"Blue Wave" Investment Lessons: New Bull Market? - Weekly Blog # 654

 

Mike Lipper’s Monday Morning Musings

"Blue Wave" Investment Lessons: New Bull Market?

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

This is an investment blog, not a political blog. However, there is an uncertain parallel between the two, which happens much less often than the pundits believe. I believe there is a more important link between the two and both move on human actions for unproven reasons. In both cases what we really know are their actions, they do not reveal their deeply held innermost driving motivations at the voting booths or trading venues. Since both arenas produce reams of peripheral data, you can often see similarities thought processes. Thus, it is quite possible that the undisclosed motivations can be teased out, with particular focus on clues to future actions.

“Blue Wave” Investment Observations

Because polling has replaced much of what was previously street reporting, there is a narrowing of sources of information. Various  readily available polls conformed to one another, making it easy to accept them as accurate (the big megaphone advantage). The funders of polls, either the media or the candidates, chose among the cheapest available. (Phone interviews conducted by students or other low paid part timers, filling out preselected forms.)

Individual and institutional investors are bombarded with the views of pundits using their megaphones. Markets, like elections, follow the crowd. (They don’t have the benefit of wagering at the racetrack, where the betting odds are based on the ratio of money bet on a horse compared to the total bet on all horses after deducting local taxes and track fees. They are the original crowd funding mechanism and have very little relationship to the probabilities and possibilities of specific races. The horse with the smallest payoff odds is called the favorite [chosen by the most bets]. History shows that favorites win roughly one-third of the time. Highly favored horses often have payoff odds that are a fraction of what is bet and are called odds-on favorites. They on average win about half the time, but their winning doesn’t fully fund future bets. The odds on the other horses in the race are often called long shots. When they win, they pay off multiples of their original bet.) Successful bettors in politics and at the racetrack always look for long-shot opportunities and never exclude the possibility of a long-shot coming in first.

The belief in a Democrat win was based on the probability that they would raise more money than the Trump forces, which they did. This is similar to believing in Napoleon’s “God is on the side of the bigger battalions” and is like investing in the largest company in an industry. How a size advantage is used is most crucial, a lesson learned by General Bonaparte and some investors. In this case it was relying more on general media than social media for support. We have found that successful institutional investors do their critical analysis internally, with supplemental analysis provided by smaller research shops.

One of the tenants behind the “Blue Wave” projection was the “Great Leader will lead”. Looking at incomplete results, members of both Houses won with bigger percentages of the vote than the top of their ticket, demonstrating once again that all politics is local. The implication being that members already looking to their 2022 and 2024 campaigns don’t owe anything to the top of their ticket. Passage of legislation from the White House is not going to be easy. Democrats in the House Representatives will soon have to select the chairmanship of three house committees. In two cases there are at least three announced candidates, which makes one wonder about the effect of these internal deliberations on the long-term unity of the party.  

As is often the case, the problem with the generation of the “Blue Wave” was the composition of the decision group. Too often, groups try to avoid confrontation and become a cheering squad of sycophants, leading to confirmation bias. Contrarians make most decisions better by challenging the majority point of view. They either reinforce the argument, or force consideration of their contrarian views.

Regardless of the Election: Are We Staring A New Bull Market?

For roughly three months the major US stock market indices have been in a trading range. The market indices of the two next largest economies are also pausing. Both the Nikkei 225 and the Shanghai Shenzhen 300 have risen markedly this year, with the Japanese indicator at a 29-year high, although still about 50% below its all-time high. The internal Chinese market that is opening to foreigners and their own high-saving population, may be waiting for US leadership or looking to act as a hedge against a troubled US domestic market. 

Before we think about the future progress of stock markets, we should think about where we are, and that requires determining the significance of two realities. 

• First, can we treat 2020 as a single event, resting after finishing a ten-year bull market? It ignores both the fastest recession and recovery in history. 
• Second, the valuation gap between so-called “growth” and “value” has widened. In most stock markets the performance gap is approximately 40% and the spread continues to widen. According to the S&P Dow Jones Indices, the five leaders this week were Internet Services +10.18%, E commerce +9.96%, US Large Growth +9.90% and Islamic Tech +9.05%. I am particularly pleased to see the non-US participants, as investing is a global activity and important investment trends tend to jump national borders. As an example of the commonality of thinking in various markets, the following currently have average yields within 64 basis points above 2%: Russell 1000 Value, MSCI World, MSCI World ex USA Small Cap, MSCI EM. 

Assuming the 2020 market and the performance spread are appropriately discounted in current market valuations, I turn to other structural observations:

• Private clients have a lot of cash on the sidelines
• The NASDAQ Composite has been the best performing major index this year, going up most and declining least. I think this will change. Sophisticated traders play a bigger role than at the larger listed market. There are far fewer passive players in the NASDAQ. Active investors read political movements better than those in other markets. I sense they are fundamentally worried and will wait for more clarity on their taxes.
• No market indicator is always right and some are frequently wrong, which in the market analysis world are labeled contrarian indicators. One of the most reliably contrarian is the AAII weekly sample survey outlook for the next six months. After being bearish for a long time they are now more bullish. Subscribers please share your views.

What am I doing?

At my largest custodian the top ten positions represent 50% of the account. Four of the holdings are investment companies and three are relatively narrowly focused mutual funds. I treat Berkshire Hathaway as a smartly diversified trust account for beneficiaries as an investment company. Four stocks are operating companies good at what they do. One is a publicly traded fund management company good at creating newer ways to invest. The final is NASDAQ, which has intelligently broadened its business. For our managed accounts we only invest in mutual funds that can fit the individual needs of each account or portion of an account. 

 

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

https://mikelipper.blogspot.com/2020/11/bigger-risks-than-election-weekly-blog.html

https://mikelipper.blogspot.com/2020/10/managing-mistakes-weekly-blog-652.html

https://mikelipper.blogspot.com/2020/10/momentum-is-slowing-under-too-many.html

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Be Vigilant when Relying on Patterns

Introduction

In last week’s post I discussed that many investors are only interested in outcomes and not the causes of the outcomes. These investors search for repeated results and expect the same patterns to be continued into the future. For the last two weeks I have been drawing lessons from California Chrome’s losing the Belmont Stakes, and stated that it was a bad bet. Those who wagered on that result were betting that the colt’s past pattern would continue in this most difficult race for three year olds.

Those who follow history of sports, politics (Eric Cantor), theater, and human emotions all have experienced disappointment when the winning streak is not continued. The reason I said that the bet on California Chrome was a bad bet was that the betting odds were odds on, putting up more ($5) to win less ($4). This assumed a much higher degree of certainty than warranted on a young, head strong colt in the spring of the year.

Keynes lost several fortunes following patterns

In the June edition of the Financial Advisor Magazine there is a good article on John Maynard Keynes and his investment experience. There is no question that this Cambridge University don was exceedingly bright and had all kinds of ambitions. As an economist he was also a researcher and looked for patterns in commodities and currencies as well as US and UK common stocks. Each failed to produce a winning result every year and also led to large, (but less than market) losses in 1931. He did beat the UK market in 12 out of 18 years, which is exactly the ratio one would normally expect from a very good professional investor. The sad part of this experience in terms of the rest of the world is that various governments took his economic theories to be unassailable laws. If people only would have used the concept of applying a winning percentage to absolute belief in his economic laws, the world would have been a better place. Instead we had a Republican President of the United States intoning “We are all Keynesian Now.” This was almost exactly at the very moment of history when the US allowed its budget to get out of hand and began peace time deficits that continue to this day, which has led to a relative decline in the US standard of living.

Favorable patterns that may not hold up.

All humans look for patterns in everything they do. Even well-trained analysts look for what they hope for is certainty in patterns. Being a contrarian by nature I look for a reversal of trends, but currently markets are accepting the following patterns:

1.  On a year to date performance basis the Dow Jones Industrial Average is up +2.2% and its Utility average is up + 15.5%. This suggests that focusing on sectors is more important than the level of markets.

2.  Many portfolios are centered on various market capitalization levels which S&P provides. However the best performing S&P level is its 500 Index up +6.2%, and its worst is its Small Cap Index +2.1%. This suggests that market caps are relatively insignificant. We will see if this is true in the next major moves, particularly on the down side.

3.  Low perceived quality as measured by those stocks listed on the American Stock Exchange gained + 16.3% compared with those of the New York Stock Exchange + 5.5%. In 2014 (and for the last several years) higher quality, particularly of balance sheets has hurt relative performance. I doubt this trend will continue in an economic downturn. (Keep an eye on the default rate in high yield bonds.)

4.  Enthusiasm for various political leaders’ statements as to the future of their economies going through restructuring has driven their markets to possibly unsustainable comparisons. The Indian Sensex index is up +18.6% and the Japan’s Nikkei is down -3.5%.

5.  David Herro in his search for economic trends noted that the old indicator, an increase in lipstick sales, is being replaced by an increase in nail polish as an indicator.

6.  The trouble with following patterns slavishly is there is no room for a “black swan” occurrence.

Pattern Analysis can be useful

In a recent report Standard & Poor’s compared the performance of Large-Cap mutual funds to their respective S&P Benchmarks, showing in each of the last six years that the majority of funds beat the indices. The range of beats goes from 81% in 2011 to 51% in 2009. I found this data set interesting in that it shows actively managed funds can perform as well as the benchmarks. More significant to me is the extremes of performance. The low number occurred in a sharply rising market and the high number in a market that was declining in many sectors. My explanation for this result is that the indexes do not hold cash reserves where mutual funds do. Coming off a bottom, “cash is trash” and hurts performance, whereas in a falling market cash acts as a cushion. As I believe that this pattern will continue in our managed accounts, I have been cutting back on our use of index funds as a preparatory move for a future decline. (The impact of this move is to slightly raise our overall expense ratio.)

Moody’s^*  believes “Exceptionally thin spreads typically credit cycle slumps.” As the yield spread is historically small between low credit instruments and high quality ones, I believe that this is a pattern worth noting. This is particularly true as we are seeing a concerted push on the part of both mutual fund houses and brokers to invest in unconstrained fixed- income funds. Even various government agencies are concerned and have discussed an idea of trying to put some redemption constraints on bond funds, which I do not believe will happen politically. Further to the discussion is a comment by a former Federal Reserve Governor in referring to bond fund redemptions as “liquid claims on illiquid assets.”

^*Owned by me personally and/or by the private financial services fund I manage

Perhaps, my searching for the top of the stock market that precedes a major decline is misplaced, possibly the top will be caused by a malfunctioning fixed-income market. After all, the last major decline was caused by Lehman’s inability to fund itself in the short-term market. 

What patterns do you use?  

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All Rights Reserved.
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