Normal or Abnormal Decline Approaching?Weekly Blog # 499

Introduction

Future stock market declines are inevitable unless we modify human behavior. Also, as days follow nights, after the declines there will be future rises. None of these statements are new or profound. The critical questions are, what to do in anticipation and during a decline?

John Vincent messaging through Seeking Alpha, regularly reviews the 13F reports filed by investment management organizations as to their stock holdings. In reviewing a number of independent investment managers with over $1 Billion in their portfolios for the third quarter, I have observed some trends.

First, many managers who have sold recently acquired positions did not report significant profits. Secondly, sales of shares acquired years ago are producing large returns, some on the order of two, three, or four times original cost. Since my investment clients and I are long-term investors, it is the second observation that becomes something of a guide to our management philosophy.

Since few or any managers consistently buy at the bottom (or sell at the top), there will be periods of time that they will likely hold positions at a loss before they eventually sell at a profit. Thus, the critical question is how big a loss is acceptable as a price to earning large profits? A further and more difficult question is, how long does one have to wait to get into a profit condition?

Accurately predicting the future without incorporating a mistake is a fool’s errand. However one can apply both logic and past history as a guide. Stock prices regularly decline for periods of one year or longer, “normally” two to three times over a decade. These corrections may be 10% or more up to so-called “bear markets of 20%+.  Few investors have experienced getting out at or near the top of a “normal” decline and getting back in before prior peaks have been achieved. Thus one is probably better off holding through a cyclical downturn and subsequent recovery.

On the other hand once a generation stock prices decline in the range of 50% or more. We have had bouts of these types of declines in 1973, 1987, and 2007-9. In the last two cases we held through the declines in part because we recognized the potential market risks after the decline had begun. There is a greater risk that the recovery period could be extended. The recovery from the “Great Depression” of the 1930s lasted until the mid 1950s for the average stock and in the case of one of the popular growth stocks, RCA, until the mid 1960s. Thus, there is a real advantage to attempt to sidestep an “abnormal” market decline.

Even if we can determine the odds of a forthcoming decline, particular diligence is required to separate a future “normal” decline when the odds favor holding through the decline and an “abnormal” decline when side stepping would be advantageous. I am considering to attempt the last task. I do this with the hope that my heritage will give me an advantage. The family folklore is that in the late 1920’s my Grandfather persuaded  his clients to pay off their margin loans and go to cash. The family legend is that they did.

Next I am examining the current conditions to separate which of the current trends point to a future “normal” decline and which could be indicating a larger problem. 

Trends that Presage a Decline

No single present trend guarantees a future event and even the aggregate weight of trends do not guarantee a particular result. One of the useful concepts learned at the race track and as an analyst is to assign odds to various factors that could influence the result. Always leave room for “racing luck” or “unknown unknowns” as well as unintended consequences. Nevertheless, reasoned analysis is better than relying exclusively on hope.

Sentiment Overriding Numbers

Utilizing the distinction that S&P* is making between Growth and Value components of the S&P 500, one can see two different stock markets being created. Value stocks are being evaluated on both the basis of their financial statements and the near-term price and volume trends in their business. Using many measures these stocks are being valued within the range of fair value. Their stock price trend is moving up in tandem with an economy that is somewhat errantly expanded. However, the value stocks are moving slowly compared to the growth component.

Led by a little more than a handful of stocks labeled as the FAANG group, Growth stocks are significantly outperforming the aforementioned Value stocks. This is happening globally and particularly in terms of Asian security prices.

One of the reasons that up to the present I felt that the next market decline would be of a “normal” type that we would hold our good stocks through the cycle, is the general lack of enthusiasm for stocks. I have not seen the kinds of enthusiasm I saw in the run up for the Dot Com bubble. Nor did it reach the levels of enthusiasm seen many years earlier in the South Sea Bubble or the Tulip Bulb craze. But the level of enthusiasm for certain stocks and for the market in general is worth watching. Two of the lenses that I look through are the research that Liz Ann Sonders puts out for Charles Schwab & Co.*  and the weekly survey by the American Association of Individual Investors (AAII). This is a very volatile time series. In the latest week only 29.4% of those surveyed are bullish as compared with the prior week when the reading was 45.1%. If, over time, the bullish contingent numbered consistently over 40% and the bearish group is below 30%, I would be nervous short-term, as I view this particular indicator as a contemporaneous measure.

Fixed Income Signals

As has been often pointed out that most of the modern declines in stock prices were preceded by some disruptions in the fixed income markets. We have already seen some price nervousness directed at the High Yield bond  market in spite of no generally expected increase in defaults by the major credit rating agencies. This nervousness has not yet been felt in the intermediate credit market. Barron’s has two bond indices, one labeled Best Grade Bonds which saw its yield rise 5 basis points this last week. The other  measure, for the Intermediate Grade bonds, saw its yield drop by a single basis point. This suggests to me that there is wide scale disenchantment with the credit market this week.

My main worry after the collapse of Lehman Brothers and Bear Stearns is not the price/yield of credit instruments but their availability in a stressed market. Recently I have mentioned that the market for US Treasuries is considered to be the most crowded and is under investigation for price manipulation in the related foreign exchange currency markets. There are some professional press articles raising concerns about liquidity. A liquid market is one where trades can be executed without moving prices. Most high grade markets are extremely liquid almost all the time. The meaning of the last sentence pivots on “almost.” At the final point of their crunch both Bear Stearns and Lehman could not access the repo market to satisfy their desperate need to refinance short-term debt.

I don’t have any independently derived measures of liquidity.  However, I may something of a mirror image of available liquidity looking at major Money Market funds. (Remember when Lehman went down it caused one large Money Market fund to “break the buck” or to be slightly valued below the level of its deposits including interest earnings? They had to suspend redemptions which could have created a “run” on Money Market funds if the government did not step in. Thus, liquidity is very important to Money Market funds.  JP Morgan has four large multi billion dollar funds in the US. These four range in size between $21 Billion and $140 billion. What is perhaps of interest in this matter is that three of the four have between 50% and 64% of their investments maturing in eight days or under. Only their 100% US Treasury Securities Money Market Fund is much more exposed to longer maturities, with only 21% maturing in eight days or less. This difference could be due to a belief that the owners of this fund are less likely to need cash as quickly as the owners of the other funds.

Two of the four funds have more than 50% of their holdings in repurchase agreements, largely with other capital markets providers. (What we do not know is whether JPMorgan is on the other side with the same organizations so their net exposure may well be much less.) The real key to the questions as to the size and nature of short-term liquidity is that it is a matter that is currently being worked on by the major participants - not because they want to for the tiny current interest rates - but because they must to keep the global financial system working.

The Thanksgiving Weekend Visit to the Mall

As many of our long term subscribers to these blogs may know, my wife Ruth and I visit the glitzy Short Hills Mall in New Jersey to frequently do our market/economic research. Due to family commitments, we could not get over to the Mall until Sunday afternoon. The Mall was crowded but not jammed. The high end stores were generally attracting a good crowd, but this was not universally true. While a number of jewelry stores were busy, Tiffany looked sparse as some of the others were almost vacant. Both Verizon and Apple* were doing good to great business, we think. While some couples had a handful of bags, they did not seem to be burdened down. There were a few empty store spaces and ads for sales help were generally lacking. I had the feeling that most merchants were not over-inventoried, as some were in the past. All in all a good but not a great beginning to the shopping season. We don’t yet have a view on the online business and whether shopping habits have shifted.

     

 From an investment viewpoint retail will do okay but won’t be a leader.

*Held personally or in the private financial services fund I manage.

Conclusion

We should be careful with our investing. There are too many moving parts to this puzzle to be dogmatic, but risk levels are probably rising.

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Short & Long Term Gifts to Investors

Introduction

Traditionally in many societies there is a festival to give thanks for the harvest. At this Thanksgiving I find a lot to be thankful about as an investor and portfolio manager. While I personally have a lot to be thankful for, I am going to focus on the gifts that we can share with all investors. As regular readers have learned, I tend to look for investment clues to various future timespans. My comments will be arranged with the most current inputs first extending out to longer timespans.

The Richest Market

At the moment the US has the richest and most profitable market in the world for most goods and services, which means we can benefit not only from what we produce, but also what was produced elsewhere at relatively reasonable competitive prices. Thus, the celebration of "Black Friday," a market shopping holiday, but not an official government holiday, is an important event to be observed, literally. Each year my wife Ruth and I visit The Mall at Short Hills, one of the glitziest malls in the US. For many years we have visited there either on the official Black Friday or the next day if we think we can find a parking place. The following is a brief report on our visit that a number of our long-term readers expect.

We could quickly authenticate the belief that shopping online would seriously eat into the shopping at stores. While considerably more crowded than normal, we were able to find a parking space in six minutes versus under a minute normally. As trained people watchers, we quickly noted that there were more people than shopping bags greeting us in the mall. For the most part shoppers came in pairs or larger groups with one an active shopper and the other either an approver or a payer.  While there were a number of men in the mall the prime shoppers appeared to be women, often in groups that were intergenerational - from pushers of strollers to some using canes along with posses of high school and college age young women. A number of these wore full makeup and were dressed as "fashionistas." The younger women crowded into Aritzia, a shop that my Granddaughter works for as a "style advisor." From an investor’s perspective these purchasers were showing signs of optimism as they are getting ready for a better near-term future. (I don't know whether they have been infected by the Trump Stock Market or this was just youthful exuberance.)  Macy's reported that their website had to shutdown three times during the day due to volume of visits.

We saw no signs of major door breakers of very large discounts, even though we did see signs of 30-50% discounts. With the exception of Apple* cell phones we were not aware of any “must have” products that people, particularly men, must have. The Apple store was extremely crowded but not outside lines. It was well staffed and apparently productive. The Verizon store was less busy but a good crowd. The AT&T store had very few customers in a large store.

^* I own shares in Apple.

From an intermediate term investor standpoint, I am wondering whether we should be looking at cell phones as a product or as an entry point to services revenues? In many ways one uses the device to deal with the service sector. (For those who are interested I would be happy to discuss my view that Apple is eventually a service company.)  There may be a much more important clue here.

In reviewing economic statistics from many developed countries, service revenues and the number of employees are growing faster than those involved with manufacturing. I wonder whether we have entered a post manufacturing world, where manufacturing's function is to produce entry points to services; e.g., cars will be needed for Uber drivers and users not for personal ownership. If this is half right, the political implications are mammoth. The out of work workers and miners may not get their old jobs back regardless of long-term trade deals, unless we enter into large scale military wars. In the absence of manufacturing and mining jobs; infrastructure, education, and healthcare will need qualified labor. This will be difficult but not impossible to achieve. (If domestic labor does not fill these needs, immigrants will.) A lot will depend on the individual, some will see themselves as individually empowered and will create their own opportunities. Others will hope that as a group there will be a solution to their problems and may be disappointed.

Other Thanksgiving Gifts

The next thing most likely will be seen as a threat, but I view as a potential opportunity. We have been indoctrinated to believe China has replaced Japan as the second largest economy. On a purchasing power basis it is actually bigger than the US. In many ways this is a plus. The US is no longer the main growth engine for the world. Even though it is being guarded as a fortress, the potential Chinese market is large and under-served. The challenge for the new US Administration in the long run is not protecting our domestic market but opening up the Chinese domestic market as it grows. This will not be easy as both of us will be facing financial problems over the next four or five years. The odds favor that we will have our own economic recession, which may be independent of a stock market decline. China is a central command and controlled  economy which is becoming more free with the rising power of local government and the private sector. This transition will be halting and difficult. The true strength of our economies will be measured as we go through the coming problems.

Water as a Gift

Over the lives of our children and certainly our grandchildren it is quite possible that quantities of potable water will be more valuable than oil as our world evolves. Unless we change our dietary patterns our growing populations will consume more and more waters through the food we consume. At some point oil for transportation will be less important as we are going to be living closer together and will be using more fuel efficient vehicles. In a geopolitical sense we used to think that we in the US were blessed by having only two land borders, even though we have gone to war with those to our north and south. In the world that is evolving, our actual benefit is that we are abounded by the Atlantic, and Pacific Oceans and the Caribbean. Through the technology developed by a company now part of GE, we have developed the ability to desalinate large quantities of salt water if we can get enough electrical power. I am convinced that both the cost of electricity will decline and the price of water will rise so the North American countries will be well supplied with water.

Question of the week: Can you employ any of these ideas from this Thanksgiving message to your portfolio, life, or political beliefs?

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Thanksgiving and Investment Performance

Introduction

Most cultures have a harvest festival where people give thanks for what they have gathered. I am particularly blessed by the opportunity to communicate with such intelligent people globally through both this blog as well as through my investment responsibilities. One of my investment blessings is uncertainty as to the future. Contrary to many people’s belief, uncertainty is the arena where most investment gains are made; as various elements sort themselves out prices will react appropriately. However once things become crystal clear the vast majority of the price movement has been achieved. Thus I am thankful for levels of uncertainty as I attempt to deal intelligently with expectations.

Expectations

Faithful readers of these posts know that I visit the nearby Mall at Short Hills each Thanksgiving weekend. My report this year is mixed. By far the biggest attraction with long lines of grandparents, parents, and children was an expansive display of products and photos based on Disney’s “Frozen.” I marvel as how successful the “House of Mickey” has been with a product that was in public domain that they didn’t invent, but brilliantly promoted. The other big winner was apparently the iPhone and related merchandise. The large Apple^* store was jammed, but did not have outside lines. A much smaller Verizon store was quite crowded. AT&T’s much too large store had a sprinkling of people within it. While this mall ranges from mid price points to high prices, the high-end stores looked quite empty. My walking conclusion is that it will be a good season for Apple and not so good for high-end shops. I do not have a big feel for the purchases over the Internet. Some retail groups have jumped on to it, Macy’s claims that it is the fifth largest seller on the net.

^*Owned by me personally and/or by the financial services fund I manage

From an economic viewpoint the absence of many “must have” purchases may mean that the savings (not spending) ratio will not retreat from its current 5% level. The use of debit cards is probably not going to soar.

Liquidity concerns

One set of expectations on the part of members of the SEC is the rapid redemptions in bond funds and ETFs when interest rates begin their “inevitable” rise. Quietly they are asking leading fund groups and their independent boards about plans to handle the expected tidal wave. Curious to me they do not appear to be as concerned about equity liquidity which I believe under the present shortage of trading desk capital could react just as quickly. In terms of investment performance in both the debt and equity markets, it has paid off to invest in large, but illiquid positions. We will be watching intently as to how those portfolios that have been more illiquid than others handle any significant squeeze on liquidity. (More on this relating to performance below.)

Longer term economic expectations

Pensions & Investments magazine (P&I) and Aberdeen Research conducted a poll on Macroeconomic expectations over the next ten years by region. The majority of respondents would improve as shown in the following ratios of improvement vs. decline:              

                  

Market Location	Ratio Improve vs. decline
Emerging Markets	47% vs.13%
Frontier Markets	36% vs. 18%
Brazil	33% vs. 17%
China	31% vs. 31%
Japan	16% vs. 11%
non-US dev.	11% vs. 7%
Canada	9% vs. 4%

Other major regions including US, UK, and Europe were expected to have deteriorating macroeconomics over the ten year period. I have little confidence that these projections will work out as expected. However, I believe that they are useful in understanding current price/earnings ratios in these markets.

Performance analysis

One of the elements that I am thankful for this holiday is that we are in deep discussion about managing one particular new account’s money. A vital key to a high level of satisfaction is to agree as to what is important to be measured. I have difficulty determining a worse measure to make decisions as to hiring or firing a manager than raw absolute performance or even relative performance to some securities index. These are not the primary tools we use in selecting funds for a portfolio of funds. As J.P. Morgan himself stated, he only loaned money on the basis of the borrower’s character. Thus we want to understand the managers as individuals.

We also recognize the need to be patient and that is why we look at long-term developments.

There have always been some spectacularly performing managers often with very successful sales people attached that I do not believe. Many times when I dig into their records I find a particular, undisclosed relationship that is the main engine of their success. Some of these engines can keep functioning for a number of years until they are found to be wanting. One of the keys to our analysis is to try to determine where the good and bad performance come from. In some cases all of the extreme performance comes from a limited number of securities. I remember one quite ordinary fund with a skilled portfolio manager salesman touting its good performance. When I looked further into the fund’s performance I noticed that all of the truly great performance was coming from a single analyst. I suspected that he would quickly find better employment elsewhere. When that happened the air was let out of the fund’s good numbers which eventually led to the sale of the management company.

The significance of turnover and fund flows

A rapid turnover producing a good record is not as valuable to me as one whose portfolio is turned over more slowly. The first fund may possess trading skills which are often relatively transitory while the second one may have real selection skills. As even the best investment managers have periods of significant underperformance, we need to understand both the causes of the underperformance and what the manager does about it. The impact of cash flows and how they impact the portfolio has a distinct implication to evaluating the result. Often a surge of money coming in can overwhelm either the position size or the number of holdings. (An important corollary of the surge is what the organization does with its increased profitability. Does it change the life style of the key investment personnel?) Withdrawals or redemptions can reverse some of the behavior changes. However, we are not disturbed by the outflows. I have never seen a portfolio that couldn’t benefit from some pruning.

The question that I am currently grappling with is how to introduce sound judgment into the investment performance question. With the large group of very intelligent investment professionals and sound investors reading these words, I appeal to you for help. Your assistance will give my accounts and me something to be thankful for.

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Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2014

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.