Significant Turnaround? Two Fearful Histories - Weekly Blog # 614

Mike Lipper’s Monday Morning Musings

Significant Turnaround? Two Fearful Histories

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

Current Pictures 
All three popular US stock market indices have price charts indicating a top of some magnitude. Market analysts view these tops as a sign of a reversal of a major trend. The questions facing investors today:

1. Is this a correction of perhaps 10% and an opportunity to buy a favored cheap stock?
2. Is it a cyclical top with a potential decline in order of magnitude of about 25%?
3. Is it a less frequent structural change that might cause a displacement of 50% or more?

2020 is still very young, but current markets as reflected through mutual fund performance are showing dramatic trend divergences. Year-to-date through last Thursday, the only mutual fund investment averages above 4% were: Global Science & Tech +4.86%, Large Cap Growth +4.09%, and the more domestically oriented Science & Tech +4.07%. Declining Equity Mutual funds were Natural Resources -8.38% and Basic Materials -5.15%. Commodities declined even more: Energy -11.35%, Basic Metals -7.18%, and Agriculture -5.02%.

After generating net sales earlier in the year, High Yield mutual funds and ETFs suffered significant redemptions this week, while higher credit bond funds continued to draw positive net flows. The Wall Street Journal' s weekly chart of 72 securities indices, currencies, ETFs, and commodities, only saw 24% of them registering gains. The spread between the price of gold and gold mining stocks also narrowed. These data points are  not encouraging for those looking for higher stock prices.

The task for professional analysts and portfolio managers is to examine the current data and look at possible alternative future directions. Most bright futures take care of themselves and the job is simply trying to optimize the rate of return. The less frequent downsides need to be reviewed more carefully, because for professionals there is much greater career risk.  The owners of capital need to blame someone other than themselves for major declines, but often take all the credit on the upside! I therefore periodically examine the chances of cyclical and structural declines, without excessively focusing on when they will occur.

What's Wrong? 
A top followed by a significant decline is usually identified with an event that focuses people's attention, although it often has little to do with the underlying cause. How the underlying cause for most wars is explained is a classic example. For example, school children are taught that WWI began because of the shooting death of Austria's Archduke by a lone anarchist. The truth is, the balance of power keeping competing nations in check after the Napoleonic era was breaking down. The growing strength of Germany, combined with weaknesses in France and Russia, led to them creating self-defense alliances with weaker states. Note, hostilities did not begin until six months after the tragic murder. It was the movement of Serbian troops threatening Austria that brought Germany and Russia into military conflict.

Somewhat like the US entry into WWII being caused by a single attack on Pearl Harbor, resulting in a Declaration of War by the US against both Japan and Germany, plus Italy. The Coronavirus is similarly be blamed for the decline in most stock markets around the world. The virus has led to one hundred or more deaths of the thousands infected. Unfortunately, there will be more, but it will eventually be contained and cease to be a problem. What it has done is to dramatize the importance of China to World Trade. Although China has contributed about half of global GDP growth, it still represents a relatively small number. The markets were showing weakness for some time before the advent of the virus and many industrial stocks and commodities were flat or declining in the latter part of 2019, if not before.

The 1929 peak in October marks the begin date of the Great Depression, but few realize that by December 1929 the Dow Jones Industrial Average had fully recovered. (Perhaps, there is still hope for stock traders this year.) There are always a number of factors that contribute to making a top and its subsequent decline. The current ballooning expansion of credit is one of the conditions shared by events leading up to the 1929 crash. "Bubble or Nothing" is the title of a study by The Jerome Levy Forecasting Center LLC, which makes the following observations:

1. The last three US recessions were ended by ever larger inputs by the federal government.
2. Economic recoveries were successively smaller after each recession.
3. Private credit has expanded at a faster rate of operating assets and operating income.
4. Most national governments are already operating with a deficit.

I would add that astute bond investors are already conscious of these conditions and are shifting their purchases to the highest quality non­-government issues, reducing their immediate commitment to high yield. Also, I find it very interesting that the performance spread between the price of gold and the price of gold mining shares has narrowed. In the modern world, other than when currencies become worthless, the main reason to buy gold is in anticipation of inflation. However, there is none in the government published data.

What to Do?

1. History has favored buying high quality and holding it for long periods of time, if it remains high quality. 
2. For US individual investors, the step-up at death is one of the best ways to pass wealth on. (That may not always be the case!)·
3. It does not mean we all abandon buy and hold strategies and become traders. However, it does force investors to focus on the timing of planned cash expenditures. 
4. The size and composition of the payments reserve needs attention, recognizing that guessing the future is fraught with mistakes. Based on present conditions, I suggest that payment reserves for the next five years be invested only in high quality paper, with up to 50% in maturities under one year. 

What about Long-Term Money? 
The history of greed and fear cycles indicate we cannot avoid periodic tops and declines. I suggest that intermediate length accounts be prudent and hold reserves of at least 25%, with maturities of five to seven years as a limit.

For those investments meant to be long-term or legacies, recognizing that within a generation you are likely to experience a structural top. As long as there are sufficient payment reserves, I would not add any additional reserves, except for those who can use opportunity reserves effectively. Many fiduciaries can't or won't.



Congratulations to Clark Hunt for his team winning the Superbowl, demonstrating the value of teamwork.



Question of the Week: What is your sense of timing as to the market and how is it expressed in your portfolio?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/01/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/01/is-it-always-brains-over-flexible.html

https://mikelipper.blogspot.com/2020/01/architectural-sway-points-and-current.html



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A. Michael Lipper, CFA

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ON the ROAD to CAPITULATION and RECOVERIES - Weekly Blog # 552

Mike Lipper’s Monday Morning Musings

ON the ROAD to CAPITULATION and RECOVERIES

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

                                         

Every connection to life has its own ups and downs. One of the major translation errors from the singular precision of mathematics to the real world in which we live and invest is the implication that the shortest distance between two points is a straight line. Not that it is incorrect, but in the real world of dealing with people and their money, straight lines are a fantasy. As sure as days follow nights, we deal with changing observations based on changing conditions. Thus, we should educate ourselves and others about cycles. In the two-dimensional world these are linked in time by plotting ups and downs, or if you prefer the mathematical term, their representation is sinusoidal. Actually, even that picture of reality is incorrect, cycles travel in multiple dimensions. Meaning that we cannot totally rely on past cycles being repeated exactly in the future. Thus, in planning for our investments we cannot rely solely on history. We need to be aware of the differences between past cycles and current conditions. Even more difficult is guessing the differences in future cycles.

As an investment manager for long-term institutional and individual investment accounts I am now focusing on identifying the coming bottom for stock prices and more importantly the nature of the recovery from the bottom. The answers to the second question are to an important degree a function of whether we will be hitting a cyclical or structural low point. There will be elements of both types of declines in the bottom, but one usually is more predominant.

CYCLICAL BOTTOM 
Most cyclical bottoms are created by dramatic change in sentiments based on very current stock price changes. One example is the (AAII) weekly sample survey. Three weeks ago the American Association of Individual Investors reported the percentage of respondents that were bullish was 41% and bearish 31%. This week AAII reported 25% being bullish and 47% being bearish. Barron’s produces a confidence index based on the difference between high quality and intermediate quality bond yields. Unlike the AAII statics this index usually moves less than one percent from week to week and has only moved 2% over the last year. It moved 2% this week compared to the prior week, in a direction that demonstrates there is concern in the bond market. (While the AAII numbers are highly volatile and are often negative indicators for future stock price moves, history suggests concerns in the bond market precede those in the stock market) Another indication of concern is that 14 of the 25 best-performing mutual funds for the week were Precious Metals Funds, a rarity. A sudden surge in gold mining stocks and funds after a long period of poor relative performance indicates worry rather than hedging.

Most of the time recommendations from transaction focused brokers and fee paid investment advisers are similar. However, brokers are currently recommending the building of cash positions (To build future buying power), whereas advisers are continuing to recommend holding on to stock positions. This dichotomy may reflect the “growth/value” dilemma. “Value” stocks, which are often significant dividend payers, usually fall less in down markets and underperform in up markets. “Growth” stocks tend do better in up markets and did quite well into the third quarter, led by the FAANG + BAT stocks, although they have given a lot of that back in the less than two months since then. Investors traditionally feel that the loss of a dollar is twice as painful as the pleasure of a dollar of gain. Thus, while some more mature investors are concerned about the size of their money pile, those that have cash flow needs are more focused on the expected terminal value of their accounts. (As an investment manager it is our job to work with accounts to achieve the proper balance.)

As Yogi Berra said, you can see a lot by observing. My wife Ruth and I did our usual “Black Friday” investment research visit to the glitzy Mall at Short Hills. Our overall observations were:

• Mostly women shoppers, often in groups consisting of three generations
• Good but unobtrusive security
• Shoppers very selective, with some quite empty stores. Specifically:
• Apple(*) - Quite full, but no outside lines
• Verizon - Better than normal, but not crowded
• AT&T - Actually had a few people there
• T Mobile - Some traffic, possibly due to being opposite Apple
• Starbucks - Jammed
• William Sonoma - Very busy
• Canada Goose - Lines outside, with limit access
• Tiffany - OK
• Hermes, Gucci, and Chanel - All busy

Relative to prior years I would give it a solid B, perhaps a B+. (I wonder whether the strength of the women’s’ shopping can be tied to changing demographics, economics, and shifting voting patterns and are these cyclical or structural?)

Market analysts might consider that this week the DJIA, S&P 500, and NASDAQ composite reached prior lows. This could represent a double bottom from which a price recovery could take place. If it were to happen, we would have experienced a cyclical decline with the relatively gentle capitulation that occurred this week.

STRUCTURAL DECLINE
While most of the time the stock market anticipates a recession, it doesn’t happen every time. The 22% one day decline in 1987 was unrelated to an economic recession, whereas The Great Depression of the 1930s combined an overpriced stock market with an out of balance economy and government errors. Historically, investors without trading skills are better off within a year or two after a cyclical fall, if they stay invested in their reasonably diverse stock portfolio or funds. On the other hand, a structural decline can take much longer to recover from and some companies and sectors won’t come back. Thus, out of prudence, I look for signs of a future structural decline and there are a few that need to be watched.

1. The Bank for International Settlements (BIS), the bank for central banks, is pointing to the rise of “Zombie” companies. These are companies whose return on invested capital is below their cost of capital. If these conditions continue the companies will not be able to generate the money to grow and will eventually consume their own capital and commit suicide. BIS sees the number of these types of companies growing. An expected rise in interest rates without an increase in return on invested capital will have them trapped.
2. Several young people entering the financial services business have asked me where they should start. I have suggested that if they can get exposure to past mistakes in workout situations and/or bankruptcies, it is much better than focusing on the successes of the firm. Thus, I try to learn what I can when one of these surfaces. David’s Bridal, a chain of stores selling wedding gowns and related materials announced it was going bankrupt. The press chalked up the problem to a change in young people getting married and wanting less flamboyant weddings, which may be true. However, I think there were other problems that an outsider could see. For example, too much inventory, slow cash conversion, sloppy credit extensions, and their second set of private equity owners over-leveraging their relatively high purchase price. (I cannot comment on the critical issue of management)  The over-leveraging of a high acquisition price is far from unique in today’s world. Years of interest rates not high enough to absorb credit loses combined with a sharp increase in relatively inexperienced people at non-bank credit institutions making loans is a prescription for trouble, although it does not parallel the sub-prime credit expansion that contributed to the last financial crisis. Interestingly, we are seeing some non-bank mortgage companies withdrawing from their market.
3. I believe the financial services sector is critical to the workings of the global economy. As an investor in this segment I know that at times one can make money in these stocks, but not always. Nevertheless, I study it because of their centrality to the system. I am seeing activities that suggest some career investors in this segment are concerned about growing concentration. Merger and Acquisition activity is increasing to improve revenues and reduce overhead (people). Suggesting that this is a drive is to maintain or improve profit margins and returns on invested capital, rather than growing the business. 
4. Two of the sharpest minds in our business see this as both an opportunity and a challenge. The first is the very well known, often contrarian, chairman of Berkshire Hathaway*), who was working down an excessive amount of the $120 Billion in cash by buying and additional $13 Billion in financial services stocks, including $4 Billion in JP Morgan Chase* stock.  He and Charlie Munger are still maintaining $100 billion for big opportunity investments at attractive prices. Less well known in the US is Paul Myners from the UK. Paul has had success in the investment management business in UK, US, and Hong Kong. Besides his investment management work he has also led the financial industry both in the UK Government and import industry bodies. His latest role is chair at Autonomous Research, a very good in-depth research firm covering Europe, the UK, and US companies. He is selling the firm to Alliance Bernstein which is partially owned by Axa (*), in part due to the shrinkage of research commissions, particularly in Europe.

(*) A long position is held in these securities either in a financial-services fund I manage or in personal accounts, if not both.

I always look for changes in the structure of the market that can disrupt how investors react. There are two aspects worth watching. The first is the large and still growing amount of money being invested away from publicly traded markets. Pensions & Investments magazine has published an article on foundations. It tabulated how the fifty largest foundations allocated their assets between stocks, bonds, and other investments. Other investments, which included private equity, hedge and venture capital funds, real estate, and direct investments, represented 60% of their total of $230 billion. Fourteen of the fifty largest foundations have more money invested out of the market than in it. I have seen the pull of these investments in endowments and foundations whose investment committees I sit or sat on. For a number of years as a group they have underperformed, even before fees are deducted and certainly afterward. This is in spite of a limited number of quite spectacular results from individual funds or properties. If the flows away from the market slow down or reverse there will be less leverage available to private and public companies, which could lead to structurally lower returns.

All too many investment results are phrased in terms of risk-free returns, which is translated as superiority relative to US Treasuries. One of the more successful fixed income mutual fund managers, Michael Hasenstab of Franklin Resources, has a view that US treasuries are due for a perfect storm. His three reasons are:

1. The US fiscal deficit will rise (This may be particularly true with the House Ways & Means committee in the hands of spenders who will want to match defense spending increases.)
2. A decline in bond buying by the Fed.
3. Inflation will rise.

If “risk-free” rates of return decline, it may materially impact asset allocation and overall rates of return.

Conclusion:
As of the moment, because of a lack of enormous enthusiasm at the prior peak, my current guess is that we are dealing with a cyclical decline and good holdings should not be disturbed. However, I will keep looking for increases in the list of structural issues that need to be addressed before we have a structure driven fall.

What do you think?


Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2018/11/selectivity-over-factors-weekly-blog-551.html

https://mikelipper.blogspot.com/2018/11/history-guide-not-map-or-trap-weekly.html

https://mikelipper.blogspot.com/2018/11/things-are-seldom-what-they-seem-weekly.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 - 2018
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.