Moves For 8 Months and 8+ Years - Weekly Blog # 520

Introduction

Probably the single most common investment mistake is to have a single portfolio to meet multiple needs. My suggested cure for this malady that has to leave investors not fully addressing needs is to divide the single portfolio into sub portfolios to focus on specific timespans and their funding needs. Thus, when I look at investing my first focus is on the desired cash flow to meet beneficiary needs in specific timespans, (Lipper Timespan Portfolios^® ).

Today I am focusing on the probabilities for the rest of this calendar year or about eight months. I am also looking at a period of recovery in stock prices after the next recession, which the strong odds will come about over the next eight or so years. Finally, I am looking to the period beyond my personal control or influence on various investment committees in terms of replacing very successful investment managers after a long period of successful and faithful performance.

The Remainder of 2018

As of today the only thing that will come out of the 2018 US mid-term elections is more words about the implications for the 2020 elections and some legislation in 2018 which will probably be wrong. Thus stock prices at the end of the year will probably reflect largely what is known today. One of the advantages of learning security analysis at the racetrack is first to identify the most probable result of a future race. This leads to picking the favorite (which almost always is confirmed by the lowest payoff if correct).

My nomination for 2018 is that we have seen both the high and the low for the year in the first quarter. This would result in a gain or loss of somewhere close to half of 2017’s gain. In this case I suggest that there is a 50% chance that we have seen the high and low for the year already. The remaining fifty percent could be divided in half again with a 25% chance that we go through the last top of the market and/or we retrace the gains of 2017. If one combines the most likely 50% with a new high or 25%, this would produce a 75% chance of a satisfactory return for most investors completing ten rising years.

Probable Causes for 2018 - Gains

Frequently I have referred to the weekly survey conducted by the American Association of Individual Investors (AAII) which is very volatile in part because its sample size is small. In the latest week 37.8% were bullish for the next six months, 33% were neutral, and 29.2% were bearish, as opposed to 42.8% being bearish two weeks ago. Stock markets don’t go higher when all the available money is already committed. A major brokerage/wealth management firm is suggesting its clients should sell into any rise.

Another source of cash is investors adding to their account into a rising market and the market is rising. Each of the three major stock market indices have the very same looking chart of a narrow rising channel starting from the February low points. If upside price momentum starts heating up, the old highs could be challenged. (While my clients and I would enjoy these gains, in a contrarian view breaking out of the old high could suck in all or most of the available cash and that would eventually lead to a major decline.)

Probable Causes for 2018 - Losses 

A couple of weeks ago the Masters Golf Tournament concluded with a new young champion, Patrick Reed. His win verified the old expression, “You drive for show, but you putt for dough.” In a similar fashion, stock price movements are what gets the crowd’s attention, but in the fixed income marketplace winning is achieved by avoiding losses. 

Traditionally fixed income is a seemingly dull game for the professionals. While individuals may buy bonds they often hold them to eventual maturity. They don’t trade them. Also they rarely pay attention to credit instruments such as loans and mortgages. Not only is the total fixed income market larger than the stock market in most countries, it is the source of financing of governments and large corporations.

Compared to equity returns, most fixed income instruments trade off their promise of periodic payments of interest and principal return versus lower average total returns on stocks. However, various trading organizations have leveraged their fixed income investments with borrowed money, usually from banks or the credit markets. Whenever leverage is used a small price decline can shrink the value of an investment to a leveraged owner.

Most brokerage firms, bank trading desks, and some hedge funds use leverage to support their fixed income investments. The origin of most stock market declines is a reaction to traders having their loans immediately called and their collateral holder immediately liquidating the collateral without regard for price. That is one risk. Other risks have been created by the central banks of the world that have manipulated interest rates down so much that investors have become desperate to find satisfactory yields. This has led to an expansion of the use of credit instruments beyond bonds. This has led to a situation, according to Moody’s *,  for the first time in recent memory outstanding high-leverage loans now exceed the outstanding amount of high-yield bonds.  In effect, leveraged credit investors are trading off their safety for yield. That won’t always work.

*An equity in our private financial services firm

In Europe and some parts of Asia, gold is a normal part of many conservative investors’ portfolio. This is not true for most US portfolios.  From my standpoint it doesn’t matter whether one owns gold or not, but what matters is what others are doing. A current buyer of gold sees trouble ahead. Each of us can probably create a list of future troubles. That doesn’t matter in terms of one’s own beliefs, what matters is when more people believe it. The way I follow it is represented in a chart that in the recent past depicted a high was established in September of 2017. Since January of 2018 there have been three attempts to meaningfully to supplant it. The chartists tell me that gold is in a rising triangle from a December bottom and could go through the 2017 peak on the way to challenging earlier higher peaks. If this were to happen I would be concerned as to equity and debt values.

Concerns of Jamie Dimon, Warren Buffett and Charlie Munger

Jamie Dimon at JP Morgan Chase plus Warren Buffett and Charlie Munger at Berkshire Hathaway have spent considerable time and thought about short/emergency and long-term succession. I am struggling to do so as well. I have sat on a number of non-profit boards who when faced with the need to relatively quickly replace a retiring CEO look for someone that possesses a skill set that the older CEO did not have and that seems to be more important than continuing the good attributes of the retiring CEO.

Since my professional responsibilities as well as family requirements have to do with the replacement of investment managers, largely of mutual funds, it appears easy to replace funds that are deemed to become poorly managed in their execution of their process, which is much more important than periodic poor investment results. What is difficult to do is to replace a successful manager such as the three gentlemen mentioned. No two people are exactly alike and future periods are going to be somewhat or completely different than the successful periods that we have enjoyed in the past. Do we search for a copy of the successful manager? Do we look for some one quite different? What are the missing skills that will be needed in the future that are not needed presently? How do we assess success? How long a trial period is reasonable, particularly if we enter difficult times? I would be greatly in your debt if you could send me an email or even a snail mail with some of your views to these questions.

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

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3 Potential Risks - Weekly Blog # 495

Introduction

Contrarians are useful even when they prove to be wrong. In forming an investment committee for a non-profit institution of professional investors, I felt it was incumbent on me to somewhat balance the committee, largely populated by generic optimistic money managers with at least one contrarian that was well skilled in finding good shorts. While it would have been inappropriate for this institution to sell short betting on falling prices, the answering of some bearish views were useful in appropriately constructing our long portfolio which did well. We were better prepared to be long-term investors on the long side for reviewing and appreciating contrarian views.

Current Thinking Process

Stock markets around the world are rising well ahead of current sales and earnings, even adjusted for modest growth projections. The buyers are enjoying what could be called a “melt up.” Economic sentiments are moving higher.

While I do not know how long these trends will last - be it a day or multiple years - I believe it is critical to consider the potential risks that are currently apparent to this long investor and manager.

First Risk: Simplistic Decisions

On October 26th The Wall Street Journal published a multi-page critique entitled “Morningstar Mirage” which purported to show that the firm’s various ratings were not helpful in making decisions as to what mutual funds to buy. The article decried the marketing power of Morningstar’s ratings, not recognizing that at least since the 1930s funds that performed well attracted the most sales if they were known. In the same light there was no real discussion of the questionable mathematical processes used to reach its conclusions.

The biggest risk to investors is not the Morningstar Mirage. The biggest risk is that the financial community believes that investors want simple answers to complex questions. Sales people who can get very limited time with both their prospects and their accounts are trained to use the KISS principle, (Keep It Simple Stupid)” in their communications. It has never been clear to me whether the communicator or the investor was stupid.

Often people spend more time at a sporting event or preparing a special meal then they do making investing decisions which can have significant impact on their lives and those of the beneficiaries. At the game each play, each course or each critical ingredient is thought about deeply. As the readers may be aware I learned the basis of securities analysis at the racetracks, spending hours on each race. I am told that one of the most successful racehorse owners in the last 30 years in the UK spends a great deal of time on the races and the breeding of her horses. We should do no less than Her Majesty.

When Hylton Phillips-Page, my VP of Fund Selection and I analyze a mutual fund we spend a long time getting to understand how the fund, its managers, and supporting organizations impact the past results. A much more difficult task is guessing how we think the past will not be simply extrapolated into the indefinite futures. The term futures is a recognition that there will be interruptions of past trends as conditions change.

The risk of simplistic decisions is much broader than choosing mutual funds.  Not only investment decisions, but all types of other decisions, including political, career, and other personal decisions are put at risk when given only cursory attention. The past is useful as to what happened and more importantly what didn’t.  Most studies of human decision-making involve a number of biological organs. The brain and our senses are very complex and they interact differently when conditions change, and they are always changing.

Second Risk: Credit Withdrawals

In each of the general write-ups of major stock market reversals almost all the attention is devoted to stock prices. In truth almost every major stock market decline was slightly preceded by the withdrawal of credit support. Since we are not out of October, we should first start with October 28, 1929, the biggest single day drop in the Dow Jones Industrial Average up to that point. On that day, the index dropped 12%. Most recounts do not include the fact that the market had been dropping since August and a good bit of the buying was done with borrowed money called margin. The borrowed money came from the major banks who issued it to the brokers, who in turn offered it to their clients on the basis of their portfolios. The banks used call loans to the brokers using their clients’ collateral. As the market declined in the late summer and early fall of 1929, the value of the collateral fell, reducing the safety for the banks that were starting to call their loans. The brokers called their margin accounts to put up more collateral which most didn’t (or were not able to) and were rapidly sold out of their holdings. This is an example of a non-price sensitive insistent seller.

A similar thing happened in 1987 where in one day, October 19, 1987, the DJIA fell 22.6%. European stocks were down about 10%. Portfolio insurance used futures to hedge long institutional positions. Many of the futures contracts were margined against the long positions owned by financial institutions. In Chicago there was no requirement to be able to short on a price uptick as there was in New York. When New York opened there was a wall of sell orders.

A somewhat similar occurrence happened with the collapse of Lehman Brothers when the “repo market” to finance its fixed income inventory was closed to Lehman due to a different set of rules and expectations in London.

Trying to avoid a future similar event, the Dodd Frank Act focused on what banks and others owned, not the risk in their loans. I suspect that most of the inventory owned by the Authorized Participants, (the market-makers for Exchange Traded Funds and similar products) are highly margined. At some point the providers of these loans may get nervous as to their collateral cushion and may want instant repayment which could create a problem.

There may be similar potential problems in both the US Treasury and Foreign Exchange markets where high leverage is available.

Third Risk : Career Risk

If investors are guilty of simplistic investment decisions, professionals live in fear of being fired either by clients or employers, This is a particular risk if someone needs to publicly report performance or work for publicly traded companies. Thus, despite reasonable long-term results, near-term absolute and even more importantly - relative results - drive terminations. This is normally a mistake on the part of the terminator for two reasons. First, most of the time there is a partial or complete recovery. Second, and much more dangerous to the investor is the choice of the replacement, often a manager that has good long-term results which are appropriate for a decline, but poor results in expansions.

Bottom Line

Risk is always with us and it is the highest when least expected. Drive on two-way streets, they are safer.

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A. Michael Lipper, CFA

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People Decide, Numbers Report Investment Success

Introduction

The actions of people drive investment results. Numbers are an abstraction of the various realities that people produce. Quantification is useful in reporting history, not motivation. As a long-term student of investing and the investment business, I have seen repeated failures of extrapolating a given set of numbers that produce very different results. At best past numbers are useful as to what has happened in the past of repeated results.

Why Repeated Numbers Won’t be Predictive

People are not machines. Most of us live, think, and emote in the current time period. While our memories do produce faulty or incomplete renditions of the past that we often use as judgments, we don’t always. We don’t follow the old paths, all the time because of change elements perceived or real.

Change Agents

I believe that the presence of change agents occasionally lead to change in behavior. Some but not all change agents are physical, emotional, political, and may be a result of new personalities entering the decision process; e.g., the titular or actual investment committee. Thus I believe it is useful to apply more weight to the study of people than numbers. (This is quite an admission for a green eye-shaded CFA^® charter-holder.)

Investment Personalities

I suggest that it is worthwhile to practice the art form, not the science, of people watching with open eyes and empathy. The three useful areas of the study of investors are:

• The specific investor
• The collection of investors
• Speculators called “the market” and financial intermediaries

Each is quite different, intermittently changing, making false starts and reversals and are sometimes unwilling or unable to state clearly their intentions and motivations. Our good friends the technical market analysts and other quant type analysts and managers believe that their recorded actions are sufficient for predictive purposes. They will be right some of the time but often miss a major change in the mood.

The Decision-Making Investment Committee

As a practical matter for some individuals and institutions there is a singular decider who makes final decisions without benefit of external counsel. In addition they are legally empowered to make investment decisions,  consult with others and/or are heavily influenced by external sources. Having chaired, sat on, or served various investment committees, I have learned some investment committees, in truth,  make all the decisions. Others are essentially ratifiers of outsourced chief investment officers (OCIOs) or are driven by the chair or other dominant personality. What I have experienced even with a number of people on the formal or informal committee is: change one person, and the direction of the committee may change. The new person may be the change agent for a reluctant prior group, a dynamic leader, one with a different set of investment or management experiences. The informal committee may include a personal lawyer, tax accountant, neighbor, spouse, significant other or a friend of your golf buddy.

“Time to Judgment”

There are two interrelated statistical periods which could be the current quarter, year, length of term expected on the committee, lives of beneficiaries or eternity. (We have suggested that the portfolios be sub-divided in terms of payment streams into timespan portfolios from short operational needs all the way out to legacy considerations.)

Measures of Success

After the targeted investment period(s) are identified, a key question is what measures of success to use. The first duty of a fiduciary (and we are all fiduciaries for ourselves and others)  is to deliver returns sufficient to meet expected spending levels. Thus one of the measures is in real, after-inflation returns. If the beneficiary is tax paying, the payment to the beneficiary should be after taxes.

That is the easy part. Much more difficult are the appropriate measures of investment success and prudence.

Indices made up of individual securities were never designed to be prudent portfolios, but rather a measure of perceived central tendencies. To me these are inappropriate measures.

Usefulness of Mutual Fund Performance Databanks

I suggest the comparisons should be with other investors which are operating under the same constraints as the account. 

My experience is that the most transparent Databank on performance is mutual funds. These can be segmented by investment objective, size, expenses, turnover, tax efficiency, consistency of performance and other factors. 

  

In most periods the bulk of investment performances will be centered in the middle of the performance array. Thus I suggest to divide performance into quintiles. The beauty is that one can treat those funds in the middle quintile (40-60). Then an interesting analysis would allow one to examine the frequency of quintile performance by quarters over long periods of time or when the portfolio manager or policy changes. This type of analysis will demonstrate the investors patience. (Over an extended period of time a number of different investment philosophies will produce similar results, but quite different interim results.)

In assessing the investor or investment committee, their actions over time will have a great deal to do with their ultimate success. The best time for them to make changes within their portfolios of securities or managers is when performance is so good that it is likely to be unsustainable. The other criteria for their future success is whether or not they are developing a long-term plan on how their assets will be managed beyond the Principal’s lifetime.

Measuring “The Markets’” Personality

A look at history will show that a high percentage of the time markets move within reasonably well defined price and valuation boundaries. Unfortunately, these periods produce pedestrian returns. It is the extreme periods which might be 10-20% of the time that will capture the big gains and losses. These periods are often tied to perceived external changes. Europe enjoyed a long period of economic expansion due to the use of Latin American gold that was brought back which made their currencies stronger and created inflation. Wars can be both good and bad for stock, bond, and commodity prices at different times. Discoveries of natural resources and technology can create important changes and reversals. The very same factors that cause dramatic change in one market will not in others due to the mood of the market. There are times almost every item will be positively at other times the same items will be viewed negatively.

At this moment the US stock and bond markets are highly priced but showing relatively little momentum except in certain narrowly defined sectors. There are two elements that other times would cause some concerns, but may not presently.

The first is what economists call a “Minsky Moment” after an economist that many felt should have been awarded a Nobel Prize. His concern was for the unbridled growth of speculative borrowing/lending. This is the type of activity where the borrower expects to roll over the debt and not generate the capital to pay it back. Some are focusing on China’s industrial and real estate debt. I am concerned of the attitude of various governments and non-profit institutions here in the US who intend to cover their fund raising needs through new debt that they expect to be rolled over.

The second element is an examination of the daily price chart of the NASDAQ Index in the Wall Street Journal. (This is a technology-driven index. Technology prices have now risen to the peak level seen in March of 2000.) If the prices do not fall appreciatively, it could lead to what the technical analysts at Merrill Lynch describe as a failed pattern. These two elements may be “straws in the wind” and blow away, but watching people’s changing moods will have some impact on near-term prices.

Financial Intermediaries’ Personality

We used to live in a world of single purpose intermediaries. They were either transaction-oriented, making their money largely through the bid and asked spreads and/or commissions or advisors which earned largely through percent of asset fees. Theses are now being effectively combined into multi-purpose entities. Within the financial community many former service providers are now competitors. Through this homogenization process the prices for services has come down but it is not clear that the quality and integrity of service has improved. Banks have morphed from being financial services department stores to perhaps the full financial services mall. If money is involved, so will be the banks. On a real estate basis we are seeing many of the old temple-like head offices becoming restaurants or event spaces which has happened in New York and Philadelphia. (We had a graduation lunch for a magna cum laude grandson in a space that used to be the main banking hall for the First Pennsylvania Bank, the fist bank in the US until it merged.

While some of the intermediaries have large amount of capital it will be used primarily for them to make money for themselves rather than for their clients. They are hiring PhDs from Caltech and other leading research schools to convert their processes from seasoned employee functions to automation. There is not the same service attitude from machines and call centers that were previously bestowed on us by the familiar faces of yore.

The great damage sustained in major declines was suffered by investors who feel abandoned and dumped their good investments. With fewer people who have the investors best interest in mind to consult, there is a probability that a number of investors will believe that they are condemned to live through their own Minsky moment.

Question of the week: How well do you think your financial service providers really understand your needs and will be there when you need them in a general market meltdown?    

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

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Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.