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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Inputs to Implications - Weekly Blog # 797

 

Mike Lipper’s Monday Morning Musings

Inputs to Implications

 

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

 

The Use of Inputs

There is a known cure for the narcotic attraction of investing. We can’t help but view any inputs as possibly having implications for our investing deliberations. The best we can do is to quickly review the plethora of daily inputs and reject most as unimportant, or alternatively sent to Warren Buffett’s desk basket, labeled “too difficult”. With that thought in mind, the following inputs and possible implications crossed my mind this week. See how many you can reject and how few are important enough to require your further research. Alternatively, you can send me your questions.  The inputs below are in the order they reached my consciousness, not of their level of importance.

 

Inputs & Implications of August 13^th week

1.  The Value of Competition: On the surface regulators see vigorous competition as the best way to achieve the lowest price for consumers and the highest wages for workers. For the long-run sake of society, the primary value of appropriate competition is the evolvement of a sector that can sustain itself and develop useful new products and services.

 

Implications: Placing a priority on competitive prices, wages, profitability, research, and national security, will likely hurt other players in the industry. No single force seems bright enough to allow for the enthronement as a Czar to oversee the industry. History suggests that mandatory leadership does not work. The best results are achieved when those involved compete against each other and let the marketplace decide the outcome.

 

2.  Input of what is the market is saying. Most of the time there is not a single market and therefore a single market index is not that important. In an overt simplification of markets and indices, you can use the following generalization to see what each of the markets is saying.

 

The Dow Jones Industrial Average (DJIA) is the most followed by individuals getting their market views from local media and politicians. The importance of the index is its reflection of votes, not dollars.

 

The Standard & Poor’s 500 is the single most important index for investment institutions and corporate managers. The latter group is often incentivized by its own stock or industry relative to the index. Institutional investors are conscious of the flows into and out of their portfolios relative to the index. The SPX is often used as a forerunner of employment trends.

 

The NASDAQ Composite is useful in measuring the level of speculation in the market, as it generally tracks the performance of younger and somewhat smaller companies. Most speculations are based on the belief that the future of the stocks within the index are improving. That is why the index has been more volatile in recent years, with up and down tends moving faster than the other indices.

 

When discussing “the market” with someone, the first market measure they mention tells me what kind of investor they are. People see “the market” differently, and while the main elements of the market move at different rates, a good bit of the time they mostly move in the same direction.

 

3.  “Pro Inflation” input. Very few people are publicly in favor of rising prices, although their specific actions push prices higher. Truckers, autoworkers, pilots, and other Teamster’s unions are among those pushing prices higher.

 

Considering the low productivity of businesses and non-profits, a meaningful wage increase will lead to higher prices and generally worse services. The current administration’s restrictions on energy production, onshoring, the mandating of employment practices and union membership, add to inflated prices at the consumer level. The implications are that the movement of interest rates will not be enough to sufficiently bring down long-term inflation.

 

4.  Standard & Poor’s is no longer using ESG ratings in assigning credit ratings. (I wonder whether they should actually include it as a negative, reflecting the negative consequences of a company that puts social spending ahead of its obligation to bond holders, stockholders, and fellow local and national taxpayers.)

 

5.  China’s export and import numbers have declined meaningfully. Some of it is due to US government policies. Is this wise from a purely US standpoint? (It could be as disastrous as FDR’s prohibition on US companies selling petroleum to Japan in 1933, after they were precluded from the carving up of the German Asian colonies.) China’s imports of US goods are paid for from their export earnings. There is also a risk of China dumping products on the markets of our “European allies”. Implications are that the US is reverting to isolationist policies, following a war that is the preamble to the next war.

 

6.  Input: More than half of young Arabs in North Africa and the Levant are considering leaving their homes in search of better jobs. Implications: This desire is similar to those in China and many youths in the US who are also in search of well-paying jobs. This appears to be a global demographic urge. Arabs are part of this urge even though one of the stock market indices produced by Dow Jones Standard & Poor’s is labeled Islamic Technology.

 

The youths want good jobs and employers want good workers. I wonder whether it’s a global problem concerning the lack of sufficient rigor in their home, schools, or even religion? Discipline, respect for others, and following rules could be a global issue that makes future progress more difficult.

 

7.  Input- the stock markets appear to be having a bout of complacency, with the VIX declining 14.84 this week vs 17.10 the prior week, and 19.53 a year ago. We used to think of the 30 level as normal. The bond and credit markets seem concerned about risk in the near term, with the continued inversion of higher Treasury yields for 2 years vs ten or thirty years. All of them are in the 4% range.

  

Implications: Permanently higher interest rates with the level of risk about equal through the whole long period. As a student of history, I have my doubts. I suspect too many investors are focused on current conditions extrapolated to the indefinite future.

 

8.  Every large country regularly prepares for future offensive battles and defensive wars. China follows this pattern. Two indications: A Chinese national serving in the US Navy on an armed amphibious ship was caught selling photographs of critical equipment to a Chinese agent. (As a USMC Combat Cargo Officer, I served on an armed troop amphibious ship. I believe that if China attempts an opposed amphibious landing on Taiwan, it will need a number of such ships and an experienced crew, both on the ship and on landing craft.

The US has two army type forces, the regular army, and the reserves/National Guard. The Chinese have a similar set-up, with their Militia normally assigned defensive tasks. They are however receiving training in the use of drones and other more aggressive functions. This suggests the main army will have other responsibilities or will need replacements for some of their people that are wounded or killed.

 

9.  How different is the level of investment performance compared to that in the past? One thing I do each week is to look at the performance of the 25 largest long-term mutual funds. Going back to 1926 the S&P 500 grew about +9% per annum, without any deductions for expenses and transaction costs. How does that compare to fund performance?

Of the only four funds which gained between +10.08 % and +14.33%, three were passive and one active. Three fixed income funds were slightly negative. The remaining funds gained between +6.41% for a value-oriented fund and +8.66% for a large-cap growth fund. The bulk of large equity managers produced returns in the mid +7% range, which was somewhat behind the passive index before adjustments. The implication of this analysis is that it may be appropriate to use +7% as a goal for large-cap institutional money.

 

Working Conclusion

Stock Market investors are not incentivized to change their portfolios, while fixed income investors attempt to price in credit and market risks.

 

How many of the implications are real and/or likely?

The following table may help you focus.

Indication            Implication            Accurate            Important for investment  

1.    Competition

2.    Market indices

3.    Pro inflation

4.    ESG, positive or negative

5.    China

6.    Attitudes of youth

7.    Complacency & worry

8.    Preparing for war

9.    Long-term equity expectations

I'd be delighted to learn your views.  Please let me know.

  

 

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Mike Lipper's Blog: Markets Are Time Frame Exchanges - Weekly Blog # 796

Mike Lipper's Blog: Possible Investment Lessons - Weekly Blog # 795

Mike Lipper's Blog: Cross Winds - Weekly Blog # 794

 

 

 

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On The Way To The Bottom? - Weekly Blog # 730

                                    

Mike Lipper’s Monday Morning Musings

On The Way To The Bottom?

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

When amid a campaign with no predetermined finish, it is difficult to guess both the timing and the result. We are in that position today and the best we can do is guess. Generally, there are two approaches to guessing. The first is to evaluate past contests and the second is to focus on current conditions. I will briefly do both, including two surprising differences.

History

Each market and/or economic decline is different. Pundits use labels for stock markets, such as market phase, correction, and bear market. Economic declines are divided into cyclical and structural. None are tight descriptions, but are somewhat useful in describing what has happened, with some predictive value.

Stock Market Declines

A fall of 20% from a former peak is called a bear market, a decline of 10% is labeled a correction, and a smaller decline is called a market phase. The problem today is the three popular US stock market indices can each be labeled with a different name:

DJIA               -8.82%  =  Market Phase

S&P 500           -12.28%  =  Correction

NASDAQ Composite  -25.06%  =  Bear Market

The majority of the public and therefore politicians get their brief market news based largely on the DJIA. Securities distributors and thin staffed financial institutions use the SPX, while professional traders pay attention to the NASDAQ. No wonder there is confusion concerning the current state of the market and to some extent where it may go. Almost by definition, the greater the decline the sooner a bottom is reached. Long-term subscribers know that I often find the NASDAQ composite a better market predictor than the others two measures. The NASDAQ led both on the way up and down. The reason for this is the junior index having proportionally less passive (index) investors making specific stock judgements. 

If you accept this analysis, then we have reached the level beginning a bottom, as most bottoms occur after a 25% decline. Consequently, followers of the NASDAQ can start to believe the bottom for this market is in range. This view is backed up by the level of transactions on the NYSE and NASDAQ, plus the number of new lows for the week ended Friday. On a year-to-date volume basis, the NYSE is +6.98% and the NASDAQ -6.10%. Last week the number of new lows on the NYSE was 649, versus 1023 on the NASDAQ. (In analyzing the NASDAQ, it is important to recognize that technology stocks were the leading sector, both rising and falling. (In the long-term future, I believe “tech” stocks will be among the leaders, but not necessarily the same names.)

Cyclical or Structural Economic Declines

Cyclical economic contractions are much more frequent than structural changes. Typically, cyclical contractions are caused by excessive money supply growth, which leads to too much borrowing and inflation. 

Symptoms 

We are currently experiencing those symptoms. The M2 measure of money supply growth is currently +13.21% on a year-to-year basis, which clearly includes what politicians call stimulus and I call political bribes. Not surprisingly, this has led to the JOC-ECRI growing +17.37% this year. (The good news is the index dropped 1.51% this week). Consequently, it is reasonable to speculate a recession is in our future.

The critical risk is political leaders transforming a cyclical downturn into a structural one, as they did globally in the 1930s. This is not a prediction, but as a trained US Marine I am always alert to a sneak attack and need to be aware of the risk. There are currently an unfortunate number of parallels with the 1930s. Despite a general economic expansion globally, there is a vocal minority that can be leveraged by politicians (Remember, I believe Mark Twain said the job of a politician is to find a parade and get in front of it). 

Current leadership is becoming more autocratic in several countries. Small regional wars have the potential to become global wars e.g., Ukraine>>>Black Sea >>>Asia Minor >>>>East vs West?.

The French Presidential election demonstrates much of the population votes against. This election conforms to the view that there are almost no popular governments, just more popular than the opposition. This in turn makes long term plans difficult, which in turn also makes investment judgements difficult.

Question: What do you think?

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

https://mikelipper.blogspot.com/2022/04/short-long-term-thoughts-weekly-blog-729.html

https://mikelipper.blogspot.com/2022/04/is-this-great-investment-era-ending.html

https://mikelipper.blogspot.com/2022/04/wwiii-slightly-delayed-bear-market.html

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A. Michael Lipper, CFA

All rights reserved.

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