Mike Lipper’s Monday Morning Musings
Contrarian Bets and other Risks
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
A good bit of the reported sentiment suggests we are entering a significant market decline, followed shortly by a recession. To the extent that these opinions represent the popular view, my training at the New York racetracks suggests a contrarian view. The popular view is driven by a two day, eight-hundred-point decline in the DJIA, or an approximately 3% change compared to a frequent daily movement of about 1%.
There are two statistical measures that are also pointing down. These have often been wrong in terms of the direction of the US stock market for the ensuing six months, as indicated below:
- American Association of Individual Investors (AAII) surveys a sample of its membership each week to determine if they are bullish, neutral, or bearish on the US stock market. Extreme views are those values above 40% or under 20%. This latest week, Bullish sentiment was 21% and Bearish 39%. Three weeks ago, showing how volatile these views can be, the Bulls represented 35% and the Bears 28%.
- The buyers of Put and Call options are very focused on the near-term and when the Puts (bets on stock prices declining) reach historically extreme levels, they become contrarian indicators. Last week the ratio of puts to calls on the S&P 100 Index was 236 to 100. Similarly, the overall ratio of puts to calls was an above normal 73 to 100, normal is 60/100.
Longer-Term Risks
I previously noted that one of the most successful corporate pension funds moved out of equities years ago after they produced a 20% annual gain. They thought the result was unusual because it was between 2 and 3 times their actuarial assumption, suggesting they should withdraw from equities until the following year.
There are hardly any two-year periods with two back-to-back +20% gaining years. As of the end of the first nine months of 2019 there were 14 mutual fund investment objective averages producing +20% or more returns. Of these, the two biggest gainers in the last ten years on an annualized compound growth basis were Large Cap Growth +13.37% and Multi-Cap Growth +13.21%. I suspect that the average fund in those two categories was loaded with what we used to label FAANG stocks (These averages with the leading performers are clearly doing a lot better than +20%).
Perhaps even more instructive is that the leading investment objective average for the last ten years was Health/Biotech Funds, which rose +15.41% but gained only +6.2% in the first nine months of this year. (For those who are going to be judged by their performance over the next five years it may be prudent to reduce exposure to managers that have produced +20% gains this year, with the understanding that these reserves will be recommitted to equities near the end of the next recession.)
There are other risks beyond staying too long with oversized winners. The biggest one has two names, prediction risk and execution risk. Most future projections are linear in nature and tend to be top-down, starting with aggregate demand or top-line revenues. Sports gives us two examples where this doesn’t work.
While I used to manage the National Football League-NFL Players Association Defined Contribution Plan, I do not claim to be a football analyst. However, I suspect more touchdowns are earned by broken plays than those illustrated on chalk boards in training camps. One of the great heavyweight boxers used to say that plans evaporate the moment your opponent hits you in the face. Far too many analysts and investors take future guidance from a company as a somewhat guaranteed plan. To me, I try to focus on the execution risks of any plan. I try to get some understanding as to what could go wrong and most importantly who will fix it. What I learned in the US Marines was that officers issue the orders of a plan, but enlisted men (particularly the corporals and sergeants) accomplished the missions, regardless of what is on paper. That is why in looking at operating companies I like to have an idea of who the supervisors, directors, and department heads are. With funds, while the portfolio managers are important, the key decisions are in effect often made by the analysts, traders, marketers, salespeople, administrators and occasionally the chief investment officer. These are the people who will execute the reality and are critical in our decision-making process.
One final set of risks bearing down on the current investment process comes with the initials ESG (Environment, Social, and Governance). This is not the appropriate vehicle to discuss the validity of the arguments for and against these tenants. My concern is that beneficiaries will suffer because insufficient attention is paid to prediction and execution risks. Below is a list of past predictions in terms of climate change which have already proven to be wrong:
Year Prediction
- 1966 - Oil gone in ten years
- 1970 - Ice age by 2000
- 1976 - Scientific consensus of planet cooling, famines imminent
- 1977 - Department of Energy says oil will peak in the 1990s
- 1988 - Maldives islands will be underwater by 2018
- 1988 - World’s leading climate expert predicts lower Manhattan underwater by 2018
- 1989 - Rising sea levels will obliterate nations if nothing is done by 2000
- 2005 - Fifty million climate refugees by 2020
Source: Calafia Beach Pundit quoting Mark Perry’s blog
While most of us are occasionally wrong in our own predictions, we need to understand the basis for forming the prediction.
The Biggest Risk to Fixed Income Investors
Having just questioned the process of predicting, I call to your attention a presentation made by Theresa Gullo, Assistant Director for Budget Analysis of the Congressional Budget Office to the National Association of State Budget Officers on “The Long-Term Budget Outlook”. The bottom line is that the CBO estimates that there is a two-thirds chance that federal debt will be between 71% and 175% of GDP in 2039. The two biggest culprits are major health care programs and net interest. Of the major developed countries, the only two running a surplus are South Korea and Russia. It seems likely to me that that many governments will increase their efforts to overcome the drawdown from innovation by materially increasing the global rate of inflation. This raises the potential of insufficient funding to satisfy fixed income beneficiary needs.
Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/09/mixed-near-term-after-recession.html
https://mikelipper.blogspot.com/2019/09/capital-cycles-changing-weekly-blog-595.html
https://mikelipper.blogspot.com/2019/09/concentrate-or-diversify-2-questions.html
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A. Michael Lipper, CFA
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