Stress Tests - Weekly Blog # 740

                                    

Mike Lipper’s Monday Morning Musings

Stress Tests

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

Next Phase

Investors are not happy with the current phase of the market, which could be labeled a transition starting in late 2021 or January of ’22.

We left a stimulated expansion and rising US stock market for a contracting “bear market” and likely economic recession. 

The stock market performed its traditional function by discounting the future and falling before an economic contraction began.

The Federal Reserve was on its original mission, performing the function that it is perhaps best suited to accomplish, the protection of the banking system. (One can question the wisdom of assigning other responsibilities to the Fed.)

The Fed has learned that banks should have balance sheets assuring their survival in potential economic contractions. The Fed consequently required banks to show they could survive possible severe economic conditions, without necessarily predicting them. 

The tool used created very severe stress tests. The way the Fed used these tests limited the bank’s commitment to expansion and dividend increases. All banks passed the minimum requirement in the last stress test, although JP Morgan Chase and Citi were refused permission to immediately raise their dividend.

Many were shocked that JP Morgan was not given permission to raise its dividend. Afterall, the country’s largest bank had styled itself a fortress to defend its depositors from major problems. (Including ourselves) From the Fed’s perspective the bank was expanding too fast, especially if a very serious economic contraction materialized.

Surviving investors learn from changing conditions and I am now applying stress tests to how I manage money for clients and my family.

How Deep & Long a Decline

Applying an overly stringent set of filters to the oncoming contraction is creating stress for me and our accounts. Over the last two weeks the US and Chinese stock markets rose, while bond credits and commodities declined. A rise in stock prices is normal during bear market rallies on below average volume. 

The decline in the other asset types is worrisome, as they tend to be owned by more risk aware investors. In general, these asset types generate less capital appreciation than the average stock and are time constrained. Stock investors often view moves within the fixed income and commodities markets as warnings for the stock market.  

An offset to this bearish picture is to remember that falling prices and low volume should be viewed as an opportunity. Howard Marks, an old data client and very successful investor is quoted as saying “Today, I am starting to behave aggressively”.

Strategic Selections

Picking the highest performing strategy at the exact right time will produce great results, but good luck achieving that. 

For prudent risk-aware investors, a more comfortable strategy is the right combination of a limited number of strategies. This is an artform that great portfolio managers demonstrate most of the time.

My personal stress test perceives the adoption of at least five logical strategies as we exit this interregnum phase.  

Five Strategies

1. There have only been a small number of bear markets without a follow-on recession. One example is the Fed’s gigantic growth of money supply during the Trump period. It came so fast that a “value investor” like Warren Buffett did not have the opportunity to buy large amounts of good companies at fair prices.
2. In a “normal” cyclical recovery, asset prices for stocks drop to sounder levels as probable results are discounted. 
3. Structural recessions usually address economic imbalances through the liquidation of debt, which often requires a well-known financial player to collapse in some financial crisis. Currently, the largest debtor relative to revenues is the US government. (The continuing obligations of the US government are materially greater than its tax revenues, leading to increased levels of deficits.)
4. A depression is triggered by the political establishment policy mistakes intended to solve short-term problems requiring deep social restructuring. A classic example was the tax and tariff policies of the late 1920s, followed by the radical restructuring attempts in the 1930s. This turned a 5-year cyclical recession into a 10-year depression.
5. Stagflation occurs in a period of slow revenue growth combined with high inflation and unwise regulation. We suffered such a period in the 1973–1982-time frame.

The five strategies listed are in rough order of the shortest expected lapsed time in a bear market without a recession, and the longest stagflation. Another critical time scale is your expected investment period. For the longest periods, e.g., a grandchild’s college endowment, very little in the way of reserves are needed. More reserves are needed to offset potential losses due to unfortunate timing in shorter time periods.

Selection Guidance

Over extended periods, the aggregate performance of “growth” and “value” are about equal. However, there are two main differences in the selection process; tolerance for volatility and how the main financial screens are utilized.

Growth investments tend to be volatile based on news. You consequently need to pay intense attention to any element impacting the income statement, particularly net cash generation excluding all uses of cash or buying power.

Value investments appear less frequently in the media and thus tend to be less volatile. This is particularly true if they pay a regular dividend, which is hopefully growing. The adjusted balance sheet is the most important document in their selection and includes the current pricing of all assets and liabilities. Additionally, the value of people, customers, brand name, patents/copyrights, or under-utilized resources need to be added. You need to add all reasonable contingencies, including the shut down costs of work sites and people. In many cases, a forensic accountant and bankruptcy lawyer is needed.

WHICH DIRECTION?

The main reason this blog is titled “Stress Test” is that there are currently “green shoots” of positive information as well as disappointing signs. Reasonable analysts may disagree on both the importance and characterization of listed items in the proper category. Nevertheless, I pay attention to all as possible signals of things to come. 

I welcome all views that agree and disagree the view expressed.

Positives

• The JOC-ECRI Industrial Price Index weekly change was -2.47%
• The AAII 6-month bearish view was 46.7%, vs 59.3% the prior week. (This was a move back from a very extreme position the prior two weeks, viewed by market analysts as a contrarian indicator.)
• Copper prices are recovering from a high price in April due to rising Chinese demand.
• In last 3 months, M-2 money supply growth was only 0.08%.
• Fed funds futures prices are dropping.
• The bond market appears to be capitulating,
• The combination of China producing both a hypersonic stealth bomber and a 4th generation aircraft carrier, should be good for defense spending.

Negatives

• According to the American Farm Bureau annual survey, the cost of a July 4th picnic has risen 17% in the past year to $69.68.
• Tech companies, among others, are laying off workers.
• The Atlanta Fed is forecasting a second quarter contraction of 1%. 
• I wonder how much of the relatively low trading volume on Friday was short-covering before the long weekend.
• The claim that the market is priced more attractively now than earlier in the year looks questionable, as pundits are using current prices and what I believe to be “stale” earnings estimates. The severe drop in June sales may have led to considerable write-downs of inventories and prices. 

IT IS IN PERIODS LIKE THIS THAT INVESTMENT MANAGERS EARN THEIR FEES.

 

Please share your thoughts for the next great investment idea.

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

https://mikelipper.blogspot.com/2022/06/switching-prime-focus-weekly-blog-739.html

https://mikelipper.blogspot.com/2022/06/are-markets-getting-too-far-ahead.html

https://mikelipper.blogspot.com/2022/06/pick-investment-period-strategy-weekly.html

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Copyright © 2008 - 2022

A. Michael Lipper, CFA

All rights reserved.

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Haven’t Found Bottom Yet! Investments & Military Win by Committing Reserves Successfully - Weekly Blog # 732

 

                                

Mike Lipper’s Monday Morning Musings

 

Haven’t Found Bottom Yet!

Investments & Military Win by

Committing Reserves Successfully

 

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

Investment Success Defined 

Avoiding losses and participating in “bull markets” is the objective of my blog. To accomplish this goal, one needs to expect some losses. However, the key is to not lose too much capital, so gains are multiplied. The strategy I use builds up reserves when the prices of what my clients and I own are high compared to perceived general market risks. I allow capital reserves to build up to the point of meeting conservative cash expenditure expectations, plus a trading reserve for future investment. Years ago, insurance companies set up “valuation reserves” to capture gains above 20% to use for the next upswing. Inherent in this strategy is the assumption that there will be periodic down markets. The trick to making this a successful strategy is the proper timing and approach to committing reserves. 

 

Committing Reserves 

This is the single most difficult task, both for an investor and military leader. In each case the reserve can be wasted by committing too early, and that is why it is often committed piecemeal. For an investor it is important to identify a time and price soon before a price rise, whereas for the military it is near the point of exhaustion of the enemy’s supply chain. It is for this reason a market’s reaction to current events becomes much more important.

 

Why No Bottom Last Week 

 In theory, I should be calling a bottom for last week. We had a relief rally on Wednesday after the Fed publicly acknowledged inflation was more than transitory and committed to successfully addressing it. The next day, led by “growth stocks”, the market wiped out considerably more than the prior day’s gains, with further losses the final day of the week. 

Historically, the price level for the stock market occurs either before or after the high-volume day, when sellers feel compelled to liquidate at any price. We did not see this happen last week. I noticed at least three inputs that questions the longer-term outlook for stocks. 

 

“3 Strikes and You’re Out” 

This is what the baseball umpire yells when a batter misses the pitched ball three times. Perhaps that was the proper call for the week, with the three strikes against the Fed being their attempt to hit the inflation ball out of the park. However, they failed to see the very fast pitch delivered by the seasonally adjusted money supply. M2 grew 12.11% year-over-year, even after considering the current rate increase and three additional anticipated 50 basis point increases to 2.5%. This may be all the politically diseased Fed can do as it ignores the major cause of inflation, the stimulus (bribes) fed to the economy by the White House over the last two administrations. (I don’t know how much of the Russia-Ukraine war expenditures are in the current M2 numbers). 

Immediately following the rate rise, the major banks raised their prime rate to 4%. Remember, in theory the prime rate is reserved for the bank’s best credits and does not include much of a loss reserve. Currently, most banks are overflowing with deposits and a lack of good loans. Most commercial bank stock prices are also languishing based on their near-term outlook. If major banks require 4% on almost riskless loans, what should the investing and depositing public require from other financial institutions in the way of yield? This is the second strike against the market and the Fed. 

 The third and final strike is a curve ball ordered by the FTC and SEC. The regulatory mandates they extended way beyond prior policy practices.  If this expansion is permitted, public companies will expand less and many private companies will never be traded on US stock markets. 

To demonstrate how much the reach of these agencies has expanded. The newly appointed chair of the FTC recently announced she was examining the proposed takeover of Twitter by Elon Musk and a group of associates and lenders. The SEC simultaneously intends to examine the disclosures of ESG and compensation. (This could lead to transforming the current cyclical decline, from a bear market in progress to a secular recession/depression, following their FDR model.)  

 

A Bully Hits Someone Who is Down 

 Each week I view stock markets through the lens of mutual fund performance. Most of the time it is wise to pick an investment period that includes an up and down price market for analysis. This week I examined the latest fifty-two weeks, which includes both rising and falling markets. I found that there were only twenty categories that had positive returns out of 110 peer groups. The highest return was for the average commodity energy fund, which gained 97.33%. The smallest gain was 0.12% for dedicated short funds. The vast majority of the winners were asset heavy with a perceived marketable value. There were no intellectual property winners. Inflation is driving stock prices and the government is contributing to it, rather than addressing inflation, the biggest single tax on the financially disadvantaged. 

 

Question: Is your portfolio’s current value keeping up with inflation adjusted spending? 

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

https://mikelipper.blogspot.com/2022/05/three-worries-april-near-term-slowdown.html

https://mikelipper.blogspot.com/2022/04/short-long-term-thoughts-weekly-blog-729.html

https://mikelipper.blogspot.com/2022/04/is-this-great-investment-era-ending.html

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Is This Great Investment Era Ending? - Weekly Blog # 728

 

Mike Lipper’s Monday Morning Musings

Is This Great Investment Era Ending?

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

In recorded financial history two of the most important tools are Gresham’s Law and Arbitrage. Applying these tools may aid in thinking about the current decline in stock prices, which is likely to evolve from a cyclical bear market or a secular change into a structural change. (As with any prediction of the future, the analysis of the present can be incomplete, leading to incorrect judgements. Recognizing these risks, I hope it is useful to analyze the present and speculate on the future.)

The following observations may be germane to the analysis:

1. Most governments want to stay in power and attempt to do so by growing the money supply, providing food and other critical resources to keep most of the population tolerant of them. As with any gifts, there are costs disguised as taxes and restrictions. These “gifts” have now become very expensive, generating excessive inflation and lower currency values, which in turn impacts purchasing power.
2. Many restaurants and other retail establishments no longer take coin of the realm, but only accept credit card payments.
3. Around the world there is increased demand for crypto currency vehicles.
4. The invasion of Ukraine by Russia has focused countries on critical shortages of energy, selected other minerals, fertilizer, and most importantly food.
5. Wars are often fought between countries perceiving near-term differences in their supply of critical needs. We are approaching the possibility of a different kind of World War. Instead of East vs West, it is likely to be North vs South, with northern populations declining and southern populations growing. This sets up a transfer of resources and relative power.
6. No country has an absolute mastery of technology.
7. Global mass-communication implies widespread dissemination of both correct and incorrect information
8. Relative investment performance no longer favors the generation of sales, earnings, net cash, investment income, and similar measures vs the attraction of future products and services. (Within their respective investment leagues there are new leaders without much benefit of history or success.). 

Please add your own observations and communicate them.

Gresham’s Law came out of the observation that when governments use a less valuable currency in place of older coins with a higher mineral value, the holders of the older currency hoard it. In terms of usage, the less valuable currency drives out use the more valuable currency. Is that happening today?  If it is happening, how will economies restructure under that pressure?

One standard analytical technique is to look at an object, such as real estate or an artwork, and differentiate it from other measures. One wishes to own the lower priced instrument, hoping it will graduate to the level of the higher valued instrument. Sometimes it works, but the real value is the perceived price differential, which becomes an article of faith.

Just as Latin American Gold changed the entire European economy for approx. two hundred years, changes resulting from the imbalances observed above will likely have substantial ramifications for us all, especially for our heirs.

What do you think?

There are a lot of things happening that can be described as pointing to the upside, despite a negative picture overall. There are five mutual fund peer groups averaging better than 20% year to date: Natural Resources +31.55%, Global Natural Resources +22.86%, Energy MLP +22.26 %, Commodity funds +20.70%, and Latin America funds +20.54%. Similarly, there are commodity pool peer groups holding futures or commodities: hogs +27.5%, wheat +25.2%, soybeans +23.4%, orange juice +22.7%, and sugar +22.5%. It appears the invasion of Ukraine may have a bigger impact on the global food supply for Europe and China than energy. It may be fitting that this change is appearing now, as we close a financial, economic, and political era.

We should now begin to look carefully, finding what will work for us as well as against us. We are due for surprises and some difficulties, along with some victories.

Thoughts?                 

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

https://mikelipper.blogspot.com/2022/04/wwiii-slightly-delayed-bear-market.html

https://mikelipper.blogspot.com/2022/03/not-much-weekly-blog-726.html

https://mikelipper.blogspot.com/2022/03/relative-or-payout-returns-in-periods.html 

Did someone forward you this blog? 

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

WWIII Slightly Delayed, Bear Market Accelerating, Prepare for Bull Market - Weekly Blog # 727

 

Mike Lipper’s Monday Morning Musings

WWIII Slightly Delayed

Bear Market Accelerating

Prepare for Bull Market

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

Chatter from Moscow, Turkey, European Capitals, and the confused and confusing White House, seems to indicate attempts to avoid raising the price of confrontation, with the hope that internal political problems in almost all countries will lead to lower military commitments. Possible but unlikely based on US actions before WWI and WWII, which appears to be the script that the former Obama White House staff is following through their statements. Focusing on socially restructuring the US economy instead of spending on qualitative and quantitative defensive needs has opened the window for aggressors. This has happened twice before and appears to be happening again. The political focus on US domestic policies and the growing gap in preparedness has encouraged the aggressors to attack.

In the long run our growing weakness is perhaps the product of the schooling system, from Nursery school up through PhD programs. It has produced many uneducated, undisciplined, and unhealthy students unsuited for the military and entry-level jobs. 

Bear Market Signs

Current and prior administrations saw imbalances in the economy through a top-down approach. They found it acceptable to increase money supply growth, which eventually led to an increase in the size of the federal deficit that unleashed inflation from its constraints. Today, many look back on 2019 as the base-case for a healthy economy, although problems existed on some corporate and personal earnings statements. There were clearly social imbalances and school systems were well on their way to producing unemployable people. 

Many see the large jump in 2021 earnings and extrapolate those gains further into 2022. However, if one looks at the growth rate from 2018 through 2022, it is far lower than prior growth rates and precedes the anti-profit and anti-trust executive actions proposed by the current administration. We are currently seeing materially lower earnings projections and planned tax increases that will hurt earnings in 2023, which will potentially impact corporate spending in 2022. 

The one main securities sector enjoying the current market is the energy sector, which The White House is blaming for inflation and suggesting it should be punished, rather than taking responsibility for its own actions. These actions are not going to lead to increased capital expenditures in the “oil-patch”.  

Preparing for the Next Bull Market

As I have previously mentioned, I am trying to focus where possible on looking across the valley of the bear market and likely recession to climbing out of the swamp and beginning the next bull market phase. I have written in the past that if one slashes the wrist of a securities analyst a historian will bleed. One advantage I have over most other market-oriented analysts is access to the portfolio holdings of many open and closed-end type vehicles around the world. Rounding out this area, I also review the financials of a more limited number of fund management companies. From these inputs I have gathered some observations that have led to successful long-term investment performance. I intend to share these thoughts with our subscribers through forthcoming blogs.

#1 Biggest Contributor to Performance

Rarely in securities analysis courses or books is the importance of weighting portfolio components attributed to long-term performance results. Interestingly, when writing the Investment Company Act of 1940 at the Mayflower Hotel in Washington, the fund industry lawyers recognized the importance of weighting as a characteristic to fund owners. 

Most funds are legally designated as diversified funds, which restricts the initial cost for each security to a maximum of 5%. As a practical matter, very few funds are so concentrated that any position exceeds 5% at cost. Additionally, most funds do not want to have any single position represent more than 10% of the voting shares of a company. Doing so would classify them as an inside investor and would impact the tax treatment of the sale of such a position. Most large funds chose to own many positions, with a large position representing 2% - 3% of the portfolio. An S&P 500 index fund will obviously own 500 plus stocks. 

Every stock, at any given time and price, has its own potential risk and reward in the eyes of investors. By combining these stocks with others, the entire portfolio takes on its own risk/reward characteristics. The smaller the number of positions, the larger the impact of a single position. I prefer a concentrated portfolio when I have confidence in a fund or manager and prefer a portfolio with a larger number of holdings if I am less confident but still want to participate in the market or sector. This is the filter many use in their selection of managers.

Over time, as holdings rise or fall due to changing prices, it is not unusual for a portfolio to have a limited number of holdings do very well while another group does relatively poorly. For illustration purposes, take a highly concentrated portfolio with initial positions of 5% each. After a length of time, the 10 best performing positions might represent 75% of the portfolio instead of the initial 50%, with the bottom 10 representing 25%. The winners will then represent 3 times the amount of the losers. Without a reversal in fortune, you would be far less diversified and could be more at risk of a loss.

Many of us initially take small position sizes when entering a new position, resulting in many holdings over time. However, some of the newbies don’t work out and some of the larger positions decline in relative value, causing wealth to not grow proportionately. We generally own a number of heavy hitters and a farm team. I recently looked at a very successful portfolio which had grown many multiples of its initial cost. Even though there were very large gains in 10% of the positions and 90% of the stocks were unproductive, wealth grew many times its starting value. This result was due to 10% of the stocks producing 90% of the gains.

One can also weight by industry or investment characteristic. For example, turnaround, new product, low cost, good management, takeover potential, local business, yen based, etc. The important point in terms of analysis is to divide the portfolio into meaningful segments that lend themselves to making useful decisions.

For a limited number of subscribers wishing to have a discussion, please send me your portfolio data and I will be glad to help use this tool in decision making.     

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

https://mikelipper.blogspot.com/2022/03/not-much-weekly-blog-726.html

https://mikelipper.blogspot.com/2022/03/relative-or-payout-returns-in-periods.html 

https://mikelipper.blogspot.com/2022/03/building-your-future-winning-portfolio.html

Did someone forward you this blog? 

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Are We Going to Get “Ds”? - Weekly Blog # 694

 

Mike Lipper’s Monday Morning Musings

Are We Going to Get “Ds”?

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

School Communications

In the dark ages when I went to schools that used letter grades, the letter D was dreaded because it indicated you took the class, got credit for it, but did not get credit toward graduation. Today we live in a world where changes in sentiment are often a precursor for changing results.

With that in mind, I read the Barron’s Review & Preview column at 3:30 Saturday morning. The column was based on the latest University of Michigan Consumer Sentiment Survey, which called the reading a “stunning loss of confidence”. Sentiment in the first half of August dropped 13.5% from July’s reading. The University of Michigan survey noted that over the last half century there were only six deeper cuts. Clearly this was an emotional response. 

My job as an investment manager requires balancing potential risk and reward. In most periods both range between 40%-60%, although these normal bounds of expectations are exceeded every now and then. As this could be one of those periods, I believe it is now analytically appropriate to look at more dramatic expectations on the downside. 

Investment Implications of Declining Ds

Investors are unhappy for the following reasons:

Disappointment 

• The potential loss of US and Afghan lives
• Acceptance of being a smaller global military power
• Government generated inflation through excessive money supply growth
• Rising energy prices
• The personalities of political leaders at various levels
• While not pleased, investors are not sufficiently worried to generate taxes on extra taxable gains

Discouragement

• After the very large gains achieved from the March 2020 bottom, some give back is expected 
• Concerns over the increase in speculative activity in the public and private markets 
• The unknown impact of the Delta variant potentially lengthening the forthcoming correction 
• Normal pruning of portfolios makes sense to eliminate investments with weak prospects or questionable sponsorships 

Disappear

• Growing cracks in society, the economy, and politics are not being addressed with enough attention. Their impacts will reduce the comforts of capital long-term. 
• Well-guarded, dispersed reserves and controlled expenses become more important.

Depression

• While highly unlikely, a depression is possible due to mistakes like the March 13, 1930 passage of the Smoot Hawley Tariff. Up to that time many people felt Herbert Hoover was a great humanitarian and good President. Herbert Hoover lost re-election in a landside because he agreed with the political forces supporting the farm block. They had suffered a few years of bad weather leading to a substantial rise in farm indebtedness and low-price agricultural imports. Some US manufacturers were also hurt by imports. What was not evidently considered by US politicians was their raised tariffs being reciprocated by most other countries. This led to world trade and the value of our currency declining. One could argue that it also accelerated the rise of totalitarian governments in Germany and Japan. Hopefully, we won’t make a similar mistake in the future. However, if we experience a depression, survivors should be able to invest in good assets managed by talented people.

Lessons from Bob Farrell

Bob Farrell was the head of research at Merrill Lynch for decades. From his perch he saw both the markets and the actions of Merrill’s customers. Because his firm had the largest number of retail customers, he saw much more than the rest of us did. Thus, his “10 Market Rules to Remember” is well worth bearing in mind, particularly in a low volume rather trendless US stock market.

1. Markets return to the Mean
2. Excesses usually lead to opposite excesses
3. Excesses are never permanent
4. Rapidly rising or falling markets usually go further than expected and don’t correct sideways
5. The public buys mostly at the top and least at the bottom
6. Fear and greed are stronger than long-term resolve
7. Markets are stronger when broad and weak when narrow
8. Bear markets have three stages: sharp down (-20% or more), reflexive rebound (“suckers’ rally”), and a long-drawn-out fundamental downtrend.
9. When all “experts” agree, something else will happen
10. Bull markets are more fun than bear markets

Applying Farrell’s Lessons

Rule 9 warns of unanimity of expert opinion. I suggest that rule be applied to the latest report by the UN experts on Global Warming stating “It’s just guaranteed that it is going to get worse”. They further state that it is “unequivocal” and an “established fact”. 

While I don’t know what the future will bring, there is a large body of contrary opinion based on current and prehistoric geological history. I have been privileged to listen to Caltech professors and students who have a range of views, although they have never expressed the degree of certainty the UN scientists proclaim. 

Two other predictions of certainty from US government sources raise questions as to the accuracy of their expressed opinions. Next month will be the fiftieth anniversary of President Nixon closing the “gold window”, where foreign governments could buy gold at $35 an ounce. This was meant to protect the US against imported inflation and protect the value of the US dollar. In the last fifty years we have had both inflation and a decline in the purchasing power of the dollar.

More recently, the Congressional Budget Office (CBO) issued its analysis of expected labor productivity. For the period 2021-2031, they expect the potential labor force to grow 0.4% per annum, compared to 0.5% in the 2008-2020 period. They suggest it will produce labor productivity of 1.5% in the next decade compared with 1.2 % in the prior period. I question the conclusion, although it is possible if there is large scale automation and qualified labor to operate the machines and computers.

When I was in school taking “true and false” tests, we were urged to doubt any statement that carried the words “always and never”. This fits well with my real source of education, the racetrack, where there never was a sure thing other than the track and government taking a piece of the action before I got paid.

 

Application of this blog’s lessons

1. A change in sentiment can lead to a change in market direction, possibly soon.
2. Wherever and whenever possible we should be adopting the thinking expressed by Bob Farrell.
3. Be wary of predictions with an extreme view of certainty.
4. Learn from mistakes and teach those lessons.  

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

https://mikelipper.blogspot.com/2021/08/mike-lippers-monday-morning-musings_8.html

https://mikelipper.blogspot.com/2021/08/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/07/mike-lippers-monday-morning-musings_25.html

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Investing Successfully – Weekly blog # 525

Introduction

Investors often unconsciously think about their assets and investing. Our own actions, as well as those of others, create opportunities to add or subtract from our assets through opportunities or threats. Our sum total of assets in life is a culmination of our experiences, including thought patterns. For most of us, far too little of our time is spent on consciously thinking about how we invest our resources, emotions, energy, and financial assets. The purpose of this blog is to develop our investment thinking.

The first step is to take an inventory of how we spend our careers, emotions, energy and capital to further our goals, as undefined as they are. The second step is to begin the process of deploying our limited financial assets, beginning at its easiest least threatening level. (For almost all of us, our assets are more limited than what we want to accomplish with them.) The third step is to spend some time and energy on what I will label Capital Motivation.

Capital Motivation

Capital motivation, in an imperfect world with imperfect people, is to optimize not maximize how we focus our emotions, energy, and intelligence in deploying our financial and other assets. We need to begin a task that will never end, listing the threats and opportunities that are before us right now. How should we optimize our capital against each of the major opportunities and threats facing us? This sounds like an almost impossible task, but begins first with conversations both with ourselves and others to draw from our experience banks. Even the most financially knowledgeable institutions and individuals do not have all the answers. They are addressing their perceived needs as best they can and in many cases recognize the unanswered threats and opportunities that stretch out before them. In reality we are all sinners in this task.

What is Your Capital?

Those of us that invest in individual securities and funds recognize that fundamentally we invest in people. When analyzing any specific investment the single most important factor is the individual personality driving the investment in terms of the timing of inflows and outflows, as well as goals. Using a concept as old as The Bible, each of us are relatively short-term renters of the assets we currently command. Over time they become the temporary assets of others, known and unknown as well as those of the global society. This is why I believe any investment plan, self generated or produced by an adviser, needs to start with the individual decision maker and perhaps terminate with the welfare of the corporate and/or individual beneficiaries.

Our single biggest asset is our reputation for integrity, not only to others but also to ourselves. Eventually we need to deliver on our promises to ourselves as well as to others. In effect, when we promise we are creating a contract and we will be known for our ability to complete our contracts and in many ways the art of investing is dependent on our ability to live up to our contract. It is in this light we manage the mix of our financial and other assets on the continuum between capital appreciation and capital preservation.

Capital Appreciation 

Through accidents of life and our own hard work we have a pile of assets which most often come with some encumbrances. Part of the strings attached to our assets, plus a desire to grow them to meet future needs, is the continuous need to manage the appreciation of our assets. There is risk of loss in everything we do and the opportunity to appreciate assets itself comes with risk. On the surface, most of the time risks appear to be equal or exceed identified rewards. It is our skills, integrity, and energies, properly committed, that change the ratio of risk to reward. Outside of internally produced risks, there are two others.

As long as society promises to take care of those who don’t take care of themselves there will be taxes and they will be likely to be progressively higher on higher income. Perhaps the biggest reduction to the value of your investments is the inability of governments to compensate you completely for what they spend, as through their control of the creation and supply of money, they induce inflation. Inflation not only increases expenses, it lowers the value of our intellectual and financial assets. Over a family’s lifespan, inflation could be the biggest hurdle to meeting perceived goals.  These two societal payments also influence capital preservation. To overcome drags on our wealth we look to different capital appreciation approaches. While there may be some income element in our choices, the main benefit we are looking for is higher terminal prices than our initial costs.

There are many ways to attempt to achieve gains. In searching for good investments there is a false assumption that looking initially or only at past performance is the best means of accomplishing this goal. This presumes that the future will be very much like the past, which rarely happens. I utilize a holistic approach in examining not only the entire asset base, but also the potential risks to the individual capital owner.

For example, look at a university that is heavily dependent on government grants and contributions from science based workers. Working with the investment committee, they could decide that tech spending is cyclical and their capital should be invested contra-cyclically away from technology. With the very same set of conditions the investment committee, because of their own experiences, could decide that they are well versed in the issues and in the long run can tolerate this kind of volatility.

At this very moment, most stock and bond prices are flat to down this year, with principal gains in a handful of global tech stocks and their satellites. In these circumstances, a family with a combination of aging seniors and grandchildren entering college years could choose to optimize cash generation rather than aggressive capital appreciation, as they might have done in the past. Again, this is a particularly difficult time to make this judgement. Interest rates on high quality paper, while rising a bit recently, is absolutely lowering the value of fixed income because of the threat of rising global inflation. In addition, reinvestment risk on maturing investments is cyclically raised. The implementers of these decisions could benefit from discussions with their investment advisors, tax preparers, legal advisors, and family.       

Capital Preservation

Capital preservation is not the opposite of capital appreciation, but more like the other side of the coin. We all start with a bundle of talents, energy, and some money. We, over the lifetime of an individual, family, and institution, convert capital appreciation to beneficiary spending and interim investing. What is interesting is that during the investing period we are judged by investment performance, including the generation of cash. However, at the end of the period, and all periods end, we are judged by the aggregate size of the capital. All too often this is translated only as a sum of money. What should be included in this final assessment is what the expended capital has done in known and unknown people’s lives. (Read Andrew Carnegie’s views not necessarily his actions.)

What should we do now?

Any morning is a good time to change our future by making changes to our investment portfolio. I ask myself this question every weekend when I analyze the average investment performance of mutual funds as produced by my old firm, now part of Thomson Reuters. My conclusion is that at most one should consider tinkering with the mix of funds in specific portfolios, but not implement wholesale dramatic changes. The inputs to my thinking can be summarized as follows:

Year to date Average Investment Objective Performance
• No matter what size, growth funds are up 2X value funds
• World stock and bond funds are flat to down
• High Quality Bond Funds are down more than their coupon
• From David Rosenberg, at Gluskin Sheff since 2009, 13 million people are new to finance careers
• The last bond bull market began 35 years ago

“You can see a lot by observing”  

A wonderful quote from Yogi Berra and something we attempt to think about when making only minor modifications to our various investment portfolios. My wife and I just returned from, in many ways our graduate school, The Mall at Short Hills on a drab and occasionally rainy Sunday of the Memorial Day weekend. This is a very upscale market place which had a good size crowd, but they carried relatively few shopping bags and were there with one or more other people. It seemed to me that in terms of their wardrobe and other shopping needs, they were tinkering at the periphery of their sartorial assets. If something at Amazon was priced right or had particular appeal they would buy and perhaps more than just one. (As usual, the Apple* store had the most people and a longer than usual line for specific appointments.) Many of these people are either direct investors or participants in salary savings plans, 401(K), 403 (b) and 457 plans.  Their shopping ode suggests to me that in terms of their financial assets, while they make tinker at the edges of their portfolio, they are not currently driven to make radical changes.
*Personally held in investment portfolios

The tinkering that I am suggesting to various portfolios is as follows:
• In longer term equity portfolios look to good managers out of phase.
• Longer term international funds and quite possibly selected emerging markets should be reviewed.
• Sacrifice fixed income yield for shortened durations.
• Plan for a busy fall and a difficult 2019-2020.

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A. Michael Lipper, CFA
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