An Awkward Moment with Frustration not Exhaustion - Weekly Blog # 591

Mike Lipper’s Monday Morning Musings

An Awkward Moment with Frustration not Exhaustion

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

Trying to develop a sound long-term investment strategy at any time is difficult, as most of the time we are clearly not at a top or bottom of a significant market move. We wander along an uncertain path to an eventual turning point, but each day, or in my case week, I must read the current sign posts to decide whether or not to change direction on the path I am traveling. Currently, there are three difficult choices to select from:

1. Stay reasonably fully invested in the upward sloping secular trend, accepting that there will be periodic cyclical movements.
2. As the opportunities and risks in today’s world are not the same as in the past. We should become increasingly defensive by building meaningful cash reserves.
3. Prepare for global policy mistakes that causes devastation.

I put the chances of being correct for each of these choices at 65%, 30% and 5%, respectively. On an overall basis I would improve my odds by sub-dividing the portfolio into timespan segments and periodically re-weight the commitments to the segments based on both perceived future conditions and the changing needs of the beneficiaries.

These three working conclusions are based on the following inputs:

Secular Continuation with Bouts of Cyclicality

• Most of the current volume is being generated by those that have a short-term time horizon. They are being whip-sawed by politically oriented news which is generating a lot of frustration. However, it is not generating the quantity of transactions representative of final exhaustion, or a complete retreat from participation.
• Nevertheless, traders are making decisions based on liquidity e.g. compare the ratios of advances to declines on the NASDAQ 211/314 vs. NYSE 411/229. (In general stocks on the NYSE trade in greater volume than on the NASDAQ) 
• Net flows into and out of ETFs shows short-term withdrawals this week. The two largest withdrawals totaled $4.6 Billion and the two largest net purchases totaled $1.2 Billion. The S&P 500 and MSCI Emerging Markets were sold and Consumer Staples and Gold were bought. 
• Even after Friday’s drop of 3% for the NASDAQ it is till up +16.63%, whereas the DJIA is up only +9.87%. Both gains will probably be larger than the total earnings gains for 2019, suggesting the market is looking for a good 2020.

Game Changers

• Lower interest rates and less binding loan covenants are likely to cause more bad loans.
• Only 42% of weekly prices are rising. Could we have deflation in goods and inflation in services and imported goods?
• Last week the interest rate offered to depositors went from 0.65% to 0.73%, suggesting that banks are increasing lending in face of slowing demand for products and services.

Global Mistakes

• The battle for dominance is essentially driven by defensive needs, not land or market dominance.
• The Chinese have been thinking in these terms for more than a thousand years. The earliest example of their well-developed thinking is in the writings of Sun Tzu entitled “The Art of War”. Jessica Hagy has produced a book that visualizes Sun Tzu’s thoughts. These should be understood by other world leaders and are shown below:
• Hold out baits to entice the enemy
• Feign disorder and crush them
• If your enemy is secure at all points, be prepared for him. If he is in superior strength, evade him.
• If your opponent is temperamental, seek to irritate him. Pretend to be weak, that he may grow arrogant.
• If he is taking his ease, give him no rest. If his forces are united, separate them.
• Attack him where he is unprepared, appear where you are not expected.
• These military devices, leading to victory, must not be divulged beforehand.
• The general who wins battles makes many calculations before a battle is fought.
• The general who loses a battle make but few calculations before-hand.

The Asia Times has an article entitled “China now has edge in Indio-Pacific”. It is based on a think tank report from an Australian group named United States Studies Centre. The study raises the question “Could the era of US military primacy in the Pacific be over? Their view is that internal conditions within the US suggests that it will not fully fund the needs of its National Defense Strategy. At the same time China is building a capability which in a surprise attack would destroy or cripple some or all of the US’s Western Pacific main installations in Guam and Japan. (Interesting that the report did not name our forces on Iwo Jima and in the Indian Ocean.)

My Point of View
As a former electronics, aerospace, broadcasting and conglomerates analyst, I have seen the power of small electronic components change massive companies and markets. The current “trade war” was designed to protect the primacy of our semiconductor technology, which is critical to both US and Chinese defense efforts. To paraphrase Admiral Alfred Thayer Mahan’s statement of Who controls the Seas, controls the world. I believe the two Emperors of China and the US are acting as Who controls (leads) semiconductors and related technology controls the defense of their countries.

An Important Question
Considering how long value focused managers have suffered, can we build portfolios that are able to survive a similar period, regardless of our investment strategy? Any thoughts?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/08/short-term-recognitions-plus-longer.html

https://mikelipper.blogspot.com/2019/08/sentiments-approaching-reversal-points.html

https://mikelipper.blogspot.com/2019/08/is-last-week-significant-weekly-blog-588.html



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Guessing the Impact of China on Investments

I am neutral as to what China means to the world of investing. However, I am certain that changes within China will have an enormous impact on how we invest and more importantly, how successful investments will be in the long run. I once thought the term “Chinese Puzzle” referred to a children’s game. Now, I believe it refers to the number one challenge facing the world.

Since we have returned from Asia, I am much more conscious of the huge amount of information that we can receive both from China and various groups active in China. Over the last several weeks, in almost every investment (and in many cases, political) discussion I had, the impact of China comes into the conversation. There is much to learn and I am learning.

Elections

There are two critical elections occurring in China. The whole idea of elections (and even more surprising, competitive elections) is new in this controlled society. The first real popular election of any kind was the one this past weekend in Wukan, a village of some 13,000 (out of a nation of 1.3 billion), to replace a local government that was overthrown by an armed population after corrupt politicians paid too little for the ceased land that they then sold to developers. That the central government did not brutally repress the revolt is truly remarkable. The provincial leader who decided on this new course of action is himself a candidate for a seat on the nine member Politburo Standing Committee, which runs the party and the country. He is opposed by another rising provincial leader who is espousing the singing of politically correct party songs and other throwbacks to the Mao era.

These elections will say a lot as to China’s future.


Chinese commercial law

This past week I attended a seminar, “Doing Business in China: What Investors Need to Know About Dispute Resolution in China.” The program was put on by Debevoise & Plimpton, based on efforts from their Hong Kong office, and Fangda Partners, from the experiences of their three Chinese offices. The illuminating talks described the current trend to increasingly rely on internal courts as distinct from offshore jurisdictions. For me, there were two surprises. The first was that there is no penalty for lying in a civil case. Further there is no discovery demand in these cases. Second, and some might like this within the US, there are no damages assessed. Proven losses will have to be repaid. These two factors suggest that you want to resolve disputes before they get into the courts. Fangda Partners quoted “The Art of War,” by Sun Tzu, “The best victory is to defeat your enemy BEFORE the fight.” What these elements suggest to me is that new entrants into China should be counseled by “old Chinese hands” before they enter the game. On this basis, I would be cautious on counting on new entrants.

Adam Smith Plays a Role

In discussing investing with a very smart US Portfolio manager, he felt that much of the gain from using Chinese labor has already been achieved. In 1776, Adam Smith informed the world that certain countries have specific advantages. In the case of the Chinese, until recently their advantages were, at least in the coastal locations, a highly productive, hard-working labor force with low wages. As I have noted in earlier blogs, it is the policy of the Chinese government to raise wages as part of its attempts to reduce social disruptions. Combining this drive with the apparent peaking-out of the size of the work force, the low wage advantage will shrink in terms of China. In this portfolio manager’s view, that for a number of multi-nationals (both in the manufacturing and intellectual property businesses), gross margins from China are likely to decline as they have in the US for these same companies. There are two investment implications if you accept this view. First, watch what is happening to gross margins of those companies that are doing a lot of work in China for the export market. The second implication, which is already happening, is to see whether the shift of production to India, Vietnam, Thailand, Malaysia, Philippines, and perhaps selected countries in Latin America and Eastern Europe, continues. India, which is currently going through its own problems with politics and corruption, is of particular interest with the size of its young English speaking population, and the announced drive to create hundreds of new universities.

A broader thought and danger

A further investment implication of these trends is that we live in a dynamic world where the length of our visibility into the future is becoming shorter. If we have fewer years of reasonable certainty, in theory, the product of our discount methodology of future value will decline. Our investment strategies may have a shorter life span than the buildings we are creating. Under this type of thinking, overall valuations are likely to decline as measured by price/earnings ratios.

Some Chinese fortune cookies

In reading all that I can about China, I am amassing a large number of nuggets. Some of these may be tasty in the future; others may turn out to be quite sour. (I would be happy to discuss these items with any member of this blog community.)

• There are concrete plans to construct the Pan Asian Railway with over 81,000 kilometer of track connecting China (and its products) to 17 nations; including markets in South East Asia, Central Asia and Germany. (Historically the Mongols did a similar thing.)
  
  
• On March 9th, hard data on industrial production and fixed asset investment in 2012 will be revealed.
  
  
• One factory in Japan produces 10% of all the 42-inch television sets in the world. Some claim that there are only 15 workers in the plant. Is this a possible future model not only for China, but for the rest of the world? (At some point will manufacturing not be human labor intensive? This, in and of itself, would materially change our economies.)
  
  
• The February Purchasing Managers Index (PMI) in China was 51, showing some expansion.
  
  
• Chinese home prices declined, continuing their 19 month descent. The Chinese government is playing a major role in the control of permits and the availability of credits through the banks that are owned by the government. As an outgrowth of the housing slowdown, Chinese banks are trading at record lows relative to their stated net asset value. (I suspect that this is somewhat common around the world. However, I take a different point of view; that the markets do not believe the stated book value of banks and perhaps other companies. Thus, when this period is over, we may find that some are selling at several multiplies of book value. I would rather put my analytical faith in the markets over the work product of the accountants and their corporate clients.)
  
  
• The wave of Chinese companies entering the US and Hong Kong markets appears to be reversing, as numerous companies are going private (at prices I believe to be well below their IPO levels).
  
  
• Bloomberg carried an item that bears researching: the net worth of the Chinese political leaders is believed to $89.8 billion, compared with the aggregate wealth of the US President, Supreme Court and Congress of $7.5 billion. There appears to be a great amount of wealth from China that wants to invest beyond its borders.
  
  
• I am always fearful, particularly in rising markets, so any indication of rising speculation of the “animal instincts” makes me nervous. I believe from my discussions with both professional investors and other so-called sophisticated investors there is a great deal of interest in buying Exchange Traded Funds (ETFs). The nature of these people is that they are much more short-term oriented than the average mutual fund buyer. Thus, when the firm I previously owned, now known as Lipper Inc., estimated that the net purchases of equity ETFs was $7.5 billion in the week, while equity mutual funds had an outflow of $260 million, I get more nervous.
  

Please share your thoughts with me.
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