Implications of China vs. US Timespans

Introduction

A number of years ago a good friend attended a Chinese Embassy party where a very senior member of the government commented that while the West owned the watches, the Chinese owned the time. This critical distinction has stayed with me in terms of looking at investment horizons.

One Belt One Road

While there has been some US coverage of the “One Belt One Road” meeting in Beijing this Sunday hosted by Xi Jinping with Vladimir Putin in attendance, most of the US attention has been focused on the dismissal of one employee at the discretion of the President. As a long-term investor, I believe this is a misplaced focus. On the Chinese side the implications of the massive One Belt One Road Initiative may have implications into the next century. The US focus appears to be on the electoral contests in 2017-2020.

I find it is interesting that China is using a staging investment philosophy somewhat similar to our TIMESPAN L Portfolios^®. China announced some of the outlines to this the One Belt One Road Initiative in 2013. From an economic vantage point it was a brilliant way to export its excess steel and cement capacity in building long line railroads and some internal subway systems. It also would reduce shipping costs of Chinese manufactured products that potentially could be exported to 60 countries, part of the land and sea bridges.  This is somewhat like President Eisenhower's US interstate highway building program that required new federal highways to be built with the ability to handle the transportation of heavy tanks.  As the rail and port facilities are built, China (even without moving its military) will have strengthened its ability to influence all of the surrounding countries. Some have called this drive as "Globalization 2.0.” Compared to the Russian leader in attendance, the US is sending a senior director for Asia at the National Security Council. While there is definitely a military threat in this initiative, by far the bigger threats are economic and political.

The One Belt One Road Initiative is not without substantial  risks. The planned funding requires a series of public/private partnerships. Every analyst and most investors should have knowledge and respect for past histories. Around the world in the last half of the 19^th Century, there was a surge of railroad building. The British were particularly active in South America. I suspect that almost every railroad company started during this period eventually went bankrupt. In one case the largest and most powerful UK merchant bank almost went under because of its Latin American exposure. I can not think of a long line US railroad that did not enter or threatened to enter bankruptcy. Some of the same problems exist today. One of the Chinese-backed African rail lines is not expected to reach breakeven for the first eleven years, and we all know how reliable the predictions of breakeven have been. 

If we of short memory fail to remember the global distribution of less-than- healthy US residential mortgages, we could have a replay with global distribution of private partnerships through the growing power of Chinese financial services companies. Thus, for the global investor there is both downside and upside as this initiative grows. I maintain that no matter what you invest in; stocks, bonds, commodities, real estate, currencies, or intellectual property, your returns could pivot on what is happening or rumored to be happening in China.

What are the US Markets Focused On?

Investors into the US market are focused on the very short-term to intermediate future while China is exercising its long-term options.

The following are briefs tidbits that have crossed my computer screens this week:

1.  Dow Jones Industrial Average - A minuscule decline closed on of the two price gaps in its current chart. The other two major stock indices, S&P 500 and NASDAQ, still have price caps. (One wise market analyst suggests that we need a 5% decline before we can resume a meaningful upturn.)

2.  JP Morgan has noted that 37% of NYSE volume is executed in the last half hour of the trading day as Index funds rebalance.

3.  There is some justification in the adage “Sell in May and Go Away.” Since 1950, the period November through April does better than the other six months, 71.64% of the time.

4.  According to its inventor, the CAPE ratio, used as a valuation measure, explained about 1/3 of the variation in the ten year returns. (Surprisingly this is roughly the same chances of a favorite winning in most horse races.)

5.  Ray Dalio, who manages one of the largest hedge funds, sees no major economic risk in the next year or two. (This could be an important cautionary flag.)

6.  The highly respected GMO seven year prediction for real return on stocks is -3.8%

7.  Vanguard believes we are in a period of slow growth; e.g., a 60/40 asset allocation will produce a return between +3% and +4.5%. (If they are correct, which I doubt, the average foundation will be liquidating its base each year if it has a mandated 5% pay out.)

8.  Turning to the increasingly popular European investing, there are two points worth considering: (a) the current price of the Stoxx 600 Index is where past rallies have peaked out, and (b) over half of the ETF flows into non-domestic funds came into three Index funds and these were somewhat smaller than the ETF redemptions in two domestic Index funds. (These suggest to me that main players in the ETF market are trading-oriented, and may not be patient during surprises.)

Investment Conclusions

Despite the reputation of highly speculative retail Chinese investors, the Chinese government is playing a long game.

The US market is increasingly short-term focused. This may, over time, give us longer term investors a bigger barrel to fish in.

As we structure various markets I am wondering whether our assorted valuation measures need to be adjusted due to fundamental changes in supply and demand.

Any thoughts? 

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Copyright ©  2008 - 2017

A. Michael Lipper, CFA

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Reading What is There and What Isn’t

Introduction

We are all information junkies. I am always questioning trying to find out what might be important. Thus I am absorbing both hard and soft data in my investment diet. I never know what can turn out to be a good source of facts, knowledge, or perspective; for instance my dentist, who is something of a data hound about his practice. While I was a captive in his chair and being a bit upset he was not streaming the daily programs from Bloomberg TV as usual, we were instead discussing the importance of data. He then gave me a bit of insight. On the cover of his data notebook there was  the following quotation:

“Everything that can be counted does not necessarily count; and everything that counts cannot necessarily be counted.” -Albert Einstein

Not only did this make sense but I am a bit addicted to Dr. Einstein as a great mathematical physicist. My wife Ruth and I have stayed in the rooms that were used by the good doctor at the Athenaeum, the faculty club at Caltech where he visited regularly. In thinking about what Albert Einstein contributed it occurred to me it was not new data that he discovered, and not only to recognize the meaning of what was known, but also what was not captured in the data. He identified what was missing.

If only the pundits who were wrong about the outcome of both the BREXIT referendum and the last US election knew how to look at the data that was and wasn’t, they wouldn't have been so embarrassingly wrong.

I am going to review a set of investment inputs which cross my desktop screen to seek to extract both their meaning and what is missing.

China

To my mind there is no more important topic for long-term investors to track than China. Many believe that it is only a matter of time before China will become the largest economy in the world and all that occurrence implies. We would be badly misled if we applied the lessons from our own history to China. First, we come from political cultures where our leaders for the most part were trained in law, military, or farming. Most of the current leadership in China spent time learning engineering. As part of that experience they were indoctrinated into rigorous planning as a dominant discipline. While there may be periodic disruptions there, their life is much more orderly than is what is experienced in the developed economies. 

When Premier Li, states that there will not be a hard landing as their economy shifts to fulfilling internal demand for goods and services from being export driven, I am reasonably confident that the record, as published, will show that the Premier was correct. His was not an idle boast. The Chinese political school attempts to study every conceivable possibility. They want to be good generals that are never surprised (or defeated) like Julius Caesar who claimed a great victory in what is today's France and then spent the next three days burying his dead. Also as Steve  Roach from Yale University has written from his long experience in China, the leaders know that shifts in global leadership are gradual not abrupt. Their planning doctrine allows them to be patient as long as they are making progress every day.

In the real world not everything goes as planned. For instance the public traded price of Huishan Dairy  dropped 85% in one day. From what I have been reading, many successful entrepreneurs are involved with many different activities. These men and women, are often highly leveraged, possibly with bank loans from friendly local/regional banks which they have significant stock positions.

What was not there? First disclosure, in this case the entrepreneur was missing for at least one day. Second, there was no market mechanism to slow or halt the decline, (nothing exists in China and other places like the old US specialists on the floor of the New York Stock Exchange) or in this case similar to other markets after a ten or fifteen percent drop, trading is suspended. Third, there is no equivalent to the Glass Steagall and similar Acts to avoid commercial interests affecting loans and stock purchases of banks. I suspect in a still planned central economy we will see these holes filled. Nevertheless, Western investors need to recognize the practical differences between their home markets and the newer markets in China. (This is why my accounts prefer to use mutual funds that are managed by specialists who have been trained locally.)

While in the US we are still waiting on the surge in infrastructure spending to repair our railroads, roads, bridges, tunnels, and airports, China is well ahead in its construction phase. What is quite different is that in their drive for the "One Belt, One Road" strategy they see it as a way to export their overcapacity in steel and related industries. They want to do this for trading purposes and bringing other nations and markets closer to them. Perhaps more importantly it would somewhat lessen the reduction in heavy industry jobs. I also believe like with the Eisenhower Interstate Highway system in the US, the "one road" program would aid the shifting of military people and goods where needed quickly both internally and to the borders.  All of this is dependent upon detailed planning and a high level of engineering.

United States

Applying Dr. Einstein's approach to two US focused factoids may give us some pause for thought:

Credit Suisse notes that the number of publicly traded stocks in the US has dropped in half from 1996 to the present, 7300 to 3600. (I think that is an over-simplification and could be those stocks just listed on the exchange; nevertheless there is not doubt that the number of public companies has declined.) Whatever the actual number except in industries where there is significant capital risk (technology and consumer demand for fashions) entrepreneurs are preferring to stay private until they receive an appropriate bid for the company. I know that was my idea. Not only are investors disadvantaged by this trend, it is quite possibly the economy will suffer also, as private companies with less debt will tend to be smaller in terms of revenues and job creation. The current Administration wants to reduce regulation to address this problem. I suggest they also need to focus on death taxes on private companies. There have been too many family farms and businesses that had to be sold to pay death taxes. This was a concern for me.

Combined with the reduction of the number of publicly traded companies there has been a twenty-fold growth in the number of CFA^® Charterholders (Chartered Financial Analysts) which did not serve as a barrier to entry that some may have wished. If the number of eligible securities is down and the number of analysts is rising, the odds of analysts discovering new worthwhile investments is declining.

One of the results of the difficulty of finding a lot of new worthwhile investments is the growth in popularity of Exchange Traded Funds and Products. Some analysts, portfolio managers, and security salespeople have gravitated to ETFs and ETPs.

The theory behind this was that the markets move in broad trends and the prices of ETFs would mirror the performance of the underlying stocks. Increasingly this is not exactly the case. Starting with July 8th 2016, my birthday and the birthday of the Dow Jones Industrial Average, the yield on the 30 year US Treasury went up 48%.  An ETF that was meant to mirror  the move in the 30 year Treasuries was up only 43%. The 5% difference was attributed to fees, interest expense, volatile derivatives, and a shorter bond life. Admittedly this is an extreme occurrence.  If there is an increase in volatility, as expected by some, it may be difficult for the ETF managers to exactly mirror the index they are meant to be tracking closely. All of life is cyclical. At times market prices will track very closely to the center of their universe and this is called concentration. At other times the target universe experiences more diversity. I think we have entered such a phase and we will see an increase that various passive products are not tracking  the performance of their universe because they don't own enough of the winners and too many of the relative losers.

Question: What are sensible investors missing?

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Copyright © 2008 - 2017

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