Week in Conflict Leads to Buy List - Weekly blog # 764

Mike Lipper’s Monday Morning Musings

Week in Conflict Leads to Buy List

 

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

            

 

 

Trading Didn’t Tell Us Much 

Over-simplification: Buyers largely believe that inflation is the sole problem facing the market and the Federal Reserve will take care of it by managing short-term interest rates. As the stock market went up the first two days of the week, more shares transacted at rising prices. 

 

The next two days saw prices decline in reaction to a greater than expected fall in November retail sales. Department stores led with a more than -2.5% decline compared to an overall average decline of -0.6%, vs. an estimated decline of -0.2%. (Visits to the high-end The Mall at Short Hills in early and mid-December saw a lack of salespeople, incomplete stock, and vacant stores.) There is a second group of investors, some of which were trading and many more not. I call them Realists. 

 

Friday’s transactions were partially misleading in that over $4 trillion dollars’ worth of options came due. Options users often hedge individual securities, exchange-traded funds, and other derivatives. On Friday both the NYSE and NASDAQ traded over 5 million shares on the downside, vs. a total transaction count of 5.4 million shares on the NYSE and 5.5 million shares on the NASDAQ. (Remember, about 40% more shares were traded off the exchanges.)  1.7 million and 2.4 million shares were traded on the upside. (Thus, I am not sure how to interpret these actions, other than them giving us a clue on the size of the speculative market.)  

 

Although the believers will hopefully be right, it does not appear it will be soon. Economists have created an index of leading indicators which are still going down by about 1% per month. The believers, particularly those that are Washington oriented, focus on national numbers. They do this because it leads them to policies where they can harvest votes. The realists are more attuned to measures that track the wealth of the country and the world. This year the aggregate wealth on main street has been rising due to an inflated sample of real estate prices rising faster than public portfolio values have been declining. These people recognize their good fortune but worry about inflation and the decreasing purchase value of their currency. 

 

A leading retail-oriented broker indicated their clients have been buying mostly corporate/municipal bonds and commodities, while selling declining US government bonds. Thirty-year bonds have fallen 35%, the worst in over a century. (Never have they fallen 3 years in a row.) 

 

Commodities are finishing the year as the best asset class for a second consecutive year. Commodities are going up in price because of actual and perceived shortages, both at the industrial level and to a lesser extent at the food level. When demand drops for industrial goods in a dampening economy, some commodity prices will also drop. This is exactly what OPEC+ fears, a fall in demand.) 

 

Brokers also see a sharp increase in the purchase of tax-exempt bonds. Many of these bonds are backed by expected state and local income taxes. These revenues will likely drop when individual and corporate income drops and won’t be meaningfully offset by rising rates for political reasons.

 

Thus, in an attempt to preserve investor wealth and purchasing power, a major portion of their wealth may be exposed to rising interest rates and a decline in purchasing power. After which rates could fall if “The Fed” reduces them. It is exactly the reason I am suggesting long-term prudent investors begin investing a portion of their assets in something that was previously mostly attractive to seniors. 

 

Tactical Reserve Preparation 

This time it’s different in that capital is being temporarily retrieved from risk assets. (The length of time out of the market will be determined by changing investment and personal conditions.) Since none of us know what the future will bring, we should utilize some of our money to defend against the possibility of stagflation, which could last ten years or more. This has happened twice in the last century.  

 

The tactical reserve is best structured by buckets. One bucket being long-term oriented and another short-term. The latter would be kept in locally deposited savings accounts, money market funds, and 2 year or shorter US Treasury paper.  

 

The larger portion, or perhaps the total of the tactical reserves should be invested in Equity Income stocks, an old asset class that is slowly becoming available. For many years these investments were difficult to find due to low interest rate yields. 

 

Currently, 2-year US Treasuries are yielding 4%. In this weekend’s WSJ I was pleased to find 48 stocks out of list of the 1000 largest equities yielding above that number. My filter was common stocks yielding between 4.0 and 5.99% whose price/earnings ratio was below 15x. Every investment has risks and those with yields of 6% or more are believed by the market to have some capital risk. Also, stocks with a P/E above 15 may not have earnings approximately equal to twice the current dividend. Most of these companies regularly raise the dividend at least as much as inflation. Another helpful characteristic is a significant number of shares being held by a family or other interested parties, like some pensions, endowments, and income oriented mutual funds. 

 

While there is some portfolio diversification in the list of 48, it is not as diversified as the broad-based market indices. The largest common denominator on the list is financial companies, with a heavy collection of domestic and foreign banks, particularly Canadian. The list includes Citigroup. Real estate and utilities are also prominent. I was pleasantly surprised to see 3 fund management company stocks I own in order to participate in a growing financial services business. Furthermore, there were names of major holdings in the investment companies I own. I also found some names of stocks I should investigate for inclusion in my tactical reserve or other portfolios. 

At this point the task shifts from security selection to portfolio construction and ongoing management. As we are building a tactical reserve, we need to avoid unnecessary exposure to losses. The first rule is to reduce risks by diversification. The best way to start is to have a beginning portfolio of at least five holdings, which hopefully will grow to ten distinct holdings in time. Pick your holdings from each of the sectors - Domestic banks, foreign banks), non-bank financials, life insurance, property owners, energy providers and servicers, industrial producers of needed products, and utilities. (Some pay dividends in dollars while making their money in different currencies, including commodity aided currencies like the Canadian dollar.) Be careful to limit the maximum single holding to twenty percent of this account.  

 

When operating the account, small cash distributions should be transferred to the cash account. If the prices of the holdings drop ten percent more than the market, stop buying. If prices fall twenty percent or more, consider selling half or all the holding. 

 

Remember, these operating procedures are suggested for the tactical reserve account. A different set of rules and procedures would be more appropriate for accounts having different target dates for payments. The other important thing to remember is that the quicker an investor learns humility, the bigger the ultimate return.    

 

For long-term subscribers who will share their intended use of the list with me, I will make the list available to them.   

 

 

 

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

Mike Lipper’s Blog: What does your 4.0 Profile Tell You? – Weekly Blog # 763

Mike Lipper’s Blog: Week Divided: Believers vs Investors – Weekly Blog # 762

Mike Lipper’s Blog: This Was The Week That Wasn’t – Weekly Blog # 761

 

 

 

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Faulty Decision Processes at Change Points - Weekly Blog # 607

Mike Lipper’s Monday Morning Musings

Faulty Decision Processes at Change Points

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

On the surface stock owners are expecting seasonal presents----unless they have already received them. By Friday morning media headlines were mostly good and had set up a favorable 2020, unless one looks deeper. Frequently, I reference a chart in the Weekend Wall Street Journal that measures the change in the current prices of stocks, commodities, currencies and other investments. This week 65 of 72 prices rose, suggesting some form of inflation is mounting. The numbers hawk in me saw a possible problem, as we normally see positive category price changes in the 31-42 range. (The seven falling prices were: S&P 500 Real Estate, Natural Gas, Lean Hogs, Yen, S&P 500 Telecom, US Dollar, and corn). The out of normal price behavior made me think about the benchmarks that investors use to guide their decisions.

The most prevalent sales pitch in moving investors into or out of securities is a short comparison of two alternatives. If “A” is larger than “B”, “A” is a buy. This assumes the measure is relevant to the needs of the investor and most importantly, the relationship between A and B is reasonably constant and meaningful. Currently, the price of gold mining stocks is going up, yet the price of gold is flat. One could say that this is compensation for the plentiful risks in mining. Alternatively, some stock buyers expect gold to become more valuable due to the fall in the dollar. Regardless of the reason, the market for physical gold is not sharing the same enthusiasm. Perhaps the comparison is faulty, as one alternative represents a view of future attractiveness and the other a measure of current value. This dichotomy suggests that simple statistical comparisons need to be understood more fully.

As someone who’s developed a large number of open and closed-end fund indices, I question whether many benchmarks are relevant in making decisions as to the future value of investments. This week my old firm noticed that two mutual fund categories, equity income and utilities, were getting net inflows, while other equity categories were not. Some buyers, perhaps spurred on by their wealth managers or other investment advisers, were attracted to these two investment categories because of their comparatively high dividend yields and/or lower volatility. In our investment management practice we rarely use funds from either category. If some of our accounts need current income we use higher yielding funds, but not the highest. Furthermore, we prefer to use funds growing earnings and cash flows that pay higher dividends. A few growth and income funds have delivered both rising dividends and capital appreciation for years, which over time has given investors a better return than either Equity Income funds or Utility funds.

There were two recent articles in The Financial Times that I believed should have been tied together. The first, based on Morgan Stanley research, was titled “Investors Braced for Low-return Decade after years of Robust Growth”. The article compares the last ten years to the last thirty years and estimates that current investment performance is below both. Initially, I felt they’d failed to adjust for inflation and currency depreciation.

A few pages later there was a news article about the rapid movement in the location of magnetic north. It has been moving for 500 years, causing navigators on land, sea, and in space to adjust their navigational instruments. To me, the second article reflects the reality of change and should also be required before we apply benchmarks. The world of medicine adjusts for changes in height, weight, and other characteristics when it compares modern people to those in the past. Popular stock and bond market indices should also be adjusted and consider both the world we live in and what the future might hold. “Political scientists” that use pooling data to predict attitudes and voting preferences also need to adjust their slicing and dicing of the population and the way they collect data, which will be between expensive and very expensive.

A Barron’s panel of experts have concluded that the S&P 500 will rise 4.1% in 2020. The precision is breathtaking, but if you actually believe the number wouldn’t it be prudent to sell now and wait for a better re-entry point, likely to occur in most years? (This applies to tax-exempt and not tax-deferred investors).

Alternatively, a contrarian indicator is the number of puts vs. calls traded on the S&P 100. Last week the ratio was close to three times normal. While buy and hold investors in aggregate have a better record than traders, those in derivative markets and on NASDAQ are better short term. I believe we will remain in a sentiment driven trading market for a while longer, which could be emotionally trying for investors. However, those who are steadfast will likely accomplish most of their realistic long-term goals.

Please privately share what you think with me, as my crystal bowl is unusually cloudy.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/12/investors-are-worrying-about-wrong.html

https://mikelipper.blogspot.com/2019/11/contrarian-stock-and-bond-fund-choices.html

https://mikelipper.blogspot.com/2019/11/mike-lippers-monday-morning-musings-all.html



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University of Investing Through a TIMESPAN Lens

“Today, if there is a run out of US Treasuries because of the Volcker Rule and Dodd-Frank,

 there is not enough liquidity at current prices.”

Introduction

I feel that each day is the first day of attending a very learned university. In my case it is a University of Investing. I search each item that crosses my screens, my desk, or interactions with others for possible meaning for my clients or my family's investments. Every day there is so much to learn that without some attempt to organize the inputs one can get overwhelmed. Thus I am suggesting that the inputs be organized into class structures as if one progressed from basics to advance courses. After the confusions from the recent elections, including (as I compose this blog) the Italian referendum allow me to demonstrate how I place inputs into a somewhat organized structure.

Freshman Level

It is at this level one learns basic principles that one applies throughout life. One could do far worse than to have as your initial investment professor Jason Zweig, the erudite columnist for The Wall Street Journal. There is wisdom in his opening sentence to this week's column on the attractiveness of small-caps. He wrote, "When markets go way up, your enthusiasm should go down." This wise cautionary statement should be applied to all asset classes and individual investments. Applying this to various popular leaders also may be wise. Remember in both the sports arena and the political world the crowd’s purpose is to build up a person or an idea to an untenable height to then have the pleasure of watching them fall. Coming out this class one should believe in moderation. One needs to be prepared for some failures along the way, which does not signify that in the long-run our hero or heroic idea will not work out.

No freshman year should be complete without some field work. It is important to identify what other people think. More importantly it is critical to learn whether opinion leaders should be believed. Thus, the next course might be devoted to the various Pew surveys, in this case reported on by Kopin Tan of Barron's. When asked in terms of trust, the respondents indicated their level of trust was 33% in the military, 24% in medical scientists, 5% in media, 4% in business leaders and 3% in politicians. As a US Marine now in civilian clothes and a senior trustee at Caltech, I believe in the ranking order if not the numerical results. I wonder where the average academic would place? The investment lesson drawn from this survey is to focus on what people actually do and what they can do by themselves.

Sophomore Year

This is often the period of students knowing it all because they believe that they have decoded the world and know what is actually happening. They have learned that this has been a difficult performance year, particularly beyond the popular mechanical averages. What they may not appreciate is that there were many ways to produce above average returns. There were eight separate mutual fund investment indices that produced double digit returns as of Friday. The lead was Small Cap Value +22.82% which was followed by a number of other small, mid caps, and multi-caps both value and core. More interesting to me that in addition to these, both Large-Cap value and Equity Income made the double digit list. This suggests to me that while being in the favored asset class helps, individual security selection was also important. A somewhat similar conclusion can be derived from examining the ten best performing fixed income fund categories. In the year to date period when the average general US Treasury fund had a 0.61% return, there were ten taxable fixed income objectives that gained between 4.26% and 11.34%. The top five were:

Fixed Income Objective	Year-to-Date Performance
1.  High Yield funds	+11.34%
2.  Emerging Market Debt Hard currency	+  8.78%
3.  Loan Participation	+  7.96%
4.  Multi Sector	+  6.17%
5.  Emerging Market Debt Local Currency	+  6.08%

To show the trading mindset one can look at this week's flows into specific Exchange Traded Funds (ETFs). The second largest inflows were to First Trust Industrial/Producers Durable + $740 million and the largest redeemer First Trust Consumers Staples -$707 million. This suggests that main players in  ETFs are trading not investment organizations and as they grow and narrow their focus they can be a disruptive influence on some stocks some of the time.

Combining the first two sophomore class lessons, one of the best technical market analysts is close to calling the end of the thirty five year bull market in US Treasuries. As essentially an equity investor, I am worried of a repeat of what happened to emerging markets debt and equity when Russia defaulted on their own Treasuries. While this was a specific isolated problem, trading desks that owned them found that they were substantially below minimum capital requirements and sold whatever they could to get back into capital compliance. Today if there is a run out of US Treasuries because of the Volcker Rule and Dodd-Frank, there is not enough liquidity at current prices. Thus various banks, brokerage firms, and leveraged hedge funds will sell what they can to meet capital needs which means they could be massive sellers of equities. This condition may never come to be, but a rumor of it could cause almost the same level of damage. For the moment in one part of the fixed income market there is some lessening of risk. Moody's^* has reduced its estimates of high yield default risk.

^*Owned personally or by the financial services fund I manage.

Upper Classmen and Women

Once the students get closer to graduation from their protected environment they should be focusing on jobs both in general and specific for them. The pre-lawyers and pre-politicians in the class will be quickly disappointed to find in various constitutions that there is no requirements to create jobs or preserve them from economic realities. For some time students and their academic advisors believed that this was the function of the reigning government and if not this one, the next one. In a global world the reality is that government using its tax power on present and future generations does not have direct ammunition to create all the desired jobs. As my fellow Caltech Trustee and neighbor pointed out to me in a well reasoned reaction to last week's blog, (copies available for the asking), that the US has been shedding manufacturing jobs since the 1950s and Western Europe, Latin America, and Japan are following. It is his guess that China has or will soon enter this phase.

There is a growing need for employees in the service sectors. The problem that I see is that these openings are not being currently filled. The cover story is that the applicants don't have the requisite skills. My experience as an employer is that too many of the applicants don't have the right attitudes of providing honest service to customers, fellow employees, supervisors, and owners. Far too many don't know how to budget their time, money, and efforts. They don't show respect to others that is the foundation of a successful service operation. Today we all are competing with international competitors and we need to respect them as well. I suspect that today's students will need to adjust their working life plans. In southern Europe the current official working life is 33 years, in Northern Europe it is 38 years. I have been working for sixty years and expect we should prepare today's students to plan to work in service industries for forty-five to fifty years.

Senior and Graduate Studies

Often one of the parlor games after a sports or political team loses is a post mortem as to where to assign blame. I remember a lot of books and words generated as to how we "lost" China. The plain truth is we never really understood China and never did own it.  As investors we need to come to grips on why China is gaining more power. It actually starts for us in an elementary school practice no longer being followed. In school every month we had to contribute savings from our allowance to a local savings bank account. We were being taught savings. This is not done today. As a matter of fact, one of the critical differences between us and Asians is their aggregate savings is about on-third of their GDP. In the US and Europe it is closer to one-fifth. Play out the benefits of faster capital growth and a materially-oriented younger population.

This is one of the reasons that I believe that the results both for good and less so will pivot on the events in China and the rest of Asia. From an investment standpoint we need to hedge our own success with some attention to them.

On a longer term basis after we get over the focus on job creation and preservation, when are we going to see organizations that will gain political prominence because they represent consumers and possibly another group representing savers?

After Graduation

Through these four phases of investing education you can see the logic behind our approach to TIMESHARE L Portfolios^®. 

Sunday Night’s Headline

 “Euro falls sharply against the dollar after Italian Prime Minister Matteo Renzi suffers a heavy defeat in Sunday's referendum.” There is a need to study more in terms of implications for near-term investing in Europe.  This could well be similar to the immediate Brexit decline and snap-back.

__________

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