Manageable Risk - Weekly Blog # 790

 

Mike Lipper’s Monday Morning Musings

Manageable Risk 

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

 

 

 

Uncontrollable and Controllable

Every day in almost every activity we can increasingly be the victims of bad things. That is certainly true of our investment activities. Short and long-term weather, misjudgments of governments, inflation and deflation, as well as other accidents. Essentially, these are beyond our personal control. We can try to anticipate or at least recognize these risks and attempt to take some defensive measures.

 

Controllable risks can be addressed by our own actions. In our investment actions we should be aware of the various mistakes we could make. Both large and small errors should be avoided, usually by being more patient. In making investment decisions it is wise to remember what our changing attitudes bring into the decision process. This summer may be a particularly important time to recognize that we may have entered a new phase of the market.

 

The Game May Have Changed

If you pay attention to what various pundits in the media, political office, or investment circles are saying, we are either in a "bull or bear" market. Quite possibly we are in neither and have not been in either for some time.

 

Market cycles don't follow calendars or the movement of selected indices. Investments don’t move in lockstep with one another either. My particular laboratory is the weekly performance 109 identified mutual fund sectors invested in equity, debt, currencies, commodities, and combinations of largely publicly traded investments.

 

For a two-year period ended Thursday, 83% of the individual sector averages were negative. The 28 sectors showing gains were led by Japanese funds, Energy and Natural Resource funds, Capital Appreciation funds, Alternative funds, S&P 500 index funds, Short-Term funds, and Money Market funds. (Some stock indices also reached higher price levels in this period.)

 

Two Down Years Suggests a Change

We have quite possibly entered a different phase of the market and economy. We may have entered a period of Stagflation. In the last century there were two such periods, the Great Depression into early WWII, and the mid-1970s to late 1980s. The latter period killed a popular view of buy and hold forever. In both periods there were periodic and unsustained rallies of 20% or more for the indices, and much more for individual stocks. Both periods of stagnation were led by government actions attempting to prolong an aging economic expansion. These government actions hurt investor confidence levels and suggested to the public that the economy was better off left alone in returning to equilibrium.

 

Some investors currently have equity money hiding out in bonds and money market instruments. These investors are itching to bring their equity commitments back up to "normal" level. They view declines as good opportunities, which they occasionally might be, but not often. Investors should not be impatient. If we are in a period of stagflation, averaging in with a small percentage during disparate time periods makes the most sense.

 

Long Shot

We all gamble on the future and have two choices about predicting the future-extrapolation of the present or making changes to it. On a day-to-day basis extrapolation is the most likely. The longer the time period, the more extreme the changes. There can also be periodic Minsky moments of great change.

 

What happened in Russia this weekend was a dramatic event that will undoubtedly change what happens in Russia for some time. The long shot is what could happen in how the US is governed. This is not a prediction, but an examination of what could happen.

 

First, we should understand what happened in Russia this weekend. Russia does not have a large, disciplined, and battle trained army. Consequently, it had to use a number of private armies, the biggest of which was the Wagner Group led by Yevgeniy Prigozhin who disagreed with the leadership of the regular Russian army. He claimed the Russian army told Vladimir Putin that Ukraine was going to attack Russia with the help of NATO. He also complained that Russian forces were killing Russian sympathizers in Ukraine. The feud got so bad that Putin ordered Prigozhin be arrested. This caused Prigozhin to send his troops to within 120 miles of Moscow, before some settlement was reached and the arrest warrant was dropped. It was arranged for Prigozhin to go to Belarus, a Putin friendly country.

 

The key point for the US is that Putin now has less confidence in his advisers. When powerful leaders lose confidence in their people, it is often like a disease or plague potentially leading to isolation. As this plague can impact any dominant, semi-isolated person, it could impact the current White House. There are many observers who say the current "Obama White House" and Cabinet is possibly the worst performing the US has ever had. If the President is re-elected, he will be a lame duck, making him an unattractive boss for any rising politician. Thus, major changes are expected, either for career choice reasons or due to the President's wishes.

 

Changes in interest rates will have a relatively small impact on the economy. Considering inflation is generally caused by excess demand over supply driving prices higher. What is needed are customers willing to pay higher prices for more attractive goods and services. This, however, is not what Washington is looking to do,  so there may be a change.

 

Future Outlook Appears Troubling

• After a trend is recognized investment groups often change their published outlook for the period ahead.
• It has become popular to expect business conditions to get increasingly more stressed, with interest rates rising and loans becoming more difficult to get.
• China, the second largest economy is facing its own debt problems, both at the provincial level and in real estate. The big difference is how they are handling a problem similar to that in the US. They are doing it differently.
• The latest US academic test scores show 13-year old's materially declining in reading and math. Perhaps most damaging is a drop in reading for pleasure, which appears to be at a record low.
• The Chinese central government has outlawed tutoring children in order to create greater equality, although parents and grandparents feel differently. A recent article in The Financial Times shows "illegal'' tutoring thriving, at least in the top cities. Tutoring is viewed as a way to improve a student's chance of getting into better schools and universities and consequently getting a higher paying job. When constructing investment portfolios, you should consider the consequence of a decline in US secondary school learning and a decline in college applications while China and other countries show improvement in preparing future leaders.

 

Conclusions

Investors need to recognize change while continuing to focus on long-term goals.

 

 

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

Mike Lipper's Blog: Predictions Suffered Last Week - Weekly Blog # 789

Mike Lipper's Blog: Head Fake, Unrecognized Opportunity, or a Minsky Moment - Weekly Blog # 788

Mike Lipper's Blog: The Course to Explain Last Week - Weekly Blog # 787

 

 

 

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Head Fake, Unrecognized Opportunity, or a Minsky Moment - Weekly Blog # 788

 

Mike Lipper’s Monday Morning Musings

Head Fake, Unrecognized Opportunity,

 or a Minsky Moment

 

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

  

 

 

Searching For Direction

Because low US stock market transaction volume immediately followed the attainment of a new bull market milestone, the media proclaimed we had entered a so called new “bull market”. I wonder if it is true. I believe it is either a head fake, an unrecognized opportunity, or a Minsky moment.

 

Those of us who have watched or played competitive sports are familiar with a team’s attempt to mis-direct the opposition by using a well-timed head fake to draw the opposition into a perilous position, leaving them out of position to defend against a scoring opportunity. The media proclaimed we entered a new bull market following the S&P 500 exceeding a former high point. The transaction volume since then has been quite low. More to the point from my perspective, the NASDAQ Composite is still 17.6% short of its November 19^th, 2021 peak. The reason this is significant is that for some time the tech laden NASDAQ Composite Index has been the leading performance index.

 

Another interpretation is that it could be an unrecognized switch in performance leadership to the S&P 500. Supporting this view is the proportion of declining stocks vs total stocks traded being considerably lower than it was last week for the NYSE (1.9%) vs the NASDAQ’s (4.6%). Byron Wien is reported to have pointed out that it took 3 years to recognize the market hitting bottom in 1982. There is a similar slow recognition that we have entered a new bull market with a new leadership, which might include financials, transportation, energy, and materials. This could be the reason one of the stocks I own and hold in managed accounts (Berkshire Hathaway) was the leading dollar volume stock traded this week. It is an owner of these kinds of companies.

 

There is a third possibility, the entering of a so-called Minsky moment of a dramatic change. In looking at the movements of the market I look to the expertise of the management of mutual funds. In so doing I look at the data from my old firm, now marching under the banner of the London Stock Exchange Group. In its weekly data through Thursday night, I noted a statistical relationship. In a number of peer-groups the asset weighted performance was materially better than the median performance in the peer groups shown below:

 

        Average 2023 Performance through 6/8/23

Peer Group            Asset Weighted             Median

Large-Cap Growth           13.61%                10.28%

Growth                     14.54%                10.36%

Global                      8.47%                 6.52%

 

There are probably two reasons for the consistent gap between the weighted and median performance. The first is the substantial holding of at least 6 of the 10 biggest stocks in the larger funds in the peer groups. Second, the absence of floor specialists and trading capital on major trading desks has impacted liquidity.

 

If we are entering a Minsky moment it is conceivable that leadership could change dramatically from large to smaller market capitalization stocks. Just this week the leading mainstream peer group was Small-Cap Value, which on average was up +7.31% compared to +3.23% for all stock funds.

 

Other Considerations

1.  One of my worries about the current period is that the gains have tended to be small. The problem with small gains is that errors or other problems can wipe them out unexpectedly. During the first quarter the S&P 500 essentially broke even. More frightening is that analyst project a decline of -5.4% in the 2^nd quarter. They expect a 3^rd quarter a recovery of +1.7%, with a +9.0% gain in the 4^th quarter. Considering the number of errors reported in many sectors and companies, I fear these mistakes may wipe out many of these numbers.

 

In the past many of these mistakes would have been caught by supervisors. Unfortunately, many supervisors have voluntarily left or have been pressured to leave. Some misguided managements see the lower compensation paid to younger workers as improving margins. However, the higher margins don’t consider the inexperience of the new workers. Some managements prefer inexperienced workers who do not bring up delaying cautions. (We see this on some trading desks.) While employees who switch jobs often get twice their normal compensation raises, these pay increases are now declining at twice the rate of the increase paid for workers to stay.

                                                                                             

2.  Regardless of whether an investor owns a Chinese stock, he/she is impacted by the second largest global economy as a consumer of low-priced imports from China or as an employee of an exporter to China. To the extent the US restricts its dealings with China for political reasons, other countries may choose not to.

 

We invest globally, both in terms of making money for our accounts and also to hedge some of our domestic investments by owning some Chinese stocks competing against China. At this point in time, I believe every American should follow activities in China.

 

Headlines from China

1. The substantial unemployment in the 16-24 age group. I suspect many of them are better educated and disciplined than our own youths who don’t have similar attributes.
2. Second and related is the expressed view of the Chinese equivalent of our Secretary of Defense who said that a war with the US would be disastrous for them. This removes the European approach to people out of work.

3.  People at the top of the US financial ladder have some of the best investment and tax advice money can buy. I find it instructive that the top 0.1% have substantial amounts invested in haven partnerships and individual haven securities. The next 10% have very little in haven partnerships, but a lot in individual haven companies. I suspect those at the very top are concerned about preserving their wealth for others. While they fear inflation, they are more concerned about taxes. Perhaps we should be thinking long-term?

 

 

 

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Mike Lipper's Blog: The Course to Explain Last Week - Weekly Blog # 787

Mike Lipper's Blog: TOO MANY HISTORIC LESSONS - Weekly Blog # 786

Mike Lipper's Blog: Statistics vs. Influences-Analysts vs. AI - Weekly Blog # 785

 

 

 

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Chinese Emperors Learn “All Roads Lead to Rome” - Weekly Blog # 587

Mike Lipper’s Monday Morning Musings

Chinese Emperors Learn “All Roads Lead to Rome”

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

Before focusing on the underlying geopolitical/economic elements in our current tensions, we should focus on the immediate signals highlighted below:

1. As of this week seven of the twenty-one US Diversified Equity funds averages and five narrower sector fund averages have gained more than +20%, including the average S&P 500 fund.  Years ago, a manager of a corporate defined benefit pension plan with an excellent long-term record had a tactical rule. In any year that he was up 20% he went to cash. This was not a market timing maneuver, he believed that earning two to three times his actuarial assumption was enough in any year. It didn’t warrant taking any additional market risk in that year. There would always be opportunities the next year, particularly if there was a flow of new money. Some investors should follow this approach with their equity investments today.
2. Many so-called balanced funds or accounts don’t like high quality bonds. What they are holding in their fixed income allocation is meant to cushion a fall in a declining equity market. However, their fixed income allocations have assumed considerable equity type risks in currencies, high yield, or credits with very light covenants. This is particularly worrisome when the proceeds of these issues are used for increased leverage, without any substantial new earnings power being generated. Thus, many portfolios marketed as conservative investments have more than stock price risks embedded in them. Michael Cembalist of JP Morgan Asset Management is particularly concerned about leveraged loans, which are 95% covenant lite in Europe.
3. Are we approaching a time where a radical change in thinking about future trends is required? Typically, many financial and economic organizations publish their mid to long-term forecasts over the next three months. They include forecasts on domestic and global GDP, rates of inflation, interest rates, market concentration and favored industries/individual securities. They are produced by learned individuals or teams and are based on the continuation of present trends. In other words, their forecasts are like the US Fed, “data dependent”. Odds are, many of these forecasts will be right in their extrapolations, with relatively low payoffs. They run the risk of a “Minsky Moment” after a long period of stable results. (A Minsky moment refers to a sharp decline in prevailing market sentiment and economic productivity after a long period of widespread optimism). I think we are due for such an occurrence, particularly in organizations headed by long successful leaders close to their last hurrah. Remember the planner’s curse, “Men plan and God laughs”. Looking at the composition of the Dow Jones Industrial Average, not one of the thirty names is from the original list. Even the S&P 500 index funds have annual turnover due to acquisitions or lost market capitalization. I suspect we are due for a series of unexpected surprises, suggesting that after the 2019 gains we should be willing to build opportunity reserves, not market timing reserves. A future blog will address market timing issues more fully.

“All Roads Lead to Rome” - What Chinese Emperors Learned
The critical lessons of geopolitics and their accompanying economics are driving our two modern emperors today, the leaders of China and the US. The first era they should recognize is ancient Rome, which turned the Mediterranean into a Roman lake. Their power did not rest solely on the strength of the Roman legions, but more importantly on the success of their engineers in building roads and water viaducts. These were critical in supplying their capital center with imports of grain and captured slaves.

Over the centuries the Mediterranean held the keys to other powers. It was the last leg in the importation of spices and other materials from the “silk road” to Italian City states. The 15th century Europeans realized the nautical/military power of the Chinese when their armed junks entered the old Roman lake. (Due to a sharp change in the attitude of the Chinese government, which recalled all of their navy and destroyed their ships, their Navy was largely destroyed). Soon thereafter the Dutch replaced the Portuguese as the suppliers to Europe for much of what used to come overland. The Dutch East India Company (English translation of BOR) built a fortified base in Indonesia and controlled the South China Sea and much of the Gulf of India.

These strategic lessons were not lost on the Germans. They believed that whoever controlled “The World Island” (EuroAsia including Africa) controlled the world. The US view was enunciated by Admiral Alfred Thayer Mahan. (When I first read his views at Columbia I did not realize that he had spent two years there before going to the Naval Academy.) His basic view was that he who controls the seas, main islands and critical ports, controlled the world. He was particularly sensitive to “property” between 30 and 40 degrees latitude.

Underlying tension between the US and China today
I have always believed the tariff issues with China and other countries were a way to get vital national securities issues on the table. Going back to the roads of Rome, it’s apparent an empire is vitally dependent upon imports of critical supplies. (To some degree imports are dependent upon the combination of capital transfers and money earned from exports.) Unlike the US, China is much more dependent upon the import of energy, very high-quality semiconductors, and similar items, many of which are imported through the South China Sea and related bodies of water. China feels that it is a national imperative to control access to their country. Even with a fully developed “one belt, one road”, the land route is insufficient. Officially, the US is for the international right of free navigation of all major water routes. Like the Soviet Union, China wants to escape encirclement. China recognizes that at some point it may have to fight its way out of a perceived trap. In the modern world one of the weapons of choice is technology, particularly advanced semiconductors. Both sides recognize that they have attractive internal markets for other’s goods, as well as capital that can be used for their own imports. 

Investment Conclusions
We should learn from both boxers and wrestlers. In terms of tactical investment decisions, be a counter puncher looking for the rare opportunity, but as a wrestler stay engaged and use the opponent’s weight as leverage at critical points. Bottom-line looking ahead, after investing focus on up-to-date strategies, successful investing.


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

https://mikelipper.blogspot.com/2019/07/apollo-11-investment-lessons-weekly.html

https://mikelipper.blogspot.com/2019/07/us-stock-markets-new-highs-misleading.html

https://mikelipper.blogspot.com/2019/07/twin-problems-not-enough-greed-and-too.html



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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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