The Confidence Game - Weekly Blog # 701

 

Mike Lipper’s Monday Morning Musings

The Confidence Game

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

The Rules of Life

Whether voluntary or not, by taking our next breadth we display confidence in knowing it is beneficial for us. Consciously investing relies on a series of confidences:

• That we can make a difference having a favorable impact.
• That we have the skills needed to achieve the desired goal. 

When we apply these hurdles to investing we are applying the following articles of faith. 

• That on balance the positive trends we see can be extrapolated into the future.
• That perceived negative threats will be moderated, or at the least don’t represent insurmountable hurdles.
• That we have enough skill or luck to execute. 

The range of executions vary from radical active changes to passive acceptance that we are in an acceptable condition for the moment. Regardless of our decisions, we are making choices that affect us and others.

Our level of confidence impacts where on the spectrum of actions we are likely to reside. I sense a number of people investing as fiduciaries or for themselves losing confidence, causing them to contemplate making contrary investment decisions. In addressing these signs of change I rely on history as a guide. This is a blog about investing for the long-term and is not an instrument of political criticism.

What’s Changed

The ways policy decisions are made and communicated has changed dramatically since the mid1930s. Both Hitler and FDR were expert on the use of Radio speeches or “fireside chats” to move their populations into accepting war as the only answer for their ultimate protection. Other political leaders did not fully grasp this change. (Wendell Willkie counted heavily on his positive relations with the major newspaper publishers and editorial boards. Unfortunately, his support was lacking in a couple of midwestern states, costing him delegate votes at the 1940 Republican convention. My ever-vigilant brother noted that I misspelled his name in the last blog.)

JFK’s telegenic personality vs.. the dour faced Richard Nixon cost him many young voters. LBJ, President Kennedy’s successor, had little choice in running his own election campaign due to constant negative television coverage of the Vietnam war.

Donald Trump had the benefit of a more intense polling, harkening back to the packed and enthusiastic crowds attending Revivalist meetings 100 years earlier. He generated these crowds in many states and communities where network television was not a believable presence. 

Throughout history, the one constant has been the increased speed of communication. Currently, most people get their political news through their computers. This was particularly true during the “lockdowns”. Two critical differences from the television network reporting of earlier years are:

1. The absence of the FCC’s mandated “fairness doctrine”, giving some acknowledgement to the opposition’s point of view, has filled the news hole with paying commercials.
2. Today, social media appeals to their perceived audience and rarely takes time to give a balanced view. The commercial art of visuals has also greatly improved. With a global platform of news and uncensored opinion the world is constantly being “informed”. 

Confidence in the US is Changing

As is often the case, the US bond market is directionally ahead of the US stock market. Many investors outside the US are very conscious of our economic/financial problems. As is customary for good investors, they hedge their bets. If they are high quality fixed income investors the standard way to hedge their currency risk is to buy US Treasuries. On a secular basis the foreign exchange value has been regularly declining vs other “strong” currencies, in part due to our expanding deficit. Markets adjust to perceived risks and in order to offset the currency risk the yield demanded for US paper in the global markets has been higher. However, in the last couple of years the perceived risks in other currencies seemed lower and their yields were consequently lower than those in the US.  

A couple weeks ago this attitude changed, with the yield on US paper rising and prices declining. This “shook-up” the equity markets which were selling at record levels. As almost all traded markets are priced off other markets, if Treasury yields rise the future return in other markets will also have to rise to remain competitive. Consequently, other fixed income rates will rise and if fixed income yields go up equity prices will go down. Market analysts are very conscious as to the inverse price trends of high-quality bonds vs high price/earnings ratios stocks e.g., FAANG and other tech stocks.

Causes of Declining Confidence 

 There is no mathematical formula for confidence. Psychologically, investors consider many different factors important to them. The reason for the long review of political communication is that government is one of the major contributors to individual and institutional investor confidence. In a simplistic model, governments have two broad buckets of policies and executions. Using this approach I will briefly list some of the critical elements in each bucket.

Policies addressing the following challenges:

Belief in US promises

Big Central Government

Borders

Business Relations

COVID

Inflation

Military Leadership

Political Leadership

Taxes

Executions

Afghanistan – For 20 years we have hired both US contractors and local people, including military and police forces, to keep our commitment relatively small. We made actual and implied promises of the eventual relocation of these people to the US and broke these promises with the way the US pulled out. (Many other countries may be questioning the steadfastness of the protection we are providing them. Are they at risk of high social spending in the US leading to financial constraints which might result in a hasty and poorly planned/executed retreat?)

Big Central Government - The main reason it took 12 years between The Declaration of Independence and the issuance of the US Constitution/Bill of Rights was the fear of tyranny by a strong central government. The result was a Constitution limiting the power of the central government, with most power left to the states. In two clever ways the Founding Fathers deemed that the Capital should be built in a swamp, having high humidity in the summer and cold during the winter. Furthermore, under President Washington the original cabinet had only four members: the secretaries of State, Treasury, War, and the Attorney General. Currently, there are 24 members plus 9 Principal officers. The current attempt to have a national law governing how elections are handled, considering individual states have that responsibility, is just what our founders were afraid might happen.

Borders protect and enhance all states. With most of the developed world facing shrinking populations, the US needs more workers and future students to continue our growth. However, they should be people who will contribute to our society, as most legal immigrants have in the past. We must control all our borders to make this happen.

The government’s role concerning businesses should be kept as small as possible. Businesses are not licensed or set up to serve the social needs of a community. They should choose to be good citizens, as it is good for their business and their people. Misapplying the anti-trust statues will reduce employment and send more jobs overseas. Practical companies, including professional practices, have already established foreign production capabilities to supply both US and international clients. I often see new CEOs of global companies coming from beyond our borders. They have the experience of running smaller versions of their US companies, whereas domestic candidates have not experienced managing a complete unit. We need these executives working with us rather than for international competitors.

The COVID pandemic was amazingly well handled in the production of vaccines. Compared to other countries, the deployment of the vaccines and related regulations and services was not as good. (It may or may not be important that the deployment was under a different administration than the initial production.) My real concern is whether most children, particularly those with special educational needs, will ever catch up with students educated beyond our borders. Longer-term, this will have an enormous impact on our long-term wealth production.

Increasing inflation has many causes, some caused by the present administration. I Increases in living costs are most painful for lower wage people, including the current rise in the cost of gas, with more expected for this winter’s heating. The increases are due to the US government restricting the growth of the petroleum production and pipelines. In addition, the cost of increased regulations is forcing businesses to add expensive people, which customers will eventually pay for through higher prices or lower wage increases and job numbers.

For some time, Military Leadership has been heavily influenced by relatively junior generals or admirals being promoted because of a perceived relationship with critical members of Congress or the White House. This may be why the President “didn’t hear” any objections to the way the pull out of Afghanistan was planned. The Chairman of the Joint Chief of Staffs, by calling his opposite number to assure him that our senior most military officer would alert the target’s command structure if President Trump ordered an attack on China, might also be a symptom of this problem. I will let others decide if this was close to being a Benedict Arnold act. What concerns me even more is that we are meant to have the military subservient to civilian control. We would like to see other countries follow the same practice so that the world not be governed by an international group of military officers.

The current day-to-day political leadership of the country is centered in two places, the senior, unelected, staff in The White House and the aged leadership in the two houses of Congress. We have never seen a less impactful political gang in control of the Presidency, the Senate, the House of Representatives, most lower court judges, most permanent government workers, and the media. The “circular firing squad” they have created suggests they are not ready to govern effectively. For those responsible for planning future investments, this chaos introduces more questions than answers.

The Founding Fathers knew, and many political leaders know that tax legislation is the power to destroy. The current administration’s tax motivation is to deploy tax revenue from the “rich” to pay those with lower wages. One might call these “bribes”, under the theory that these people will show their “gratitude” by voting for the source of their grants. As bad as this is for democracy, it may not be the real motivation. The real motivation might be income tax regulation to destroy or curtail a major source of contributions to the Republican Party. (During our history we have only had income taxes during wartime. Through close to half of our peace time existence, tariffs collected on imports were the main source of running our small national government.) As a matter of financial history, any large-scale deployment of money creates leakage from both sides of the transaction. Some of the leakage will result from inefficiencies created by not having appropriate procedures and some will be easy to plunder. More impactful will be the legal diversion to put elements of income and wealth beyond the scope of the regulations. (The lawyers and accountants will earn their high fees.)

Reactions

This is a continuing movie. While we may think we know the end, we don’t know the timing. Based on history we should now be in the midst of a meaningful correction, although in evaluating the indices it hasn’t really started yet. Only a small minority of stocks in small industries rose this week. 74% of the Wall Street Journal’s list of market changes declined.

One of my worries is that on the Monday the trading markets dropped, I assume a higher than usual portion of the transactions were not reported on the relevant exchanges. One possible indicator is the after-hours price drops. In a list of stocks I am following because my accounts own them or are considering them for future purchase, 31% had further declines of 2.3% to 4.9% below their last sale on their formal markets. I am worried there is not sufficient capital available for the trading desks to absorb a major decline.

Tactics & Strategy

 In terms of trading tactics. After almost every decline there is some sort of price recovery of market averages that takes many stocks near the levels they were selling at immediately before the decline. (Some issues won’t get that bounce.) Certainly, by the second day I would be a seller of any position that I would not choose to own for years into the future.

Strategically, as a long-term investor I would hold positions that should be held for competent heirs until new information questions the long-term, after recognizing the need to pay capital gains. I would also use down markets to look beyond one’s normal comfort zone to broaden the opportunity set.

What do you think?     

   

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

https://mikelipper.blogspot.com/2021/09/two-confessions-weekly-blog-700.html

https://mikelipper.blogspot.com/2021/09/observations-prior-to-excitement-weekly.html

https://mikelipper.blogspot.com/2021/09/3-thoughts-to-ponder-weekly-blog-698.html

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“New Normal” Unlikely to be a Repeat - Weekly Blog # 635

Mike Lipper’s Monday Morning Musings

“New Normal” Unlikely to be a Repeat

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

Analysts love history, believing the future will be a repeat of the past. Almost every force for change today is itself changing. There is so much changing that there is a great temptation to retreat to cash or a central value index. Quite probably, the least realistic and useful diagram for the future is a straight line. However, there are a series of mathematical manipulations that may be useful in identifying the multiple “New Normals” we will go through.

I believe it was in the second year of algebra that we were introduced to simultaneous equations. In these equations each formula has a different unknown, requiring each to be solved before completing the entire equation. There were other useful exercises that could also be helpful in our search for an investment strategy. The first, which was mislabeled as geometry rather than logic, was proving theorems. In that exercise we segregated math formulas between those that supported the theorem and those that did not. The correct solutions were based on the logic displayed, not the number of pros and cons. Perhaps the most useful math we learned was the math dealing with circles and semi-circles. I believe that learning to think in circular patterns is much more representative of the reality of human (market) behavior.

Where We Are is More Important Than How Far We’ve Traveled
Utilizing the two-sided balance sheet approach, I will divide the current inputs between those I perceive as positive for long term investing in equities and stock funds vs. those that increase the risks of losing money.

Positives
In analyzing data we look for indicators that on balance successfully predict the future. Positive indicators are normally correct more than half the time. However, what is even more valuable are the rare negative indicators. On a contrarian basis they are correct more than 75% of the time.

1. One of the best negative indicators is the sample survey of the American Association of Individual Investors (AAII). In the latest week, for the second week in a row, the survey is increasingly bearish, 48.9% and 47.8% respectively. A more normal three-part distribution has numbers in the thirties, as it was three weeks ago when it was 38.1%. Rarely do the weekly readings go over 40% and it is extremely rare for any choice to exceed 50% for the six-month outlook. 
2. Private clients at a large US brokerage firm bought equities for the first time in eleven weeks.
3. Individual investors are not constantly wrong, although they tend to make up their minds slowly and consequently tend to be wrong at turning points. (Data is no longer corrected on transactions below 100 shares, so we can no longer use the odd-lot theory.) If we look at total flows, we see net purchases of $11.3 billion for fixed income securities and funds, including $2.6 billion going into TIPS and $5 billion net outflows from Equity. These flows are forcing the prices of fixed income products up and their yields down. This reflects market action and is not a predictor of future interest rates.
4. We appear to be in two different markets at the same time. The daily stock price chart for the NASDAQ Composite is in an uptrend and has been establishing new highs. The other two main market index price charts look to be forming a temporary top, despite 24% of the S&P 500 being invested in FAANG stocks plus Microsoft. In 2013 the same stocks represented 9% of the index.
5. Rising freight volume carried in trucks is expanding, leading to capacity expansion.

Negatives

1. The Citigroup Panic/Euphoria Model is predicting a bearish period one year away.
2. Investors are pouring money into fixed income, even though there is a long-term expectation for higher interest rates driven by inflation. One example of this is a repeated issue of a 100-year bond from Austria, a country without a particularly bullish outlook. A pitch used to sell very long bonds is that it avoids having to make more frequent decisions, which can be wrong!!!
3. Some US investors are investing outside the US or the dollar. Of the 25 best performing mutual funds this week, 16 were precious metals funds (gold), 3 were emerging markets funds, 2 were China Region funds, 2 were India funds, and only 2 were invested in domestic small caps. Except for the precious metals group, the individual holdings in the other 9 funds appear more important that a sector bet.
4. The VIX indicator of worry is selling at twice last year’s rate.
5. Friday’s volume rose, which is not normal in the summer months, revealing interesting results that need to be further examined. The stock of T. Rowe Price lost 7.62% for the week, even though it published good results. On Friday, Janus Henderson had a market volume of 10.66 million shares, where the normal volume is 1-2 million shares.

Conclusions

1. We should not expect some clear straight-line news any time soon. That is not to say various pundits will not extoll these points of view, but on careful examination the precision of their views will come into question.
2. Despite what various political leaders state, we live in an increasingly integrated world and that is a net good thing, although it has a price, among other difficulties.
3. At today’s prices we are being paid to take long-term equity risk and are not being compensated similarly for fixed income risk taking.
4. We should focus on the announcement of capital expenditures in order to see how much is being invested in new products and new distribution, or see if it is being used to lower existing costs.

What Do You Think?   

 

Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/06/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/06/data-driven-reactions-dangerous-weekly.html

https://mikelipper.blogspot.com/2020/06/caltech-data-heretics-go-to-track-for.html



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A. Michael Lipper, CFA
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Contrarian Bets and other Risks - Weekly Blog # 597

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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Copyright © 2008 - 2019
A. Michael Lipper, CFA

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Reduce Investment Mistakes with Deeper Observations - Weekly Blog # 583

Mike Lipper’s Monday Morning Musings

Reduce Investment Mistakes with Deeper Observations

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

Loss Reporting and Analysis
One of the most useful exercises from the track is making a report on losing bets. Often in reading these reports it becomes clear that I overlooked or didn’t value an observation highly enough. This type of oversight is common with all investors and analysts. This blog utilizes some observations from our visit to Australia plus some additional insights from pouring over the Barron’s Market Lab data and current news events.

Crowding, Protection or a Bigger Target
Crowding for protection vs. becoming an enriched target for predators? One evening at sundown we watched waves of 13-inch fairy penguins unite and stream ashore, forming columns to enter breeding and birthing locations hidden on land. We have seen similar patterns in Africa, where hordes of zebras and other animals gather. In each case there is a lesson that there is safety in numbers. The predators tend to be solo or are in such small numbers that they can’t eat them all, when the group is found, some will not survive.

As I have often said, the art of investing is somewhat like a narcotic, its effects make it difficult to avoid thinking about investing. When I see a large crowd gather together and move as a group, I can’t help thinking of investors crowding into the limited space of a single investment or sector. The problem is that by gathering together they have created an appealing target for predators, who only need to attack a very limited number of victims to fulfill their needs. Several brokerage firms have been producing lists of crowded trades, which can be very specific and include market segments like US Treasuries of specific maturities or other investments in a crowded trade condition. Year to date through June 27th, 2019, only 4 of the 21 US Diversified Equity Fund investment objective averages gained 20% or more and in the sector funds universe only the two tech categories gained more than 20% (A crowded target for the press and politicians.) To some degree the FAANG* and BAT** stocks represent crowded trades and some of them are showing signs of peaking, which may be temporary.

(*) Facebook, Amazon, Apple, Netflix, Google. (**) Baidu, Alibaba, and Tencent)

Unrest in Southern China
Australia’s largest trading partner is China and thus anything to do with China is of great interest to Australians. With the cooperation of the Chinese authorities, the National Gallery of Victoria has beautifully prepared an extensive exhibit on “The Terracotta Warriors”. These unique sculptures of a large military force meant to protect the self-proclaimed First Emperor of China in his afterlife. As an accomplished horse breeder, he conquered all other tribes and ruled for only 14 years until his death. The Emperor was named Chin and his name became that of the nation he founded by simply adding an “a”. He introduced numerous measurement systems that were used throughout his empire and while he was a genius in many respects, he was also very brutal.

Upon his demise he was replaced by the Han dynasty, which lasted for 400 years. They seized control by leading the first of several revolutions, starting in the south. The first emperor in the new dynasty was much kinder and introduced farming as distinct from nomadic life. Today, the Han people are still among those that dominate China. One cannot help thinking that the present leadership of China must be aware of this history and consequently are concerned about the unrest in the southern part of their country.

What the Stars Tell us About Ourselves
On two separate occasions we went into the desert with a group of tourists to gaze at the stars, constellations and planets. Initially we waited “for the stars to come out”, which was an inaccurate statement of fact, but correct from the viewers standpoint. Later, the intervening clouds disappeared, and the stars became visible. We were informed that other stars would move into our view later that evening, which was again an inaccurate comment. This is exactly what the ancients thought until Copernicus began his scientific study leading to the realization of a round earth, although it’s actually an elliptical shape bulging at the equator. This again was an observational point of view, not the correct recognition that the earth is rotating on its axis. From an analytical perspective, investors and politicians should understand that we live in a relative world where useful measurements include both relative changes and absolute movements.

Conflicting Information on Climate Change
Formerly, investors spoke of “global warming” but now refer to it as climate change. This raises the issue of the regular rotation of climatic change. For example, the Danes farmed in Greenland for 300 years, even though geological studies show that water occupied much of the land mass we know today. As with most scientific studies, we are coming up with conflicting information that should be considered in the data mix.

We were told for example that the southern coast of Australia is receding due to the rising waters from Antarctica. The increase in ice around Antarctica has led to the dumping of cold water into the stream that circulates around the ice mass. This in turn has forced the warm water trapped below the ice to move out and attack the southern coast of Australia. However, on Australia’s north coast the land mass is growing, effectively moving the continent slowly north! I am not properly trained to deal with the conflicting evidence, but I can recognize that conflict exists.

There is no question that countries have not enforced enough barriers to coastal building. That is not new in my home state of New Jersey and is something that has been a legal matter since before the American Revolution. Waterfront property is almost always sought after. How much climate change is a function of human activity remains uncertain, at least in my mind?

Separating Pollution from Climate Change
What is certain is that human activity bears major responsibility for pollution, which can be addressed. Years ago, Pittsburgh was almost always clouded with smog from the burning of coal in steel production. With the cooperation of locals, they were eventually able to bring about brighter skies. Progress, albeit slow, is being made to reduce smog from autos in the Los Angeles Basin. The Chinese people and government have in some cases taken draconian steps to address their pollution problems, while other countries remain further behind.

It would be useful to separate the discussion of pollution reduction and the elimination of climate change, because the facts and history are quite different.

Current Inputs
One of the difficulties in determining useful inputs in periods of controversy is what to believe. The Washington Post did a good job of identifying the gross exaggerations coming out of the two democratic beauty contest evening panels, although they are not an altogether unbiased source. There were similar unrealistic statements on the other side too, which left me wondering if we have discovered a useful indicator: Veracity is inverse to volume? (It has generally worked in stock and manager selection.)

Observations on Tariff Chatter

1. 80% of the Consumer Services stock segments have risen year to date, but just 20% of the materials segment have. This suggests that stock buyers believe the consumer sector can absorb the tariffs, but the demand for materials is looking questionable.
2. The Dow Jones Transportation index is rising at a faster rate than the Industrial average. The stocks in the transportation index largely carry freight, which appear to be rising more than the decline in energy stocks. Transportation shares also attract more professional investors and less individual buyers.
3. The announcement of the restarting the tariff discussions was silent on the real, long-term concerns of the participants. Tariffs were supposed to be a method to get the critical discussion started on defense issues like the South China Sea, critical technology required for global leadership, and enforcement procedures.

Conclusion
Future spending is the reason that people save/invest. My bet is that in the long run carefully chosen equities and equity funds will be productive.


   
Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/06/our-investment-mistake-is-in-labeling.html

https://mikelipper.blogspot.com/2019/06/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2019/06/on-right-learning-from-left-weekly-blog.html



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To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

2 Speed vs. 2 Directions: Old Better Than New - Weekly Blog # 566

Mike Lipper’s Monday Morning Musings

2 Speed vs. 2 Directions: Old Better Than New

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

                     
                     
Investment survival and successful investing are often in conflict. This  age-old quandary is facing us now. We instinctively know that losing money does not promote successful investing. This thinking is captured in the first two great rules of investing: Don’t lose money and Don’t forget the first rule. Unfortunately, the modern solution to this puzzle, Alternative Strategies, doesn’t work most of the time.

According to the latest data from Refinitiv (owner of Lipper data), there are 1507 mutual funds investing in 8 different types of alternative strategies, with assets of $239 billion. Similar strategies are followed by numerous hedge funds. The Investment Company Institute (ICI), the mutual fund trade association, has 5 categories of alternatives. Within the ICI roster of alternative categories, the range of liquid assets is between 42% and 14%. The asset composition of alternatives includes liquid assets (cash or short-term debt) and two or more active groups of risk and debt related investments. The managers of these funds use liquid assets to cushion the periodic volatility of their more active investments, with the cushion theoretically improving the alternative portfolio’s relative ranking vs. active investment funds. While this will produce a slower speed of decline, it is rare that these strategies produce better rates of return over time. Even though cash was the only major asset class to generate a gain in 2018, it is extremely rare for the same long-shot horse to win two races in a row as a long-shot. (One of my lessons from racetrack handicapping)

Starting at least in the 19th century trustees of wealth used a balanced approach, often owning both stocks and bonds. Many early US mutual funds were balanced funds. They followed what appeared to be a sound strategy, as stocks and bonds moved in the opposite direction (two-way street) most of the time. The reason for this divergence is that bonds generally increase in value when stocks appear to be risky. This yin-yang relationship is less true today, as the movement of interest rates is driving both equities and debt.

The 757 balanced funds with assets of $485 billion gained +7.31% on average in 2019, better than the averages for all alternative asset categories. This was also true for the 5-years through this past Thursday, where balanced funds averaged a return of +5.08%. Only one of the alternative categories slightly beat balanced funds for the past 52 weeks, +3.05% vs. +2.51%. I suspect the reason for the balanced funds superior performance was that on average they only have 6.07% invested in liquid assets, compared with the 42%-14% mentioned above.

Short and Long-Term Observations
Short-term
The American Association of Individual Investors (AAII) weekly sample survey of its members are now reporting that 42% are bullish compared to 20% being bearish. This is a very volatile time series and often a negative indicator.

Long-term
 Since 1926 the annualized total reinvested return for the S&P 500 has been +10.1% and the Russell 2000 +11.9%. These factoids deserve a couple of ancillary observations. For a long period of time the equal weighted S&P 500 performed better than the more popular market weighted version, suggesting there may be more relative market risk in the popular FAANG shares. The better performance of the Russell 2000 suggests that the acquisition of its  companies has overcome the drag of its component companies with  losses. The shrinkage of the number of attractive small companies has led to managers like T. Rowe Price and Longleaf closing their small company funds. This could have the impact of raising the prices of some small-caps due to a perceived shortage.

Question of the Week:
What level of decline do you think you can tolerate without making material changes?


 
Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/02/lessons-from-warren-buffett-and-italian.html

https://mikelipper.blogspot.com/2019/02/could-biggest-risk-be-confirmation-bias.html

https://mikelipper.blogspot.com/2019/02/some-retire-while-others-sense.html



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A. Michael Lipper, CFA

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Four Investor Risks - Weekly Blog # 508”

Introduction

For equity investors and many workers, things are going well. While the upturn is relatively new it is pushing out fears of declines for many. Investing is an art form that pulsates through various themes and it would be wise to recognize past patterns of their ups and downs. Some look to history for specific fact bases to avoid. A more useful review of the past is identifying emotional/psychological patterns that repeat themselves throughout history.

One of the advantages of being steeped in the history of mutual funds is one can see repeated patterns which in the past have acted as beacons of troubled waters. These beacons identify past problems without promising avoidance of future ones. In my ongoing study of mutual funds and similar vehicles I am seeing four potential subsets of problems that current investors should be tracking in their investment thinking. Non mutual fund investors often have parallel concerns.

1.  High Growth Investing

In most stock markets most of the time there is a subset of traded securities that is leading the market higher. Often these are either reporting or expected to report higher earnings. Their products and services either at present or in the future have little in the way of completion. Some of their perceived advantages may be temporary. These high growth performers enjoy stock price momentum. In the current market place these would be the FAANG + Baidu & Tencent.  These leaders have driven the performance of a significant number of mutual funds and other managers. Their upward momentum can reverse quickly due to any real or perceived changes in their advantages.

2.  High Quality Growers

A coterie of high performing funds was divided into two groups of strongly performing funds and stocks, (1) high growth, and (2) Long-Term quality. Coming out of the recovery phase of the equity stock market decline, ending in March of 2009 and becoming more pronounced after 2015, the perceived to be high future growers gained momentum. A second group of stocks rose in prices but at a slower rate of appreciation. This second group was often developing a broader product line with a higher service component than some of their higher earnings competitors. An interesting question is when the high earnings stocks and funds enter a decline will the companies that have a better balanced business portfolio be treated better?

3.  Agent Career Risk

One of the emotional realities of employing an Investment Advisor is that often in the mind of the capital owner is the distinction as to who is responsible for the investment gains and losses achieved. Emotionally the gains are in part attributed to the wisdom of the owner and losses are largely consigned to the agent/investment advisor. 

As of the time of decision making whether an agent is to be retained or not there are two very different quandaries. The first is the past record of the account including the various alternatives that could have been used plus the cost and bother of execution. In addition, one needs to add into the mix the personality of the capital owner, including tax attitudes. Another important consideration what should be the measuring rod for comparisons and what is the relevant time period. The second set of questions starts with a belief as to the nature of the future investment period and the likely differences from the recently completed period.

4.  Capital Concussion

The future is always difficult to predict. This is particularly true today. We have entered the first of what I suspect will be a series of changes in tax laws, regulations, and court cases as well as state and local changes. Further these changes will impact both individual needs and desires of present and future beneficiaries. These evolving changes in total may dramatically alter not only each of its investments, but also the structure of the investment markets.  

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Single Portfolio Cannot Do Multiple Jobs - Weekly Blog # 502

Introduction

Would you choose to go to a pharmacy that had only one medicine, a plumber who had only a wrench, or an auto repair shop that had only a screwdriver? My guess is no, you would want a reasonably complete set of tools with some being alternatives to a given general solution. Yet most individual investors and many institutional investors gather their securities investments in a single portfolio and report to themselves and others in terms of a single performance result for the most current period. This is similar to going to an inadequately supplied pharmacy, plumber, or auto repair shop! For this very need, I have developed a different way of arranging investments. My preferred structure is based on the timespans that investments specifically need to perform in terms of cash generation and asset price performance. This structure, TIMESPAN L Portfolios®, leads to the way I examine all of the various inputs to making investment decisions including the weighting of buy, sell, and holding choices. Thus, I am continually looking to solve simultaneous equations with multiple unknowns to drive specific solutions.

TIMESPAN L Portfolios

I am using four separate portfolio structures as filters to examine inputs. (I would be happy to discuss with subscribers the various inputs as they may apply to their portfolio structures which are mentioned.)

Current or Operating Portfolio

This is the portfolio that must need current operating payment needs. For far too many this is their only focus. Current price performance becomes paramount to all of their investment thinking. In these nanosecond responses to news/rumors, global marketplaces speed to change directions that may be more important than the depth of thought. For example this weekend there are two inputs that can shape actions. The first is that on Friday, December 15^th, the NASDAQ Composite’s price broke out of a month-long constrained price pattern. For some this may be a bullish event. For most of this year the combination of mid and small technology companies plus the well known FAANG companies were driving the major stock market indicators. For the last month while the NASDAQ was flat, the Dow Jones Industrial Average and the S&P 500 were rising. There was a worry that if the performance leader was not moving higher, the followers would eventually stall as well. Thus the Friday breakout could be viewed as important. This is particularly true because in the week that ended Thursday night the only US Diversified Mutual Fund averages to decline were those of the Mid and Small market-caps, excluding the Short Biased funds which also declined.

The second input was the volatile American Association of Individual Investors’ weekly survey showed a major jump of bullish investors to 45% of their sample compared with 37% and 36% the weeks before. The progress of the US tax bill was probably the cause for the surge. I personally find this as extremely premature. As of Sunday I have not seen the conference committee’s full draft. There is still room for some changes as both houses pass a bill. As a practical matter until we see the implementing regulations which are likely to be more complex than the bill itself, we won’t be able to carefully apply the bill to our own taxes. Relatively soon there is likely to be a Tax Corrections Act plus there is a good chance that tax and/or civil courts will modify the regulations.

Both of these inputs are speculative but give support to the bulls near-term.

Replenishment or Presidential Cycle Portfolio

This is an unusual portfolio device to replace the funds allocated to the operating portfolio that have been expended to meet the current needs of the account. Its timeframe pivots on probable changes. These changes may be in terms of political or corporate leadership. The second element would be significant if the bulk of the investments are concentrated in companies with critical roles to their success leaders.

At the moment this portfolio has the biggest hurdles to climb. In the normal course of market history it is reasonable to expect to see a stock market price decline and recovery in periods of four to seven years. Currently, it appears we are building toward a peak. The very inputs mentioned for the Current/Operational Portfolio shows signs of providing the missing enthusiasm which is present immediately prior to a peak. One of the ways to get stock buyers to join in on the rise is to suggest that the rise is not a cyclical phenomenon but part of a long-term growth trend. We are already seeing broker’s headlines declaring “Global Economy Stronger for Longer.” We are also seeing earnings estimates going out to 2020-2022.

As a young junior analyst struggling to come up with annual earnings estimates I became apprehensive when I started to see the justification for buying certain stocks on the basis of their purported five year projected price/earnings ratios after a “hockey stick” type of growth pattern. The result did not turn out well. We are now seeing estimates that global stock markets may reach levels of $100 Trillion and at least one company expected to reach the $1 Trillion level.

US investors are not blind to all of the risks in today’s marketplaces. Their aggregate response to these risks is to invest outside of this country. The largest single net flows this year are into International/Global Equity mutual funds and ETFs, with the latter being driven by institutional owners. Perhaps it is warranted as most markets are selling with price/book value prices below those in the US. (There may be less massaging the book values than the reported earnings.)

Endowment or Post-Decline Portfolio

I believe it is reasonable to assume that there will be both a stock market decline and a recovery which eventually will lead to much higher price levels. There are two keys to benefiting from this prediction. The first is the careful management of assets going into the peak and recovery cycle and the second is to benefit from the probable change in market leadership.

The endowment period is probably as long as the youngest decision maker is in that position, but likely more than ten years.

Typically new leadership comes from overlooked companies and sectors that have gone through major structural changes during the peak/decline cycle. This is often the type of period where prior momentum plays lose ground to contrarian plays. I have two examples of this thinking. The first could be Britain. Because of necessity, the UK comes out of BREXIT stronger than when it entered the divorce procedures. As is often the case the winners could be centered in the mid and small-cap domestic oriented companies.

The second good endowment prospects are what we use to call “warehouses.” These were not physical warehouses, but stocks that would not lose much value in a decline and had reasons to have a better than historical experience in the future. Today there are two, somewhat controversial, opportunities of interest. The first is the oldest warehouse for more than a century, AT&T. While in truth it is the recast Southwestern Bell along with a number of acquired former Baby Bells. I am not attempting to guess the final result of the proposed merger with Time Warner. My interest is focused on the likely leader in the Fifth Generation internet which could well be dominated by AT&T as the technological and capital leader. The declining value of their long lines infrastructure could be reversed.

The other warehouse that is even more controversial is General Electric, which was the first large company I analyzed. The slimmed down current company is essentially being rebuilt around its capability with engines. The power business, particularly in the conversion to the use of natural gas, should be a major plus. The aircraft engine business is very attractive in terms of the parts and services involved. What are labeled their healthcare products are in reality supplying the mechanical/electronics patient movement businesses.

I view both of these stocks as substitutes for ten year US Treasury Bonds, which currently yield 2.4% and AT&T yields over 5% and GE 2.7%.  The income from the bonds is fixed. I suspect that the two warehouses will raise their dividends at least equal to published inflation if not higher. Further over time their pension expenses will decline through pension risk transfer contracts with Prudential Financial or other insurance companies. Also I expect that the number of employees and their ages will decline easing their retirement expenses.

Legacy/ Future Generations’ Portfolio

The nice part of managing money for this portfolio is that I won’t be around to see whether it works or not. I hope it does work because it will be important for my grandchildren, great grandchildren and their beneficiaries. This is the most challenging portfolio. While some of the future winners will be leaders from today, some will be a surprise. It is in the latter group that I am focusing on in the beliefs that there will be some changes which will lead to good investments.

The first idea is that much of what we invest in today is anchored in the so-called permanent or physical world. In future generations I think we will be living in more fluid situations. Even today’s tax bill may be driving to praising liquidity over permanence. Individual ownership of real estate could give way to greater rentals. With the growing retirement capital gap we may need to increase savings and get higher returns on our capital as we live longer and more expensively. My guess is that we will see more century and longer bonds,  possibly perpetuals.

The second idea derived a bit from the first is that business and industry structure can and will likely change. We are already entering a phase of vertical as distinct from integrated mergers. The recently proposed merger of Aetna* into CVS/Caremark is being analyzed as a process to lower the cost of drugs. I see some other, more important long-term advantages. First, as a data-hawk the idea of putting the aggregate data in terms of medicines with health and life insurance statistics could have enormous advantages to the companies and could well provide better healthcare for patients. There is perhaps an even bigger potential advantage to the proposed merger. CVS is used to their customers coming to them. Aetna has to go out to get their insured through direct or agent sales efforts. With the increase in marketing and sales supported technology the dollar levels of future sales could expand materially.

* Shares personally owned 

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A. Michael Lipper, CFA

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Contact author for limited redistribution permission.