Turning Point or Bump? - Weekly Blog # 645

 

Mike Lipper’s Monday Morning Musings

Turning Point or Bump?

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

Investors can go to school on the lessons learned from September 2-5, 2020. Each day’s lessons can help determine the longer-term implications, suggesting either a turning point, a correction, or a bump. (As usual, my views focus on shepherding the assets of institutions and individual long-term investors.)

Record Index Highs of September 2nd 

All investors are captive to the media and pundits on their platforms. In this “sound-bite” world, the movement of “the market” is described by referencing one or more “popular indices”. If you believe them, the market achieved a high in terms of the recovery, year-to-date, or for all time. The reality is quite different. Using the Standard & Poor’s 500, a high point was reached. However, excluding the five tech-oriented winners and focusing on the investment performance of the other 495 stocks in the index, the average performance for 2020 was -2%.

Reaction to Tech Dominance - September 3rd 

The replacement of three stocks in the Dow Jones Industrial Average and the impact of Apple’s stock split highlighted that the index was becoming more captive to technology. For market historians, the emphasis on tech could follow past patterns of DJIA changes, which tended to occur late in their cycle of market leadership. The probable reaction in a low transaction volume market was to sell with “the market”, which at one point had the DJIA falling more than a thousand points before a wave of buying reduced the losses materially. However, this brought in another wave of selling which caused the DJIA to fall back toward its lows of the day.

The Battle on Friday, September 4th 

This preceded the three-day Labor Day holiday weekend and I suspect margin accounts, particularly those that were heavy users of options, were forced to put up more margin or sell out. Traditionally, margin calls are met by liquidating positions held by the owner or the source of the borrowed funds. I believe that what made this liquidation different was that some of the selling was done by new users of options, some of which were young, inexperienced electronic traders. In addition, there is a printed rumor of an Asian investor holding options on $50 Billion worth of securities. Market makers often take the other side of a derivative trade, which would have added to the volume on a low volume Friday. Few active market participants wished to carry large positions over this weekend.

September 5th - Kentucky Derby Lessons

Long-term readers of these blogs recognize that I’ve learned more about investing at the New York racetracks while at college, than sitting in a New York classroom. With only thirty minutes between races, one learns quickly. Thus, reading about The Kentucky Derby today, I see investment lessons.

• The single most important factor in making an investment decision is guessing the magnitude of the potential return. The known denominator for the racetrack bettor is the approximate quoted odds for a fist place finish. (The odds for second and third can be calculated by hand, with a little bit of work.) The smallest odds are for the horse that the weight of money believes will win. Favorites only win about 1/3rd of the time and extreme favorites require the bettor to put up more money in addition to the wagered amount. These so-called odds-on favorites only win about ½ of the time. The favorite for this Derby was going off at 3 to 5, which means that a bet of $5 would win $3 in addition to the return of the original wager. To me these are normally bad bets, as “things happen”, or if you prefer “racing luck”. It is like investing in the most valued stock in terms of the highest price/earnings ratio or similar measures. As I expected, the odds-on favorite ran a good come from behind race to finish second, but the slightly less raced winner paid off substantially more.
• Present conditions are rarely the same as those in the past and they sometimes dictate the result. In this case, as with most Kentucky Derbies, there were probably twice the number of horses racing than usual. Passing tiring horses requires the effort and skill that some horses and jockeys don’t have. Furthermore, for the favorite in the race, it was run with a shorter home stretch than the race immediately preceding it. This favored the horse leading at the beginning, as the race to finish from the last turn makes it harder for the oncoming horses. With publicly traded stocks, the different conditions can be subtle but meaningful accounting differences, as well as the dates of their announcement. As the US stock market is institutionally driven, large market forces are the only buyers able to move highly popular stocks. (Generally, I prefer under owned stocks and funds that own them. Recently, this has been the exact wrong strategy due to the high concentration of ownership in a limited number of companies.)
• The team behind a horse can be very important. The winning team for this Derby had a trainer who has now won the most Kentucky Derbies of those still training and runs a very people-oriented operation. He and their connections were cheering for the winner in the name of an assistant trainer who had just broken his arm when one of their entries fell on him. Among the owners are a syndicate of 4,600 investors, giving them access to substantial capital if needed. 
• The trainer instructed the jockey, a previous multiple Derby winner, to use the whip on the left side to keep his young, fractious colt from getting too close to the rail. The rough equivalent I use in picking mutual funds for our clients is applying the decision processes to both a particular fund and its management as a whole. I pay particular attention to the level of specific knowledge portfolio managers and their supporting analysts have on individual issues.
• Finally, there are horses that do better at particular tracks and distances. Today, many managers are primarily focused on near-term performance years.  Some believe we are in the last phase of an investment cycle and are delaying the sale of principal positions until they reach an expected peak in 2021. There is also one large brokerage firm advisor who thinks that the “new normal” will usher in a new, long cycle. Our job is to select the appropriate length of the current market for each account based on their needs and internal policies.

Question of the week: 

Do you think last week was a turning point or just a bump in the road as we move higher to a new event or stimulus? 

     

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

https://mikelipper.blogspot.com/2020/08/caution-ahead-emotional-turns-likely.html

https://mikelipper.blogspot.com/2020/08/mike-lippers-monday-morning-musings_23.html

https://mikelipper.blogspot.com/2020/08/mike-lippers-monday-morning-musings.html

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A. Michael Lipper, CFA

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Labor Activity Needs Protection

Introduction

The nature of humans is to labor to make better and safer lives for themselves and their families. The unfortunate image coming out of today’s school systems and many of its union-dominated teachers is that manual labor and skilled labor by employees is to be celebrated only on Labor Day in the US and similar holidays elsewhere.

I see labor all around. Certainly the homemaker producing meals, keeping house, and often serving as the household purchasing agent is laboring. Laboring also are the portfolio managers who are acting, along with others, as stewards for the retirement funding of employees. Many of these put in more hours than some that are punching a time clock or equivalent.

On Labor Day 2014, I think we should be thinking about how to make all that labor a better value. At the first level we should see how to improve unemployment and under-employment. At the next level we should be paying attention to retirement funding. Finally, almost all laborers desire to take care of beneficiaries after they are gone. This post will share some of my own thoughts on each of these topics.

Mismatched openings and job seekers

As someone who speaks with various employers and particularly entrepreneurs about their future progress, I often learn about the need to fill particular positions within their organizations. Often they cannot fill existing (or more importantly new positions) not because applicants don’t have the required skills. If the employment decision was left to a computer match procedure, it is estimated that all or almost all the roughly four million job openings would be filled very quickly. But that is not the case when are faced with hiring fellow humans.

I don’t know where so many of these applicants get their work-related attitudes; whether from their families, friends, or their teachers. The first hurdle is that the world or others owe them a job. The second is that they have pre-conceived notions as to the conditions of employment which they think they should dictate. In many cases they do not grasp how a commercial organization functions to provide what the clients expect and need. Too often they anticipate that their co-workers will make room for them and coach them on the first day as to how the work and social elements really work.

I believe that everyone within an organization is a salesperson meant to convince every contact that his or her firm is absolutely the best organization to meet people’s needs. We are all involved with sales and service. People who want to join a firm need to feel loyalty to the firm, its customers, managers, and fellow employees. The sad truth is that there is not enough of these people, thus a number of the openings will not be filled.

The cost of vacant jobs

The economic and financial impacts of not filling the vacancies are significant. As long as people are unemployed the cost to the society will be high in terms of taxes paid and more significantly a shortfall in consumer purchases. There are also, at this time, important investment implications to the unfilled openings. Organizations will not be operating at optimum productivity levels. Profit margins will be less than what they could have been. Today there is concern that profit margins, not profits, have reached record levels. If these slip, even with higher sales generated profits, the valuation afforded these stocks will decline, as they will be viewed as more cyclical and thus could lose their place in some portfolios.

Profit margins are under pressure in numerous employers and particularly in health and financially oriented concerns today. Due to increases in compliance and supervisory responsibilities, companies are being forced to hire good but unproductive people in terms of bringing in more sales. This is hurting existing margins. When we combine these pressures with much more restrictive activities mandated for the financial community the results are significant layoffs at numerous banks and other financial firms. Major clients are already seeing a decline in the levels of service and supervision. I suspect that this trend will continue unless there are major changes in regulation.

Retirement funding awareness

One of the potentially major upticks for labor in the US is the ability to influence its own retirement funding. The switch to Defined Contribution plans from Defined Benefit plans can produce a retirement account that more closely represents what the specific employee wants from the available alternative options rather than being bundled with all other employees. The various 401(K), 403b and 457 plans leave the responsibility of choice to the individual. These plans need to be carefully constructed in terms of levels of contributions, matches, vesting, fees and expenses.

I am pleased that according to BrightScope, the Number One plan based on these characteristics in 2013 was the Second Career Savings Plan for the National Football League and the NFL Players Association that I have advised as to the construction of nine specific fund accounts.

The reason for the nine accounts was to allow the Players to decide how they wanted their money to be invested, in a collection of mutual funds or separately managed accounts that generally clone their advisor’s funds. Other retirement accounts that we manage are customized to the needs of the employee base. However, all investors including retirement plans are exposed to both stock and bond markets. With that thought in mind, we all should ask whether there are parallels between Labor Day 2014 and Labor Day 1929.

As was noted in The Wall Street Journal, both days had just past the 2000^th day of a bull market. In the case of the earlier market it continued to rise in September and started its cataclysmic decline in October 1929 to recover in December but the damage had been done to the confidence in the market and eventually the economy.

Should employees and other investors totally jump out of the market with the belief that they will jump back in at materially lower prices?

The great portfolio manager, Peter Lynch, who built such a great record at Fidelity, is quoted as saying that more has been lost by investors trying to execute such a maneuver than the size of the losses at the bottom. In addition, I would be particularly careful investing substantially in high quality bonds now. Instead of celebrating that the purchasing power of bonds is now stable to perhaps rising which will help the long punished retirees, the central banks such as the Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan are very much interested in raising the rate of inflation to spur more risky investment as a way to create jobs. If they are successful, the purchasing power of bond principal and interest will decline. Based on their past record they may not be successful.

Helping beneficiaries

All of us who are looking to the future for the benefit of families and others such as universities, hospitals, and other non-profit groups need to invest over multiple time spans. In prior posts I have discussed our Lipper Time Span Fund Portfolios which are designed to meet the different needs of beneficiaries. With the measurable possibility of a significant market decline sometime in the next five years we have created a Replenishment Fund Portfolio concept (REPPORT) to replenish the capital that will be spent over the next two years to meet operating needs by the Operations Fund (OPPORT).

The Replenishment Portfolio probably has a mixture of equities and fixed income funds or securities with a maturity of five or fewer years. With the recognized risk of a significant decline and Peter Lynch’s warning, a conservative approach is warranted. At this point I would select funds that invest in companies that have relatively little debt but compared to others have high returns on assets, equity, and invested capital.

At the other extreme in terms of time spans, the Legacy Fund Portfolio should be looking into funds that invest in companies that are spending wisely in research and development plus intelligent brand building. If these companies do spend wisely they will be creating the kind of unassailable position often called the protective moat. At that point they should be producing substantial excess capital, fulfilling Warren Buffett’s favorite structure of a company that has both a moat and a fortress. On the way their financial ratios are unlikely to match those found in the Replenishment Portfolio.

Question of the Week:

 

Where and how are you finding new good people to hire?
__________

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Copyright © 2008 - 2014

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.