment caries both rewards and risks throughout its existence. There is no such things as a riskless investment. The key to assessing the size of a risk is what a knowledgeable, disinterested, investor would pay for an asset producing an acceptable rate of return relative to all other investments. This may be the reason that on the more actively traded NASDAQ the number of stocks rising was 8.5% vs 5.8% falling, compared to 18.4% rising and 3.2% falling for the NYSE. 

Rate

Rates tie streams of numbers together, like miles per hour. Most of the time in the investment world the two streams relate to interest rates, earnings growth, sales, and book values compared to prices. The wise investor adjusts the first stream for the probability of it continuing the current movement. The price may also need to be adjusted for the likely size of the investment. (Remember, quoted prices are for small purchases, take-over prices are normally higher than pre-bid prices.) 

Rank

Rank is an orderly display of participants based on criteria such as length of period, size, volatility, etc. One should remember there is nothing that promises the sustainability of completed periods. The winner may have been slowing down or speeding up immediately before the end of a period. Also, first place gives no indication of any negative event impacting one of the participants, which may not reoccur. While repetitive high rankings are assuring, it is not a guarantee of future results. In picking funds or stocks, you need to adjust for the change in skill of each participant. Because conditions change, one should not place too much emphasis on repeated success. Remember, winning streaks almost always end.

Time

By far the single most important variable in choosing an investment is the period to be measured. Unless an investor believes they have superior trading skills, they should focus on one or more time periods. The longer the period, the more likely the return will be smaller. The number of full participants will also decline through acquisition or failure. 

The following set of observations may be relevant in applying attention to today’s details:

For the current calendar year through last Thursday, the best mutual fund macro peer group was US Diversified Equity Funds +12.02%, followed by Sector Equity Funds +11.96%, Commodity Funds +11.59%, World Equity Funds +6.82 %, and Alternative Equity Funds +1.84%.

Keep in mind that this data is for almost one-third of a year. The 12% return for US Diversified Equity Funds and the +9.53% return for All-Equity Funds is close to the long-term stock average of +9-10% per year, which excludes fund expenses. This raises the question of whether an investor should stick around for the rest of 2021. If you were to stay invested this year, a contrarian might invest in the average World Equity fund, which has generated roughly half the gain achieved by US focused funds. Of the 25 best performing mutual funds this week, 10 invested in the China Region. A leading broker noted that investors were buying European Equities, inflation-oriented investments, and “value” stocks. They were selling high yield and emerging market securities. (Note that the five largest tech stocks have a combined market value larger than all the emerging market stocks.) 

Most large gains by investors result from holding stocks and equity funds for a long time. An example of the effect of compounding is the US Diversified Equity Funds return of 12% doubling in 6 years. (Which assumes an annual return of 12%). If the compounding rate were 9% it would take 8 years and at 6% the doubling would take 12 years. 

We rarely live in an average year. Based on history, roughly two-thirds of the years rise and one-third decline. Because of the compounding effect investors have more money in their accounts than simply multiplying decades of average performance. Results can be very satisfactory. Hopefully we will recover from increased “rates, regulation, and redistribution” in the future.

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

https://mikelipper.blogspot.com/2021/04/the-other-side-weekly-blog-677.html

https://mikelipper.blogspot.com/2021/04/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/04/respecting-opposition-market-weekly-bog.html

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Adjust Investment Tools for Next Phase - Weekly Blog # 667

 

Mike Lipper’s Monday Morning Musings

Adjust Investment Tools for Next Phase

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

As Rules Change, or are Better Interpreted

For many years to the extent possible, I managed the Defined Contribution Plans for the NFL and the NFL Players Association. At the time of each Super Bowl, when asked which team I was rooting for, I replied “for those in the black and white uniforms”. I hoped the officials would see all the relevant plays and correctly interpret the changing rules of the game. As it turns out, that was good training for watching the constantly unfolding investment games between buyers and sellers, various regulators, shifting weather conditions, injuries, mistakes, and pure luck. None of the results were pre-ordained and would be argued about for many years into the future. I approach each market and market phase with the same weariness in preparing for the next market phase. Part of the preparation is examining the terms used to describe the game, and when appropriate improve definitions. This exercise may be particularly important this year, as it appears we are close to a crossroad.

Enthusiasm vs Crumbling Underlying Structure

Many global stock markets are rising in February, despite the historical odds that after a decline in January there is only a 22% chance that the remaining eleven months will produce a profit. The general media, revealing their political views, interpret the various executive orders and other political pronouncements as accomplishing their goals, and see an economic expansion beyond the release from the lockdowns. It could happen, but the odds of complete success are unlikely. 

The current small-cap +5.03% and emerging market +3.07% leadership in January is like other late stages of the past. Fixed income funds often lead equity funds in terms of direction. For the year through Thursday night, the average S&P 500 Index fund was up +3.16% vs -2.95% for the average General US Treasury mutual fund. Another worrisome note is the size of margin debt, which perhaps due to short squeeze actions has reached record levels.

A good investor should look beyond stock prices to see a different economic view, which I attempt to do. Large futures speculators are increasing their shorts in copper, Eurodollars, S&P 500 minis, emerging markets, and US Treasury bonds. In recent blogs I mentioned the Industrial Price Index rising compared to a year ago and this week it accelerated to a gain of +33.18%. The bond market recognizes these tensions and the yield curve has continued to steepen. Even the Congressional Budget Office sees that inflation will likely be over 2% by 2023. (My guess is that it will be a lot sooner, raising the cost of financing the politically generated deficit.)

Understanding the Tools of Security/Fund Selection

Headline writers and many marketeers prefer short words to describe complex tools, e.g., “growth” and “value”. These create good pictures or charts, with ever rising growth and ever declining value. Would it be so. As with the changing weather at a football game, conditions change, as do the useful definitions of terms. 

Speculators essentially bet on what others will pay for their shares, bonds, or loans in the future and a successful speculator primarily knows his/her markets. An investor is a partial owner of a company that at some point could be purchased by a knowledgeable buyer. It has been the motivation of buyers and sellers in marketplaces around the world since recorded time. Perhaps in response to the “great depression”, securities analysis became a separate academic subject, distinct from older economics courses. 

Benjamin Graham was a successful analyst/portfolio manager/investor. He was also a good writer as an adjunct professor at Columbia University and worked with Professor David Dodd in writing the first textbook on Security Analysis. Graham and Dodd were primarily interested in avoiding unnecessary investment losses in their writings and emphasized the use of financial statements, particularly balance sheets. In early editions of their six-edition book, they emphasized anticipated liquidating value, an issue appropriate during a depression.

While Ben Graham is often erroneously called the “Father of Security Analysis” and the first value investor, this is not where he and his partners in a closed-end fund made most of their money. The fund became a dominant shareholder in an insurance company which had no real equity left on its balance sheet. What it did have in this period of substantial unemployment was a customer base of relatively low wage employed government workers. They saved and ended up controlling Government Employees Insurance Company (GEICO), which Warren Buffett analyzed and eventually bought outright.

Years later I personally had the honor of taking the Security Analysis course under Dave Dodd, but I disagreed with him and believed that growth was an important factor in choosing investments. He  quickly shut me up by indicating how much money they had made on their investments. Years later, as a small entrepreneur, this led me to include growth and more importantly the evaluation of key people in making successful investments. (In evaluating three cases, one had to be closed, another was key to a bigger product, and the third was very successful). As a side matter, I was particularly pleased to receive the Benjamin Graham Award from the analyst’s society in New York for a private matter requiring some investigative skills a few years ago.

Today, when I review financial statements, particularly the footnotes, I have little confidence they will reveal the “true value” of the company. We live in a litigious world and accounting practices are designed to protect the accountant, the underwriter, or the company itself against lawsuits, rather than to ascertain value. However, there are some very good analysts that are pretty good at finding the range of values for a company. These analysts don’t publish their work, as they are employed by investment bankers, private equity funds, or serial acquirers. While they don’t publish, the price of their bids and deals are known, and this sets the market price for similar deals. If I can’t get enough data, I use the multiple paid for earnings before interest, taxes, depreciation, and amortization on successful bids. 

To understand value investing, one needs to understand where the current market is and what is best indicated by the price of deals. These in turn are influenced by the level of interest rates used to discount future growth and the cost of acquisition.

How to Measure Growth

Many believe that any number larger than the previous number is growth. For valuation purposes however, what is useable are growth comparisons. They should deduct inflation, exclude acquisitions, currency changes, and the impact of changes in regulation or competition. To me, each period may be different, so a long period growth rate can be misleading. 

I like to see the consistency of growth rates. There are times when highly variable growth rates leading to above average long-term trends are valuable and times where a more consistent return is more valuable, particularly for accounts that have finite payments requirements. (For mutual funds, we measure both total return and consistent returns.)

What about both Growth and Value?

In truth many companies go through periods of growth and value. IBM, before it changed its name and was under Tom Watson’s management, had so much debt that it was viewed as an underwater stock. Years later, it became the prime example of a growth stock and later still its growth slowed to the point where at times it was viewed as a value stock. Because of various recent changes I don’t know how to characterize it. What I do know, is that past financial history is not of much use to an outside investor. 

Since many companies go through numerous growth and value changes, I favor looking at many periods. However, it is more important to look at changes within the company, including the people hired at the senior and entry level, changes in product/service/prices, and the reaction to competition/regulation.

Conclusions

1. Look at how things are, don’t overpay for history.

2. Expect surprises!

3. Take partial positions initially.

4. Admit mistakes quickly and serially.

Your Thoughts?

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

https://mikelipper.blogspot.com/2021/01/is-gamestop-missing-event-weekly-blog.html

https://mikelipper.blogspot.com/2021/01/are-we-strolling-promenade-deck-of.html

https://mikelipper.blogspot.com/2021/01/contra-messages-weekly-blog-664.html

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“That Was the Week That Was” = Change - Weekly Blog # 638

Mike Lipper’s Monday Morning Musings

“That Was the Week That Was” = Change

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

Introduction
This week’s title is not for code breakers but refers to series television title that was the name of a comedy review from the early days of network television making fun of the strange things that happened during the week. In prior blogs I quoted Lenin regarding the slowness of most historical trends to develop, but that accelerate in just a few weeks. “Change” is a sudden disruption of past trends, which great investors anticipate. Good investors recognize changes early when underway, while average investors are trend followers and poor investors extrapolate trends far too long.

Week ended Thursday-July 16th 
The prior investment performance trends that had gone on for over a year were disrupted. (Based on experience, the most accurate performance data terminates on Thursdays, avoiding the rush to start weekends that begin on Friday afternoons for some. This is particularly true during the summer.) Past performance results were led globally by up to ten large tech-oriented companies, providing vital internet services to people who were “sheltering in place”. These companies were supported by up to forty important suppliers. The strong stock price performance of up to fifty companies gave the impression that our economies were in a “V” shaped recovery, if not the early stage of a bull market. If one looked at thousands of other companies, the lift off the pandemic bottom was more modest. The two tables below show a distinct change in performance leadership for US registered mutual funds in rising order of change for the week ended July 16th:

S&P 500 Index Funds    +2.02%

Large-Cap Value Funds  +4.89%  
Multi-Cap Value Funds  +5.42%  
Mid-Cap Value Funds    +6.58%  
Small-Cap Value Funds  +7.35%  

Large-Cap Growth Funds -0.70%
Multi-Cap Growth Funds -0.47%
Mid-Cap Growth Funds   +0.40%
Small-Cap Growth Funds +1.45%

This is the first week in memory that value funds not only beat growth funds, but meaningfully so. Also, I find it of interest that the size of the stock market capitalizations in fund portfolios impacted performance so markedly. The declining order of performance in the week may well be the cost of liquidity required by heavy traders.

The performance disruption of past trends also occurred in the performance of SEC registered, internationally invested mutual funds.

China Region Funds           -5.30%
Emerging Market Stock Funds  -2.20%
Latin American Funds         +0.30%
Japanese Funds               +1.44%
European Funds               +2.94%

Of the 25 best performing mutual funds this week, 16 were small caps and 13 were value focused funds. (Obviously, some good performers made both lists.) China Region Funds have been the leading geography to invest in for most of this year, while Europe has been going through a very long turnaround. As is typical of the future discounting attribute of stock prices, they are further along than economic reports. One should bear in mind that all numbers are based on translation into US dollars from local currencies. Thus, the presumed relative safety of US dollars could be impacting the above numbers. The S&P/Dow Jones Indices track 32 markets. In their latest report, 25 rose and seven declined, with one of the seven falling being US large growth.

Applying Change to Selections
While security holdings change very little in many fund portfolios, some constantly evolve. Those that make a limited number of changes believe that investors wish to own the kinds of securities they see in periodic reports. Others believe that their investors want the results of the following principles, which can lead to changes in both the weighting and names in their portfolio. Below is a list of tactical moves that one fund manager is applying as they react to the changes in perception of future developments.

Selling inputs (To generate cash for investment opportunities)

1. Selling into rising strength
2. Selling to normalize size of positions
3. Selling into poor M&A activity

Buying Inputs (Building future sources to meet needs)

1. Buying into declining prices
2. Starting new positions in the best companies in a troubled sector
3. Increasing market share of the stock that’s not already discounted
4. Buying into strong balance sheets, spending discipline, and free cash flow generations, even when current earnings disappoint
5. Expect rising oil and energy prices over next year or two, within a bear phase
6. Capacity cutbacks create opportunities that create trading opportunities

Any thoughts?


 
Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/07/currently-selling-more-important-than.html

https://mikelipper.blogspot.com/2020/07/july-4th-lesson-need-to-hire-wise-not.html

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



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Copyright © 2008 - 2018

A. Michael Lipper, CFA
All rights reserved
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Our Biggest Risk: Change - Weekly Blog # 492

Introduction

The proper function of active portfolio management is to be aware of possible forthcoming change and to anticipate its arrival.  It is this very function that we are least prepared to accomplish well and therefore the biggest single risk that we and our investors share. They at least have the benefit of being able to blame their professional managers, but since they selected the managers this is self-deception.

Why are we so unprepared to anticipate and take some advantage of future changes? In an over-simplification, the description is the differences between Art and Science. There is a great amount of art in what scientists do, and artists utilize science, often well. The difference in its simplest form is the scientist starts with existing formulas and focuses on what is there. Some artists focus on what is not apparent and perhaps what in their mind should be.

In the portfolio management world the scientists are guided by specific or at least implied facts that have repeated themselves enough so that they become rules, laws, or the current term - factors. All of these are a product of a mental prison. The prison can be labeled EXPERIENCE. If the timing of these “portfolio scientists” is propitious they may make relatively small gains.

The gigantic gains in terms of rewards or avoidance of pains comes from sensing what is not readily seen by most at the time. In the recent two weeks I became focused on long-dead geniuses. The first was the Nobel Prize for the efforts led by professors and laboratories of the Jet Propulsion Lab that Caltech manages in proving Albert Einstein’s 100 year old theory as to the impacts of gravitational waves in space. (This achievement only took over 1000 people and over $ 1 Billion NASA dollars and a strong contrarian view.) Nevertheless within a few weeks after the beginning of its operations, they were able to detect a number of collisions of black holes that release a huge amount of measurable energy.

Last night my wife Ruth and I enjoyed a magnificent musical performance conducted by the incomparable Xian Zhang and the New Jersey Symphony Orchestra playing Beethoven’s Emperor Concerto for Piano and Orchestra. Beethoven is another example of a genius well ahead of his times. What I didn’t  know was when Beethoven composed this piece in 1809 he anticipated the development of the modern piano different from the one of his day. It would take a half century before the present day piano arrived.

Today we are the beneficiaries of these geniuses’ work; one and two hundred years ago they saw what was not  seen by the rest of their professional colleagues. Perhaps for us in the portfolio management business the lesson is avoiding some of the penalties from using outdated instruments and thinking.

I have been concerned as to how to prepare for future changes and how they will impact future generations of beneficiaries of the art of portfolio management.

Future Political Changes

In last week’s blog I alluded to both the French and Russian Revolutions and that the early leaders of dramatic changes were replaced by more radical leaders who appeared to be able to more quickly accomplish structural changes that were promised. Today on every continent we have leaders who have sold themselves to the voters and other decision-makers as change agents that are being bogged down with the lack of sufficient political power to accomplish their promised goals. At some point, if the inability to make major structural changes continues, the present crop of change agents will be replaced either through the voting box or more violent means either from the Right or the Left. My fear is that due to technology and global economics we could enter a post-national world that may look like City/States with defense, military, and economic alliances. In such a world, the force of law on contracts may be quite different than what we are enjoying today. 

I don’t know whether the changes will be good or bad or more likely both. Neither do I know who will be the winners and losers. What it does suggest is that it may be prudent to be widely diversified not only in terms of geographies, but economies, and perhaps most importantly, the rule of law and taxation.

Financial Structure Possible Changes

Most of the readers of this blog and I are much more focused on equity investing than fixed income investing. The historic reason is that stocks are where we can profit the most. We tend to forget about the bond market. This is a mistake for three reasons:

1.  The bond market is bigger than the stock market around the world.

2.   Equities are leveraged directly or indirectly by the borrowings of governments, businesses, and individuals.

3.   The basic contractual laws were developed to establish “fair dealing” between lenders and borrowers which is also the basis for rules for equity owners.

Today, the size of unfounded  and contingent obligations question to the lenders that each and every future dollar or equivalent will be paid on a timely basis without significant increases in taxes and other transfers.

One of the tenets of being a contrarian investor is to get increasingly concerned about one sided markets. In many countries, (including the US) there has been more money going into bond funds than stock funds. These funds and many retirement funds are buying bonds pushing their prices up and yields down. Historically the differences in yields were an indicator of perceived risk. What are the financial markets saying when the yield on US Treasuries are 2.3% which is the same yield as the market is placing on emerging market stocks? Now the best thing that can happen to the owner of Treasury paper is to get paid the maturity value upon its liquidation, nothing higher. Over the next ten years the dividends on Emerging Market stocks can rise or fall. Clearly the Emerging Markets have trade, product, and currency risks that the Treasury paper does not. The equity market appears to be much more discriminating as shown in the yield table of equity indices below:

Below 2%	2-3%	3-4%	Above 4%
India	Japan	France	Australia
S. Korea	Mexico	Italy	Russia
China	Germany	Sweden
US	Brazil	United Kingdom
	Canada	Spain
	South Africa

Each list starts with the lowest yield, the most favored country in the yield range.

The stock markets appear to make significant distinctions that bond aggregates do not. There are some skilled bond investors working in the emerging market space. One that came to my attention this week has top three holdings in Kenya, Senegal, and Iraq. For lots of political, social, and religious reasons some investors might object to investing in these or other countries, their withdrawal as potential investors could reduce the number of buyers and make higher yields available to other investors.

As a contrarian I expect the flow of money into bond funds will be at best counterproductive,  if not producing meaningful losses. I am also concerned that the brokers and advisors who put investors into bond funds will lose face and clients for  their actions. Much of the flow into these funds comes from large broker dealers and large registered investment advisors. As much of the flows have gone into fund companies that also offer stock funds, hopefully the fund houses will be able to convert a significant portion of the residual bond investments into stock funds to preserve wealth and give the investors a chance to recover some of the expected losses. If this exchange happens now the scenario may work. There is a dreadful chance that the switch will happen concurrent with an eventual top of the equity market.

Equity Market Structural Risks

The European Union in January will put into effect rules that will have the effect of reducing payments for brokerage delivered research that may impact institutional trading around the world. From an investor standpoint this will likely remove the research support for many smaller companies which will lower their potential market value. This is occurring at the same time that in the US for various administrative rules and tax implications, the number of publicly traded stocks has been cut in half from the number of publicly traded stocks of years ago. It is much too early to tell whether the currently discussed tax bill and the desire of the Administration to reduce the burden of regulation will have a positive effect on stock prices. It would not be the first time that the unintended consequence of changes has the opposite impact to the government’s desires.

Investment Policy Considerations

As we may have entered a world where the historic factor type of rules based management may produce competitive results, it could be the time to drastically increase diversification. This is not just adding to the number of securities in the portfolio. It means having an increase in the number of themes used in the portfolios. It could well mean to begin a position in some of the currently worst performing segments such as agricultural commodities. It may mean to invest in local securities around the world. For us who manage portfolios of funds we may need to add new managers who think differently than some of our very successful present managers.

Bottom Line

We may have entered a period of structural changes that we need to recognize and begin to take actions to protect the assets of future generations.

Question to Dwell on: Can you evolve your thinking ahead of the headlines?    

__________

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Avoid Incomplete Data + Overconfidence

Introduction

Far too many investment mistakes can be blamed on incomplete data and overconfidence. In the real as distinct from the theoretical or academic world it is difficult to avoid these traps that have hurt us from time to time. The best that we can do is to be aware of the traps and to avoid putting too much confidence as to “what we know.”

Focusing on the Wrong Measurement Gaps

Perhaps Larry Summers was reading my blog post when we I was questioning the validity and perhaps the utility of building government and financial policies on Gross Domestic Product. My concern is that there is little or any attempt to include unreported income within GDP. The former President of Harvard, Secretary of Treasury, and frequent pundit stated that he wished to abolish large denomination currency bills, for instance the $ 100 dollar bill and similar sized notes in other currencies. His view is that these pieces of paper are mainly used by those involved within the higher echelons of the underworld. At least with that projection I believe he is largely accurate. But he is missing a far more important set of facts published by his own organization. The Harvard Kennedy School found that the US Tax Gap on unreported income was 14.5% of reported tax liabilities in 2006. Other countries have different degrees of shortfalls: UK 6.4%, South Africa 23%, Bangladesh 36%, Thailand 53% and Pakistan 70%. On a global basis someone at the UN felt that the global tax gap was $2.1 trillion.

As far as I know, no one has taken these tax gaps and other less than complete estimates to adjust various GDP figures. Any student of high end purchases should question the sources of the money spent and saved. I have felt that observing the inhabitants of leading countries might be a more valid factor than what one could derive from government statistics. Since ancient times as soon as many people became wealthy in their own eyes and after fulfilling the needs for conspicuous consumption they found acceptable ways to both invest and to hide some of their wealth. They have been doing this long before there were paper currencies. Abolish paper and there will be substitutes, physical and perhaps electronic.

My real concern is that the growing size of the hordes of large currency is probably the best clue as to the size and growth of unreported income. One expert believes that some small businesses and trades people could approximate 50% of their activities as transacting below the tax radar. As a student of both history and human behavior I do not expect radical changes in behavior. What I am concerned about is almost every top/down pontification by political and financial pundits starts with a verdantly express view as to what GDP will do in the immediate future, and therefore various proposed actions are appropriate. Yet the statistical base of their argument is inaccurate and possibly seriously flawed.

Thus until governments around the world massively increase the money they spend on gathering and analyzing their data, Professor Summers please do not now take away an important source of the growth of real world wealth just yet.

Overconfidence

Just as I believe that high confidence in GDP and many other government statistics is unwise, our uncritical confidence in future actions should be avoided. This is very tough to do. In our very busy lives we do not have time to cognate about future implications of present or past actions. One of the characteristics of the human race is the ability to convince others. Those that are better at this than others are our marketers. They often start with given themes for their targets to choose. The salespeople have learned to keep their pitches compact, or in their language “Keep It Simple, Stupid” or the KISS principle. That doesn’t always work out well. As a professional investor or perhaps a surviving professional skeptic, I need to always guard against the exhilaration of an enthusiastic pitch.

Washington’s Mistakes

We can always learn from properly portrayed history. Saturday night my wife Ruth and I attended the birthday celebration for General George Washington at his Mount Vernon home as we try to do each year. Saturday night’s principal speaker was Nathaniel Philbrick, who talked about his forthcoming book Valiant Ambition, on the implications of the interactions between General Washington and Major General Benedict Arnold, an eventual traitor to America who could have caused the US to be militarily defeated. The interesting part of the discussion was the author’s contention of Washington’s ability to learn from his many mistakes. He changed his strategy from one of highly confident and occasionally well-executed battles in my home state of New Jersey and less successful battles elsewhere, to an eventually successful war of attrition that was increasingly unpopular in England.

Our Own Historical Experiences

I am always trying to learn. As a long-term investor with a fiduciary responsibility I need to be on guard as to the power of our own historical experiences. We should look well beyond our own experience to those of others in different times and places. At some point in the past, based on their experience, too many home buyers, underwriters, and mortgage owners thought that house prices would only periodically stay flat or rise, never decline. (I have not read the book or seen the film “The Big Short, which I am told is excellent. I have been reluctant to see it for it does not place the original cause for the collapse at the feet of the US Congress.) Obviously, with 20/20 hindsight it is clear all the way along the chain there was overconfidence. Part of the KISS principle in selling this paper was the growing population and their supposed growing wealth. Often one heard “Demographics is Destiny.”

Some of the same argument has been put forth for investing in Emerging and Frontier markets particularly in securities of consumer discretionary companies. In many cases these pitches drove the valuations for these securities way above those of somewhat similar companies in the developed world before they recently corrected. This is not to say that they may now be more realistically priced. (Some of these stocks are found in some of the mutual funds that we own for clients and ourselves.) The vastly reduced level of confidence and increased level of investment research improves the long-term odds for those that are patient.

At the moment I am wondering whether there is a nexus of incomplete data and recently-experienced overconfidence. There is a well documented rush to own passive index funds either through mutual funds or through companion Exchange Traded Funds (ETFs). For those who own these securities there is a high level of confidence that history will repeat itself and these vehicles will perform relatively well. The incomplete data part of the picture deals with off board trades, the aggregate size of the intraday trading long and short, the financial condition of the market makers and authorized participants that can create and contract the size of an ETF. Further correlations within markets are widening with very few large cap stocks rising and pushing major indices higher whereas the majority of stocks within the S&P 500 declined in 2015. Other signs of changing demand include an increase in the level of the VIX. Further, over the last sixteen years bonds out- performed stocks, while some believe that for the next sixteen years stocks are expected to outperform bonds.

Change in the structures of demand for securities is likely to cause a change in the structure of the market that was not anticipated.

Question for the week if not the year: What changes in the structure of the market are you prepared for?

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