Caution Ahead: Emotional Turns Likely - Elections and Coronavirus - Weekly Blog # 644

 

Mike Lipper’s Monday Morning Musings

Caution Ahead:

Emotional Turns Likely-Elections and Coronavirus

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

When the battlefield is quiet, expect to be attacked, is a lesson from the US Marine Corps. For bullish equity investors the low volume of August trading should signal a need to expect change. The most dangerous short-term change is one spurred on by emotions, rapidly bringing into action holders of excess cash or large equity holdings.

The calendar provides two events that could quickly galvanize emotional responses, the forthcoming US election and reports of successful vaccines/therapeutic COVID-19 treatments. Both could mobilize a large amount of almost instant trading from thrilled and disappointed investors. Based on a lifelong study of turning points, I suggest caution on the part of investors who believe in rusty or non-existent trading skills. Furthermore, very soon after the announcement a counter trend could appear, reducing the size of the initial pop and in some cases completely reversing it. As more information becomes available, the implications of the announced event will often become clearer. Even if further information reinforces the initial announcement, the length of time varies before complete utilization becomes evident. Thus, investors will have time to calmly adjust their holdings. 

Profitable courses of action build on some factors present before the headline event, while others will have little to no future impact. Some will advise you of the critical present factors supporting the future event, I am not so privileged. All I can do is briefly list some of the factors that might support the trends post the announcement, including the subsequent reversal moves:

• The biggest investment news of the week was the changing of the components of the Dow Jones Industrial Average (DJIA) and the reweighting of Apple*. The current producer of this most senior of US stock indices is S&P Indices, owned by Standard & Poor’s, who consults with some of the editors of The Wall Street Journal when making changes. On Monday they will delete Exxon Mobil, Pfizer, and Raytheon Technology, adding Sales Force, AMGEN, and Honeywell. In addition, on the same day the weight of Apple in the index will be reduced due to Apple’s four for one stock split. It will be replaced as the company with the heaviest weight in the index by United Health.

Because of the dominance of Dow Jones through its wires and publications, most investors tend to believe that the DJIA measures the US stock market. That a thirty-stock market price weighted index is “the market” with its’ 30 stocks and not the S&P 500, the Russell 3000 or the Wilshire, with its original 5000 stocks, shows the power of the media. Clearly, global indices have even more components. Nevertheless, the DJIA has done a reasonable job of tracking high-priced US stocks. Part of its success is due to dropping components when their outlook appears to be slowing. (Some components comeback into the index after a large merger.)

While most market followers will continue to use the DJIA as a market measure, I will not for the next twelve months. While statisticians will link the new components and the reduced weight of Apple, I believe they have created a new measure. After one year I will see the level of correlation with the S&P 500 and if the gap is close, I will return to using it as a measure. Once again, the editors may have done a good job of changing the components to represent our economy. Over the more than one hundred years of its existence, they have done a good job of switching the emphasis from consumer products, to industrials, to tech and then to high-tech.

(*) Owned in personal accounts

• Record high prices achieved this week for both the S&P 500 and the NASDAQ Composite confirms the view that the American Association of Individual Investors (AAII) sample survey of market direction for the next six months is a contrarian  indicator. For the first time in many weeks the leading bearish prediction fell below an extreme reading of 40%. 
• 79% of the WSJ’s weekly prices rose. This may reflect some shortages, but it also reflects merchants trying to increase prices to make up for forgone profits. Despite many learned economists being quite sanguine on inflation, I expect the Fed to get and exceed its desired 2% inflation target.
• Unfortunately, I expect layoffs will rise for a while. The Russell 2000’s second quarter estimated revenues dropped -19%, with earnings dropping -99.1 %. This indicates to me that smaller companies have kept their staffs to preserve their hard to get employees. So far, third quarter revenues have not risen much. There is a good chance that instead of preserving the work force the focus will shift to preserving the firm. I suspect private firm closings indicate a similar trend.
• The bond market is moving contrary to the stock market. Of thirty-one fixed income mutual funds investment objectives, only twelve gained for the week and they were equity tinged high-yield or pro inflation vehicles. The maturity yield curve tightened, with maturities of more than two years rising.
• There may be more longevity to the current market than appears. Typically, markets don’t peak until they exhaust all available cash and there is a lot of cash on the sidelines today. In addition, there is a lot of capacity to increase margin borrowing.  Remember, margin can be used to support short sales, as well as the more popular long purchases.

Working Conclusions:

• Trading oriented accounts should be prepared to make lots of small moves and be willing to reverse direction when appropriate.
• Capital appreciation accounts should look for bargains by being contrary.
• Capital preservation accounts need to recast their portfolio in one or more other currencies to determine their risk of only evaluating their accounts in dollars. European investments may look attractive for “value” oriented accounts and Asian investments could be attractive for long-term growth investors. Multi-generational investors should develop an understanding of the long-term outlook for selected investments in Africa and the Middle East.

Share your reactions and thoughts with us. 

     

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

https://mikelipper.blogspot.com/2020/08/mike-lippers-monday-morning-musings_23.html

https://mikelipper.blogspot.com/2020/08/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/08/rotating-leadership-likely-on-horizon.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.

Extreme Popularity Creates Risk - Weekly Blog # 541

Mike Lipper’s Monday Morning Musings

Extreme Popularity Creates Risk

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

Risk from Other Owners
Too many investors focus their analysis on the risks to the issuer of their securities, as well as external factors like the political economy. The big lesson learned from major price declines is that the single biggest risk comes from the other owners in the securities. When it comes time to sell in a period of high anxiety, the other owners become competitors until the exit is completed. That is the missing lesson from the series of articles on the price collapse in sub-prime mortgages, Long Term Capital Management, Lehman Brothers, and the Reserve Fund. In each case the specific liquidity problem of the issuers triggered a market liquidity crisis for other securities and markets.

The history of big crises is captured in those three letters =big. Due to the popularity of investing in a security or type of security which absorbs liquidity on the way up, there is often insufficient capital to provide liquidity on actual or rumored mass exits. In other words, at the point of contemplated or actual exiting, there are few to no buyers left.

Could we be approaching such a situation in the credit market? Will it stampede the corporate bond market and possibly the stock market? Will the stampede include some bank capital positions? Maybe.

When? Now or Soon?
Timing is the most difficult tool in the investing art form. As with our favorite portfolio strategy of sub dividing a portfolio into separate time spans, there are three different approaches depending on time spans. Randall Forsyth in Barron’s stated “Since 1950, September has been the worst month of the year for the Dow and the S&P 500”. That is the immediate worry period.

The great economist Hyman Minsky identified that periods of stability bread instability. This makes sense, as far too many investors take current conditions and extrapolate them into the indefinite future. That is a lazy way of thinking. Change occurs every day, most of it small, but the increments add up leading to an unrecognized reality, until there is a shock of some sort. Investment committees and wealth managers are particularly susceptible because they are planning finite periodic distributions.

The longer-term change is a slow recognition of a faulty set of assumptions. There is one visible today, utilizing mutual fund performance data from my old firm Lipper, Inc, presently a part of Thomson Reuters. For the last five years there have been two trends that  cannot continue forever and have been contrary to investors best interest. For the last five years through August 30th, the average US Domestic Long-Term Fixed Income Fund has grown at the rate of +2.55% per annum, in contrast to the average US Diversified Equity Fund which has grown +11.11%. During the same period there has been a net flow into bond funds and a net redemption in equity funds. The biggest net redeeming group has been Large-Cap Growth Funds, which gained +15.78%. Possibly, those that guide investors will wake up during the next decline and sell out of their fixed income funds, which presumably will go down less than the stock funds, and recommit their assets to stock funds. (Some may overcome the relative pleasure of losing less, but most won’t until much later.) Even in executing this maneuver, they will probably still be behind most stock fund investors who stayed through the period.

The Two Biggest Risks
The first is that we have moved from a pattern based on business cycles to one based on capital cycles. Almost all activities used in inflation defenses have become directly or indirectly leveraged by the use of borrowed money or float. The financial community, in order to supply the necessary funding to make the system work, has moved from sole reliance on stocks and bonds to rapidly expanding the use of credit instruments. Most brokerage firms and other investment organizations have entered the credit markets as packagers and sellers. The competition to become the dealer in the paper has become intense and has led to weaker covenant constraints in the underwritten bond market. Many of these instruments are traded in private markets, with little public price discovery. These are conditions that could well be a ticking time bomb under the whole financial market. There will be actual or rumored defaults on these instruments.

As with the current concern for contagion in Emerging Market bonds, stocks, and currencies, it may be time for similar fears in the credit markets. The contagion risk is not primarily in the instruments themselves, but in the capital structures of both the leveraged holders and the market makers. When a holder of damaged or defaulted paper recognizes the problem, its immediate need is to restore its capital cushion. Typically, the way they do this is by selling their most liquid holdings to raise as much cash as quickly as possible. A sudden and desperate need for capital in one market often flows into other markets. Thus, it is possible a credit market problem can cause disruption to the bond market, which in turn can affect the stock market. Remember, most of the time investors and traders value their holdings relative to other securities. If the other securities are weak it impacts the value of their securities.

The second big risk, and this is over considerable time, is the cost to the ultimate beneficiaries of our wealth, which in times of stress may withdraw from the combat of investing. Cash becomes too comfortable and low-price opportunities are missed, sacrificing future earnings growth. These losses are much larger than the temporary losses resulting from riding sound investments down before they revive.

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

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 - 2018

A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.

Entering the Most Dangerous Market Phase: In Three Parts

Introduction

Many years ago I heard an unoriginal line in the elevator (lift for my British friends) coming down from the New York Stock Exchange Luncheon Club. “Do you know how to make a small fortune,”  the old floor broker asked then he quickly supplied the answer, “start with a large one.”

There are two important axioms about a major stock (and bond) market decline.

1.    Big losses are only possible after big gains. This is not quite as earth-shattering as Sir Isaac Newton’s discoveries. But the result to one’s portfolio is indeed grave.

2.    Historically by far the biggest loss suffered by investors is not the decline from the peak to the bottom. A much larger loss over time is sustained by the disheartened investors who feel foolish or embarrassed by the loss and withdraw from participating in future markets. One of the reasons that those of us who entered the US market in the mid to late 1950s did so well was that many of the more senior investors were concerned about another Roosevelt 1937-38 type collapse and so were sellers and not buyers.

Part 1: The Market Can Go Higher

My last several posts focused on some of the pre-conditions present in past peaks. I am not flashing red lights for investors to come to a stop of what they are doing. I am stressing that I perceive the need for additional caution. I fully recognize that the stock markets in many countries can get further extended by those who are focusing on the upside by touting the following points:

1.    In a chart supplied by Strategas Research Partners and T. Rowe Price^*, after 57 months of expansion of the last 13 Bull Markets, the average gain was 165% which compares with our present rise through mid November of 164%. Thus we are on track in terms of up phases. There were four Bull Markets which showed further up-side. In terms of greater S&P500 advances the 1990-2000, 1932-37, 1949-56 and the 1982-87 Bull Markets performed greater than we have achieved in this phase. The first two on the list had gains of about twice to three times what we have gained so far. So there is potential for more upside. Morgan Stanley^* is leading the cheering section with a published view that we will see 2014 on the S&P 500 in the year of same number.

2.    The financial conditions in Europe are not only not getting worse, but Moody’s* is selectively raising up various lowly-rated sovereign debt ratings. (In the end, if he could have held on, Jon Corzine would have made money on MF Global’s leveraged bet on the euro.)

3.    Surprising to some, the US domestic economy is showing a pickup in growth. One might wonder whether what we need are more bouts of government shutdowns to help productivity?

4.    There appears to be some chance that we won’t see another US government furlough program as some members of Congress are putting together a budget that takes us through next year’s elections.

Part 2: Deep Structural Problems Are Not Being Addressed

All is not well or improving in our world with some very serious structural problems not being part of current proposals.

1.    We live in a paradoxical world where there is substantial unemployment and under-employment at the very same time that businesses cannot find qualified applicants to fill job openings. The missing elements for the employers are not just a mismatch of training skills. In talking with employers what are missing are basic academic skills, work and discipline attributes as well as work-oriented integrity. Even with an expanding economy many may not find work. In effect we have structural unemployment.

2.    Around the world the size of individuals’ retirement capital is significantly insufficient. To the extent that this lack of retirement funding is going to be addressed by individuals, the only place that they can get the money is by spending less and saving more which will hurt our consumption models.

3.    As a nation there is every chance that, in aggregate, US health care costs will go up beyond various budget assumptions. The strong odds are that society will pay more with less-strong odds that the quality and efficacy of health will improve to the same degree as costs will rise.

Part 3: The Trap is Being Set

There is nothing that I have laid out in this post that is startling new. Most investors will focus on Part 1, the upside. With the rising momentum people will not be overly concerned about Part 2, the problems not being addressed. This behavior is similar to the aforementioned Sir Isaac Newton who bought and then sold out of the parabolic rise in the South Sea Bubble caper only to be sucked back into re-purchasing out of envy and then again lost all that he had committed in the subsequent collapse. He fulfilled the same role that my professor friends at Caltech have demonstrated in the study of the brain which focuses on past successes or pleasures. As a junior securities analysts we quickly learned of the power of the greater fool theory. For a long time fools have more buying power than prudent investors.

What to Do?

I have five suggestions:

1.    Be careful it is easy to get sucked in, many bright people will.

2.    Focus on investment with well-financed companies that have quality products and services that remain essential in the future. You probably will earn less, but probably will also lose less.

3.    Reduce the ratio of your net purchases to your net sells. While cash is the equivalent of trash today in these low interest rate markets, Warren Buffett has amply demonstrated his acumen at Berkshire Hathaway^*, emphasizing the value of cash during periods of stress and accepting under-performance until the rising cash pile can be used dynamically.

4.    Remember that future opportunities will occur and in the long run that will be good for you.

5.    Use the time horizon strategy I have previously suggested separating your intermediate time horizon investments from your longer-term investments. (Please contact me if you would like these posts emailed to you.) The intermediate investments should be current price-oriented. When the bidding for these good companies gets excessive on a historic basis, be a supplier (seller) into the market. Ride out your long time horizon investments and when they periodically decline due to short term factors buy more.

Do You Disagree? Please let me know I am always anxious to learn from wise people.

^*Stocks of the companies mentioned are either owned in my private fund or are in my personal portfolio or both.

 _______________________

Did you miss Mike Lipper’s Blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

The Alphabet Bottom

As mentioned in my book, MONEYWISE one recognizes an optimist by one who gets out of bed in the morning. As optimists, after any significant decline, we start looking for signs of a bottom and we use chart patterns as our models. We label bottoms as they appear to be described by letters. The most dramatic is the “V” shape where there is a sharp decline to a singular point price level and then a recovery without any meaningful interruptions. We see these types of bottoms in a single day chart. They signify that a large seller or sellers are accommodated by getting out at any price. Then the buyers come in to buy cheap stocks. Most of the time a single “V” bottom does not lead to a substantial recovery, but prices turn down again and form another “V” at similar prices. This formation is often labeled a “W” or, if separated by some time, as a double bottom. “V” and “W” bottoms appeal to short term traders who have taken advantage of exhausted former owners. The new owners or more correctly, renters, look to enjoy an immediate robust recovery. These people are not the readers who will get the most out of Money Wise.

The longer term investor who thinks in ten year and longer goals, and who will get the most out of reading Money Wise, will be looking at what can best be called a “U” shaped bottom. This bottom formation takes a while to develop, in some cases, years. Often this pattern is typified with low relative volume, a narrow trading range which can exhibit high daily volatility but not much forward movement. The result is that there are fewer market price headlines and commentators refer to dull or mixed markets. Few analysts focus on the fact that during this time of base building companies are catching up to their stock prices and are moving ahead of them. Often during these periods companies sort out their opportunities, they leave certain businesses, price points, and distribution channels. New, invigorated management come to the fore at the operational level and some changes are made at the executive level.

I believe that we are in a “U” shaped pattern which should allow long term investors to feel that in general they have seen the bottom and begin to look for the elements of better stock prices. These elements will not be in the headlines or sound bites, but can been seen in walks through shopping areas and malls. The numbers of cars on the road or searching for parking spaces are other clues. Lack of inventory in stores and plumbing supply locations can be viewed positively. I am starting to see some glimpses of these clues. Thus, I am cautiously betting on a “U” shaped bottom as in the United States.