Searching for Bottom, Understanding, and Select Futures - Weekly Blog # 620

Mike Lipper’s Monday Morning Musings

Searching for Bottom, Understanding, and Select Futures

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

“The Bottom”
Even before the end of hostilities, survivors begin to determine how bad is bad when someone is attacked. Is this the bottom? For those in and around the stock market there is lots of history to provide clues. At 9:26 AM on the 13th, Larry Goldstein, a very successful micro-cap fund manager and a junior analyst in the same shop with me years ago, wrote the following:

The factors that make a bottom in the US stock market include a combination of climatic selling with an intraday reversal, combined with a breakthrough announcement on testing and treatment for the Coronavirus...This will turn, it always does.

On Monday he was generally right. There was a sizable price gap opening in the DJIA compared to the previous day’s close. The low for the day (21,159 vs 21,200 Thursday close). The close on Friday, which may be close enough to fill the gap, was 9% higher than Thursday’s close.

A Largely Predictable US Stock Market Fall
What was not predictable is the size of the decline in one month’s time. A student of history could have predicted two out of the three causes for the decline. I know of no way to predict the rapid spread of Covid-19, although it’s clearly possible that some in the medical sphere had knowledge of Chinese conditions. The rapid spread of the Coronavirus was a convenient time for Russia to attempt to grab a much larger share of the oil market from US shale frackers and “swing” producer, Saudi Arabia. A student of 19th century world trade history would not have been surprised.

In the 19th century a great German military strategist proclaimed that war was just another way to execute national policy. In the 21st century one could easily substitute trade wars for military wars. Some may even suggest that Germany provided the muscle for WWI due to that country’s late economic development. Germany needed more global markets but found themselves blocked by the trading strengths of the US, Great Britain and others. One could also point to the Japanese attempt to build a “Co-Prosperity Sphere” as being a contributor to the Pearl Harbor attack.

In the current era, China’s contribution of at least one quarter of the growth in world trade was dramatically changing. Under their command economy they needed to create both employment and a rising standard of living. They were evolving from being an export driven economy to having greater reliance on internal market development. Thus, the growth rate of their exports declined, so too would the rate of import growth. The trade issues with the US added to these contractions, Europe lost some exports to China and they received lower price imports diverted from the US.

Europe’s general economy had slowed and in some cases was approaching stall speed, while Russia and Saudi Arabia attempted to catch up with the more developed world through massive capital projects. Both are critically dependent on oil exports to generate the capital needed to hold off the global drive of popularism. Thus, the Russian move to capture greater market share makes sense, it came with much lower prices, contrary to the Saudi’s own needs.

Remember, most large expansions by industry and government are debt financed. The equity market is often slower to react to economic trends than the fixed income market. That is exactly why the following quote from BlackRock’s CIO of Global Fixed Income was so unnerving.

“If you don’t know where the safest asset in the world is, it becomes impossible to figure out (where) everything else is.” 

This uncertainty for the week ended Wednesday led to net redemptions in corporate investment grade bond funds of $7.3 Billion and $5.1 Billion from high yield bond funds. (More on the threat of the bond bomb later.)

Going Forward
The odds are favorite that we have seen the bottom of the major US stock market indices for some time. (I am guessing there is a 60%-75% chance that this is a correct assumption.) I assume any top or bottom will be tested before investors accept a major turn in the cycle. The test can be above or below the bottom, but it will have less sustained force behind it. I have reasonable confidence in the turnaround as a result of measuring the price differences of our closely followed roster of financial services stocks, between Wednesday and Friday closing prices were within 0.3% of being equal.

The reliance on reported earnings per share is a worry for equities. It is a much-manipulated figure due to changes in accounting standards, federal/state tax rates and rules, plus buy backs. Utilizing I/B/E/S data from REFINITIV, analysts estimated that fourth quarter reported S&P 500 earnings would be +10.2%, but net income only +8.2%. That spread widened from 2% in their first quarter 2020 estimate to 2.4 % (+14.3% earnings and +11.9% net income). Since mid-February, or even earlier, no one is holding to 2020 earnings estimates.

The reason for showing the spread is that analyst and perhaps corporate management believe others will accept the reported per share numbers. I always look at any equity in terms of what a knowledgeable person in that or an affiliated business would pay for the entire company. I believe most acquirers would start with net income in building their price bid, or 20% lower before adding premiums and discounts. Thus, many stocks were priced too high, historically they normally are priced at a discount to what an occasional acquirer would pay.

The problem of valuing fixed income paper is more fundamental. There is far too much reliance on debt in our society. Starting with most governments running a deficit, businesses issuing debt to meet current needs, and individuals use debt through credit cards and other devices to cover living needs.

Too many in the population are not using debt to leverage their equity in the purchase of investment producing assets. Those that properly use debt, their underlying equity assures the lender is not taking the first or possibly the largest long-term risk. These days, most debt issues are largely for refinancing existing debts, not increasing earnings generation. (Most of the time, long-term gold owners use their gold positions to hedge against the valuation of other assets. However, after an extended price rise, such as now, they use some of their gold to meet current cash needs or payoff their debt.)

Opportunities 
In many respects we have involuntarily entered a new era. Because Coronavirus it is now critically important that most families be connected electronically. Instead of traditional European style food shopping where one goes to the food market daily, we will attempt to regularly store essential food needs for two weeks or more. We may change our entertainment mix so that more is delivered electronically and less in theaters and stadiums. Universities and other schools may have to learn how to educate differently, rather than putting on classes and giving exams on paper. Perhaps we will need to reconfigure the structure and size of campuses and student housing.

To me, as both an analyst and entrepreneur, I believe we have this year a unique opportunity to build soundly without paying too much attention to the impact on the record. We have involuntarily entered a “gap year” and the track handicapper can throw out one or more races as long as the horse, jockey and trainer are building skills.

As an investor and portfolio manager for others, I am going to be searching for what will be different after these crises are over. Covid-19 and similar problems will be addressed with increasing success throughout the year. Near-term energy prices will settle as market forces find equilibrium points. The “debt bomb” will take much longer, perhaps a generation of both write offs and long-lasting penalties.


Discussion for the week: I am happy to chat with subscribers and explore the opportunities they did not see as we finished 2019.         



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/03/searching-for-bottom-and-plan-weekly.html

https://mikelipper.blogspot.com/2020/03/should-changes-in-markets-change-your.html

https://mikelipper.blogspot.com/2020/02/hate-doesnt-work-for-investors-weekly.html



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On To Stock Peak; Mild Danger - Weekly Blog # 497

Introduction

Gift buying is strong selectively in US and China this week. While political leaders emote, speculations in stocks are increasing and fixed income vehicles are displaying fault lines. Current concerns produce hurdles, not walls that can’t be breached. One of the benefits of segmenting portfolios into sub portfolios based on time horizons is to be able to focus on the impacts of various influences. This is the rationale for developing the TIMESPAN L Portfolios^® and how we look at the current picture.

Next Two Years

While most investors swear allegiance to being long-term investors, almost all that they consume in the way of views is what to do right now and that will be judged on the basis of the next month, quarter, current year and next year. They over emphasize whatever near-term payment concerns they have and ignore the impacts on longer term needs. If that is the tune that investors are currently dancing to, I will display what I believe to be relevant to this period’s dance.

In a consumer driven economy one should look at shoppers. At the local high end mall Saturday night it was crowded with people carrying a small number of shopping bags. We got the sense beyond buying, that  shoppers were examining prices, styles, quality, and inventory. At the crowded Apple^* store there were lines of buyers that began in the morning and were still present in the evening. What is on sale for shoppers are items that they could buy either at many stores, or they came to buy in one particular store, online or both - but they came to spend money. There were so many of them at three of the restaurants within the mall that the wait for tables stretched to an hour or beyond. 

In China the wonderfully manufactured Singles Day apparently once again produced record orders for merchandise and services. The purchases broadened out from buying for someone special to the buyer to the buyer herself or himself.

These controlled shopping frenzies were also present in the stock and bond markets. In the US, S&P^* has developed a quality ranking array which is different from its credit ratings. In the credit ranking array the objective is to gauge the odds on timely payment of future payments of principal and interest. Balance sheets and their future projections drive the credit ratings. On the other hand, the quality rankings are based on the income statements and the ability to grow them. In the last month particularly (and also for the latest twelve months) the companies with the low to lowest quality rankings had the stocks that appreciated the most. Obviously these stocks were perceived to have prices that deeply discounted their futures.

* I personally own shares in these stocks

Individual stock investors as measured by surveys of the American Association of Individual Investors (AAII) have a similar view as to the shoppers. In the last two weeks the percentage of those surveyed has dropped their bearish views from 33% to 23%. While this is a very volatile time series on the basis of casual conversations, it seems to be reflective of current thinking.

Equity Fund Leaders

In the week that ended Thursday, the weekly 14 of the top performing 25 performance leaders for the week were the Natural Resource and Energy Commodity funds. Six out of 10 losers for the week were with bank-heavy financial services funds. 

The enforced hotel “guests” in Saudi Arabia are probably a stimuli for the leaders. UBS points out that 70% of the world’s growth in GNP this year was caused by rising commodity prices both in energy and industrial metals. The decline in bank oriented funds could be an over-reaction from a view that materially lower US corporate taxes will be delayed and may be smaller than expected. On both the up and down sides of the week one can see the influence of news/rumor on near-term prices. I maintain the long-term trend of future energy prices were not changed by the Saudi arrests nor have the tax rates for banks changed the long-term generation of earnings and dividends of banks beyond perhaps a one time bump in 2018 or 2019. 

Fixed Income Markets Display Longer Term Concerns

Most often stock market declines are preceded by weakening fixed income markets. We are seeing some concerns being expressed in fixed income prices/yields. High Yield bond prices fell this week. Normally these, in effect, stocks with coupons which is what one wag called junk bonds, fall with the increase in the expected default rate or an actual unexpected default. Moody’s^** who typically has the best, but not a perfect record on expected defaults, is now expecting the stock market to rise because of low and declining expected default rates.

** Owned in a private financial services fund that I manage.

The fall in junk bond prices could be a reaction to the discussed restrictions on the tax deductability of interest charges to 70% of EBITDA, Earnings before interest, depreciation, and amortization.  A large amount of refinancing is expected over the next two years -  particularly by the mid to smaller energy companies that could be placed in jeopardy and possibly bring on defaults. 

Each week I look at the fixed income fund performance data from my old firm, now a part of Thomson Reuters. I have noticed for some time that US Treasury funds have consistently done better than US Government funds that often pay more interest than Treasuries. This has been true for at least five years for longer maturity funds and at least three years for the shorter ones. This must indicate that for some reason Treasuries are more valuable than higher earning agencies. I suggest one reason for this is that US Treasuries are being used as collateral for loans where agency paper is not as readily acceptable. Further I suspect that this collateral is backing loans for dealer and hedge fund securities which include positions in Exchange Traded Funds and Exchange Traded Portfolios. It is significant to point out as to the level of speculation in these markets that Deborah Fuhr  of ETFGI reports that globally this year, listed  funds that leverage have seen their assets grow 14% to $77 billion.

One of my market structure concerns is that financing inventory positions for market makers, authorized participants, hedge funds and brokerage firms is normally done with call-loans. A call-loan can be called with very little, if any, notice. Often when the loans are called the only way to pay it off is to sell some of the easily traded holdings. These are not price sensitive sales but are persistent. As in the past this can be a cause of an internal market panic. I do not rule out a recurrence of such an activity.

Endowment Period Concern

The focus has been first on low productivity of human labor. Next it has turned to capital productivity which is being addressed increasingly by additional leverage. I am now becoming more aware of research and development productivity. In each of the three productivity challenges part of the answer is better selectivity of people, projects, and research targets. All of these are being addressed, but with limited near term success.

Part of the problem is that there are shortages of attractive alternatives. Hiring more, poorly prepared laborers; committing more financial resources to low return ventures; not achieving technological breakthroughs in research; and utilizing the wrong scale for development won’t solve the problem. We need to both make smarter decisions and examine the structural impediments holding back productivity including education, appropriate returns for risk capital, and avoiding unwise intellectual property constraints. Some progress is likely in the very long-term. I just hope it arrives quickly enough to meet the retirement needs for today’s workers and students.

Misallocation of Capital

One of the advantages of focusing on Mutual Funds and ETFs is while they are large contributors of capital to our global society, they are also part of the institutional and individual mind set. For the latest twelve months looking at positive net flows of money coming into mutual funds with aggregate flows into investment categories, there are six each bringing in over $20 Billion. Five out of the six were bond funds which may do relatively little to address the productivity issues raised above. The more additive value to longer term corporate investment are equity funds. Unfortunately in spite of very good investment performance recently they are in heavy net redemptions with Large Cap Growth funds shedding $76 Billion and Large Cap Value funds $49 Billion. These net redemptions are almost actuarial in that they were purchased years ago to meet future needs which are now apparent. In the past redemptions were met by new sales. Currently it is more profitable for the financial community to redirect flows to other products. While some at the retail level is being directed into ETFs the bulk of their flows are from trading establishments that have short-term holding periods and rarely buy new IPOs. Nevertheless ETFs on many days have more net flows than the much larger mutual funds. Over the same twelve months previously mentioned, there were six ETF categories that generated over $20 Billion each. Five went into equities and one into bonds. Their flows are not likely to provide the long term risk capital that is needed for increased productivity of labor, capital and R&D.

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