Anticipating Topping US Stock Market for Portfolio Managers vs. Stock Pickers - Weekly Blog # 662

 

Mike Lipper’s Monday Morning Musings

Anticipating Topping US Stock Market

for Portfolio Managers vs. Stock Pickers

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

                           

                   

                           

Warning: How Markets Approach Tops

Perhaps fittingly, markets reach tops in a similar fashion to countries going to military wars. There are two phases. The first can go on for a lengthy period of a year or more, with the slow destruction of the ability to successfully fight back. The second is an immediate event, which galvanizes the opposing forces into military action. The assassination of the Archduke in WWI and the Attack on Pearl Harbor in WWII are two examples. In both cases the general population was not paying attention to the deteriorating conditions and they were truly surprised by the triggering events. Those in power were not surprised that an event could trigger hostilities and there were premature warnings if one looked for them.

With the US stock market nearer a probable peak than a bottom, I sense an oncoming peak followed by a meaningful decline. I just don’t know when, although I have a pretty good idea who will be blamed for it.

Topping Signs

The first sign is the public’s wish for a better year than the last, often expressed as a bigger gain in the US stock market. The raw gains for the Standard & Poor’s 500, with dividends reinvested, was +18.40% for 2020. A level roughly twice the long-term average of +9% to +10%. The average S&P 500 index fund, with $1.9 trillion entrusted to them, gained +17.91% with dividends reinvested and management, administrative, and transaction expenses deducted. As good as these results were, they were below the average return for US Diversified Equity Funds, a gain of +19.14% on $10.3 trillion in assets. Even with the history of a strong November and December being followed by a year producing returns of +10% or more, one should be cautious in expecting the 2021 return to be better than 2020. 

Excessive speculation with increased leverage weakens all but the strongest financial structures.  Excessive speculation is often an open invitation for enemies to embark on bold adventures (Pearl Harbor). There is no doubt we are experiencing rampart speculation, 2020 had the fastest bear market and included a record level of IPOs and an equal number of SPACs (Special Purpose Acquisition Company). In addition, 2020 saw a record level of margin debt and a new generation of inexperienced investors rapidly trading on home computers, somewhat like the “roaring twenties”. 

Accelerating inflation also weakens the defense mechanism of a society. The JOC-ECRI Industrial Price Index ended the year at +24.44%, with 81% of the weekly prices rising in the weekend edition of the WSJ. Other cracks are also visible in the economy, with landlords and their banks speculating on when and if their tenants will pay their rent. One also hears of some officially unemployed workers only willing to work off the books. Integrity is often forgone in periods of speculation and inflation.

We should not attempt to remove all speculation from the markets, as we would be killing opportunities to take risks that have paid off very well in 2020, shown in the performance of the following mutual fund averages:

Alternative Energy Funds     +92.89%

Global Science & Tech        +65.00% (C)

Science & Technology         +52.21%

Multi-Class Growth Equity    +42.89% 

(C) Canadian Information Technology stocks +80.65%

Typical Stock Pickers Play Differently

Picking stocks is an old art form encompassing both short-term gambling and long-term investing. One of the main mental attitude differences between an almost exclusive focus on picking stocks and portfolio management, is that stock pickers focus almost exclusively on the performance of individual holdings, whereas professional portfolio managers focus on the performance of the entire portfolio. This usually leads to a stock picker having a more limited number of holdings, with many driven by the same market dynamics. Many newer stock pickers are entertained by the frequent examination of price volatility, intending to hold if his/her stock prices rise relative to other immediate alternatives. The focus is often on what is happening in the market and/or in the headlines, not on the fundamentals of the company which happens to have the same name as the stock. If the stock disappoints, the player sells and either buys something else or totally withdraws from the market, until a new wave of speculation gets his/her attention. In viewing the history of stock-pickers, one is reminded of what is said about pilots “There are old and bold pilots, but there are no old bold pilots.” 

That speculation burns out many inexperienced traders is unfortunate, not only for them but also for the nation. We have reached a point where the number of new companies equals the number retiring, either voluntarily or involuntarily. Among the reasons are demographics, labor and other capital productivity, regulation at various levels, and tax rates. One of the reasons US productivity was a world leader was the birth rate of new ventures and the success of some. Among the biggest advantages a stock picker has is that he/she does not have to play and record of results is not known. If the record is self-disclosed, it may not be believed. 

The Professional Portfolio Manager Plays a Different Game

The biggest risk for most professional managers is career risk, either losing employment or reputation. Furthermore, the portfolio manager is constantly being measured against supposed peers and externally identified time periods. At times absolute and relative investment performance are paramount and at others presumed risks is critical, whereas for some accounts cash generation is most important. For example, in 2020 the same account could be a relative leader or laggard and finish the year with very acceptable results, depending on the period selected. In some cases, when an institution borrows money during a period of economic strain, cash generation or volatility is critical to making payments or maintaining credit ratings. Because of COVID and a disruptive economy, some institutions have become much more sensitive to short-term results, whereas others look at the same characteristics through a longer-term lens and see new opportunities and risks.

In contrast to the stock picker, a portfolio manager looks at each investment not only in terms of its investment merit, but also its role in creating the appropriate balance in an account in terms of risk and reward. While a stock picker would ordinarily be delighted to have every one of his/her holdings do well, a professional portfolio manager would be concerned, fearing a change in the impetus driving the market could make the portfolio a very risky vehicle. In income-oriented portfolios, the timing of flows is critical to meet payment obligations and that can put constraints on the structure of the portfolio.

Unlike the private investor, most professional portfolio managers can’t afford to be out of the market, as most outstanding performance requires ownership on key turnaround days. The best a manager can do if the market is moving differently than what is perceived to be correct long-term, is shift the relative volatility of the portfolio, with a willingness to move quickly into higher volatility when the trend is what it should be.

How are You Protecting Against Unwarranted Speculation?

• Ignore?
• Raise Cash/Short-term vehicles?
• Change Volatility?
• Prune holdings which don’t help?
• Or something Better?   

I like quoting Ben Graham, not only because of his well-earned knowledge but because of the New York Society of Securities Analysts gave me an award named after him. He is quoted as saying “the essence of investment management is the management of risk, not the management of returns.”

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

https://mikelipper.blogspot.com/2020/12/stud-poker-new-swamp-game-weekly-blog.html

https://mikelipper.blogspot.com/2020/12/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/12/searching-for-surprises-weekly-blog-659.html

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

Searching for Surprises - Weekly Blog # 659

 Mike Lipper’s Monday Morning Musings

Searching for Surprises

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

                           

                        

Julius Caesar, in writing about his victory over the Gaul (now France), claimed he was never surprised as a military leader but spent three days burying his dead. To me, that is the definition of a painful surprise. One of the responsibilities of a prudent investment manager is to avoid as many meaningful surprises as possible. A meaningful surprise is one that prevents the accomplishment of a strategic goal.

To accomplish this goal, one should keep an eye on the significant changes to conditions of future battles that others are not anticipating. An aware investor probably anticipates more change than occurs. Also, some surprises won’t be anticipated, but will be helped by a quick reaction coming from being prepared for surprises. My attempt with this blog is to identify possible future surprises that will disrupt the return to the past “normal”.

Competition is Changing

There are two ways competition changes, through composition and conditions. In the investment arena we are seeing a number of old large investment groups acquiring mid-sized competitors, either through buying the whole company or a critical portion of it. These are different than in the past and are industry deals to pick up assets without keeping duplicate administration and marketing structure. Over the last couple of weeks we have seen two examples of non-standard bulking up of assets, where needed capabilities were believed to have been acquired. Morgan Stanley (*) acquired Eaton Vance (*) to broaden its distribution capabilities beyond its own largely wealth management force. In a somewhat similar fashion, the owner of the Delaware Funds (Australian money manager Macquarie Group) is buying the fund management assets of Waddell & Reed. The two acquisition targets have been in the fund business for many decades and are older than their larger acquirers. Competitors will now face a broader product line and an entrenched competitor in more distribution channels. These transactions are signaling that fund management peers should expect stiffer competition in the future, likely through fewer competitors. A sign of these concerns occurred last week when Jaime Dimon asked competitive investment bankers in an investors meeting to surface attractive M&A candidates to him for JP Moran Chase (*). One can see the urge to acquire is very high if the largest US bank in terms of assets, with its own investment banking group, asks for help with their own M&A.

(*) Mentioned securities are either owned in managed accounts or personally

There are some who believe the size of passively managed pools will be larger than actively managed pools by 2022. I hope that is true, nothing will be better for actively managed money than fewer competitors. Another way competition changes are when the rules of the game change. Nielson has indicated that in 2022 it will be able to track the inclusive viewing habits of television and much of social media, assisting national and local efforts to gather consumers and voters. Much of the success of E Commerce is based on its display and pull through the internet, while most “big box” stores rely more on television and print advertising. An advantage of older media was that it may have added credibility to the merchants and merchandise offered. To the extent that benefit still existed, I believe it was largely lost through the last presidential campaign as these mediums erroneously broadcast the belief of the great “blue wave” and other elements of questionable veracity. This has already contributed to the decline in the number of daily newspapers. While well managed Department stores will survive based on their merchandise skills, there will be fewer of them. While one can’t guess all the new regulations and fees/taxes that will be heaped on the distribution system, the safe bet is that it will be more expensive to distribute products and services in the future. If anything, the value of brands will likely be enhanced.

The Ticking Time Bomb of Inflation

Almost all engines have pressure release valves or mechanisms and this is equally true for human interactions and economics. When a pressure release mechanism is blocked, additional pressure is applied through other  releases. Major Central Banks, directed by their national governments, have successfully prevented interest rates on government bonds from registering the inflationary pressures that have been building in their economies. This pressure has been  reflected in both the world of commodities and currencies.

In the last couple of blogs I focused on the JOC-ECRI Industrial Price Index, which could be rising at close to a parabolic rate. This week on a year over year basis it is reading +19.65%!! This index is heavily influenced by the price of scrap metals, which are critical in the manufacture of steel and related products. Much of the demand is coming from Asia, particularly China. Large commodity speculators are significantly long almost all industrial and agricultural commodities, except for T Bonds and S&P Mini futures.

At some point in the not-too-distant future the size of the US government debt will prevent foreign buyers from buying US debt that pays less than the perceived inflation rate. Both residents of the White House and Congress in both parties have contributed to this explosion of interest rates. It will hurt the non-investment class most, as they can’t escape its effects through non-dollar sources of income and capital protection.

Investment Conclusion

Bank of America (Merrill Lynch) probably has the wisest recommendation, “Buy Prudence, sell exuberance”. Because of the rise in the number of IPOs and SPACS, exuberant speculation appears to already be present. I tend to believe that trading on the NASDAQ is savvier than on the New York Stock Exchange (NYSE). The NASDAQ is more individual stock oriented than the NYSE, which is used extensively by index funds and subject to many more public investors. Last week the NASDAQ with only 16% more issues had 5 times more new lows than the NYSE. So be careful, remember the name of the game is the survival of your capital, as it periodically grows. 

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

https://mikelipper.blogspot.com/2020/12/an-investment-dilemma-with-possible.html

https://mikelipper.blogspot.com/2020/11/mike-lippers-monday-morning-musings_29.html

https://mikelipper.blogspot.com/2020/11/approaching-multiple-turning-points.html

Did someone forward you this blog? 

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.