Increase in Bearish News is Long-Term Bullish - Weekly Blog # 882

 

 

 

Mike Lipper’s Monday Morning Musings

 

Increase in Bearish News is Long-Term Bullish

 

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

 

                             

 

Another Term for History: Uneven Cyclicality

In describing the behavior of people and other animals the terms of optimism and pessimism are appropriate, particularly the extreme emotions in overcoming risks. These actions drive all kinds of markets, including climates. Extreme increases and decreases occur irregularly, with people forgetting the pain caused by collapses.

 

We may currently be entering a negative economic cycle, possibly caused by an exaggerated political cycle. The biggest danger in focusing on the probable down cycle is retreating from a continued effort to search for early up-cycle clues.

 

A lawyer who practiced at a bank during the Great Depression mentioned that he hired workers every day to work on bad loans. During this period there were some activist investors who purchased defaulted securities, hoping to hold them for a partial or full recovery of face value. Some of the more well-known players were Ruth Axe, Max Heine, Ben Graham, and David Dodd, among others. Current conditions are not yet at this level of pain, but some smart people are examining the potential for such a period, both in the U.S. and elsewhere.

 

What is Happening Now?

Moody’s (*), in its latest proxy statement, predicted a continued multi-year decline. PIMCO is reluctant to buy long-term US Treasuries. Small and Mid-Cap stocks are dropping more than large-cap stocks on down market days because there is only liquidity in large-cap trades. This suggests that sizeable positions may have to be held until there is a sustained recovery.

(*) Owned in client and personal accounts

 

The two major consumer confidence surveys showed sharp drops in their March reports. One long-term negative factor facing the US is the relative unproductiveness of the entire educational process for investment capital. In the public school system, the number of administrators has increased eleven times the rate of growth in the number of students. (Sitting on a number University boards I have seen the same tendency at their level.) The mental health needs of the students have almost become a sub-industry. Many homes are not effective educational sites either.

 

What are the Investments Prospects?

As someone who basically learned analysis at the New York racetracks, I turn to the availability of numbers and ratios. Most dollars invested in equities are for funding needs beyond ten years. Consequently, I am using the median investment performance of the larger peer groups of mutual funds for the last ten years, as shown below:

    Large-Caps      8.50%

    Multi-Caps      7.92%  

    Mid-Caps        7.57%     

    Small Caps      6.82% 

    International   5.19%

(I think the overall range of 8.50% - 5.19% is a reasonable compound return for the next 10 years, considering the two years of 20% or more in the last 10 years. However, I don’t think the rank order of the peer groups will work out the same as it has in the past. Large-Cap performance is too heavily dependent on a concentrated group of high-tech companies. Small and mid-caps should benefit from buyouts and the movement of talent from larger companies to smaller companies. International funds may be the beneficiary of reactions to US government actions. I recently added Exor, the Agnelli family holding company, to my personal portfolio.

 

With so many controversial views expressed, I am interested in learning your view.

 

 

 

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Mike Lipper's Blog: Odds Favor A Recession Followed Up by the Market - Weekly Blog # 881

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Mike Lipper's Blog: Separating: Present, Renewals, & Fulfilment - Weekly Blog # 879

 

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Relative or Payout Returns in Periods - Weekly Blog # 725

 

Mike Lipper’s Monday Morning Musings

Relative or Payout Returns in Periods

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

Throughout life we learn that successful investing is an artform, which means that people with different perspectives view actions differently at different times. Thus, no single investment fits the needs of everyone. With that starting point, we believe successful investing is going to be different for each of us and should not be taught based only on numbers and regulations.

I believe the single most important starting point in investing is identifying the period of investment. Our current culture is very much focused on now, with the media reinforcing that view. To the extent a future period is mentioned, it is tomorrow, next week, month, or year-end. Even when we state the decision period, we don’t describe the terminal date. For example, we know that US stocks on average produce high single digit returns for long periods of time. Thus, an 8% return for 2022 could be forecast. That could be considered a good or bad return compared to alternatives. Early this week, a positive return half that size could have been acceptable. By the end of the week, any annual return below 20% would be considered dismal.

The financial and popular media place us in a relative world, making comparisons of what they believe are competitive investments. After all, stock prices are subject to the same risks and rewards! This is a gaming or gambling attitude. Most of the money we are responsible for use current investments to produce total returns for use in future periods. Consequently, we think about returns compared to the expected uses of the money, with sufficient excesses to cover periodic shortfalls. While the size of the excess pool could be based on actuarial assumptions, it is more likely to be a comfort factor. (One reason many bear market survivors don’t do well in future periods is that they carry with them the fear of even worse future markets. It is quite possible that after a large decline one should reduce the size of the excess reserves.)

PORTFOLIOS STRUCTURE

The first recommended step is to sub-divide the investment portfolio into time-focused sub portfolios. Considering the current unsettled global, political, and financial conditions, I suggest the first sub portfolio cover expected payments between now and the end of the first year of the next president. The excess over payments might be in the order of 30%, declining as stock prices decline.

The second sub portfolio should cover the period after the first, perhaps going through the expected lifetime of the principal owner. The reserve component should be no more than half the first sub-portfolio, because based on history markets generally rise 75% of the time.

The final sub-portfolio should anticipate being expended after the expected lifetime of the principal owner. The volatility reserve should be half of the second portfolio’s.

ASSINGING CURRENT MARKET DATA TO PORTFOLIOS

Caution: My investment views are for the most part contrarian to popular views. They take advantage of the historic experience that when contrarian views succeed, they have a larger payoff than popular views, whose benefits are usually already in current prices. However, contrarian expectations do not come into fruition as often as popular views.

Immediate Portfolio

The American Association of Individual Investors (AAII) six-month sample survey shows 22.5% being bullish and 49.8% bearish. Extreme readings are normally under 20% and over 50%. Market analysts use this as a contrary indicator. (When these numbers reverse, watch out.)

Up and down transaction volume is also something of a contrarian indicator. In the week ended Friday, the NYSE had more shares moving up than down, 20 million vs. 10 million. Normally they are more balanced. After a long period of declining prices, the next upward spike is often caused by short sellers or custodians buying to cover shorts that need to be liquidated. While the relief rally on at the “big board” gained all five days of the week, the DJ Transportation Index was up only 3 days, and the Utility Index was up only 2 days. (Unless the upward movement broadens out, the rally may not be able to sustain itself for long.)

Working Portfolio

According to a recent survey of institutional managers, growth stocks were not favored over value stocks for the first time in many years. Since 2007, the MSCI ACWI ex US Growth index has been flat (Morgan Stanley Capital International All Country). (If this view is maintained, the relative multiple of growth price/earnings ratios will decline and represent a bargain at some point. But it also may suggest that earnings will grow at a materially slower rate. Another possibility is earnings outside of US Growth companies growing faster than those in the US, along with their stock prices.

Estate Portfolios

Each week Barron’s publishes the performance of the 25 largest US Equity Oriented Mutual funds from my old shop. Only five management companies placed funds on this list: American Funds (Capital Group) - 10, Vanguard - 9, Fidelity - 3, Dodge & Cox - 2 and PIMCO - 1. The total net assets of the funds range from $125 billion for Growth Fund of America (Capital Group) down to $53.8 billion for Vanguard Wellesley/Adm. (Note: all these funds have been serving investors for many years and American, Vanguard, and Dodge & Cox have done a good job of capital preservation. This may be important to their fund holders and distributors, although at some point in the future I expect to see more capital appreciation-oriented funds on the list, at least for a while.)

In all the discussion on the availability of petroleum, politicians and US Government people forget that the Bakken reserves represent over 500 billion barrels and would last for more than 100 years at current consumption levels. I believe the combination of our fuel and refinery expertise makes this supply one of the cleanest in the world. Considering the declining number of US based refineries and the low margins in the business, there could be a temporary bottleneck that could be addressed. (Whether an investment management organization has a direct investment in energy or not, I believe a knowledgeable energy analyst is essential for a successful portfolio management business in the future.)

Question of the Week:

How much of your portfolio is focused primarily on relative returns vs meeting payout needs?

  

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

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

https://mikelipper.blogspot.com/2022/02/successful-investing-expects-unexpected.html

https://mikelipper.blogspot.com/2022/02/we-are-progressing-weekly-blog-721.html

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The Top Before the “Big” Top - Weekly Blog # 567

Mike Lipper’s Monday Morning Musings

The Top Before the “Big” Top

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

                 

                

The one certainty about markets is their rise to tops and fall to bottoms. With this knowledge market analysts have developed many techniques to identify extreme movements, hoping to spot the appropriate time to reverse course and increase the chance of avoiding large losses or improve the chance of capturing large gains. Market analysts have probably used price charts since the beginning of organized markets in the ancient world. One of the charts that has a good record of predicting future movements is called a Head & Shoulders pattern. (No statistical or other measure is 100% successful over time. Being correct roughly 2/3rds of the time produces satisfactory results and the Head & Shoulders pattern generally does that.)

A price chart is produced for stocks each trading day in The Wall Street Journal, covering each of the three major stock indices: Dow Jones Industrial Average, Standard & Poor’s 500, and the NASDAQ Composite. The three generally move in the same direction, but at different speeds. For the past couple of weeks, the three have produced the same rounding top chart pattern seen during past tops. The critical task is weather to take action based on these patterns or ignore them. I wonder if this is a sign of an important reversal, as the reversal pattern shows three distinct top formations. 

Since the current market is down a bit from the former 2018 highs, a head is in place. Combine this with the relatively brief rounding tops mentioned and this pattern is predicting the end of the ten-year bull market that we have enjoyed for so long. A normal reversal is to approximately give up between 1/3 to 1/2 of the prior gain. (If I knew for sure, each of you would be invited on my personal Boeing 747 on the way to a voyage on my battleship sized yacht. But I don’t know.)

There is a second possibility, that the pattern of the last couple weeks is a possible first shoulder to a new high above the 2018 level, with a more distant final shoulder before a major decline. The current absence of “irrational exuberance” for stocks gives me some hope for the second possibility.

Cautionary Signs for Short-Term Investors

In general, commodity prices have been falling for more than a year since they completed their own bull market. While governments and central banks have attempted drive up growth and the rate of inflation. The continuing abnormal flows into fixed income and credit funds by both individual and institutional investors, at a time when the long-term outlook calls for rising interest rates, suggests that the new buyers are either naive or believe that they have superior trading skills in an increasingly illiquid market. Finally, there is the performance of mutual fund averages through last Thursday night, showing those with year to date gains in excess of 15%: 

China Region Funds       +17.75%

Energy MLP Funds         +16.22%

Energy Funds             +15.98%

Small-Cap Growth Funds   +15.23%

Mid-Cap Growth Funds     +15.05% 

I suggest that those funds currently showing year-to-date gains of +15% are speculative and should be traded out quickly in a decline. However, if investors believe they have these trading skills, the fund categories may be appropriate for short-term focused portfolios.

Thoughts for Long-Term Investors

While short-term investors dominate trading, long-term investors own the bulk of equities around the world. For the US taxable investor, the last ten-years has fattened their prior gains. This raises a question for those seeking to leave a legacy based on a stepped-up basis, without paying capital gains tax, is it better to take the valuation now and pay capital gains tax or the alternative valuation as of the date of death? Even with a major market decline, beneficiaries will inherit more than they would have previously. Institutional Investors concerned with the use of capital for multiple generations could stay invested as some of the present holdings may serve them very well.

MOHAMED A. EL-ERIAN, chief economic advisor at Allianz, and formerly with PIMCO, Harvard Management and the IMF, has published a piece criticizing economists, particularly those within governments, for their reliance on mathematical models without using behavioral science and game theory. Markets often seem to be better equipped than economists in predicting future trends. 

There appears to be some help on the way, the Bank of England is publishing a fan chart of possible future directions in their studies. The Congressional Budget Office (CBO) is already shows a fan chart where 2/3rds of the possible outlooks lie. The CBO study predicts that the US government deficit will rise by about 50% as a percent of GDP in 2019. This could be a low estimate, as both political parties are big spenders. I suspect the next Democrat administration will easily outspend the current occupant in the White House. (This is one of the reasons to bet that inflation will rise.)

History Suggests A Brighter Future

After long periods of stagnation, beyond the world of numbers, forces have saved various societies from their foolish management. The Dark Ages in Europe effectively ended with the discovery and importation of Latin American gold. After years of war spending in 19th century Europe the harnessing of steam power brought greater prosperity, as did the use of electricity. There is a chance that our world will be both disrupted and advanced through the spread of 5G networks, which will practically reach every person, vehicle, and activity. Within this century the rising education, productivity, and savings coming from South East Asia could be another spur. Finally, the evolution of African resources and its people would produce major benefits to the world economy.

Bottom Line

We are likely to experience reversals and volatility, but also pulsating progress. While a few may have the appropriate insights and trading skills to trade various markets successfully, most won’t be able to do it. Therefore, the best position is to stay in the game at various levels with sound and occasionally good investment managers.     

 

  

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

https://mikelipper.blogspot.com/2019/03/2-speed-vs-2-directions-old-better-than.html

https://mikelipper.blogspot.com/2019/02/lessons-from-warren-buffett-and-italian.html

https://mikelipper.blogspot.com/2019/02/could-biggest-risk-be-confirmation-bias.html

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Some Retire while Others Sense Opportunity - Weekly Blog # 563

Mike Lipper’s Monday Morning Musings

Some Retire while Others Sense Opportunity

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

                                                               

                                                               

Two-way markets are generally the safest, because most investors become aware of both the future upside and downside. For those of us who were privileged to attend the New Jersey Symphony Orchestra’s Lunar New Year Concert Celebration, not only did they hear great music but they were also introduced to the year of the Pig. According to the Chinese horoscope, the year of the pig favors wealth, good fortune, and dedication to hard work. I am earnestly in favor of those sentiments for all our friends and subscribers. We can all use good fortune and a little bit of wealth and I will continue to be dedicated to hard work for our clients and family. For many investors the road to wealth is participating successfully in the primary direction of the markets. I am hard at work trying to fathom the primary direction of the markets, particularly the global stock markets. Currently there are signals that point in both directions.

Downside Signals

The near-term economic trend-rate of growth is slowing. Evidence of this emanates out of China and its pivot away from exports toward a more service-oriented economy. Signs of this are also evident in Europe, Asia, Africa, Latin America, and North America. The political picture reflects this slowdown. Markets have responded with frequent changes in direction. Underneath this increase in volatility there is a sense that we have entered into a new market.

This week’s Barron’s highlights two investment managers who announced their retirements after an incredibly successful career. Both very recently produced way below career average rates of return as the structure of the market changed. Few stock and bond investors have not heard of Bill Gross, formerly of PIMCO and more recently Janus Henderson, who for a while was acclaimed “The Bond King”. Part of Bill’s skill was his insightful short-term trading of mortgages and his ability to identify cyclical changes. His techniques are now are copied by many smart competitors. The other retiree is Steve Mandel, the portfolio manager of the hedge fund Lone Pine Capital. His long-term record of gaining 14.4% since 1998 vs. 6.6% for the S&P 500 makes him one of the best hedge fund managers. He was a successful retail analyst at Goldman Sachs and moved to Tiger Management, the home of many very successful hedge fund managers. The retail market is going through a series of rapid structural changes. One of the warnings for poker players is, if you can’t identify the “chump” or likely loser, it’s likely to be you. Thus, it’s time to retire from the game as quickly as possible. These two well-known names are not alone, a bunch of “value” focused managers who have not performed well are also in the process of considering retirement. 

Worth noting in the latest week’s ranking of the top 25 performing mutual funds, 8 were growth funds and 6 were science & tech funds. Most of these were small or mid-cap funds with a likelihood of common holdings. These appear to me to be more the result of trading decisions than the decisions of long-term investors.

Upside Signals

For some time the large and growing global retirement capital deficit has been both a concern and potentially an expanded source of new funding for investment markets. Although both political parties are aware of the problem in the US, I don’t believe discussions in the House Ways & Means Committee will produce large results.

A significant number of US corporations are raising their quarterly dividend, desiring to keep their dividend payout ratios reasonably stable. Many of their existing shareholders bought into these companies years ago and now have a cost basis that is way below the current price. While not a popular measure, the new dividend relative to the initial purchase price is producing a current yield at mouth-watering levels. If the step-up basis at time of death remains in place, the yield at cost will in most cases tend to prevent their sale. As the market structure rotates into a new phase of favoring good but not cheap companies, many of these will be like the companies that attracted Charlie Munger and Warren Buffett as discussed below.

We may have entered a “Munger” Market Phase

Charlie Munger is the long-time partner of Warren Buffett. Before they joined up, Warren concentrated on buying securities that were cheaper than others. In effect, buying the discounted vehicle in an intellectual capital arbitrage. Charlie taught Warren to buy good companies at a fair price. This switch can be seen in Berkshire Hathaway’s record of successes in buying both whole companies and stock positions, which in part is the reason we own the shares both personally and in our private financial services fund.

The recognition of a “good” company is in the eyes of the beholder. There is a coterie of portfolio managers who believe that they own and buy high quality companies in various markets and sizes. Each have found their own high-quality companies. A recognized common characteristic of quality companies is their owners reluctance to sell. Often, the only time they become available in the market is when a principal owners’ estate is selling them or when an owner is desperate for cash. Unfortunately, during periods of economic turmoil more of these jewels come into the market. We may have entered such a period.

When I look at a quality company candidate the last thing I look at is price, either in absolute or relative terms. The single most important element I look for when evaluating a company are its people. It is worthwhile remembering that the concept of an organized company comes from military organizations and groups of professionals e.g. weavers and goldsmiths. Companies were organized based on skill levels, discipline, and respect. Respect for other members of the company, critical clients, and others. Integrity within the company resulted in the reputation generated.

The same approach should be used in selecting partners in private relationships. As the sole owner of a private company who made a few acquisitions, including some that really worked and others that didn’t, I know what I am looking for in new partners who can share the enhanced value from our working together. Being smart is important, but smart is not necessarily brilliant. Smart people have a good idea of what they know and have the intellectual integrity to know what they don’t. It is the second trait that makes them good partners and different from those that are brilliant. Too often, those that are brilliant claim it is based on solving problems completely by themselves. In looking at people I find that this kind of brilliance is a sometime thing. In periods between bouts of creativity, brilliant people are often frustrated, frustrating, and difficult. Smart people, when they are wrong recognize it and seek help in new directions.

Another key characteristic to look for is high physical and intellectual energy. Often the most creative time for developing useful ideas is not during regular work time and rarely during committee meetings. The real test of a manager or management is how they work their way through problems. One will only know how good someone is when you know how they handle surprises and mistakes. Years after dealing with a crisis, some public companies  are still benefitting from their recoveries, e.g. American Express (salad oil), IBM (360), JP Morgan (whale), and Johnson & Johnson (Tylenol).

Most of the time owners of good assets are loath to part with them. We may have entered a period when more of these high-quality assets can be bought at “fair prices”, but not necessarily on the cheap. We should watch Berkshire Hathaway and other high-quality acquirers who take advantage of these opportunities. History suggests that these periods don’t last long.

A particularly difficult task in selecting companies or people is separating current popularity from long-term value creation, i.e. Hula-hoops vs. home equipment for exercising. A related concern is gauging the probability of solving future concerns.

The list of desired attributes is both long and difficult to determine and capture. Thus the strong likelihood that when they are found their price will not be cheap. If we have entered the “Munger” market, the odds may have improved.

    

       

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

https://mikelipper.blogspot.com/2019/02/should-reputations-have-sell-date.html

https://mikelipper.blogspot.com/2019/01/excessive-security-risks-weekly-blog-561.html

https://mikelipper.blogspot.com/2019/01/completion-analysis-fuller-picture.html

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Facts Trap Us into Choices - Weekly Blog # 526

Introduction

Why do very bright people make wrong choices? In our highly professional world of investments why do so many financially sophisticated investors choose the wrong investments at the wrong time and in the wrong amount?

I believe that I should always be learning. Because of my investment performance background I study smart investors who regularly make mistakes. Hopefully, I will learn to my clients and my own benefit. With the above mission in mind I was struck by an article entitled “In Defense of Ignorance” which was published in the Marathon Global Investment Review. Marathon Asset Management is a very thoughtful and successful investment manager based in London. Apparently its skillset is to focus on the supply side of economic equations and limit its input largely to facts about supply. As this focused approach has worked for Marathon and its clients, I considered this thinking in terms of my own intellectual process of transitioning from security analyst through various stages to becoming an entrepreneur and registered investment advisor.

Career Transition

As I was finishing my active duty in the US Marine Corps, my plan of action to feed my young family of three (and more planned) was to become a security analyst, study all there was to know about a leading company in an important industry and be hired by a company’s investor relations area as a person serving financial analysts. My career goal then was to be a junior officer of a large, stable, and hopefully growing company by retirement. Luckily for me it didn’t work out that way.

As an analyst my goal was to gather more facts than anyone else on a targeted company. Interestingly enough, the help of employers and analyst societies did not prepare me for the real commercial world. I had to learn, usually by observing, how to sell investment research, make sensible investment decisions, understand internal politics, seek clients, and learn how to run a business. Thus, I had to move away from the simple task of just gathering facts, as comfortable as that was, to a broader set of skills.

Analyst vs. Entrepreneur

Recently I have become convinced that much of the thinking processes of investment, business, and political leaders has evolved in a similar fashion. For a long time leadership was assigned to those who gathered the most facts. Many of them were like a good litigating attorney that gathers all the known facts about a case. He or she does not want to be surprised by something said by a favorable or opposition witness. After gathering the facts, attorneys are selective as to how they build their persuasive pitches. These types of leaders, often rising through highly structured organizations, are replaced or out-maneuvered by an executive decision-maker.

The rise of the executive decision-maker is changing our world as we know it. The old practice of following a case study of known procedures is giving away to more free-form decision-making. Increasingly, successful nations and business operators have less in common with their perceived competitors. 

It is not this blog’s mission to solve world and macro problems, but rather to focus on investments largely through investment managers and mutual funds. With that thought in mind I am wondering whether our practice of building diversified portfolios based on asset classes, size of companies, locations, and market capitalizations, which worked well in the past, is becoming outmoded. Should we assemble our managers and their funds as a good theatrical producer does with people of different talents? A good producer brings these multi-talented people together in a way that produces good results as a unit. As we move in that direction we will need a different classification system, which may be different for each client portfolio.

The only time I had some limited experience with this was when I was fencing in college. In a very short time I had to make a guess whether my opponent favored offense or defense, how to change the expected flow of events, how to lure an opponent into changing styles, etc. We know that most managers are reactive to prices or announcements, only some attempt to position prematurely. Others march to their own drummer and stay fixed in their actions regardless of other stimulants. As we have very intelligent readership of these blogs, I am wondering whether any have some guidance for me as I struggle to adapt to my perceived view of the new world of investing. Please contact me at AML@Lipperadvising.com.

For the Fact Gatherers

Demand for money is gradually rising. In the daily Wall Street Journal there is a statistical box of ten “Consumer Rates and Returns to Investors.” These indicators go from short-term to 30 year mortgages. Each are shown at their current level and their range for the year. Four of the ten are near their annual highs and none are more than 51 basis points away from their annual high.

Two items:

•  Merrill Lynch’s technical people view cyclicals as being more attractive than defensive stocks. They do not see a recession near term.

• PIMCO’s latest view is that the next economic recession is 3-5 years way.

When these two major market movers (along with most others) express their views, as a contrarian I get worried about a surprise that blindsides the majority of the thinking. I would be particularly worried if the stock market goes to another new high this year.

There is likely going to be more excitement about the opening up of the Chinese “A” share market to foreigners. WisdomTree* is warning that many stocks do not have good characteristics as investments, so be careful.

*Personally owned.

All too often professionals utilize a formulaic process rather than adjusting to the changing environment.  This leads in many cases to some bad choices.

__________

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A. Michael Lipper, CFA

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Investment Survival Lessons

Introduction

In an accelerating world, I find it necessary to always be learning. I hope to learn from almost every exposure I have. This week’s post is based on three inputs to my investment survival orientation:

1. Future vs. History

2. Markets vs. Economies/Governments

3. Levels of Patience Required

Future vs. History

In an always insightful column in The Wall Street Journal, Jason Zweig interviewed Professor Robert Shiller, the Nobel laureate in economics and the developer of the “cyclically adjusted price/earnings ratio” or CAPE. In the interview there is a particular bit of wisdom for all of us who are condemned one way or another to predict the future. Professor Shiller stated while the current level of CAPE “might be high relative to history, but how do we know that history hasn’t changed?” Asking the question is the wisdom not my answers. There are at least two reasons to believe the certainty of a top of a market.

The first reason is that we live in a very dynamically changing financial world. This is not the first time that governments and their central bank servants have been manipulating interest rates or modern day money; from the ancient times kings reduced the amount of gold and silver in coinage. Add to this that the trading markets have changed due to the use of capital restrictions, markets fragmentation, increased use of lightly capitalized derivatives and the communication of investment methods.

The second reason to question the utility of C.A.P.E. or any Price/earnings ratio measure is my training at the race track. When asked, the wagers who were putting enough of their money on a particular horse that would make the horse the favorite they would focus on one statistic almost to the exclusion of any others. (Favorites typically win only about 1/3 of the time.) With this as a background, you can sense my apprehension when entering the analytical business where the need was to quickly convey brief reasons to make an investment decision through the use of some term or label with the caveat that people would fully understand the limitations, construction, and the past record of misapplication.

 

Since almost every argument to do something in the stock market relies on a P/E ratio, I am increasingly suspicious of its utility. I prefer to understand operational revenue and pre-tax “pre-other” income growth. In addition, I look at net cash generation after debt service as comparative measures before focusing on an evaluation of management to handle future opportunities and problems. Further, because of changes in accounting reporting policies, in many cases earnings a few years back might look very different than today’s version. The calculators of C.A.P.E. use reported data for the S&P 500 companies which is just not good enough for me in the fight for investment survival.

Markets vs. Economies/Governments

While I am very sympathetic to Professor Shiller’s concern that history is not an absolute guide to the future, I do pay attention to technical market analysis. I have received separate, thoughtful warnings from analysts based in Chicago, New Jersey and London using individual tools and data that we are heading into the late stages of a long bull market. They seem to agree that it is likely that the current “correction” will be followed a rapid rise led by the late stage large-cap stocks. Nevertheless, one analyst has supplied some S&P500 benchmarks in terms of downside risks as shown:

a) 200 day moving average: 1905, breaking down from this level could bring more selling;

b) Down 10% from recent top: 1810;

c) Down 20% from top similar to 2011 or a cyclical decline: 1610;

d) Down 33% a la 1987 crash: 1350.

As frightening as these numbers are, they do not include a once in a generation decline of 50% which could take us below 1000 as compared with today’s level of 1906.13. The nice thing about market analysis is that you do not have to know what causes people to sell, just that they are selling in increasing volume and there is not a lot of incentive to buy. All three analyst sources have noted the deterioration of numerous global markets; e.g., German DAX is down -12.4% already. These market participants sense future problems that the various major governments and their central banks are not addressing. Perhaps the markets are suggesting that the Emperor is marching naked. 

Current moods of business people and investors are much more cautious than national statistics would indicate. One example may be helpful, Large Cap Growth stocks were up +2.21 % in the quarter vs. -6.39% for the much more economically sensitive Small Cap Value stocks. To show the importance of volume, on October 6^th the stock of T.Rowe Price^* closed at $78.14 on NYSE volume of 872,860 shares. At the end of the week the stock closed at $75.35 on volume of 2,643,245 or close to 3X the earlier day. The interpretation is that the firm’s income will suffer from lower assets under management due to market decline and fewer net sales.

In terms of investment survival I pay attention to the market analysts and have adjusted most portfolios that have a five year or less time horizon to be more cautious. However, each of these bright market analysts see that we are setting up in the long run a major expansion of stock prices and somewhat higher interest rates to which I agree. But this could be delayed by the political forces utilizing inaccurate data trying to create a recovery rather than seeing that they are a main cause of the current malaise. We may need new global leadership.

Levels of Patience

An advantage that I have is owning a large number of stocks of financial services companies either personally or in a private financial services fund that I manage. Thus this week I attended an Investors Day for Jefferies, which is now owned by Leucadia^*, and is owned in our fund. In one way this has been a good holding in that it is up 143% since purchase years ago. In another way it has been a disappointing holding for the last 18 months with the merged stock just about where it was on the day of the merger. Luckily other holdings did better. However, in terms of lessons it may be worth a great deal.  My reason to continue to hold the stock is that I saw it as a unique player in a rapidly changing investment banking and institutional brokerage business with a largely attractive merchant banking portfolio, a significant net operating loss carry forward and new capital resources.

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

What I was counting on was the continued regulatory pressure on the major banks and their investment banking activities in terms of their use of their capital. I was further counting on a significant a number of successful investment bankers and other highly trained technical people seeking employment with an organization that could materially increase its market share through their efforts. Where my analysis was faulty was that these changes would have effect much more quickly. What I should have recognized is that it often takes two to three years for the investment bankers to bring in more revenues than their cost.

Judging by their underwriting and deals success many of the Jefferies bankers are on the verge of becoming profitable to the firm. I should have been more patient to see the expected improvement. It was easy to recognize the pressures on the majors and the deteriorating service levels throughout many of the organizations. This is why I suggested that currently one might not open new bank relationships due to pressures throughout the organization. I thought these pressures would immediately translate to more and profitable business to the non-bank competitors. It didn’t happen on my schedule thus I am reluctant to suggest purchase at this time. I will have to see not only operating earnings coming through, but also a steady decline in Jefferies compensation ratio.

PS: Last week’s suggestion that some of the money planning to leave PIMCO should consider reducing its allocation to bonds may be happening in that the flows this week into money market funds were unusually high. I would hope as equity ratios decline because of falling prices and other disappointments that new capital can be prudently introduced into expanded equity holdings.

Perhaps, once again I need to be more patient.

PPS:  Bloomberg Television Sunday night is showing a weak opening in Asian markets which followed a report from Business Insider that the Dubai Stock Market index fell 6.5%. Be cautious and do not try to catch a falling knife.

Question of the week: Do you have plans to increase your investments in stocks?

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