What is the NASDAQ Saying to Whom? - Weekly Blog # 649

 

Mike Lipper’s Monday Morning Musings

What is the NASDAQ Saying to Whom?

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

Prior to Friday, the performance of the NASDAQ Composite Index led all other stock price indices in performance, and in my opinion, was an indicator of the future direction of the more diversified market.

Then on Friday we experienced an October surprise. The President of the US, the most prominent media political personality in the world, was diagnosed as having contracted COVID-19. An “October Surprise” has been a feature of American presidential politics and some believe it changed enough votes to swing elections. One should remember that voters do not take a verified test as to why they voted the way they did at the time of voting. There is some evidence that voters tell pollsters what they believe they want to hear, or who they think will win. Thus, there is no verifiable way to know how any specific individual voted, or why.

Most people responsible for the ownership of common stocks are long-term investors, and although they participate in the parlor game of expressing their view that it motivates their voting, it does not. Thus, the movement of stock prices or indices is not guaranteed to be predictive of voting results.

NASDAQ Against the World

Trading began on Friday after the announcement of the President’s medical condition, sending stock prices down by more than 400 Dow Jones Industrial Average (DJIA) points. Sharply fallen prices brought buyers into the market and by the end of the day the DJIA was down only -0.48%. What alerted me to something potentially signaling a major change was the NASDAQ falling -2.2%. Since reaching their all-time high on September 2nd, the S&P 500 and NASDAQ have been falling. (Remember my warning that due to changes in composition and weighting the DJIA is likely to be less reliable due to its greater tech orientation.) Until some time passes, the S&P 500 will be a more useful than the dollar weighted market indicator. By Friday’s close, the S&P 500 had dropped -6.49% for the month since achieving its high point. Over the same period the NASDAQ fell -8.14%, the difference being Friday’s price movement. Thus, Friday’s bigger decline could be significant.

What Did NASDAQ’s Friday Bigger Drop Signify?

The NASDAQ index is labeled “tech-heavy” and consequently the performance of tech stocks is disproportionately important to its investors. The only two mutual fund investment category averages gaining over 30% through the Thursday year to date period were Precious Metals +35.68% and Global Science & Tech +35.27%. (Five other investment categories were up in excess +20%) 

Someone with an eye on the political statements made by the leading candidates, and more significantly by some other political leaders concerning the large Tech companies, might ponder the implications of Friday’s tech stock price movement. The popular view is that the Democrats would like to see the economic marketing power of the leading tech companies restricted. Is that the reason the “tech heavy” NASDAQ Composite Index declined materially on Friday? (Prior to Friday, the NASDAQ’s decline from its peak was right in line with the fall of S&P 500.) What makes this view curious is that most CEOs of Tech companies are major Democrat supporters. (It is not unusual for successful candidates, upon being elected, to turn on their supporters and attempt to broaden their mandate.)

Changes in Marketplace Structure Could Be More Important Than NASDAQ Price Movements

While most investors only pay attention to the movement of the prices of their stocks, I also focus on the “inside baseball”. Who is executing and initiating the orders and how their marketing efforts are influencing what we think about their investments. It is interesting that there is rising concern over the marketing power of major tech companies, while there seems to be a parallel concern in the investment marketplace. Recently, it was noted that the five largest asset managers, in aggregate, manage more dollars than attributed to the US GDP. Even greater concentration was indicated by two announcements this week.

Wilshire Associates, a data supplier and asset manager, was sold to two private equity managers willing to provide more capital to expand Wilshire’s business. Also this week, Trian Fund Management announced that they have taken a 9.9% position in both Invesco and Janus Henderson, and announced that there should be greater merger & acquisition activity in the investment management business. These smart people were successful with their investment in Legg Mason, generating a gain of 55% for them. This area is of great interest to me, as I manage a private fund invested in Financial Services stocks.

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

https://mikelipper.blogspot.com/2020/09/there-is-incredible-shortage-weekly.html

https://mikelipper.blogspot.com/2020/09/headlines-excite-dictate-or-respond-not.html

https://mikelipper.blogspot.com/2020/09/mike-lippers-monday-morning-musings-who.html

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Positive Investment Implications...

I wish to bet in favor of an expansion of returns of investors’ capital, even though this time may be different in that we might be entering a long-term phase of flat to down stock markets. At market turning points there is usually not an over-abundance of evidence of a change in sentiment as to the long-term direction. Thus, to find clues of change I scan all information that passes through my desk and memory. The following are items that I think should be weighed and their implications examined.

Intellectual property and unfunded pension liabilities to be calculated in GDP

In July of this year the US GDP will grow by 3% due to the inclusion of intellectual property in its calculation, recognizing intellectual property as a produced asset rather than an expense-only generator. According to a Financial Times story released on Sunday, this adjustment will be carried back to the initiation of the calculation of national accounts at the Bureau of Economic Analysis in 1929. The size of this addition is roughly equivalent to the size of Belgium’s GDP and the biggest increase since the 1999 addition of software. This change is in response to the international accountants recognizing intangible assets such as research and development expenditures, and royalties on creative works (movies, television shows, books, music and theater). If these are the results of current spending to produce long lasting assets, they need to be identified on accounting statements including the national income accounts that produce our Gross Domestic Product. At the same time the revision will recognize the unfunded liabilities of public and corporate pension plans. There are many investment implications to these changes. The first is that the US economy with its large scale production of intellectual property will widen the gap from most other countries, which may play a role in the on-going deficit production and austerity discussions in the US. Second, intelligent investors have already priced these benefits into some of their judgments regarding the production of intellectual property in the biotech sector (including drug companies), as well as others. If recognized this shift, in addition to published book value, will lower the price/book value ratios that many so-called value investors favor. Also some states like New Mexico will get greater recognition for the large amount of R&D conducted there. Larger in dollar value, but smaller as percentage of total state product, my home state of New Jersey could also benefit. However the various states as well as the nation’s GDP numbers will be marked down due to the size of the underfunding of their pension funds. In most cases knowledgeable investors have understood these conditions and market prices may already be reflective.

Portfolio liquidity

Many institutional investors have been willing to accept in the case of their purchase of “lock-ups” through private equity and many hedge funds that there is a penalty on early redemptions. Recent discussions with investment committees (who are focused on providing operating funds to their institutions) have indicated a stronger than normal push to insure the liquidity of their portfolio.  They are willing to pay a liquidity premium beyond the current year’s needs to feel comfortable in meeting the requirements of their organizations, particularly if business and donor support slows down in the year ahead. At the moment there is less competition for long-term investment opportunities which in turn may lead to better entry prices or terms for lower fees or less onerous exit terms. Thus, now may be a particularly favorable time to be a long-term investor with cash to spend.

Four letter words

From a young age we have been instructed to avoid the use of certain four letter words. In this prohibition, we tend to forget two additional very important words; Love and Like. The world would be a far less attractive place without these words in practice. But there are two other four letter words that now need to be understood. The first is “real.” This term is used in reporting the impact of inflation on income and price performance recognizing that published nominal rates don’t measure the “real” cost or benefit received from a number. My problem with the designation of real is that the number for inflation is increasingly recognized as questionable. There are growing questions as to the price inputs, methodologies applied and the accuracy of each procedure. In my talks with various institutional and individual investor audiences I have yet to find people that perceive the published consumer price index is representative of their experience. I would suggest that it would be prudent to use “real” rates of return as estimated and not certain in the specific situation of the investor or citizen. The second four letter word that should be handled with care is “copy.” Something that bears no resemblance to an original will rarely be compared as a copy. The art and the investment worlds know that a well done copy is not only difficult to spot but also has many similarities to the original and in some aspects could even be better than the original. Copying is the sincerest form of flattery it is said. At the right price a copy could be a useful bargain. In the investment world which follows and mimics performance leaders, I would not necessarily shy away from good followers as long as one identifies that they are followers who could produce better, often more leveraged vehicles, than the original leaders. As long as one recognizes that those who follow are unlikely to either spot the turning points when the period of advantage is over or to be an original leader in subsequent phases. Thus, I would not reject a copy out of hand, but understand as to what one is dealing with and do so at the right price.

Investor confidence

As mentioned a number of times I follow the weekly publication of the Barron’s Confidence Indicator of the ratio of yields of intermediate quality bonds to high grade corporate bonds. When the ratio declines it is meant to be positive for stocks in the future. Most weeks the change is below 1% (100 basis points) which I consider a weekly trading differential. In the past week the decline in the ratio was 1.6% or from 67.9 to 66.3 which is encouraging to those of us that have long positions in stocks.

Markets speak to non-profits and governmental services

One of the hard realities for many non-profit institutions that are serving the public through admissions to various locations is that they are suffering from a falloff in both attendance and donor support. Very harshly, I am increasingly taking the point of view that if these non-profits were commercial businesses with the same secular, not cyclical decline in support, my attitude would be that ‘the market has spoken” and now is the time to consider basic model changes or closing down. Applying the same thinking to the deficit production machine being run by most Western governments, I believe that the situation calls for a significant model change as the public does not wish to pay in full for all of the omnibus services that it receives. The current debate is, “do we want European level of services or Asian types of government spending?” Analytically I reject that simplistic equation. I believe the tool that is called for is the surgeon’s knife not an axe. I believe that if the potential audience for a museum or concert or a government service believed that it wanted the service that was proffered they would show up one way or another in sufficient quantities to effect a re-pricing of the services. We should not close support institutions and governments entirely, but just rescale them to fit today’s demand levels. The investment implication is that there is a third way out of our box, which is to find the level of demand for services that people will fund for themselves in monetary or work terms. If we see more of this new thinking,  the future will be positive for our children and grandchildren.

What Do You Think?

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Lessons from 2011 for Earning in 2012

The year 2011 was not a good year for many stock markets, investors and advisors, (I count myself among them). However, there are useful lessons to be learned for 2012 and beyond. One rationalization is that we did not pay sufficient attention to “the Risk on/Risk off” dance. These rapid fire flip-flops were focused almost exclusively on macro factors. Macro factors included the overall levels of interest rates and currencies plus political changes. As these changes occurred or were rumored, the markets moved violently. The rapid fire changes were triggered by syllogisms. If you don’t remember your plane geometry, a syllogism is a form of reasoning with two propositions leading to a conclusion, e.g., “If factor ‘A’ is true and factor ‘B’ is true, there is only one possible conclusion.” A contemporary example might be that (a) the US is in a political deadlock, (b) a major credit rating agency lowers the US credit rating, therefore (c) the US dollar, Treasuries, and its stock market will decline. (Those of us trained as analysts of individual securities require a large number of factors to make a decision. We rarely feel absolute certainty about our conclusions, as all the facts never line up on one side.) The “Risk on/Risk off” switches created the volatility that so unnerved individual investors in 2011.

Incomplete/misleading headlines

If one totally believed the flash news, one could complete the syllogism and react quickly. Unfortunately, all too often the headlines do not include enough information to properly evaluate the news. The following are three examples of news articles premised with too-shallow thinking:

1. “A World with Too Much Debt,” * based on data from the Organization for Economic Co-operation and Development (OECD), examines unfunded liabilities and official government debt as a % of GDP. The US ranks sixth, with a figure of 620% (98% of official debt + 522% of unfunded liabilities). This is pretty scary when Spain, Italy, and Ireland have lower numbers, indicating that the US is in deep trouble, enough to hit the “Risk on” button. That is, unless you look at the details, as micro analysts do. First the unfunded liabilities are the difference between the projected cost of continuing current government programs and net expected tax revenues. Note that the figures do not take into consideration any dedicated assets to these programs. Second and much more importantly, is that liabilities are shown without any calculation as to a nation’s assets, even if it were just the government’s assets. One of the reasons for this mismatch is that the US government does not publish a balance sheet, even an unaudited one. (As regular readers of this blog have learned, I believe our credit rating should be lowered to the mid-investment grade level, not because we don’t have the assets/earnings power to pay off our debts. The downgrade is warranted due to the political unwillingness to materially reduce the US deficit production.) Bottom line, in my opinion: the US debt picture is unhealthy, but does not have to be fatal. Thus, I would delay hitting the “risk on” button.
   
   *This chart was brought to my attention by John Maudlin of Millennium Wave Advisors
   
   
2. “There is significant evidence that the economic growth in China is slowing.” The expressed fear is that to head off a slowdown in China, wages will rise. As we buy so much from China, we will be introducing additional inflation into the US that will hit the Wal-Mart shoppers hard. There are three reasons that this is interesting but not significant. First, a substantial portion of Wal-Mart sales are grocery items, of which very few are imported from China. Second, my guess is that the actual dollar value of imports is approximately matched by the combination of transportation costs, including fuel, and Wal-Mart operating costs. (This company along with a number of other US companies has been very good at finding ways to reduce costs while preserving quality.) Third, we have already seen some production has shifted out of China to lower cost sites, including back to the US, due to increased automation. An important part of the fear of a slowdown in China is that they will no longer buy US dollars and debt, and will begin to be sellers that will lower the world value of the dollar and drive US interest rates higher. One should remember that the largest single owner of US Treasury debt is the US government. In various trust funds, the US government holds about 40% of US debt. Also, the combination of Japan and the UK actually own more of the US debt than the Chinese. Perhaps most importantly, one needs to understand that the Chinese government is not trying to do us a favor by owning our debt, they are solving their own problem. Chinese producers sell their goods all over the world, often being paid in US dollars. To keep the local currency stable and reduce the impact of imported inflation, the Chinese government requires all those that internally hold dollars to turn them into the Chinese banking system in exchange for local currency. With the dollars so corralled, they buy US Government paper. As the trade surplus with the US grew over time, the Chinese became involuntary holders of our paper and very much interested in preserving its purchasing power.
   
   Like most investors and analysts I do not know what is likely to happen to the Chinese economy in the near or far term. I hope to learn more from a trip to Hong Kong, Singapore, and Shanghai beginning the last week of this new month. I would appreciate your suggestions as to investment people I should meet.
   
   
3. “The November decline of Exchange Traded Funds’ Net Issuance”
   Some market pundits have raised an alarm about the decline in the net issuance of Exchange Traded Funds (ETFs). In November, the net dollar issuance was only $5 billion, down from $20 billion in October and $99 billion year-to-date. For some, this was another reason to go for the “Risk on” button. Net issuance is the difference between purchases and redemptions. If one disaggregates the data, the biggest decline comes from a drop of $23 billion in issuance of index ETFs. I do not know with certainty the cause of this decline, however I suspect that various hedge funds and others have regular “short book” purchases, less index funds, to offset some of their short positions. My guess is that once we see the 2011 data from the Investment Company Institute, the December numbers will go back to their former trends.

The Trend is Your Friend, Go with the Flow, and 1987

In the ever-present attempt to simplify investment assertions, the two expressions “The Trend is Your Friend” and “Go with the Flow” get great market currency in a “Risk on/Risk off” market. There is a lot of evidence that these attitudes can work well for traders who can and do reverse their opinions rapidly during the trading day. Now that we know that the S&P500 for all of 2011 produced a zero return on a price basis, and the Dow Jones Industrial Average on the same basis gained about 5% , we can determine how many of these hyperactive traders actually added value to their accounts. In some respect the year 2011 is similar to the flat performance earned in 1987. Both were the third year of a US presidential cycle and both had significant foreign inputs, but with a difference. In 2011, fears of European problems held the US market in check but did not prevent many companies from producing solid earnings. In 1987, the US domestic economy had growing problems, but in this case was bailed out by its growing exports. While finishing flat, both years had sharp market breaks as well as recoveries. One can take the point of view that 1987 was the required preparatory period that would usher in the market boom of the 1990s. With the current market finishing over thirteen years of no forward movement in the averages, we are ready for a longer term explosive upside that we can explain at the current time.

My bottom line

While we need to examine macro factors closely, we also must keep focus on the micro factors and be in a position to benefit early from the next rise.

My best wishes

My wish to all the members of this blog community is that 2012 brings a happy, healthy, and prosperous year; and that we are able to increase the level of our personal and professional communications.
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Storms on Both Sides of the Atlantic

Normally I think about my blog communications to you throughout the preceding week, then I spend Sunday working on my first draft in order to get a completed version before the end of the evening. As I sit here on Saturday night before the impact of Hurricane Irene is forecast to hit us Sunday, I am concerned that some fallen trees might knock us off the electrical grid. Thus, I am pulling together my scraps of paper and other thoughts about 24 hours earlier than normal. The result is a collection of questions and observations on various bits of news and commentary I have reviewed this week.

Europe: What will it be?

There are two concerns which are keeping investors away from the stock market. The first concern is whether the US will tip into recession (more on this in a minute), and the second is Europe. At its core, the issue in terms of Europe is whether Germany will provide the capital to bail out the Mediterranean and Irish governments, and more specifically, their banks and the banks’ counter-parties in the more solvent countries. The European bureaucrats have maneuvered their creation, the European Central Bank (ECB), into buying sovereign debt issues of some of the peripheral countries in the secondary market. On September 7th, a senior German court will rule as to whether this was in violation of the law (and spirit) of the agreement to create the ECB. Logic from afar suggests that it was in violation, and now questions whether Europe as we know it will continue to exist. Any form of disequilibrium created by these events and discussions will have some unpleasant impacts on US securities, particularly commercial banks.

What does 1% (actually 0.99%) mean to the US?

The latest reading on the growth of the US Gross Domestic Product (GDP) for the second quarter, was a gain of 0.99%, generously translated to be 1%. Subsequent quarters were expected to be higher, with the final quarter generating a 3% growth rate. (Many believe a 3% growth rate or better is required to make a meaningful dent in US unemployment and under-employment statistics.) As disheartening as the 1% figure is to the economy, it suggests other concerns to me. While the financial community will gladly do battle over 1% (or as we most likely will refer to it, as 100 basis points) in this period of declining volume and excess capacity, there is a deeper concern on the part of number crunchers like me. What is rarely discussed (but is included in the full breakdown of the national accounts) is a line item called Errors and Omissions. Considering how often there are significant corrections or adjustments to federal government numbers, I wonder whether there was any growth in the US in the second quarter! My concern was heightened when I read the following excerpt from a fellow member of our blog community who is a corporate environmental counsel and a former FDA counsel. He summarized his interactions with the government:

“The overhead of any program and waste consumes a substantial fraction of the funds allocated. They are spent on feeding the 'perpetual bureaucracy' or temporary managers as administrative costs or the money is simply wasted and does not go to any economically productive use.”

Bear in mind that the government is spending roughly one of every five dollars counted in our economic progress.

Are We Creating a Self-Induced Recession?

Much has been written about the “wealth effect” which states that when people believe that their wealth is growing they will spend more. This was one of the excuses for QE2. It didn’t work in a meaningful way. But are we seeing the reverse, when the uncertainties created by the politicians on both sides of the Atlantic are causing investors to stay away from the market? There are always circumstances when investors desire to sell their securities. In the absence of securities buyers, the forced sales will generate lower prices; that in turn makes bystanders feel poorer, and therefore they reduce their spending for various goods and services.

The “Halo Effect”

Jason Zweig, in his weekend column in the WSJ, places halos on Steve Jobs and Warren Buffett, and then does a good job of reporting on the mistakes each has done without diminishing their overall record. Also, the Financial Times Saturday edition, in reporting on Mr. Buffett’s latest purchase of Bank of America preferred stock with warrants, notes a number of quotes whereby he acknowledges less than perfect foresight into financial services companies. (Disclosure: Berkshire Hathaway is a position in my private financial service fund as well as my personal account.) The halo effect is a constant worry to me in selecting mutual funds to invest for my institutional and high net worth clients. We all find it easier to invest with a successful investor than one who is currently not doing well. We gloss over the past mistakes of our heroes and focus on the mistakes of the current laggard. Mr. Buffet reminds us of his fallibility by maintaining his corporate name on a very bad operating investment he made.

As we are moving into particularly troubled financial, economic and political waters, we should be aware of the risks attached to the halo effect.

Am I Premature?

In a recent investment committee meeting with a number of well-known investment professionals, I was asked whether I was premature when I took contrary positions to the perceived knowledge. My respect for the questioner was such that I had to examine my past thinking on investments in order to answer thoughtfully. As often is the case with this individual, he was right. I tend to look at investments as an entrepreneur rather than as a trader. I look for structural imbalances and opportunities. Most of the time I would prefer to be early than late. Even though it was a favorite song of my late daughter's, when I was expressing frustration about change, I couldn’t relax to go along with her view of “Que Sera, Sera,” but she was a calmer person than me.

Reactions to any of these observations?

Note: We will be in London in late September visiting with investors and managers. Are there additional people we should see if appointments can be arranged?
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