Premature Warnings + Opportunities - Weekly Blog # 655

 

Mike Lipper’s Monday Morning Musings

Premature Warnings + Opportunities

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

The Rational

If we live long enough, almost all of life’s activities are cyclical, alternating from favorable to unfavorable. The name of the game is to be able to participate in the favorable. While many pundits believe they can fully participate by using an on/off switch, I am not that bright or arrogant. Not because of immodesty, but by studying many forecasters over the years. Some have reasonably good records, being up as much as 75% of the time. However, if one uses a three-step model (In >Out>In), very few come out with only modest changes from beginning to end, particularly if they are taxable investors. This is is not a completely buy and hold strategy, but one with minor modifications. This approach seems to be how great fortunes continue to grow. Perhaps the main benefit of this approach is being in position at the beginning of an upcycle, that most won’t perceive until the early and easy money has already been made.

What May Be Ahead?

Naturally, after large gains been achieved I look to when the giveback period is likely to begin. Economic and stock market cycles are not identical, but they tend to “rhyme”.  If stock prices do their job correctly, they should anticipate the economic cycle. This often happens, but not always.

Several contrarian indicators showed up shortly after election night. (Contrarian indicators normally have a better record of predicting subsequent market trends than nicer cheerleading indicators.) What follows is a list I use that suggests a future market decline:

• The US stock market has been in a narrow trading range since the highpoint reached on September 2nd. The three main market indices are all now resting after their recoveries since March 23rd: 58.56% for the Dow Jones Industrial Average (DJIA), 60.24% for the Standard & Poor’s 500, and 72.42% for the NASDAQ Composite. During the resting period the indices gave very little back: the DJIA -0.24%, the S&P 500 0.00% and the NASDAQ -1.88%. However, in the recent week ended Thursday night, the DJIA and S&P 500 gained +2.43% and +0.76% respectively, while the NASDAQ lost -1.53%. To me, the trading acumen of those who dominate each of the indices is sending a cautionary signal:
• The public pays more attention to the DJIA
• Institutions and particularly ETFs pay more attention to the S&P (more than half of the net $26 billion that went into equity ETFs this week went into the SPDR 500)
• More sophisticated traders are prominent in the NASDAQ. I suspect this group is particularly concerned about control of the Senate, which won’t be known until after January 5th, probably after the beginning of any new tax legislation’s effective date. (In some respect the NASDAQ is the smart money crowd)
• Market leadership is shifting more toward so-called “value” and away from “growth”. Last week, value focused mutual funds rose +3.58%, while growth funds rose +0.54%. While it is comforting the performance gap is finally being addressed, the relative value of dividends and capital gains need a lot of work. Also, payout ratios may need to be addressed if tax rates go up. 
• The change in leadership can be seen in the 104 equity fund investment objectives. For the week, 59 produced returns higher than the average S&P 500 index fund, confirming that ETF players tend to be followers of popular news, not investment fundamentals which are another worrisome indicator.
• I have often commented on the sample survey of the members of the American Association of Individual Investors (AAII), a contrarian indicator published each week. The three outlook choices for the next six months include: bullish, bearish, and neutral. A normal distribution is between 30% and 40% and this week bullish registered at 55.6%, among the highest on record. Bearish registered at 24.9% and neutral at 19.7%. The latter shows a greater level of confusion as to direction and is probably in record territory.

Economic Cycle Showing Pluses

The positive indicators are as follows:

• Copper has often been called Dr. Copper because copper tends to capture a great deal of industrial demand. Currently, the price of copper is at a 2½ year high, largely due to the recovery in China, which consumes half of the world’s production of the red metal. Aluminum and nickel are also strong again, due to a rise in Chinese and other Asian steel production.
• China is not only the current leader in industrial production, it is also showing some significant technological advances. This week, Chinese officials announced the deployment of numerous 6G satellites in space. (I don’t know what this means to the growing number of tower deals !!)
• Despite the pronouncements of price stability from the Central Banks, the industrial goods price index is up +10.56% over last year. A longer duration indicator is the dollar denominations one can get from many ATMs, now $20 and $50. Banks are making the judgement as to what their customers need most for their transactions, leaving merchants to provide smaller bills.

What Should the US Government Be Doing?

Because of the number of people involved with the Obama presidency mentioned for senior positions, some columnists are referring to the incoming administration as the Obama third term. They produced lackluster economic and social results, but have ambitions to do better this time, especially by creating meaningful social change.

In terms of impact, one change they should study is the curtailing of people’s behavior from 1920 to 1933 during Prohibition. It was meant to address crime, corruption, and taxes for prisons and poorhouses (charities), hoping to solve social problems caused by alcohol consumption. By the end of the period, not only did half the population want to imbibe alcohol, but each of the target ills were larger than at the beginning. While Prohibition was probably not a major contributor to the Depression, it’s carryover costs may have lengthened the recovery from the bottom to its top in 1937.The more socialist type moves that followed did not return the stagnant economy to growth until after WWII began. Constraining the economy with taxes and regulations when the US is losing share of global markets may not be wise.

Investment Strategy Implications

1. The first job for long-term investors is to be in a position to benefit from long-term technological improvements and a more productive population. 
2. The second is to avoid panicking in the coming decline. (Timing is uncertain, but the decline is not.) 
3. In preparation for the decline examine current investments, separating those likely to hit historic highs within the remainder of this cycle from those perceived to have higher highs in future cycles. 
4. Have a trading attitude for the first group on the way up and exit quickly on the way down. Look to add to the second group optimistically when short-term problems depress their prices.

Question: 

Whether or not you agree with the analysis, organize your thinking and see what it might suggest for your portfolio?

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

https://mikelipper.blogspot.com/2020/11/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/11/bigger-risks-than-election-weekly-blog.html

https://mikelipper.blogspot.com/2020/10/managing-mistakes-weekly-blog-652.html

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Investment Stimuli: Short-Term, Intermediate-Term and Long-Term

Introduction

Almost every moment we are exposed to various stimuli. Often we are not aware of being exposed to factors that are going to impact us at some point in our lives. One of the reasons that I conceived the Timespan L Portfolios^® is to be able to focus on the known factors that will impact investment success. As we live in a nanosecond world of instant global communication and too many instant communication devices, we are besieged by the very current items, and longer term implications are drowned out. As a defense against this condition I have attempted to assign inputs into different time buckets. While the assignments are undoubtedly imperfect, the pigeon holing helps to clear the plate to give more time to each of our client’s needs that we will attempt to fund through wise investments.

Short-Term Inputs

As an investor I try to read into the current markets for insights to the immediate future. I have found that too few investors examine the changing market structure for clues. These are some of the elements that I am seeing:

• Most people last Friday  afternoon were mesmerized by the announcement that the FBI found additional emails that conceivably will have an impact on the US Presidential election. While that is in the immediate future, to me there was a major signal to all investors. Within a period of about one hour the Dow Jones Industrial Average, the stodgiest of stock indices fell 160 points, approaching 1%. By the end of trading most of the decline was recovered. The key to me is how "thin" the market is. My apprehension is that if we have a serious negative input the rapidity of the fall could be greater. Having just come from an investment committee meeting that was in the process of changing allocations to reduce risk to the orderly payment of needs, I am very conscious that on any particular day or hour when stocks are to be sold to generate a particular sum of money, execution prices may be temporarily lower. If one uses the VIX ratio the current market is trading significantly below its historic average and way below its peak, Thus I believe we need to be prepared for substantially more intraday and daily volatility.

• High quality bond prices have been weak globally. Some point to China as the source of the instability. Spot commodity prices in Shanghai for non precious metals have been moving sharply higher recently, aluminum and zinc in particular. I suspect that the increase in demand is not an increase in likely Chinese industrial production, but a reaction to a government edict. In order to reduce a surge in heavy truck accidents, the government has lowered the size of cargo that can be carried. A further concern longer term is the fact that factory gate prices recently rose for the first time since 2012. Thus, China is no longer exporting deflation. (More on China in the intermediate input section.)

• Often mutual fund net flows can be a reaction to changing conditions. For the last four weeks it has been reported by Lipper, Inc., that there has been positive flows into financial funds. (I am the portfolio manager for a private financial services fund.)

• Once again the so-called experts have been proven to be wrong on the impact of Brexit on the UK economy. A survey of expected UK retail sales predicted a 2% decline. The latest results showed a gain of +21%. Particularly now around important elections, I question the accuracy of various predictions and pools.

Intermediate Inputs

Steve Roach, now teaching at Yale, points out China is directly or indirectly through other nations, producing just about all of the world's growth in GDP. At the moment  China is in the midst of a transition from a heavy industrial exporter to a more consumption  product and services user. While there are lots of opportunities for "hard landings" on the switch, they haven't happened yet.

In reviewing the third calendar quarter reports for brokerage firms, asset managers, and banks there seems to be a trend to reduce some of the high priced customer-facing people and building up the "tech gang." Unless revenues rise dramatically there is a good chance that some of the more expensive tech people will follow some of the investment bankers out the door. Part of the digitalization of the financial community is the awaking interest in Bitcoin, which in theory can reduce back office personnel.

One of the conundrums in dealing with the growing deficit of retirement capital globally is the individual savings rate. The FT points out that in the aggregate, the savings years are on average between 25 and 65. The periods before and after the savings years are the consuming years. While most of the developed world is experiencing little or no workforce growth, the average lifespan is growing and there is an increase in healthcare spending as we get older. Many believe that the "new normal" will include low productivity and increase costs. (I believe that there is a chance that through technology we will partly address these concerns.) However, people are worried. In a recent survey people were asked what was their single biggest worry. Of the respondents,  61% indicated that they were most worried about "Corruption of Government Officials." My guess is that people are particularly concerned about their healthcare expenditures in their retirement. I am not suggesting that the level of corruption is any worse than in other parts of our society. Just that people feel increasingly vulnerable at the end of their lives to regulation that deprives them of deemed care.    

Long Term Inputs

Often I find that a concept or thought pattern from one area in my life can have  application to other portions. For example, I have just returned from a three day offsite annual meeting of the Caltech board of Trustees. As you might expect, much of the discussion was on what the senior management of Caltech thought about what they should be doing about their future. Below are some of their topics which I have translated into our investment world:

Concentrated Excellence - Assemble only the best investments and talent, others won't do. Don't accept average.

Fearlessness & Reinvention - Don't be afraid of challenging conventional thinking and imaginatively reworking old problems. (The final proving the correctness of Einstein's 100 year old theory took 50 years of study that started with disbelief in the ability to prove it.)

Intersection of Disciplines - combine knowledge and instincts of fundamentals, price/volume studies, trading inputs and techniques with international market patterns.

Pick important hard problems - Seek large volume solutions

Heisenberg Uncertainty Principle - The mere focus on a problem changes the nature and extent of the challenge.

Committing to a funded Space Based Solar Power Initiative which will beam back to earth solar power from space could in time be a major input to our needs for energy

In summary wise investors in securities and investment organizations should strive to lead and not follow through concentrated "smarts."

Question for all of us: How do we apply these and other inputs to our portfolios and investment work?   

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