Selling: Art & Risks, Current & Later - Weekly Blog # 803

 

Mike Lipper’s Monday Morning Musings

Selling: Art & Risks, Current & Later

 

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

 

 

 

Most Difficult Decision

After a decision is made to purchase one or more securities the level of complexity escalates through one or more holding periods. The act of selling has immediate performance implications, but also has implications for the rest of the lives of the investor, their inheritors, and various governments. Because of these implications, the decision process should consider factors wider than the simple decision to purchase.

 

Decision Making

Individual investors often start their investment process by thinking about “their” money and its personal use. Over time their thinking may broaden to include their responsibilities, leading them to start thinking of themselves more as fiduciaries. Most investment money, including that in various institutions, is managed with fiduciary principles in mind.

 

However, when we bring a professional fiduciary into the picture, the decision dynamics evolve. The fiduciary unsurprisingly wants to be compensated. More importantly, in our litigious society fiduciaries want to avoid being sued. Most suits are decided on the basis of the 1830 Putnam vs Harvard (Prudent Person) case, which holds the fiduciary performance standard to what other prudent people would do with their money. This is a backward-looking judicial view. (This approach created the performance measurement business, which benefited the author and my various associates.)

 

While this approach is addressed by the so-called “Prudent Person” decision process, it doesn’t make a lot of sense for a forward-looking investor. For example, if a manager stays fully invested in a speculative securities market decline and vastly underperforms a more diversified portfolio, he would be judged imprudent for the declining investment period. However, if the measurement period included the recovery and a subsequent growth period, the entire period might be much longer than desired for a more conservatively managed account.

Where Are We Today?

Since we look at investing through short to long-term periods, the following views express an opinion, not a prediction as to three stimuli.

• Investors are fleeing China, driving many prices down. If you are a trading investor who values short-term performance, it might make sense to reduce exposure. However, there are two reasons that suggest the opposite.

1.    Betting against volume normally works better than the opposite.

2.    Without the growth of Chinese exports, world growth will be constrained.

• The three major US stock market indices had a dull to sloppy week. The S&P 500, representing the bulk of investor’s capital, fell slightly through a technical barrier. While not a prediction, it could suggest the calendar year might finish with small gains for the year. If that turns out to be true it would confirm we are in a period of stagflation similar to FDR’s depression and a model for Joe Biden.
• All three dominant political leaders: Biden, Trump, and Xi, were/are concerned with the need to create employment opportunities for younger voters and spenders. History shows others using effective ways to accomplish this goal.
• In ancient Rome, legionnaires were awarded captured farmland to provide food for Roman staff. It also served to cultivate political capital. The building of the viaducts was also needed to bring food to Rome.
• President Eisenhower pushed a national highway system, which improved interstate commerce and employed private workers. Ike had the benefit of several knowledgeable brothers, which were Presidents at local banks and Universities.
• Xi has possibly built the biggest and fastest railroad system in the world. US rail and airport infrastructure is way below many third world countries.

Now it is Your Turn

The ultimate value of these blogs is to raise discussion of these controversial views. Let’s hear from you.

 

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Mike Lipper's Blog: Investment Thinking During a Lull - Weekly Blog # 802

Mike Lipper's Blog: Need For a Correction Decline - Weekly Blog # 801

Mike Lipper's Blog: Not Yet! - Weekly blog # 800

 

 

 

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Headlines Excite, Dictate, or Respond, not Inform - Weekly Blog # 647

 

Mike Lipper’s Monday Morning Musings

Headlines Excite, Dictate, or Respond, not Inform

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

As has been previously expressed, investment markets have entered an emotional trading phase. The combination of a US election, COVID-19, a new justice for the Supreme Court, and military accidents, primes the next four months for active trading and makes it inhospitable for long-term investing.

Even when the source is a generally respected, media headlines can be misleading. The wording of headlines is often not the choice or responsibility of the author or the assignment editor, but of a very busy headline editor quick to read, but not as familiar with the topic as others.  Each person that touches an element of the news views it through the lens of their own biases. In the current emotional period it is not unusual to see political bias in each of the news elements, including the headlines. This misdirects the audience and raises questions regarding the utility of the news elements.

In The Wall Street Journal weekend edition there is a headline “Stocks Fall for Third Straight Week”, which  makes it sound like we’ve entered a bear market. (That could please some reporters/editors who have different political views than the higher priced Editorial Board Members representing the official view of the publication.) When one reads the headline, the initial reaction is to expect a meaningful weekly decline, probably double digits. Nowhere in the article is it mentioned that the Dow Jones Industrial Average declined -0.03% for the week, or that the market went up three days during the week. The article neglected to mention something that is probably more bearish, that the Friday decline had a materially larger volume of shares traded. This may be the reason investors need professional analysts to review current market conditions.

One Day Difference, Distinctly Different Conclusions

Regular readers know that my first lens on the market is through the actions of the mutual fund professionals. Historically I have relied on fund performance for the five trading days ended Thursday. I do this for two reasons: 

1. I used to hire good people from the “back offices” of fund groups and their custodians, where I learned of the natural pressure to quickly finish computations before leaving for the weekend on Friday. Consequently, the Friday calculations were generally not of the same quality as Thursday. 
2. In addition, when stock specialists set transaction prices there is a natural tendency to reduce capital exposures over the weekend.

For the week ended Thursday, US Diversified Equity Funds (weighted by performance) averaged a gain of +0.98%. However, that is not the full story. Of the eighteen included investment objectives, only one was down for the week, Large-Cap Growth Funds -0.13%. The performance of these Large-Cap Growth portfolios has been dominated by well-known tech companies. To understand the impact of the media’s focus, look at the year to date numbers, where the US Diversified Equity macro group gained +4.71%. Performance was driven by the Large-Cap Growth Fund average return of +20.24%. However, that was not the critical number in understanding the impact of the markets, where the median fund was down -3.18%. (The median is the midpoint of the performance array.) This is significant because if one adds up all the money invested in Large Cap Growth funds plus the money invested in S&P 500 Index funds, it represents only 36.9% of the money invested in the US Diversified Equity group. Thus, it is of interest, but is not a full measure of the performance of the market. The extraordinary gain from the March bottom is not so large that a major overall correction is warranted, a view contrary to one you’d get from reading financial columns this weekend. Another thing not credited is the downward selling pressure exerted on some of the best performing stocks in order to fund the purchase of 17 IPOs which began trading thus week.

A Very Bullish View

A large US brokerage firm believes the initial impact of the Coronavirus began a new market cycle, with profit margins expanding into 2021. They could be correct in the absence of any new negatives appearing, although my own view is that they could be a year early.

Portfolio Management Views

1. At some point in long-term portfolios there is a danger that every single position does well. This is dangerous because when the inevitable market decline happens, almost all the positions are likely to decline. Some late blooming positions are a sign of a prudent manager who wants to own something going up in almost all market conditions.
2. By far the largest surprise in many portfolios is my belief that we are not in a permanent low interest rate environment. Since few people are looking for an explosion of interest rates, I am of the belief that good things don’t last forever.

Questions?

What surprises are on your worktable?       

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

https://mikelipper.blogspot.com/2020/09/mike-lippers-monday-morning-musings-who.html

https://mikelipper.blogspot.com/2020/09/turning-point-or-bump-weekly-blog-645.html

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

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

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How Much Will Markets Decline: 10%, 25%, or 50%? - Weekly Blog # 610

Mike Lipper’s Monday Morning Musings

How Much Will Markets Decline: 10%, 25%, or 50%?

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

The next unknown is no longer a question, securities markets will decline. Some are now focusing on signs that most securities markets are showing an increased potential for decline. I therefore turn to an even more difficult question of how big the decline will be. Based on history, the size and length of the decline will likely set up the size and duration of the following bull market.

Size and Duration of Slump Influences Recovery+ Subsequent Growth 
One can divide stock markets falls into three categories: correction, secular, and fundamental. Each are different because their causes and impacts are different. One of the most difficult tasks for professional investors is to prepare for a decline before it happens. Most investors firmly believe that a current trend is their friend and choose not to prepare. They believe that predicting a decline is impossible. Furthermore, they believe that they will see early evidence of a decline and will be able to exit with relatively small losses from peak prices. The truth in markets and sports is that all trends eventually stop, often abruptly. What is particularly costly is the belief that the current decline is only temporary and not a cause for action.

With those thoughts in mind I’ll examine the most frequently occurring, and in many cases the most painful type of correction. Enthusiastic investors are the major cause of market corrections. They ride an upward trend of expanding price valuations that get way ahead of fundamentals. For example, many stocks have recently gained over 20%, even though earnings were likely to be down in the fourth quarter. They are also likely to be down in the first quarter of the new year, contributing to the mid-single digit gains expected for 2020.

A market correction is often not tied to an economic contraction. Paul Samuelson, the great MIT economist, is quoted as saying "The stock market has predicted nine of the past five recessions". Typical market corrections are of the 10% magnitude and only last a couple of months. In the history of market analysis, often called technical analysis, the fall is due to "weak holders selling to strong holders at discounts". The painful part of the process is not the relatively small losses sustained by the weak holders, it’s the much larger opportunity loss of missing out on the recovery and subsequent growth thereafter.

Less frequent declines occur when upward earnings and economic trends are temporarily interrupted. If the pause is caused by a specific event not expected to be repeated, long-term investors will stay committed. The problem is that what was first believed to be temporary often stretches out over time. If corporations and other investors begin to believe that a major change has occurred and their expectations of future cash earnings from their investments decline, it may cause a change in investment policy.

As many secular trends will reassert themselves, the pause should be tolerated without investors being shaken out of their positions. Demographics, education, and health are likely to be such trends. Secular changes usually happen slowly but can be recognized after a few years. There are often a couple secular changes within a decade that are capable of taking the large-caps that dominate the popular averages down about 25% from their peak levels.

The largest decline by far is caused by fundamental changes in the structure of society. A good example of this was the Great Depression, which has some parallels with conditions today. In the 1920s the WWI peace dividend freed up capital markets, encouraging both individuals and corporations to take on substantial debt. This led the politically sensitive farm community to increase production with borrowed money. Additionally, public utilities evolved into highly leveraged holding companies and Wall Street brokers enticed new investors to jump into "The Radio Boom". Each of these inputs, and others, were eventually dealt with by unwise federal government actions.

Against his own instincts, President Herbert Hoover signed a material increase in tariffs designed in part to help and protect farmers. It however also led to a major drop in world trade, particularly for labor-intensive manufactured products. One of FDR's many new regulatory agencies, the Securities & Exchange Commission, worked with an activist Federal Reserve and raised the collateral requirements for margin. While the number of radios around the world continued to grow, their prices fell. RCA, the highest quality stock in the Radio Boom, declined and did not return to its former peak until the color television expansion in the 1960s.

These and other federal government actions probably turned a secular decline into a fundamental slump, lengthening the depression from its probable end in 1937 and delaying its recovery until the WWII expansion beginning in 1942. Depending on what indicator is used to measure the decline, an important fundamental change could reduce prices by more than 50%. In the case of the Great Depression, prices collapsed by 95% in some cases, if they weren't totally wiped out.

Are there parallels today? The sharp decline in farm income spurred on by NAFTA and tariff changes could be viewed as politically motivated, as is the global impetus to lower interest rates. While the S&P 600 small-cap index was the best performing major stock market index for the decade just ended, it was the worst performer last year. The winner was large caps, with the DJIA and S&P 500 led by their mega-caps. Information technology stocks were up 50% in 2019, about double the average return of US Diversified Equity Funds. Different periods produce different results. The S&P 500’s best decade was 1950-1959, gaining +19% compounded. The worst decade was 2000-2009, losing -0.86% annualized.

Help may be on the way from the private sector if the governments around the world don't interfere. Long-term interest rates are starting to rise and at some point they may exert some discipline on the leveraging going on. However, stock markets have not done well historically when central banks have responded to political pressures and made cheap credit plentiful. As equity owners, we are better served by borrowers being disciplined and managing their debts prudently.

Symptoms More Important than Temperatures 
Experienced medical personnel are guided more by a patient's symptoms than by temperature, pulse, and blood pressure readings, as people and conditions can be dramatically different. Consequently, as an analyst I pay much more attention to symptoms than a specific numerical reading. Everything about modern living and markets happens at different rates of change (10% for corrections, 25% secular interruptions and 50% plus for fundamental change). The markets don’t readily march to a calendar either, even tax dates are only momentarily important. In evaluating stock markets, it is much wiser to watch people and how they react than fixate on specific numbers.

Contrarian Interests 
For investors not involved in competitive races, utilizing a streak of contrary thinking can lead to smaller losses and bigger gains over the long-term. On a given day a slow horse can be a winner if it is just a little faster than the others. I often see a change of leadership between small and large-cap securities, also emerging markets and venture capital investments. The most profitable bets are often contrary to the size of their flows. Consequently, I would now bet on energy stocks vs. information tech, small vs. large-cap, emerging markets equity vs. venture capital. Contrarians generally suffer smaller losses.

Question of the week: 
Do you know more contrarians who are currently broke or formerly wealthy individuals who are now broke?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/12/repeat-past-history-probable-or-just.html

https://mikelipper.blogspot.com/2019/12/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2019/12/faulty-decision-processes-at-change.html



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Copyright © 2008 - 2019
A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

Cash is a Four-Letter Word - Weekly Blog # 556

Mike Lipper’s Monday Morning Musings

Cash is a Four-Letter Word

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

                                   

We have been instructed not to use foul language in polite communication, (think of another four-letter word beginning with “F”). The time to recognize the biggest danger of a word and the concept behind it is when the word is most useful. That is exactly why I am calling to our subscribers’ attention the word “cash”. It looks like cash will be the only positive major investment class in 2018. Stocks, bonds and commodities, as well as some real estate and most currencies, except the US dollar, will all have a minus sign in front of their performance.

Major brokerage firms and various wealth management groups are heralding cash as the preferred asset class. Yes, it is better to make small positive returns than losing money. I have been studying this question for more than sixty years. Recognizing my historic bias based on my experience of using mutual funds, I use mutual funds as my primary filter. Utilizing the latest available data from the Investment Company Institute (ICI), with numbers as of September 30th, 2018, the aggregate weighted average cash commitment for all long-term funds (equity, hybrid, and bond funds) was 3.2% of assets. Most investment objectives have 5% cash or less as a percent of their total assets. This roughly represents under one year’s regular income production. Those reserves would only allow for a few additional names to be added to their portfolios and therefore would not normally be enough to make an enormous difference in performance. Unfortunately, many funds today are having net redemptions, which can only be handled by judicious selling. Many fund managers are concerned about a sudden surge in redemptions at the very same time of weak prices and limited available liquidity and do not want to commit all their cash to the market. There are two exceptions to the relatively low cash commitments, Asset Allocation Funds (18.25%) and Flexible Portfolio Funds (14.14%). While these funds often appear near the top of the performance parade in a declining market, over a full market cycle they are not even close to performance leaders.

Not only do I pound performance data concerning this issue, but I spend time with senior portfolio managers and presidents of fund management companies. There are all kinds of managers perceptive to future market declines and they often tend to be premature in terms of timing. Rarely do they commit the bulk of their reserves anywhere near the bottom. Matter of fact, when the eventual full recovery happens, they often have not fully committed to the markets moving toward new highs. Why does this occur?  Usually the recovery is based on anticipation of favorable changes not currently reported to be in place. Another reason is that emotionally the cash position is providing too much comfort. Buying after a meaningful decline requires some extra intestinal fortitude. Perhaps we should search for fund groups that replace the savior of funds relative assets with a rigorous long-term committed runner.

Recently we were able to restore appropriate equity fund levels to a cash flow account. This is an example of the advantage that some institutional accounts have over a fully committed personal account. Further, I suggested to a younger subscriber that he commit half of his cash reserves over the next six months to meet his retirement capital needs.

This post focuses on cash allocation as an input to a performance focused portfolio, which could be a semi-permanent element of portfolio management. There are other cash buckets such as planned external cash expenditures and purely opportunistic cash awaiting near term deployment. I do not know which cash bucket was used on Friday. Some of the financial sector stocks I follow showed transaction volume being 50% to 100% greater than Thursday’s volume. Friday’s combined NYSE and NASDAQ share volume was the highest since August of 2011. To me, it is more interesting to guess the motivation of buyers who are making commitments than sellers who are giving up. Traditionally, market analysts view this type of transaction volume as stock moving into stronger hands capable of tolerating currently perceived concerns.

For several long-term accounts that have periodic external payment needs, I have suggested that once a cash commitment is made it should be separated from performance analysis. This anticipates the actual expenditure but does not factor it into the asset allocation analysis. 

What to do Now!!

• Determine whether the resignations of General Mattis and the chief envoy to the anti-ISIS coalition are signs of continued political disruption which are of greater concern than trade issues. 
• Recognize that some of the signs of short-term capitulation appear to be evident, including Friday’s spike in trading volume led by stock price declines of former large “tech- leaders”. These stocks fell about 5% on Friday compared to 3% for most other stocks. The greater declines of NASDAQ stocks relative to NYSE stocks were probably the result of less liquid OTC trading books. 
• In a measure of price movements for the week, a chart in The Wall Street Journal showed that only 19 out of 72 price indicators rose, eight of them being currencies. 
• One measure of market sentiment is the often-mentioned American Association of Individual Investors (AAII) weekly sample poll of responses to the question of market direction for the next six months. The current reading showed that most of the sample were bearish or bullish, with a decreasing number being neutral. This is essentially a prediction of continued high volatility. Supporting this view are the 25 best performing funds for the week, six of which were invested in Futures, a leveraged way to bet on fast movements during a short period of time. 

We will only know later if we are at a bottom or not. What we should be doing is following the words of the famous Wall Street trader and a friend of my Grandfather, Bernie Baruch. Explaining his actions before a post-crash investigation committee of the US House of Representatives he referred to himself as a Speculator, which he defined as someone who looks to future time horizons.

Looking to the Future
Long-term value-oriented investors should change their focus away from expected current earnings reports. The great John Neff of the Windsor Fund developed his thinking as to the ultimate earnings power of companies during “normal” times. This allowed him to buy good companies at remarkably low price/future earnings ratios compared to high P/Es on declining earnings. This strategy worked for many years, both for the Windsor and Gemini funds.

Growth oriented investors would be wise to review the current issue of Barrons, which had a long article on a Venture Capital Round Table. I found two items of great interest. The three participants were investing in their expectation of future disruptions to various economic sectors: Financial Services, Supply chain Management, and Farming. To show how far out into the future their thinking extended, there was a discussion on manufacturing products in space, which they saw as a new commercial frontier. As a student of the market, the second thing I found of interest was that one of the three was a successful portfolio manager of an open-end mutual fund, T Rowe Price New Horizons (*). To some degree he and other open-end funds are investing in private companies because of the reduction in the number of attractive publicly traded small and mid-cap companies. Many of entrepreneurial companies are now waiting longer to go public.


(*) A long position is held in client and personal accounts.   



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

https://mikelipper.blogspot.com/2018/12/news-focus-may-drive-investment-success.html

https://mikelipper.blogspot.com/2018/12/investment-memory-friend-or-foe-answer.html

https://mikelipper.blogspot.com/2018/12/worries-2nd-derivative-3rd-degree-and.html

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.