Is it Always Brains over Flexible Policy in Investing? - Weekly Blog # 612

Mike Lipper’s Monday Morning Musings

Is it Always Brains over Flexible Policy in Investing?

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

Two questions:

1. Why don’t smart people always make money with their investment responsibilities?
2. When is the time to fix a leak in the roof, when it’s sunny or when it starts to rain?

The answer to the second question is obvious, when it is sunny. Why then do so many smart people fail to adjust their investment portfolios when the market is fairly, if not fully priced? Could it be that selecting good investments is emotionally more rewarding than focusing on policies that could direct future movements within the portfolio?

None of us knows for sure what the future will bring in the periods ahead. A characteristic most of us share in the developed world is the necessity to compete. We measure our results against perceived peers, or in their absence against artificial indicators that were not necessarily designed to replicate our real-world tasks.

For most investors, their responsibility is to convert the assets they manage into a series of known and unknown payments for various future periods e.g. paying bills. In order to accomplish this, they must make some difficult guesses as to the size of the bills due. Whether they like it or not they should be thinking in terms of investment survival. However, they also need to grow capital in the account to pay more bills than would be possible with current assets. This introduces a difficult and unknown risk/reward equation.

Far too many investors focus on competing with peers or indices and not on the risk/reward equation. Some professional investors also add career risk into the calculation. If they fail to please the owners of the capital, they risk losing the client and account or jobs. Unfortunately, most owners of capital and many investment executives don’t know how to evaluate their managers, except statistically or by comparison. I know of one very successful sector analyst that kept his fund from investing in it. His timing was excellent and when that sector collapsed, he was rewarded with a partnership. He eventually became the managing partner of a successful fund management firm. Charlie Munger and Warren Buffett have often said that individual investors can make better investment decisions than many institutional managers because they are not facing career risks.

Now we come to that leaky roof. The best time to fix the roof is when it is not raining or snowing. On Friday the three main US stock market indices reached a new high, as they have many times over the last three years. Stocks go up in price because more buyers than sellers believe the future will be better. They may currently be correct, but at some point in the future they won’t be. There is an old saying from the floor of the Stock Exchange that bulls and bears make money, but pigs get slaughtered. (Maybe they will be shipped to China where there is a pork shortage.)

Will the US market continue to go up? I hope so. However, in thinking about leaks in the roof I’m seeing some dark clouds that might carry rain. While the world will need more goods and services in the future, they might be in short supply at current prices. Because of geo-political fears in the US and much of Europe, the capital expenditures necessary to build additional capacity has been slim. Another capacity constraint is the working age population, which is already declining due to the falling birth rate. (It is possible that Southeast Asia and Africa will be the source of additional physical and human capacity, which is why we’ve invested some capital there.)

Should we be paying so much attention to geo-political events? I recently saw a study that looked at 21 such events, from Pearl Harbor through the killing of the Iranian general. Only 4 sent the S&P 500 Index down 10% (which is normally called a correction). Pearl Harbor was the worst both in terms of the 19.8% decline and the 307 calendar-day recovery. The average historic decline of 5% is interesting because it falls within the 3%-7% collection of 2020 institutional expectations for the S&P 500 Index. With the indices at a record high, the general’s death did not appear to affect the market. For long-term investing, JP Morgan believes you should be guided by long-term trends and not events.

What clouds are we seeing other than long-term capacity constraints? Conditions are becoming more speculative, with the NASDAQ continuing to lead the other markets. The growth of alternative styles and different trading instruments is also a concern. Furthermore, we are seeing many “conservative” institutions shift from 60% in equities and 40% in fixed income to 70/30 allocations. In the first two weeks of the year we have seen growth and tech-oriented funds gain over 4%, which translates to approximately doubling over a year if continued.

Another unsound extrapolation is that over $40 billion went into bond-like funds during the first 16 days.  This extrapolates to annual rate of $1 trillion. We are already seeing intermediate interest rates moving up. Intellectually, I suggested that it would make sense to short the 30-year US Treasury. (The trend of universities issuing 100-year bonds is spreading overseas. Caltech has now done it 3 times and I believe Cambridge is considering it too. With the average US government debt maturity under 10 years and the UK’s under 14 years, we would like to see a lengthening of maturities.) With gains in many cases over 10%, 2019 was an outstanding year for bond holders. I suspect it will not be wise to own bonds for quite awhile.

Sir Isaac Newton is an example of someone considered to be among the smartest of people. He was a young Cambridge Professor who first conceived the three laws of motion and in so doing formed the basic principals of modern of Physics. He was so respected that he was knighted, very unusual for a scientist. He became the master of the Mint, a high honor. At that time in England the government had not yet set aside money to pay its debts, so they created a lottery. The lottery involved the newly formed South Sea Company, which had dubious prospects, but the potential odds were attractive. Sir Isaac recognized the fallacy of the issue and sold his shares. However, he got seduced by the skyrocketing prices and went back in. He is thought to have lost his investment, which may have been 22,000 pounds in 1722. After the Bubble popped, he was quoted as saying “I can calculate the movement of the stars, but not the madness of men.” Clearly a very bright person who made a big investment mistake.

Subscribers, please help me and yourselves from getting sucked into the concluding whirlpool when the current enthusiasm subsides.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/01/architectural-sway-points-and-current.html

https://mikelipper.blogspot.com/2020/01/how-much-will-markets-decline-10-25-or.html

https://mikelipper.blogspot.com/2019/12/repeat-past-history-probable-or-just.html



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7 Steps to the “Big One” - Weekly Blog # 488

Introduction

One of the signs of a truly expert professional is the recognition that he/she could be wrong. This question should come up to those of us that have to develop a view on a series of futures. We should recognize that the only consistent product of following the swings in the market is humility. Actually I learned this first at the New York racetracks where it became obvious one could not pick the winner of every race and it was rare to be right even half the time. I learned that the real object of betting is to come away a net winner. Thus by proper picking, which we call analysis, and prudent handling of money, one could accomplish the goal by cashing winning tickets one-third of the time. Actually there are much bigger winnings to be had. The bigger winnings in the future come from examining one’s losing bets. Over time it becomes clear that there are a limited number of patterns to the losses which drive the analytical imperative to see whether repeated losses stem from a faulty system of analysis.

With that series of doubts in mind I am now rethinking my assurance in last week’s blog that any forthcoming market decline will be one of normal proportions and not the “Big One.” Because we think in numerical terms, a normal decline is between 10% and 25% and the “Big One” is more likely to be 50% or more and come around once within a generation.

Modeling “The Big One”

In last week’s blog I listed seven characteristics that described the lead up to one of the most famous market collapses, “The South Sea Bubble.” Summarizing the seven steps as follows:

• Displacement
• Credit and Monetary Expansion
• Overtrading
• Financial Distress
• Fraud/ Malfeasance
• Widespread Mistrust and Revulsion
• Panic Selling

Looking at the current stock markets around the world with particular emphasis on the US, I only saw elements of the first two steps to a South Sea kind of collapse. This is particularly true with the lack of enthusiasm for most US stocks and equity funds. Even with Byron Wien and Bill McNabb, the retiring CEO of Vanguard lengthening the earnings forecast period to pull down the market price/earnings ratio to more attractive levels, most investors are using shorter time periods. (When I came into the professionals’ markets in the 1960s and early 1970s it was not unusual to be quoted five forward year P/Es.) Without this stimulus there is no need to fear a major decline and periodic declines will be of normal size. During normal declines, most high-quality long-term portfolios should be maintained in place. 

However harking back to my education at the track, maybe I am missing some other patterns which could lead to different conclusions. Perhaps I should be looking at what is happening in the bond market. This won’t be easy for me. In a study of single portfolio manager Balance funds it became clear to me that, with rare exceptions, the managers that performed well did so with only a portion of their portfolios. They were either good at stocks or bonds. This finding suggests that stock and bond mavens speak in different languages and don’t communicate well to the other side. (I am experienced as a stock fund and individual stock picker and rarely voluntarily use individual bonds.)

Are Bond Prices Peaking?

For more than a year the most favored type of mutual funds have been bond funds, with Intermediate Maturity Corporate Bond funds alone receiving $ 93 Billion on a year to date basis. This flow could well be the missing level of enthusiasm on the road to the South Sea list. This could also be moderating this past week. According to my old firm, this last week was the first week in thirty seven when there were net outflows in High Grade Corporate Bond funds. Corporate treasurers and investment bankers are counting on this demand, as 2017 expectations is for issuance to top $ 1 Trillion. If accomplished it would fulfill the second item on the list of expansion of credit. With a reasonable outlook that the US and other national governments will be running deficits this year, there will be an additional monetary expansion.

Perhaps the most intriguing element on the march to the South Sea is displacement. On the equity side I counted on the internet filling that role. With my eyes now focused on the debt markets I see a much more structural set of changes which are not obvious to most investors, individual or professionals. The first and biggest change is the role of collateral for speculative loans.

Years ago the brokerage industry could make a reasonable profit through simply charging commissions. It has been many years since equity agency brokerage business was profitable. A number of different financial products replaced traditional stock brokerage business by the larger firms. By far the biggest was the margin loan business where a brokerage house extended credit to an investor at a relatively attractive interest rate. In turn the brokerage firm borrowed money from a bank against the collateral that the borrower put up. With the decline in retail interest in trading stocks this source of revenues shrank. However, it has been replaced by supplying credit to various trading entities; e.g., Hedge funds. The most favored collateral for these loans is US Treasuries. The demand for treasuries is so high that the current yields average 1.77% and according to Eaton Vance their average performance on a year to date basis is 3.15%, which is materially better than similar performance for US agencies (a gain of 2.56%). In theory, the full faith and credit of the US Treasury is a bit better than those of US Agencies therefore the yields should be lower for the treasuries and generate slightly better performance. Thus one can believe that the treasury market is experiencing some displacement.

I suspect globally one form of displacement is in the nature of the collateral that is borrowed against. Moody’s^* has noted that its Base Metals Price Index has gained 29% this year. It suggests that these gains may be due to an increased level of speculation rather than surge in user demand. Copper has risen 50% in this period. I believe that one has seen the top of the use of futures on iron ore and copper as collateral by various merchants around the world and particularly in the Far East. By the way there is a slight negative correlation over the last five years between a large basket of commodities and US stocks.

^*Held in the private financial services fund I manage

There is still one other displacement element and that is Emerging Market Local Currency bonds and funds. This is the best single type of fixed income fund for the last three years and doing very well this year in part because a number of commodity producers are located in emerging markets. The number one ranking for three years may need to have a warning label attached to it. The single worst performance period to extrapolate into the future for investment purposes is three years. In a period as short as three years often the market is going in one direction. Going back to my race track experience the odds of continuing winning after three years is remote.

Two Possible Signs of a Bond Top

This week the iShares 20+ Years Treasury Bond ETF had a year-to-date gain of 10%, that is unlikely to continue. The 10 year US Treasury yield hit a low of 2.02% closing at 2.06%.  To me these represent unsustainable levels.

My Concerns

I believe a good bit the high quality fixed income trading is on borrowed money from the banks. This is akin to the period immediately before the Lehman crisis. The abrupt liquidation of fixed income collateral spread to credit concerns in the equity market, leading to a stock price decline. While the overall level of leverage in the system is probably less, so is the flexibility of both the majors and the regulators to act.

Please Help

Communicate with me and assure me that I don’t have to worry now.

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Emerging Market Warnings, Crowds Ahead, Smaller Exit Portals

Ever since the dawn of attention to investment performance, the smart guys figured the way to outperform was to invest outside the general experience of others. Often this technique worked initially until too many others copied the strategy. As with life in general, the unexpected happened and the exits became crowded and were blocked for the late movers. This is a repeat performance of a movie I have seen before.

I am a Believer

I am a believer in investing internationally. As a trainee in my first job after my education in the US Marine Corps, I had a tour of duty within a bank’s vault to count the actual foreign stock certificates that backed up the bank’s issuance of American Depositary Receipts (ADRs). More than 15 years later, when I could start to invest for my own account, I began investing outside of the US. Over the years I have invested in Latin American and Asian closed-end funds, individual equities in Canada, Australia, the United Kingdom, Netherlands, Finland and Japan as well as private equities in the UK and France. In addition, at the time of my sale of the operating assets of Lipper Analytical to Reuters PLC, we had foreign clients buying non US-data from our offices in London and Hong Kong. Thus, I believe I have won my stars as an international investor. So why am I raising the yellow flag of caution now? Simply because it is getting crowded out there.

Petrobras

On Thursday of this last week Petróleo Brasileiro S.A. or Petrobras, sold over $70 billion worth of common stock. This was the world’s largest initial public offering (IPO). According to the Wall Street Journal, options will be available which will expand the common stock offering by 25%, including an undisclosed amount of preferred stock. (It is true that some $43 billion was an exchange with the Brazilian government for the drilling privileges to a potentially huge offshore series of sites. Nevertheless, an enormous amount of cash was invested into Petrobras.)

First Warning Flag

The sheer size of the enthusiasm for this transaction should be enough of a warning to a practiced investor, but there are other danger signs. Petrobras has been a favorite of many well-known global investors. A number of them felt that the terms of this offering were not in favor of the existing outside shareholders but were to the benefit of the government. Among those who are rumored to have sold out are George Soros and the good people at Templeton. One of the risks in any investment is that the government may turn less friendly. (This risk is valid in the US as well.) Based on my experience, foreign investors typically don’t really own foreign securities permanently. They rent them.

The Second Warning Flag

One of the better international money managers that I had the pleasure of knowing taught me the importance of the flows of money into a security. In the 1970’s, he focused on foreign money coming into the Japanese markets. He believed that the “weight of money” would lift Japanese stock prices that were clearly not bargains. He focused a good bit of his attention on mutual fund data and that was why he contacted me. His clue to exit an overpriced market was when there was a slow down in the gusher of money coming into the market.

As is commonly acknowledged, mutual fund redemptions have been larger than the rather lackluster sales of US Equity mutual funds. As of the end of August, according to my old firm now called Lipper, total net assets are approximately $4.7 trillion dollars, with only $3 trillion devoted to US diversified investing. The fifth largest collection of assets is in Emerging Market Equity funds ($253 billion). This excludes $112 billion of the more narrowly focused funds that invest outside of the US and Europe. The two collections together have total net assets of $365 billion as of the end of August, which is somewhat larger than the money invested in S&P 500 Index funds. Clearly, emerging markets are not undiscovered territory. The cautionary flags go up with US Diversified Equity funds shedding $ 10 billion in August, with $2.3 billion going in one month to Emerging Market funds. This shows a significant shift in investors’ opinion. A more dramatic indication is that in the same month $3.8 billion went into Emerging Market exchange traded funds (ETFs). I believe this latter inflow is much more speculative in nature. If you will, they are more like daily renters than annual leasers.

The growth in demand of ETFs is particularly ominous. Money can flow in and out of these funds on a daily basis. When the money moves, the managers must transact as nearly as possible to mirror an individual stock’s proportional ownership in the index. If some negative news event causes a redemption run on an ETF, they will have to sell some of each position. The history of international investing, particularly in small markets, is that when we come in we buy from the locals who feel that our valuations are wrong. When we sell under duress they understand that any price is a good price from the pressured seller’s point of view. The losses can be dramatic under those circumstances.

To put the ETF risk in perspective, each week I look at the twenty-five largest SEC registered open-end funds. On that list are five ETFs, two of which invest in emerging markets. On a combined basis these two funds have $70 billion in assets. They promise their large shareholders instant liquidity during US trading hours.

The Third Warning Flag

The next set of concerns is one of personal exposure. Over the last two weeks I have had three discussions about emerging markets. The first was with a marketing executive of a major broad line fund group who was commenting that its International/Emerging Market funds were selling very well. The second conversation was with a retired international investor who was being pitched to go back in business, focusing on the frontier markets which are exciting many people. I am hearing a great deal about investing in Nigeria and Ghana. (Memories of the “South Sea Bubble” of the 18th Century come to mind.) The final conversation was with a fund president who has been away from the market for some time and is being asked to develop a country-specific infrastructure fund as well as other frontier investments. (The Nineteenth and early Twentieth century investments by the Scottish trusts and Barings also come to mind.)

Warning

Despite HSBC’s ten point pitch to invest in the emerging markets and Western Asset’s belief in the attractiveness of the debt side of the emerging markets, I would be particularly careful now. If you are lucky enough to have been there already, cap your exposure at sometime. If you are not invested in emerging markets directly, you can gain some exposure through US companies that export or have operations in the area. As a contrarian bet I would look to large US Growth funds, they have lots of attractive companies in their portfolios at reasonable prices. They should do well enough on a relative basis over the next four years.

What do you think?
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