Understand Numbers Before Using - Weekly Blog # 851

 

Mike Lipper’s Monday Morning Musings

 

Understand Numbers Before Using

 

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

 

The most common mistake made by investors is too brief an introduction to the investment and economic numbers used by most who chatter about “the Market” or the “Economy”. For example, the three most quoted US stock market indices are the Dow Jones Industrial Average, the Standard & Poor’s 500, and the NASDAQ Composite. Each of these unique indices was created for a specific purpose and was designed for a specific audience. However, they are now used for numerous purposes worldwide, including New York, Chicago, Washington, London, Tokyo, and Shanghai. The biggest mistake is assuming the indices are identical. Although the indices all have short comings, proper use of the numbers can lead to useful insights in making decisions.

“The Dow”
The most well-known of all market indices is the “Dow” (DJIA), although it was not the first indicator from the Dow Jones newsletter writers. They originally tracked the performance of trunk line railroads as the most important stocks in the 18th Century. Later, due to the industrialization of America, they created an index of a small number of large industrial company stocks. The main readers of their newsletter were retail brokers. At that time, it was believed that the higher the price of shares the higher the quality, making them more valuable. This led the DJIA to be weighted by the prices of the shares. As is often the case, there was unanticipated demand for the results achieved by the index. Consequently, they took advantage of the wire systems of both the large “wire houses” and the press in developing a national and international market for the index. (The equivalent of the Rothschild’s carry pigeons.) Most local papers, and later radio/television, quoted the close of the NYSE market by using the “Dow”.  Thus, across the US many more people than owned shares were exposed to the index.

The Washington Applications
Political people in Washington started following the index as a measure of the economy. They used it as a gauge of what local voters thought about the economy. The Fed’s Open Market Committee consisted of a rotation of the presidents of the local Federal Reserve Banks, whose districts were roughly tied to the size of the financial assets the local reserve banks supervised. The boards of directors of these local reserve banks all have financial leaders familiar with the DJIA. Thus, the index became an unofficial factor in bank regulation.  Fed PhDs, recognizing the limits of a 30-stock index in producing many economic studies, used NYSE data to supplement the DJIA. (This thinking led to the recognition that other indices would be needed.)

Standard & Poor’s 500
Historically, the index that next came into use was the S&P 500, which was primarily used by institutional investors. This index was designed to correct the acknowledged problems of the DJIA. First, it had roughly 500 stocks. Second, it used the market capitalization of the issuer’s common stock for weighting purposes. Standard & Poor’s is a premier bond rating organization which also covers equities. The company had an extensive menu of data points that it used to assign credit ratings on stocks, which it also applied to the S&P 500 Index. Thus, we can now compare the price of various indices relative to their book values. The S&P 500 Index trades at 5.09 times book value vs 4.08 times for the DJIA. This comparison highlights the S&P 500 index’s investment in companies perceived to possess more growth than those in the DJIA.

In my work in analyzing large-cap mutual funds, which have many more assets than other slices of the mutual fund pie, I use the SPX as the first comparator before more narrowly using growth, value, and core breakouts. I similarly do the same for most global funds. Unfortunately, I can’t find enough data rich breakouts in many local markets, indicating these funds are primarily looking for local shareholders.

NASDAQ Composite
This 3rd index does not have a size bias. The index is comprised of bank stocks, local companies, and companies located in various geographic locations, including Canada, Israel, China, and numerous other countries. Additionally, it is the initial home for companies recently gone public. Consequently, many of the stocks on the NASDAQ have limited liquidity due to the low number of shares offered and/or the founders retaining a significant portion of the stock. It is not unusual to see 4 or 5 times the number of shares traded on the NASDAQ compared to the “Big Board”.  

The “Market” is Changing
Volume is more sensitive to speculative opportunities than highly rated investments and it is amplified by the use of derivatives, ETFs, off-market transactions, and less capital present on the floor. Dow Jones S&P Global is now the owner and provider of both the DJIA and the S&P 500. Even though there have been changes, there are still missing elements in market tools.

The separation between stock and commodity markets does not make it easy to provide a fuller solution to evaluate a uniform portfolio of assets and their risk modifications in a 24-hour, seven-day world. Agricultural products, impacted by weather, are important to food manufacturing and distribution industries. Many, if not most business cycles, are impacted by agricultural disruptions, real or feared. One of the causes of the great Depression was farm belt problems caused by excessive debt creation and poor climate conditions. These led to the passage of the Smoot-Hawley tariff and its global ramifications.

(While agricultural products as a percent of population is much smaller today than in the 1920s, the global impact may be the same order of magnitude.)

Moving on to the hard commodities, the timely completion of new mines and transportation systems can be disruptive to many areas, including stock markets.

For every global consumer, global producer, shareholder, and military person, the fluctuating value of major currencies is a cause of concern. This summer the US dollar dropped from $106.4 to $100.7. (This is likely to have an impact on inflation)

A Working Conclusion
Indices are a useful snapshot, but what is needed is a continuous motion picture and an understanding of what is causing the change, including built in construction biases and an identification of what is missing. If you have any thoughts, please share them.

 

 

 

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Uncertainty is Inevitable - Weekly Blog # 697

 

Mike Lipper’s Monday Morning Musings

Uncertainty is Inevitable

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

Numbers and People Are the First Traps

When a baby takes its first uncertain steps it eventually falls, despite hovering caregiver parents and others. From that instant on, the baby wishes to avoid falling. As we learn to balance our movement, we believe we have solved the problem of safely walking. Thus begins our first mistake in judgement which we apply to all activities, including investing in life and securities. While we fall or stumble less frequently throughout our lives, we accept it with annoyance, but carry on nevertheless.

Our next mistakes are our imperfect memory and learning from people. We expect those we love and/or respect to be correct in their pronouncements all the time. Only from experience do we appreciate that they can and will make mistakes. Later in our development we learn the discipline of the power of numbers, usually through achievement or time. However, we also learn that conditions change, and success or failure also changes with conditions. Thus, we should question the inevitability of future events occurring exactly as people and the numbers foretell, as uncertainty changes as we mature into risk. Whether we like it or not, we become risk assumers or hopefully risk managers.  My philosophy of life and investing is based on addressing risks whenever possible. This blog is devoted to some of the current risks I perceive, which are generally not focused on by many professional and individual investors.

1.   Sellers’ Risk

Most people view the buyer as the one at risk in any transaction. While this is true in terms of money transferred at closing, including expenses to make desired changes and upkeep, what most don’t fully recognize is the seller in one transaction becoming the buyer in the next transaction. Home prices recently reached record levels in the US, the UK, and many other developed markets. As these homeowners become sellers and eventually new buyers, they will bear the initial cost of a new home, including its desired changes and upkeep.  

Many buyers are at risk due to the vagaries of current inflation, including through delays. Most communities have not updated their infrastructure, apparent after the latest weather-related expenses, which will increase costs. I suspect local schools and universities will need to change the education being taught so their students can find meaningful employment and lives. (This will increase taxes and won’t be cheap)

2.   Co-Venture Investment Risks

In almost any investment one of the bigger risks is attempting to sell. One or more sellers can “ruin” the market by removing though sale a higher buyer. This can happen in terms of a neighbor’s home, a similar property, or a fellow shareholder. The probable or contemplated seller’s actions are difficult to guess, but it should be attempted.

Let me share an example that happened this past week. A non-US stock I own announced a 29% decline in net income for the first half of 2021 and the price barely moved. Yes, revenues rose 54% and they announced a few new items to replace outmoded products. While I was surprised by the net income decline, I was not particularly surprised by the stock price action of BYD. [These comments should not be construed as a recommendation, in part because I don’t follow its industry or its competitors.] My relative lack of concern comes from knowing two of the largest stock investors and having visited the headquarters and plant in Shenzhen. In looking to the nature and reputation of major shareholders, I relied on one of the oldest investment techniques, identifying sponsorship. 

A story that has been told from the 19th century involves a leading member of the London Stock Exchange asking another member what he could do in repayment for a favor. Replying to Lord Rothschild, he said “just put your arm around me and walk across the floor of the exchange”. With that in mind I regularly look at the owners of stocks of interest. Some funds have high portfolio turnover rates and tend to look for explosive earnings. Others, like the two owners, are long-term investors who would probably be buyers if the stock dropped temporarily. Currently, with 20 million new retail accounts since 2020, I don’t expect many to have learned to be buyers of shares that are declining in price.

3.   Market Price Leadership Rotation 

The current leading macro group investment is commodity funds, benefitting from the play on current shortages. Combine this with what I previously mentioned, some institutional investors cutting back on equity exposure after 20% gains in the S&P 500 within a calendar year. (The difficulty with this approach today is the lack of low-risk alternatives to move some stock money into.)

4.   A Potential Large Risk for the Next 3 Years

In addition to the current legislation before Congress, which is not likely to be paid for during their expenditures, there are at least two other issues Congress will need to deal with sooner or later. The current administration is discussing cutting the income tax rate on lower earnings. (I suggest it be called “lower real income for lower wages”.) A portion of the low wages paid to those who pay little if any income taxes is not likely to increase spending. To offset the cost of lower taxes on low wage earners, one should expect materially higher taxes for higher earners (This is the real motive of certain people in The White House and of far-left leaning members of Congress.) 

To offset this increase, higher rate taxpayers are likely to see prices rise for goods and particularly services. If it continues long enough, the cost of transportation and other items for low-end wage people will also rise. As profit margins decline, more business will flee the country and/or reduce risky investments. The increase in the price of oil already demonstrates the skill of the current administration. Words from the White House suggest the economic impact of the new proposal will be measured against “the success of our withdrawal from Afghanistan”. 

5.   A Longer-Term Problem that Must be Addressed

The Old-Age and Survivors Insurance, the largest component of Social Security, will run out of money in 2033. Undoubtedly this will be met with tax increases and probably a lower value dollar, which will hurt investors who are not properly hedged.

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https://mikelipper.blogspot.com/2021/08/possible-major-change-missed-by-media.html

https://mikelipper.blogspot.com/2021/08/another-but-discouraging-look-at-market.html

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

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Is the Tipping Point Cyclical, Secular or Both? How does this Influence the place of Real Estate in the Wealth Portfolio?

According to folklore, the Rothschilds divided their wealth one-third in securities, one-third in art, and one-third in real estate. A recent poll of US millionaires put their real estate investment at one-quarter. Which is the optimum choice? The answer may be found in the analysis of whether we are entering a cyclical or a secular tipping point. In modern usage, a tipping point is that point when change is unlikely to be reversed. The trends of the stock market and those in real estate are not perfectly attuned, because of the liquidity preference, securities prices move faster than real estate prices.

Now that we have completed three consecutive months of stock market gains, many believe (or at least hope) we have passed a turning point that is also a tipping point, as we enter a cyclical market recovery. In my recent series of interviews with mutual fund and hedge fund managers, I have found there is a dichotomy about this belief. Some managers, mostly mutual fund managers, see the market upturn as part of a normal cyclical recovery. For the most part, these are managers that have not changed their portfolios significantly since last summer, if not longer. They believe that the stocks that hurt them on the decline will lead them off the bottom. Led by the financials, stocks have risen. However, a more careful analysis shows the leaders in this recovery are the high momentum or high beta stocks, which suggests that the buyers are more traders than long term investors, perhaps not predictive of a sound long term increase in investment values of high quality stocks and bonds. A number of hedge fund managers are not buying the cyclical recovery story. Some see themselves as asset managers, not more narrowly defined “growth” or “value” stock managers. In numerous cases the asset managers have elected to add high yield debt, bank loans and selective mortgage debt “credits” to their portfolio. The more extreme of these managers are involved in distressed companies’ debt. Along with Moody’s * they expect a sharp increase in defaults well into 2010. Thus, as is common at various turning points, there is considerable debate as to whether what we have seen over the last three months is merely a trading opportunity or not.

The case for a secular tipping point is more difficult to recognize, and if there is one, our focus may be premature. The first place to look is the structures of the financial community. The regulated communities of banks were failing the principles of safety and soundness that allowed them to be both independent and to offer the cloak of government backing. As a result, in many cases they became temporary wards of the state (along with others). Predictably, the banks followed the shadow financial system into debt and equity positions that they did not fully understand, but had no problem selling them on to both institutional and retail customers. At the urging of banks, the government initially wanted to regulate the shadow financial system, but is now increasingly dependent upon the expertise and risk assumption capabilities of the unregulated members of the global financial community. Reluctantly, governments around the world have recognized that risk assumption is much better done in the private sector where the risk of financial failure and possible personal bankruptcy supply a much higher level of discipline than the outmoded rules issued by the government. If this change in attitude is happening, then a major tipping point is close by. If not, the three month turn at best is cyclical in nature.

The real estate market is also currently focusing on a cyclical recovery that will eat into the excessively large inventory in the commercial real estate sector. To look for a secular change one needs to look at the new construction plans. Building “green” is becoming fashionable. One can debate whether the fashion is just a politically sensitive fad in terms of global warming or an honest desire to be more fuel efficient*. Nevertheless, this trend is a considerable change to the production of buildings of all sorts of sizes and locations. However, I doubt that going green is a major tipping point. There is one possible point on the far horizon that would be a tipping point if it were to gain momentum. If we are serious about all kinds of energy conservation (from autos, homes, offices and stores), we need to encourage people to return to the cities. To make this return attractive to people, we must rebuild cities into pleasant, safe and healthy places.

What does this ramble mean to asset allocation between securities and real estate? For securities there is a good chance that we have tipped ever so slightly into a cyclical recovery, which is not at all saying that we are heading for new highs. Only if we see a secular turn in the thinking of governments and their people is there a good chance we will soon move toward new highs. Bottom line is to buy and own securities, but be prepared to sell when the cyclical recovery has been completed. In terms of real estate, almost any sale today will be a good sale . If you do not have to buy, it might be best to wait until both the absorption phase is near over and there are signs of a secular change.


* Moody’s is a position in a hedge fund managed by the author. In addition a portion of said fund will be devoted to securities in the energy technology space.