Time to Get out of the “Foxhole”? - Weekly Blog # 623

Mike Lipper’s Monday Morning Musings

Time to Get out of the “Foxhole”?

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

Quite possibly the biggest mistake in the world is not recognizing that some critical fundamentals are changing. This mistake rests on strongly held views of the future, that it will seamlessly extrapolate from the immediate past or quickly be governed by a new order that will make sense of it all. Good luck to all who believe this.

I start from the assertion that I don’t know what the future holds, either for us or our investment responsibilities. Nevertheless, we know that we cannot stay still in our present condition. Now is the time to recognize that there have been some small changes in the last two weeks that could be meaningful. They have already rewarded some double-digit returns.

In the weekly ranking of traded price changes, a minority of 24% are going up. Not surprisingly, the biggest gains were for those related to oil, which had a relief rally of 25%. However, several unrelated prices also rose somewhat. (Consumer Staples +3.46%, Copper +1.63%, TIPS +0.90%, 7-10 Year US Treasuries +0.79%, Gold +0.54%, +20 Year Treasuries +0.48%, and the Yuan +0.06%). I find the rise of both copper and the yuan hopefully significant. The commodity market players and economists often refer to copper as “Dr Copper”, because it is often an indicator of early demand. The minuscule rise in the Chinese yuan is another indicator that some things in China are improving.

Fixed Income Quandaries 
All too often people group investments with a specified maturity and expected interest rate into the same category, such as government bonds and other bonds with a high credit rating. This can be quite misleading, as evidenced in this week’s Barron’s. The Best Credit Bond Yield average dropped by 37 basis points, while the yield on intermediate credits rose by four basis points. (Remember, bond prices go in opposite direction of yields). The market was therefore pricing the safety of credit more than it was higher yield.

I was at a meeting recently where a money manager included the high yield portion of the portfolio with other bonds. I suggested that high yield paper normally travels parallel to stocks, not bonds, and he agreed.  With interest rates currently at historic lows, high quality bonds should not be counted on for income. They should be recognized as a source of capital to be reinvested into bonds at higher rates (lower prices). This is particularly true now as the yields on longer maturities are rising. (One of the reasons that retail investors with high yield mutual funds underperform total returns is that they spend the distributions rather than electing to reinvest them.) Many disagree with my view in last week’s blog that rising deficits around the world will drive inflation and interest rates higher, and in time a lot higher.

Market Structure Changes
There is some inconclusive evidence the US stock market has hit a bottom. Market analysts suggest that some time must pass for the market to establish a large base before a successful assault on prior record levels can be made. One reason this makes some sense to me is that recessions are meant to correct the excesses of a prior bull market. Perhaps the reason the previous long expansion did not go higher was too many old zombie companies not earning their cost of capital. If this was the case, the next expansion will likely be shorter.

There is plenty of “dry powder” that could fuel a big expansion. One metric Wall Street focuses on are the portfolios of individual investors and for years they looked to Merrill Lynch to provide this view. This now comes from Merrill’s new owner, the Bank of America. They have indicated that the amount of cash in their client’s accounts are at a ten-year high, with the amount in bonds at a seven-year high. Additionally, the large amount of uncommitted funds in private equity is blocking them from raising new funds. The recent market decline has brought the S&P 500 ratio of market price to book value to below 3 times, a level at which M&A deals are often considered.

Covid-19
The public, media, and politicians are looking forward to the “flattening of the curve”.  This may be occurring in Italy, Spain, and New York state in terms of death, not number of new cases. Much more important to me are the vast majority of those who died in both Italy and China having other medical problems. What I don’t know is what killed them, the virus and its complications or their other problems. The following table, provided by US authorities, lists the proportion of patients that had other medical conditions:

Chronic Renal Disease     74.8%
Cardiovascular Disease    61.0%
Diabetes                  54.7%
Former Smoker             49.4%
Immunocompromised         42.4%
Chronic Lung Disease      40.4%
No Underlying Condition    9.7%

Perhaps a positive spin on this tragedy is that it is causing us to rethink, not only our healthcare systems and personal relationships, but also the structures of business and educational organizations.

Hylton and I wish you and your love ones good health. We hope you are practicing good procedures to protect yourself, your loved ones, and the people you are in contact with. We will get through this together.

Question: From where we are today, how should we organize to make us all better?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/03/where-we-are-depends-on-where-we-have.html

https://mikelipper.blogspot.com/2020/03/stealth-bottom-and-other-considerations.html

https://mikelipper.blogspot.com/2020/03/searching-for-bottom-understanding-and.html



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Europeans Win, Experts Lose, Trading Opportunity vs.1848

Introduction

The essential difference between market followers and sound analysts is the former follow short-term momentum and the latter long-term directional changes. I embrace the second responsibility. Brexit, in my opinion, is the beginning milestone on the march to an era of more freedom of consumption and investment which will lead to better lives for many Europeans. Note I am focusing on people not present political countries.

The Perils of Over-Confidence

The focus on the needs and desires of most people is exactly what the expert class was not doing. They did not see or hear what the working class and much of the middle class were saying. The colossal surprise of the upset is only a surprise in that the expert classes of economists, political scientists, politicians, portfolio managers, senior investment people and media pundits had never considered that they were wrong. They had no plan “B.” In the US Marine Corps young officers are instructed you will only be judged on what you execute which will largely be plans “B,C,D, E, or F.”

This tendency of overconfidence will be part of a panel discussion this week at the New York Society of Securities Analysts celebrating the work of Benjamin Graham, the father of value investing. At the meeting I will be focusing on mistakes investors make keying off some of the mistakes that Berkshire Hathaway has made over the years. I have been asked about the single biggest cause of professional investment mistakes. I will discuss the overconfidence which has led to sizable losses. A similar pattern was in evidence in the London approach to Brexit. 

What Actually Happened: A tale of Three Countries

In Great Britain the London-centric experts thought the campaign would be won focusing on the fear of economic disruption. They were not listening to the people of the North of England and Wales who were primarily concerned with the loss of national sovereignty in terms of immigration and Brussels’ determined justice and procedures. These working classes and much of the middle class were fed up with what they perceived was likely to happen to them.  

One of the signs of this great division with those who wished to remain is the number of voting districts where the winning side polled more than 60%. We are used to seeing a split in many voting areas similar to the final 52/48%. The wider spread indicates to me that both sides were effectively only talking to their own and not engaging with the sizable undecided or opposed. The London-centric people initially bet over 90% of the money with the book makers that they would win only in the last few hours of the referendum, bet 90% on Brexit. (Too bad the Londoners didn’t know their history. More on that later.) Since the bulk of the more active institutional and trading money is intellectually based in London, over the preceding days they were heavily buying securities and sending similar thoughts to other markets. Interesting when the shock of the results became clear, the UK stock market declined one of the smaller falls in the world in part because only 35.5% of the indices’ revenues were domestic to the UK.

German investors suffered a 12% decline in part because 72.4% of their revenues are international in scope. One corollary measure is in the US, the Vanguard Europe ETF fell 11.3% as noted by my friend Jason Zweig.

In the US with approximately 70% of our revenues produced domestically, the main stock averages fell in the neighborhood of 3%.

This needs to be put into perspective. First, the decline essentially corrected the last several days’ rise based on our trading fraternity believing what they were hearing from London as well as significant short covering by hedge funds and similar traders. I believe the over 600 point fall in the Dow Jones Industrial Average was caused by the absence of short covering and algorithm-driven quant funds that sold as various price levels were violated. People at JP Morgan believe that from this source some $25 billion dollars were thrown on the market. If there is a continuation of the sharp decline they are looking for up to $300 billion more to be added to the market.

For those of a trading mentality I suggest at some point a near-term bottom will be reached, possibly on Monday. Current prices for many securities are back down to the bottom of their recent trading ranges which could well hold. If these trading bottoms do not hold further, declines will find other bottoms. Whenever the bottoms are found, subsequent rises could be dramatic because of the absence of positioning capital on trading desks.

While I recognize a potential trading opportunity, at the moment I do not see a substantial reason to change fundamental investment strategy. In terms of our four chamber TIMESPAN L PORTFOLIOS^® I might adjust the second chamber or the Replenishment Portfolio’s equity trading account to either take advantage of some cheaper merchandise or reducing risk if there are more violations of support levels. I would not change either the Endowment or Legacy Portfolios.

Londoners Had the Answer

The intelligentsia in London had the answer if they knew where to look. I do not know whether or not the restaurant that was in the downstairs floor of the residence of Karl Marx is still functioning. One evening my wife Ruth and I climbed the rickety stairs to his apartment which still had no electricity. At the request of the German Communist Party, Karl Marx authored the Communist Manifesto in early 1848. (A side note: because of his subversive activities in Europe he was never allowed to become an English citizen even though he was buried there.) He believed that it was in England that the revolution of the proletariat would begin because of its class structure.

1848

The main reason to focus on Karl Marx is the year 1848. This was the year of some 50 revolts by the working and middle classes throughout Europe and Latin America. These brought down a number of governments including in France. There was widespread dissatisfaction with the political leadership. Nationalism was on the rise in France, Germany, Netherlands, Denmark and Italy among other places. The violence of the revolts and the desperation of the people led to massive migration into “the new world” which in one generation proved to be a major brain drain. Lenin summed up what happened. “There are decades when nothing happens and there are weeks when decades happen.” (Courtesy of John Mauldin)

Perhaps the bureaucrats in Brussels and the current political leaders on the Continent are now seeing the risk to their structure. As is natural their first instinct is to punish the interloper, the second is to become defensive and the third hopefully to negotiate and evolve. Possibly Dr. Brendan Brown of Mitsubishi UFJ Securities is correct when he says. “The referendum result marks the start of A European journey out of a failed EU.  Britain is in the lead…There are serious grounds for hope (for) greater economic and political freedoms, prosperity and European harmony.” Greater Europe has for centuries developed official and more informal trade patterns that has produced satisfactory results both in peace and war and I would expect that to continue. In that light I believe that Europeans need the British as much if not more than the British need various European elected and non-elected states.

What to Do?

Many of the better US managed international funds have significant portions of their portfolios invested in Europe. I suspect over time these will be good investments and could find places within sound Endowment and Legacy Portfolios. For those whose preference is individual financial services securities, on a long-term basis they may wish to examine INVESCO, Franklin Resources, and Goldman Sachs all three are long term positions in our private financial services funds and have been under pressure recently. There are similar long-term attractive non-US domiciled financial service companies that I will be happy to discuss with our readers.

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“Data Dependent” Portfolios

Introduction

Future interest rate moves of the US Federal Reserve are described by its members as “data dependent.” This is meant to suggest that when a statistic reaches a certain level, a future action is ordained and carried out. The immediate present (or actually slightly old) figures determine the future according to these economists and other politicians of the top-down persuasion. Considering how bad the record is of the Fed’s predictions, it is a “puzzlement” why these predictions are given so much credence that some mythical king of Siam might wonder.

What is even a bigger puzzlement is why so many investment performance reports start explaining their performance based on the latest data dependent pronouncements. Strange that so many so-called professional investors dwell on the current price (yield or P/E) level and not what as an investor I am really interested in. What I care about is the terminal price of my investments.

The terminal price of my investments is difficult to guess, but that is exactly what I will use to meet future spending needs, whether I am acting as an individual or a fiduciary for a public or private endowment. To determine my terminal price I will need to project the range of the most likely future price trends for the investments. Estimating my place on these price curves will be determined by the range of my likely factors including spending/saving habits including health-related, some actuarial assumptions and probable reactions to cyclical markets. Not a single one of these unknowns is easy to determine. Nevertheless, each one of us unwittingly does this at every buy, sell, or hold decision we make or we allow to be made for us.

A Helpful Took Kit from the Racetrack

When we are besieged by too many questions it is useful to break them down into logical groups. At many US racetracks there are up to ten individual races a day. This translates into about 100 horses trying to win. Luckily for the handicapper, or if you will the analyst, the horses are only trying to win their specific races. These races are divided by length of the race from short to long distances, age of horse, racing experience of the horse, prior level of winnings, and whether the owner is willing to sell the horse at a specified price. One could take conditions of the race as a determinate as to which of the myriad factors on each horse that is to be considered for a bet. Out of this you could come up with a single or a very limited number of probable winners for the race. That is half the job at best. Moving away from the past you should look to see whether the horse looks healthy and is being ridden by a jockey (portfolio manager) that is experienced with this horse and others who run the same way.

While there are numerous other factors, the final decision on what to bet and how much to bet is a function of the odds or the weighted opinion of others compared to your own views. If you are in total agreement with others even if you win, the payment odds after the track's take and taxes are deducted won’t be very large. On the other hand, if your analysis leads you away from the crowd’s choice as most great portfolio managers do, your payoff will be larger but you will suffer the indignation of hearing about the brilliance of the popular choice. Racing and investing are not like picking a winning political candidate. In politics it is guessing what the majority will do rather than picking the most qualified.

Applying Data Dependent Factors to Racetrack Tools to Win

One of the reasons we developed the Lipper Timespan Portfolio concept is that different data points have vastly different impacts on portfolio orientation. For example, demographics are unlikely to have much impact on the investment performance for the next five years. Bear in mind that in the last five years today’s equity funds (now numbering 14, 834)  rose +11.79%.  Taxable fixed income funds (now numbering 4831) gained, including income, +3.66% in the same period. However, when I look to invest money for a minimum of ten years I am struck with the fact in 2014,  Germany & Japan’s average age was 46 years, Italy & Austria  44, Canada was 41.7, Russia 38.9, Australia 38.3, US 37.6 and China 36.7 years old.    

On the other hand Nigeria and Uganda averaged 15 years and three several other African countries averaged 16 years. India was in the middle with an average age of 27.

To avoid a political collapse which can lead to military problems, we will need to aid in the retirement of the senior populations of the so-called developed world which suggests that taxes on the productive sections will go up. For the teenagers in Africa we will need first to feed them, then educate them to find useful jobs with a future. 

Currently almost all general portfolios are invested largely in the Northern Hemisphere and in developed countries. We don’t have ten years to make the shift if we want to be ahead of the data dependent crowd betting on low return solutions. At some point we will need to understand demographics as we answer the cover of this week’s Barron’s, “Commodities: Time to Buy?” In building our longer term portfolios, we need to recognize that increasingly people will be living in or very close to cities, not in the country. This should refine our investments even further.

For most investments you can see a lot by just looking.  Earlier this week, in walking relatively few blocks into the local business district I saw a uniformed workman with a meter rapidly going from home to home. When I caught up with him, he announced without breaking stride that he was a meter reader and the day was so pleasant that he wanted to finish his task. Years ago, as an electronics analyst I followed companies that were developing remote meter reading that could be done from some base station. I was pleased and somewhat dismayed that my brief walking companion still had a job. I don’t know that if he had been replaced by technology he would go to the mall or the downtown where stores were looking to add sales people.

Last year I told someone that I could assemble a world class investment organization knowing a large number of investment professionals that were out of employment or were unhappy where they were. Enough of these individuals have now found their conditions have changed that I feel I could not back that statement up today. From my friends currently running financial groups I hear they are finding it difficult to find the right type of people to hire.  Because of our educational systems' failures we are likely to have increased structural unemployment such as the meter readers or the children recently graduated with liberal arts degrees. Nevertheless our economy is showing signs of strength. The five year and under portfolio is likely to enjoy both improved results and a measurable downturn which hopefully will come later.

Question of the week: Which will come first, DJIA 32,000 or 10,000?

__________    

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Get Ready to Pay For the Price of Wisdom

Introduction

August is the time that many parents and grandparents send tuitions and other payments to institutions of supposedly higher learning. We do this with the hope that our children and grandchildren will learn useful life lessons. (We recognize that so-called life lessons as taught by ivory tower academics will quickly evaporate, leaving a residue of how to spot valuable lessons in the “real world”.) But our young are not the only ones who should be prepared to enter a period of intense learning where they will be challenged. I suggest that every investor in the world is about to enter such a phase, whether we like it or not.

In a recent well written interview with the leaders of an important private-equity firm that was coming back from some serious mistakes the following points were made:

          “We had great successes which led to great mistakes.”

          “Ultimately mistakes are a bridge to wisdom.”

We are rushing up to such a bridge. We need to recognize the bridge is a toll road. A payment will be extracted from us whether or not we want to get to the other side. Further, we probably won’t be able to turn around and return to an investment period characterized as complacent, at least on the surface.

Still, calm waters

For the sailors among us until Friday the stock markets looked to be becalmed. This was in spite of Ukraine, Gaza, and Iraq battles, and economic data being published that is contrary to many learned estimates. Most so-called experts have been expecting interest rates to rise. However, by Friday 15 and 30 year mortgages, plus jumbo mortgages and rates on car loans all declined on a week to week basis. Reinforcing a feeling that the banks while fighting for market share are anxious to make retail loans, the average rate for money market deposit accounts (MMDA) also fell a bit. Many investors also do not seem to be concerned about the slowdown of the engine of Europe that is Germany.

I believe their attitude is that this is entirely due to sanctions on Russian trade. This is a concern to me on two counts. First, I believe the slowdown is being caused by deteriorating business conditions on the Continent;  Italy is already in recession and France won’t be far behind. The second count is the parallel with the month in between the assassination of the Archduke Franz Ferdinand and the first declaration of war to begin WWI. For my non-history student readers, the declaration was by Austria against Serbia.

A number of my friends who are believers in the value of charts are as usual worried. They question whether the declines we already have seen are the early stages of a standard correction to the remarkable results we have experienced in the price performance of many stocks led by small caps in general and numerous social media and biotech stocks.

I suspect we will at some point, not of our choosing, be buffeted by violent winds that will drive us back on to land again or out to sea to be exposed to greater danger.

The ultimate “Head Feint”

For my readers not familiar with American professional football^*, when the teams line up on the scrimmage line some players move their heads in what they hope will either make the opposing team think they know where the play is going to go or cause an opponent prematurely jump the line and draw a penalty. The next move in stock and bond prices may very well be such a head feint that will get many investors expecting a move in one direction, when the more significant move is in the opposite direction.

^* I have served as an investment advisor to the National Football League and the NFL Players Association for the past 20 years.

As my regular subscribers have learned I am very concerned that we could be due to have a material decline, possibly of the 50% variety. Based on the past, I believe to get that terrible decline we will need to see a sharp price rise in enough securities beforehand to suck all or almost all of the sidelined cash.

Wise lessons 

Wise lessons for forthcoming markets:

1.  Assume that each of us individually, corporately and politically will make mistakes. The key is to recognize the mistakes quickly.

2.  As skilled traders we may want to ride the momentum, but as investors, we should practice investing against the headlines and pundits.

3.  Recalculate your spending reserves. In our time span portfolio approach I advocate determining the rate of expenditures over the next two years including the potential of some negative surprises. I believe the discipline of a spending rate determination should be based on current facts not an overall budget calculation and not a copy of last year’s spending.

4.  Most investors talk long-term, but recognize that investment committees, both formal and informal may change over a five year period. Thus the replenishment portfolio to recapitalize the operating fund should expect a significant decline in the market in the next five years. (Readers of these posts should understand that it is the tyranny of these changing investment committees that I focus most of my commentary.

5.  Those investment portfolios that can expect to meet institutional or family needs beyond five years but within the expected lifespan of the bulk of the investment committee should develop target prices of securities that would make them attractive. These can be the existing names or new ones. For those who have high confidence in their analytical skills, earnings per share, gross margins or return on invested capital or similar measures can be used as triggers rather than prices. Warren Buffett looks for periodic price slumps to buy at favorable prices as did Sir John Templeton.

6.  For those who are managing their own or institutional money to meet the needs of future generations, the changes in market structure which accompany major stock price declines and other disruptive events create opportunities to find new champions which can produce spectacular value. If a number of these can be bought in the dark days, losses should be relatively small as a percent of the overall portfolio and the winners could be very meaningful.

7.  Never stop learning and looking for wisdom without being defensive of what “we know” that can prove to be it is just not so.

 

Please share with me what lessons you have learned and particularly those that you have now discarded.

__________    

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