Time to be Contrary? - Weekly Blog # 741

 

Mike Lipper’s Monday Morning Musings

 

Time to be Contrary?

 

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

   

 

 

Inconclusive Week

Few US stock market participants considered the news of the week as a reason to significantly change their current investment position.

Bear markets result from market transactions based on investment outlooks, which are sometimes wrong. Recessions are economic downturns. Most often bear markets lead to recessions, but not always.

Nothing very good or bad came to investor’s attention. The news about employment, inflation, interest rates, and politics, slightly encouraged people’s biases but did not lead to any reversal of opinions.

Two things a historian might add are: 

• A growing view that the oncoming recession will be slight and probably quick. (Interest rates from 2 to 30 years are remarkably flat for US Treasuries.) 
• A quick, shallow recession leaves little time and momentum to correct multiple imbalances in our society.

If we are not going to address our problems we should focus on the recovery, which may be shorter than in the immediate past. With that possibility in mind, one might examine some contrary thoughts concerning various portfolios.

 

Understanding Contrarian Thoughts

Contrarians probably recognize that no single school of thinking produces winners all the time. Furthermore, contrarians are not smarter than those more comfortable alongside the perceived majority of “smart” people.

The differences between the two types of thinking are as follows:

1. The majority extrapolate current trends or views, whereas contrarians expect change, even if it goes back to some prior period.
2. When the majority are correct in their predictions the returns are normally relatively small compared to those earned by contrarians. Even with the majority being correct more often than contrarians, over many cycles they will earn less.
3. As neither type of investor totally avoids mistakes, losses need to be considered. When the majority wants to exit it will have lots of company, which can depress exit prices. Since contrarians don’t invest in popular issues, they typically don’t pay extravagant prices. Consequently, their exit prices are usually closer to their entry prices. The majority loses dollars, the contrarian loses time.  

 

Summer Contrarian Thoughts

Current markets appear to rotate more on changes in sentiment than on reported financial and economic results. We won’t officially know for some time whether we are entering a recession, although many feel we are already in one. We clearly have been in a bear market decline from the peaks in January of ’22 or November of ’21.

It is quite possible the recent decline in retail goods sales is the result of growing recession chatter.

This blog is written for long-term investors, not short-term traders. Traders and investors are often on different sides of a trade, with each being right based on their own period and performance standards.

For the moment, regardless of your own point of view, assume we are progressing through a bear market into an economic recession of some length and depth. Nevertheless, we believe that at some point in the future we will be in a rising market and an expanding global economy.

Our task is to select winning investments for a lengthy period or periods. A good place to start our search is the performance periods ended June 30, 2022. As a contrarian one would reverse the performance ranking order of various investments, including mutual funds and individual securities. 

This process creates a search list, not a performance roster. Not all securities reverse their relative performance rankings as they move from one market cycle to the next. The critical research depends on finding new reasons the security in question is appropriate for the change in conditions in the new cycle. A few will.

 

An Analysis of Market Price or Market-Cap Indices can be Helpful

The Dow Jones indices are weighted by market price, whereas the S&P is weighted by the number of shares outstanding multiplied by the stock price. While the publishers make the original name selections, the individual weight of a stock is influenced by the movement of the stock price for the Dow indices, and the price multiplied by shares outstanding for the S&P.

They are both popularity measures and during periods of up or down trends their movement is determined by the unexplained actions of market participants, not direct investment judgement.

We see the same thing at racetracks using the pari-mutual odds system.  Winning horse backers are rewarded based on the ratio of the aggregate amount bet on the winner compared to all other bets, less the “take” of the track and taxes. The horse bet on most is called the favorite. All other entries will make more if they win, sometimes a great deal more than successful bettors on the winning favorite. Historically, favorites win around one-third of the time, thus those who bet only on favorites must lose in aggregate over time.

This is not necessarily true for index investors because markets go up most of the time due to dividends and expectations. However, this is not always true as in the first half of ’22, where the major stock indices were sharply down for the period. The S&P 500 index is made up of eleven component sectors and only energy stocks rose, representing just 2% of the index.

One problem for the S&P 500 index is the way market capitalization works. Of the 11 sectors, 8 performed worse than equal weighted sectors. Thus, in aggregate the weighted judgment in the market was wrong for this time-period, just like most favorites at the track.

I am not suggesting the market is always wrong, but it can be wrong some of the time. My investment suggestion is, if you select an index fund to participate in an up market, a weighted index fund makes sense on average. If you are more risk averse and feel more pain from periodic losses than from a similar gain, an equal weighted index fund is better. An equal weighted index may also be a bit safer if the current market trend has been going up for some time.

 

Is your Income or Spending Influenced Beyond the Border?

Since Adam Smith published “The Wealth of Nations” in 1776, I believe almost everyone has been influenced by different price levels, the availability of products, and opportunities influencing what we spend and earn.

Scott Galloway, a NYU Stern Professor, noted that this is in part due to individuals with foreign backgrounds coming into our country. He said “Almost half of Fortune 500 companies were founded by American immigrants or their children and more than half of unicorns (private companies worth more than $1 billion) are founded by immigrants.

While the data is not transparent, it is reasonable to believe that at least 25% of US reported corporate profits are sourced from our exports or foreign operations. Thus, I believe that for long-term investment portfolios to generate the level of income needed to buy all the items that we import now or in the future, we must invest a portion of the portfolio abroad.

If a sound long-term multi-generational portfolio is to be well balanced and provide income for consumption, it should probably be invested in both growth and value stocks. The latter’s time horizon is probably shorter than growth investments and more likely to be domestically oriented. (Due to legal and tax issues)

A reasonable approach is to look for more international representation in the growth portions of the portfolio. This is buttressed by the better math and science scores at secondary schools overseas.

The value of the dollar has been rising, not because things are getting better here, but because of local economic problems elsewhere. As a contrarian this seems to be an opportunity to buy cheaper foreign currency instruments for a long-term portfolio. Long-term investment opportunities in companies doing business in Asia should be considered due to demographics, discipline, and supportive governments.

 

A Contrarian View on Private Investing Now

One lesson from both the track and investing is that a crowd of new participants signaling excessive enthusiasm can lead to a bubble. A sign of this risk building is highlighted in a recent Wall Street Journal article headlined “Private equity Poaches Talent to Chase Wealthy”. Wonderful returns have been generated from investing in private equity and somewhat less in private debt. My concern is that practically every financial services organization is offering services to the private market. We are already seeing private companies delay going public to get higher prices through constant money raising. At some point prices will reach a peak and collapse. Successful contrarians try to not be late and avoid waiting for bargain prices.

 

Please Share Any Agreements or Disagreements

 

 

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

https://mikelipper.blogspot.com/2022/07/mike-lippers-monday-morning-musings.html

 

https://mikelipper.blogspot.com/2022/06/switching-prime-focus-weekly-blog-739.html

 

https://mikelipper.blogspot.com/2022/06/are-markets-getting-too-far-ahead.html

 

 

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Copyright © 2008 - 2022

 

A. Michael Lipper, CFA

All rights reserved.

 

Contact author for limited redistribution permission.

  

"Blue Wave" Investment Lessons: New Bull Market? - Weekly Blog # 654

 

Mike Lipper’s Monday Morning Musings

"Blue Wave" Investment Lessons: New Bull Market?

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

This is an investment blog, not a political blog. However, there is an uncertain parallel between the two, which happens much less often than the pundits believe. I believe there is a more important link between the two and both move on human actions for unproven reasons. In both cases what we really know are their actions, they do not reveal their deeply held innermost driving motivations at the voting booths or trading venues. Since both arenas produce reams of peripheral data, you can often see similarities thought processes. Thus, it is quite possible that the undisclosed motivations can be teased out, with particular focus on clues to future actions.

“Blue Wave” Investment Observations

Because polling has replaced much of what was previously street reporting, there is a narrowing of sources of information. Various  readily available polls conformed to one another, making it easy to accept them as accurate (the big megaphone advantage). The funders of polls, either the media or the candidates, chose among the cheapest available. (Phone interviews conducted by students or other low paid part timers, filling out preselected forms.)

Individual and institutional investors are bombarded with the views of pundits using their megaphones. Markets, like elections, follow the crowd. (They don’t have the benefit of wagering at the racetrack, where the betting odds are based on the ratio of money bet on a horse compared to the total bet on all horses after deducting local taxes and track fees. They are the original crowd funding mechanism and have very little relationship to the probabilities and possibilities of specific races. The horse with the smallest payoff odds is called the favorite [chosen by the most bets]. History shows that favorites win roughly one-third of the time. Highly favored horses often have payoff odds that are a fraction of what is bet and are called odds-on favorites. They on average win about half the time, but their winning doesn’t fully fund future bets. The odds on the other horses in the race are often called long shots. When they win, they pay off multiples of their original bet.) Successful bettors in politics and at the racetrack always look for long-shot opportunities and never exclude the possibility of a long-shot coming in first.

The belief in a Democrat win was based on the probability that they would raise more money than the Trump forces, which they did. This is similar to believing in Napoleon’s “God is on the side of the bigger battalions” and is like investing in the largest company in an industry. How a size advantage is used is most crucial, a lesson learned by General Bonaparte and some investors. In this case it was relying more on general media than social media for support. We have found that successful institutional investors do their critical analysis internally, with supplemental analysis provided by smaller research shops.

One of the tenants behind the “Blue Wave” projection was the “Great Leader will lead”. Looking at incomplete results, members of both Houses won with bigger percentages of the vote than the top of their ticket, demonstrating once again that all politics is local. The implication being that members already looking to their 2022 and 2024 campaigns don’t owe anything to the top of their ticket. Passage of legislation from the White House is not going to be easy. Democrats in the House Representatives will soon have to select the chairmanship of three house committees. In two cases there are at least three announced candidates, which makes one wonder about the effect of these internal deliberations on the long-term unity of the party.  

As is often the case, the problem with the generation of the “Blue Wave” was the composition of the decision group. Too often, groups try to avoid confrontation and become a cheering squad of sycophants, leading to confirmation bias. Contrarians make most decisions better by challenging the majority point of view. They either reinforce the argument, or force consideration of their contrarian views.

Regardless of the Election: Are We Staring A New Bull Market?

For roughly three months the major US stock market indices have been in a trading range. The market indices of the two next largest economies are also pausing. Both the Nikkei 225 and the Shanghai Shenzhen 300 have risen markedly this year, with the Japanese indicator at a 29-year high, although still about 50% below its all-time high. The internal Chinese market that is opening to foreigners and their own high-saving population, may be waiting for US leadership or looking to act as a hedge against a troubled US domestic market. 

Before we think about the future progress of stock markets, we should think about where we are, and that requires determining the significance of two realities. 

• First, can we treat 2020 as a single event, resting after finishing a ten-year bull market? It ignores both the fastest recession and recovery in history. 
• Second, the valuation gap between so-called “growth” and “value” has widened. In most stock markets the performance gap is approximately 40% and the spread continues to widen. According to the S&P Dow Jones Indices, the five leaders this week were Internet Services +10.18%, E commerce +9.96%, US Large Growth +9.90% and Islamic Tech +9.05%. I am particularly pleased to see the non-US participants, as investing is a global activity and important investment trends tend to jump national borders. As an example of the commonality of thinking in various markets, the following currently have average yields within 64 basis points above 2%: Russell 1000 Value, MSCI World, MSCI World ex USA Small Cap, MSCI EM. 

Assuming the 2020 market and the performance spread are appropriately discounted in current market valuations, I turn to other structural observations:

• Private clients have a lot of cash on the sidelines
• The NASDAQ Composite has been the best performing major index this year, going up most and declining least. I think this will change. Sophisticated traders play a bigger role than at the larger listed market. There are far fewer passive players in the NASDAQ. Active investors read political movements better than those in other markets. I sense they are fundamentally worried and will wait for more clarity on their taxes.
• No market indicator is always right and some are frequently wrong, which in the market analysis world are labeled contrarian indicators. One of the most reliably contrarian is the AAII weekly sample survey outlook for the next six months. After being bearish for a long time they are now more bullish. Subscribers please share your views.

What am I doing?

At my largest custodian the top ten positions represent 50% of the account. Four of the holdings are investment companies and three are relatively narrowly focused mutual funds. I treat Berkshire Hathaway as a smartly diversified trust account for beneficiaries as an investment company. Four stocks are operating companies good at what they do. One is a publicly traded fund management company good at creating newer ways to invest. The final is NASDAQ, which has intelligently broadened its business. For our managed accounts we only invest in mutual funds that can fit the individual needs of each account or portion of an account. 

 

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

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

https://mikelipper.blogspot.com/2020/10/momentum-is-slowing-under-too-many.html

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

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3 Potential Risks - Weekly Blog # 495

Introduction

Contrarians are useful even when they prove to be wrong. In forming an investment committee for a non-profit institution of professional investors, I felt it was incumbent on me to somewhat balance the committee, largely populated by generic optimistic money managers with at least one contrarian that was well skilled in finding good shorts. While it would have been inappropriate for this institution to sell short betting on falling prices, the answering of some bearish views were useful in appropriately constructing our long portfolio which did well. We were better prepared to be long-term investors on the long side for reviewing and appreciating contrarian views.

Current Thinking Process

Stock markets around the world are rising well ahead of current sales and earnings, even adjusted for modest growth projections. The buyers are enjoying what could be called a “melt up.” Economic sentiments are moving higher.

While I do not know how long these trends will last - be it a day or multiple years - I believe it is critical to consider the potential risks that are currently apparent to this long investor and manager.

First Risk: Simplistic Decisions

On October 26th The Wall Street Journal published a multi-page critique entitled “Morningstar Mirage” which purported to show that the firm’s various ratings were not helpful in making decisions as to what mutual funds to buy. The article decried the marketing power of Morningstar’s ratings, not recognizing that at least since the 1930s funds that performed well attracted the most sales if they were known. In the same light there was no real discussion of the questionable mathematical processes used to reach its conclusions.

The biggest risk to investors is not the Morningstar Mirage. The biggest risk is that the financial community believes that investors want simple answers to complex questions. Sales people who can get very limited time with both their prospects and their accounts are trained to use the KISS principle, (Keep It Simple Stupid)” in their communications. It has never been clear to me whether the communicator or the investor was stupid.

Often people spend more time at a sporting event or preparing a special meal then they do making investing decisions which can have significant impact on their lives and those of the beneficiaries. At the game each play, each course or each critical ingredient is thought about deeply. As the readers may be aware I learned the basis of securities analysis at the racetracks, spending hours on each race. I am told that one of the most successful racehorse owners in the last 30 years in the UK spends a great deal of time on the races and the breeding of her horses. We should do no less than Her Majesty.

When Hylton Phillips-Page, my VP of Fund Selection and I analyze a mutual fund we spend a long time getting to understand how the fund, its managers, and supporting organizations impact the past results. A much more difficult task is guessing how we think the past will not be simply extrapolated into the indefinite futures. The term futures is a recognition that there will be interruptions of past trends as conditions change.

The risk of simplistic decisions is much broader than choosing mutual funds.  Not only investment decisions, but all types of other decisions, including political, career, and other personal decisions are put at risk when given only cursory attention. The past is useful as to what happened and more importantly what didn’t.  Most studies of human decision-making involve a number of biological organs. The brain and our senses are very complex and they interact differently when conditions change, and they are always changing.

Second Risk: Credit Withdrawals

In each of the general write-ups of major stock market reversals almost all the attention is devoted to stock prices. In truth almost every major stock market decline was slightly preceded by the withdrawal of credit support. Since we are not out of October, we should first start with October 28, 1929, the biggest single day drop in the Dow Jones Industrial Average up to that point. On that day, the index dropped 12%. Most recounts do not include the fact that the market had been dropping since August and a good bit of the buying was done with borrowed money called margin. The borrowed money came from the major banks who issued it to the brokers, who in turn offered it to their clients on the basis of their portfolios. The banks used call loans to the brokers using their clients’ collateral. As the market declined in the late summer and early fall of 1929, the value of the collateral fell, reducing the safety for the banks that were starting to call their loans. The brokers called their margin accounts to put up more collateral which most didn’t (or were not able to) and were rapidly sold out of their holdings. This is an example of a non-price sensitive insistent seller.

A similar thing happened in 1987 where in one day, October 19, 1987, the DJIA fell 22.6%. European stocks were down about 10%. Portfolio insurance used futures to hedge long institutional positions. Many of the futures contracts were margined against the long positions owned by financial institutions. In Chicago there was no requirement to be able to short on a price uptick as there was in New York. When New York opened there was a wall of sell orders.

A somewhat similar occurrence happened with the collapse of Lehman Brothers when the “repo market” to finance its fixed income inventory was closed to Lehman due to a different set of rules and expectations in London.

Trying to avoid a future similar event, the Dodd Frank Act focused on what banks and others owned, not the risk in their loans. I suspect that most of the inventory owned by the Authorized Participants, (the market-makers for Exchange Traded Funds and similar products) are highly margined. At some point the providers of these loans may get nervous as to their collateral cushion and may want instant repayment which could create a problem.

There may be similar potential problems in both the US Treasury and Foreign Exchange markets where high leverage is available.

Third Risk : Career Risk

If investors are guilty of simplistic investment decisions, professionals live in fear of being fired either by clients or employers, This is a particular risk if someone needs to publicly report performance or work for publicly traded companies. Thus, despite reasonable long-term results, near-term absolute and even more importantly - relative results - drive terminations. This is normally a mistake on the part of the terminator for two reasons. First, most of the time there is a partial or complete recovery. Second, and much more dangerous to the investor is the choice of the replacement, often a manager that has good long-term results which are appropriate for a decline, but poor results in expansions.

Bottom Line

Risk is always with us and it is the highest when least expected. Drive on two-way streets, they are safer.

__________

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A. Michael Lipper, CFA

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Insights from Mutual Funds in 2016 and Their Influences in 2017

Mutual Funds are Important to all Investors

First, funds are an important part of many publicly traded markets around the world. On a global basis they hold more than $44 Trillion dollars today.

Second, funds provide more relevant disclosure than probably any other financial sector.

Third, much of the less well disclosed institutional investments are managed by people who received their early training in the mutual fund business. Large financial institutions often manage mutual funds in addition to their other accounts.

Fourth,  in most countries mutual fund boards include independent directors and in most cases those independent directors represent the majority of the directors. In the US the annual investment contracts must be approved by the independent directors. These directors  have civil liability for their actions (or the lack of action).

Fifth, most mutual funds are managed by privately owned management companies or are part of large multi-product organizations such as banks and insurance companies. However, in a number of global markets there are publicly traded mutual fund management companies. Their disclosures reveal important trends as to the profitability of money management and related information. From time to time we have found these companies to be worthwhile investments.

Sixth, with the world's growing retirement capital deficit, it is important to recognize that mutual funds are a major gatherer of retirement capital. Of the $16 Trillion invested in US mutual funds, $7.5 Trillion were in identified retirement accounts about equally divided between employer-sponsored Defined Contribution Plans and Individual Retirement Accounts (IRAs). Upon exiting from employer plans, investors often place money into IRAs. 

The total US retirement market is $25 Trillion with the Defined Benefit Pension market flat and expected to decline as employers choose to shed the accompanying fixed and growing liability.  There is ample scope for Defined Contribution plans to grow and could lead to an increase in the size of the mutual fund share of the market. The average individual mutual fund is currently held between four and five years, more than twice the holding period for Exchange Traded Funds. Due to the lengthening of people's retirement period it is reasonable to expect that IRAs will remain open for at least twice to possibly four times the non-retirement money in mutual funds.  

Insights from 2016

1.   In the US market there was more money entering the fund business than leaving. From first glance, most of the net gain went into Money Market funds. However this gain occurred during a time when the number of funds declined. Due to changes in regulation most of the decline occurred in the Prime Retail Money Market funds arena. Considering the emotional turmoil caused by the US election and rising interest rates, it is not surprising that money flowed into Money Market funds. While a portion of the money in these funds will never enter the long-term mutual funds arena, some will.

2.   Due to automatic reinvestment of income and capital gains, distribution funds have another source of inflows other than net sales. For the first eleven months of 2016, reinvested dividends of about $42 Billion came in from this source to Long-Term funds which meant for the eleven months the flow into Long-Term funds was positive.  

3.   Appropriately in November there were net redemptions in bond funds for the first time. The redemption rate slowed for equity funds, particularly for World Equity funds.

4.   In the shortened time horizon that many advisors and brokers are using with their accounts, they are relying on the correlation among mutual funds and ETFs.  But these are not currently working. In the performance reports issued by my old firm, Lipper, Inc, now owned by Thomson Reuters, there are twelve investment objective averages of compound performance for the last five years (through December 29^th) between +11.83% and +13.80% . Nine of the thirteen were clustered at the 13% level. A nice tight group. These are funds grouped first by the size of market capitalizations within their portfolios. These include Large, Multi-Cap, Middle-Cap and Small-Cap. They are further sub divided by investment objectives into large, core and growth.

In 2016 the close correlations exploded. The Large-Cap Growth funds averaged a gain of +2.49% and the Large-Cap Value funds gained +14.93%. Hardly a tight correlation. Thus the fund selection criteria became critically important. Market capitalization did not help meaningfully in terms of the Large Cap. Actually if one ranked performance within this subset of 12 investment objectives, Large Caps where most of the money is, came in fourth behind in rising order, Multi Caps, Middle Caps and the winner was Small Caps.

Within the market cap segments, the choice of investment objective was even more meaningful. In each case the Value funds did better than the Core funds which beat out the Growth funds. Thus in the 12 fund categories analyzed, the best was the Small Cap Value funds which averaged +27.25%, compared with the previously mentioned +2.49% Large Cap Growth.

The real lesson in owning the best performing funds in 2016 was selection not correlation.

Looking Forward to 2017

1.   Though we are in a period of annual forecasts, in many respects it should be called the period of extrapolation. Most people including analysts and other pundits  draw on what they call the use of the brains, but their real pattern is elongating some past trends into the future without limit. This is natural and is discussed in a book entitled Seeking Wisdom from Darwin to Munger which was sent to me by Charlie Munger. The book ties in with the work that I have seen from Caltech; that the brain is essentially a memory device of personal experiences. Really bright people are not limited by their own experiences, they seek to learn from others' experiences current and past. That is why I say that if you slice a vein in a good analyst, an historian will bleed. Many of the published forecasts that I have seen as of today either extend the 2016 trends or one from November 9th. In my mind neither group has learned the lessons of 2016 which could be summarized as follows:

• Search for what is not in the data.
• Events can change perceptions.
• Many people are not forthcoming as to their plans.
• There is a need to learn from others with different backgrounds.
• Doubt much you have been taught.

2.   As one who is often described as a contrarian, I need to warn that after accruing the benefits of being a contrarian in 2016, there will be some times when the apparent majority will be right. (For a while and to a limited extent.)

3.   Unless you are primarily trading, looking at new highs is not often productive of big winners. My investment strategist son suggests one should look at the new low list which could be a better hunting ground for research. He is also more focused on industries rather than large segments of the market. For me, I focus on individual management of businesses that Charlie Munger and Warren Buffett would find of interest.

4.   Many Frontier market securities and some Emerging Market stocks have been beaten up pretty hard. In selected cases their prices have much less risk within them than before.

5.   The only two fixed income categories showing double digit gains for 2016 were High Yield funds +13.25% and Emerging Market Hard Currency Debt funds +10.75%. Be careful in 2017, these are taking on equity type risks without enough equity type gains.

6.   One possible way to gauge the level of excess enthusiasm is the cost to hedge against continued growth. It has been pointed out that the cost of hedging the enthusiasm for Small Caps is that the cost to hedge the Russell 2000 is very low. Options to protect against a decline in the iShares Russell 2000 ETF  haven't been this cheap since August 2015. While there could well be technical reasons for this, one should be on guard anytime it is too cheap to hedge.

7.    One of the lessons from the election campaign is that many in the middle class and the working rich feel that the economic future is limited. In the past many of these people would have been mutual fund buyers. It is their absence from the marketplace, not disappointment with results, which has impacted fund sales. To the extent that their post-election elation is real if they come back into the market, the bears on mutual fund management companies will once again be proven wrong.  

__________

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http://mikelipper.blogspot.com/2016/12/will-etfs-factor-investing-lose.html

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All Rights Reserved.
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