Reduce Investment Mistakes with Deeper Observations - Weekly Blog # 583

Mike Lipper’s Monday Morning Musings

Reduce Investment Mistakes with Deeper Observations

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

Loss Reporting and Analysis
One of the most useful exercises from the track is making a report on losing bets. Often in reading these reports it becomes clear that I overlooked or didn’t value an observation highly enough. This type of oversight is common with all investors and analysts. This blog utilizes some observations from our visit to Australia plus some additional insights from pouring over the Barron’s Market Lab data and current news events.

Crowding, Protection or a Bigger Target
Crowding for protection vs. becoming an enriched target for predators? One evening at sundown we watched waves of 13-inch fairy penguins unite and stream ashore, forming columns to enter breeding and birthing locations hidden on land. We have seen similar patterns in Africa, where hordes of zebras and other animals gather. In each case there is a lesson that there is safety in numbers. The predators tend to be solo or are in such small numbers that they can’t eat them all, when the group is found, some will not survive.

As I have often said, the art of investing is somewhat like a narcotic, its effects make it difficult to avoid thinking about investing. When I see a large crowd gather together and move as a group, I can’t help thinking of investors crowding into the limited space of a single investment or sector. The problem is that by gathering together they have created an appealing target for predators, who only need to attack a very limited number of victims to fulfill their needs. Several brokerage firms have been producing lists of crowded trades, which can be very specific and include market segments like US Treasuries of specific maturities or other investments in a crowded trade condition. Year to date through June 27th, 2019, only 4 of the 21 US Diversified Equity Fund investment objective averages gained 20% or more and in the sector funds universe only the two tech categories gained more than 20% (A crowded target for the press and politicians.) To some degree the FAANG* and BAT** stocks represent crowded trades and some of them are showing signs of peaking, which may be temporary.

(*) Facebook, Amazon, Apple, Netflix, Google. (**) Baidu, Alibaba, and Tencent)

Unrest in Southern China
Australia’s largest trading partner is China and thus anything to do with China is of great interest to Australians. With the cooperation of the Chinese authorities, the National Gallery of Victoria has beautifully prepared an extensive exhibit on “The Terracotta Warriors”. These unique sculptures of a large military force meant to protect the self-proclaimed First Emperor of China in his afterlife. As an accomplished horse breeder, he conquered all other tribes and ruled for only 14 years until his death. The Emperor was named Chin and his name became that of the nation he founded by simply adding an “a”. He introduced numerous measurement systems that were used throughout his empire and while he was a genius in many respects, he was also very brutal.

Upon his demise he was replaced by the Han dynasty, which lasted for 400 years. They seized control by leading the first of several revolutions, starting in the south. The first emperor in the new dynasty was much kinder and introduced farming as distinct from nomadic life. Today, the Han people are still among those that dominate China. One cannot help thinking that the present leadership of China must be aware of this history and consequently are concerned about the unrest in the southern part of their country.

What the Stars Tell us About Ourselves
On two separate occasions we went into the desert with a group of tourists to gaze at the stars, constellations and planets. Initially we waited “for the stars to come out”, which was an inaccurate statement of fact, but correct from the viewers standpoint. Later, the intervening clouds disappeared, and the stars became visible. We were informed that other stars would move into our view later that evening, which was again an inaccurate comment. This is exactly what the ancients thought until Copernicus began his scientific study leading to the realization of a round earth, although it’s actually an elliptical shape bulging at the equator. This again was an observational point of view, not the correct recognition that the earth is rotating on its axis. From an analytical perspective, investors and politicians should understand that we live in a relative world where useful measurements include both relative changes and absolute movements.

Conflicting Information on Climate Change
Formerly, investors spoke of “global warming” but now refer to it as climate change. This raises the issue of the regular rotation of climatic change. For example, the Danes farmed in Greenland for 300 years, even though geological studies show that water occupied much of the land mass we know today. As with most scientific studies, we are coming up with conflicting information that should be considered in the data mix.

We were told for example that the southern coast of Australia is receding due to the rising waters from Antarctica. The increase in ice around Antarctica has led to the dumping of cold water into the stream that circulates around the ice mass. This in turn has forced the warm water trapped below the ice to move out and attack the southern coast of Australia. However, on Australia’s north coast the land mass is growing, effectively moving the continent slowly north! I am not properly trained to deal with the conflicting evidence, but I can recognize that conflict exists.

There is no question that countries have not enforced enough barriers to coastal building. That is not new in my home state of New Jersey and is something that has been a legal matter since before the American Revolution. Waterfront property is almost always sought after. How much climate change is a function of human activity remains uncertain, at least in my mind?

Separating Pollution from Climate Change
What is certain is that human activity bears major responsibility for pollution, which can be addressed. Years ago, Pittsburgh was almost always clouded with smog from the burning of coal in steel production. With the cooperation of locals, they were eventually able to bring about brighter skies. Progress, albeit slow, is being made to reduce smog from autos in the Los Angeles Basin. The Chinese people and government have in some cases taken draconian steps to address their pollution problems, while other countries remain further behind.

It would be useful to separate the discussion of pollution reduction and the elimination of climate change, because the facts and history are quite different.

Current Inputs
One of the difficulties in determining useful inputs in periods of controversy is what to believe. The Washington Post did a good job of identifying the gross exaggerations coming out of the two democratic beauty contest evening panels, although they are not an altogether unbiased source. There were similar unrealistic statements on the other side too, which left me wondering if we have discovered a useful indicator: Veracity is inverse to volume? (It has generally worked in stock and manager selection.)

Observations on Tariff Chatter

1. 80% of the Consumer Services stock segments have risen year to date, but just 20% of the materials segment have. This suggests that stock buyers believe the consumer sector can absorb the tariffs, but the demand for materials is looking questionable.
2. The Dow Jones Transportation index is rising at a faster rate than the Industrial average. The stocks in the transportation index largely carry freight, which appear to be rising more than the decline in energy stocks. Transportation shares also attract more professional investors and less individual buyers.
3. The announcement of the restarting the tariff discussions was silent on the real, long-term concerns of the participants. Tariffs were supposed to be a method to get the critical discussion started on defense issues like the South China Sea, critical technology required for global leadership, and enforcement procedures.

Conclusion
Future spending is the reason that people save/invest. My bet is that in the long run carefully chosen equities and equity funds will be productive.


   
Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/06/our-investment-mistake-is-in-labeling.html

https://mikelipper.blogspot.com/2019/06/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2019/06/on-right-learning-from-left-weekly-blog.html



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What does 2015 say about ’16?

Introduction

Does what happened in the markets in 2015 set a trend for 2016? In prior posts I have discussed trends and the general comfort in trend following as well as the advantages in terms of bigger profits or smaller losses while picking up early divergences from a trend. On the last weekend of the year it is difficult to separate the evidence between nothing new and as ordered in “Alice in the Looking Glass,” the lobsters continue their dance. Or can we identify future turning points? Let’s look at the current situation for clues.

Continue the Dance

What will continue in 2016? We will enter the eighth year of the second period of the key US decision maker being a woman. My concern is not that these were both women, but that critical decisions were made by people unelected and/or unconfirmed by the US Senate.  The first was the second Mrs. Woodrow Wilson and now Valerie Jarrett. In the first case, some of our British friends suggest the decisions made through the Woodrow Wilson White House set in motion both the lengthening of WWI and the critical impetus to WWII. Some may be seeing a similar pattern being caused by the current occupant’s last year in office.

The Federal Reserve is one of the worst forecasters in the US. No recession is in its forecasts at least until 2019. Moody’s won't go that far, it believes that the “wide high yield spread doesn’t mean a recession is nigh.” Further, “jobless rate and yield curve have yet to predict” a recession. Stephen Roach’s latest piece in Project Syndicate suggests the reason for this is “the Fed, like other major central banks, has now become a creature of the financial markets rather than a steward of the real economy.”

Wall Street focused pundits are at best predicting a flat to middle single digit gain for stock prices. Numerous pension plans and granting foundations are using portfolio gain rates between 5% and 8% in their planning for the next year. This relative caution could be the cause of business capital expenditures to decline a bit, but at the same time consumer expectations are higher than current readings. As of the last weekend of the year, the Dow Jones Industrial Average without benefit of dividends is down -1.5% and the S&P500 +0.1%. That is not the full story, the Dow Jones Transportation Index is down -16.6% and the NASDAQ 100 is up +9.1%. This dichotomy explains the results of most equity mutual funds with those focusing on growth particularly in global health/biotech providers showing average gains of +9.45%, which is the single best performing investment objective tracked by my old firm Lipper Inc, now a ThomsonReuters company. Whereas portfolios largely focused on manufacturing and transportation showed losses, they were not alone, a value focused portfolio produced flat to slight declines. Many hedge funds both equity and debt-oriented also showed negative results.

Using the handicapping tools I learned at the race track trying to find suitable bets on imperfect horses, I tend to pay less attention to annual moves of 10% positive or negative. Big gains and losses of significance come in packages with at least 20% moves, even if they are a bit abnormal in coming. Thus in my portfolio selection efforts for 2016 for investing in the year as well making choices for Timespan Portfolios with 15+years duration, I am noting but not dwelling on 2015 results.

Negative Inputs

1. Electronic trading, including high frequency trading (HFT) is dominating the trading in US treasuries and now investment grade bonds to such an extent that the short side in US Treasuries is now viewed as a crowded trade. (Crowded trades are ones when the bulk of one side of the market is dominated often by fast traders; e.g., Hedge Funds and Proprietary Trading desks. The risk involved is that these players may follow momentum at any price, thus creating extreme market movements unrelated to price and value.)

2. Globally the US dollar has become too attractive vs. other currencies. Thus, at the end of 2012 the Canadian dollar was trading at parity with the US dollar and now the Loonie, the Canadian dollar is worth about $0.72 cents.

Compared to most other countries the apparent political risks to capital in the US is less. Almost all markets reverse and some will find eventual bargains in other currencies selling some of their US dollars to buy attractive goods and services as well as securities. On a long-term basis I am looking to add to my Canadian holdings of management company stocks. On a very long-term basis I find the Australian superannuation (pension) business attractive and I am hoping to find some euro denominated attractive investments.

3. Moody’s regularly publishes the market interest rates being charged on operating leases. These are very sensitive to credit ratings of the issuer. What caught my eye is that the interest rate range for those in the investment quality group from the highest to the lowest is 2.05%. On the other hand the interest spread between the highest quality “junk” and the most risky credit available in the market was 5.41% with CAA credits having to pay 10.07% which is higher than the average High Yield bond.

One of my concerns about our manipulated low interest rates is that far too many loans are priced to cover the cost of capital and operating expenses and too little for the cost of credit. My worry, despite the Fed’s lack of immediate worry about a recession, is that the size of the credit losses will be larger than historically expected. In the case of the US as distinct from China, the growth of other financial lending (shadow banking) has grown to about 33% of total loans compared with about 4% in China. Therefore the US banks won’t bear all of the costs of distressed credits.

Positive Inputs

1. The lack of any well known pundit screaming about a major upside

move is probably the single most bullish indicator. One should always remember as in golf the purpose of the market is to create humility,

thus the chance to be embarrassed the most is missing the upside.

Various sentiment polls of global portfolio managers are also expecting limited gains in 2016. If they are wrong they will have to play catch-up ball and not only commit reserves quickly but switch out of some under-performing holdings.

2. Retail fund investors both in the US and Europe have been adding to their fixed income fund investments. The combination of rising interest rates and increased credit concerns suggests to me that flows out of bond funds will eventually find a home in equity funds.

3. We like to be ahead of the market and thus now are looking at 2017, the first year of the new US Administration. History shows the first year of a new Administration of either party is often the worst of the four years. Whoever is sitting in the Presidential chair  would be wise to bring on a recession as quickly as possible so it could be blamed on the former occupant. Also with four years to work with, the new President should be able to get the economy expanding and be seen to be creating jobs.

4. I am finding lots of companies in the financial arena that I would like to permanently own at current prices. Combining this with the knowledge that there is a large quantity of talent that is ready to move for the right opportunity suggests to me that there are lots of profitable opportunities ahead.

Bottom Line

Because I have a contrarian streak, I expect a different sort of year in 2016 and if I am wrong, I won’t be hurt much.

Question of the Week: What do you expect in 2016?

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Avoiding Shallow Statistical Judgments; e.g., Last Week

Introduction

Even long-term investors like me need to pay attention to near-term information. Often I have said the critical price risks to investors are their fellow holders. At critical times the first ones to sell get materially better prices than those that follow. Early last week quick sellers did better, but paid the price later.

Trading Speed

In last week’s blog I briefly listed what many consider the 4 most crowded trades. They are: (1) Long US Dollar, (2) Short Commodity Stocks, (3) Short Emerging Market Stocks and (4)  Long US Tech Stocks. These are sizable positions relative to current marketability in large hedge funds and other trading accounts. All of these led the parade of falling prices. While one could argue about the investment merits of these positions, what was clear by being on the most crowded list is that there was limited near-term liquidity in these trades. In order to get out of the way of the falling prices, the players had to accept lower prices quickly. For some time many of us have been pointing to the shrinkage of commercial and investment banks’ capital devoted to market making activities. What we saw early is that the total dollars of the sellers overwhelmed the dollars of the buyers. (When similar markets occurred in the old days when I had a small trading desk reporting to me my instructions were to back away and let the energy of the moment exhaust itself before we entered the market at calmer prices.)  

The intensity of the selling was apparently driven by disappointments caused by statements made by the central banks of Europe and the US. Because the world is so interconnected, in a nanosecond the sellers lined up and started to compete for exit prices and volumes. Some may wish to lay additional blame beyond reduced market making capital on the current era of accelerating speed of information flow. The Economist, like some politicians, comes down squarely on both sides of the issue. It points to in an article entitled “The Creed of Speed” that reports Apple^* customers download an App every millisecond, which demonstrates the growing interconnections and thus reaction times to news. On the other hand it points out that active mutual funds have almost doubled their patience by holding stocks for almost two years, which shows a portion of the active market is taking its time on sell decisions compared with the turnover in the S&P 500 which is under one year.

^*Held personally and/or in the private financial services fund I manage

Before turning to an important cause for the rapid decline and even more rapid recovery on Friday, I will alert you as to possible future extreme intraday and single day price changes. The most popular price index and the one with the longest history is the Dow Jones Industrial Average. I should point out that on the day in 1929 when the DJIA collapsed, it fell by 13%.  Most people focus on this market break and neglect to point out that by December of that year the index rallied to its former levels, just as we saw the rally on Friday when the DJIA made up all the ground lost earlier in the week. What is critical is that in 1929 the average non- index stock did not recover to former peak levels. This lack of full market representation by most indices raises questions as to their utility for sole decision making (more on this later). Having warned you as to the utility of using an index for decision making, I should also warn you about my statistical, not investment view, as to a potentially huge one day move in the DJIA. Because the market structure has changed since 1929 and due to worsened regulation in addition to the abolition of floor specialists and reduced capital devoted to market making, I suggest that a 10 to 15% move measuring from the low to high price on a crisis day is more than possible. While this might make the news and give the pundits a lot to talk about, it may signify far less than it appears at the time.

The Real Cause for Concern

As a card carrying Chartered Financial Analyst (CFA) and someone who learned analysis at the racetrack, I have never had enough numbers. People in the global investment community use numbers to build models  of what has happened and our best guesses of the future. In truth we create statistical abstractions. I would like to have all the money that has been bet on the “best horse or stock in the race.” Not too often do we get our numbers individually wrong, more often we get the weighting of the inputs wrong. Most of the big errors come from not understanding the human equations of the managements in depth as well as the critical group of customers. In addition there is the Mark Twain quote of what will hurt us is what we know is not true. Combine this with the ever present quantity of racing luck covering the unknowable. Thus, to me the sole or main reliance on statistical measures can produce small gains and big losses, particularly losses of opportunities.

As an example I recently heard about a fund group that we think highly of losing an institutional client because the client’s consultant didn’t like that the fund group’s stock selection did not look like the average fund of that type. This is a statistical comparison, not an investment judgment. I could see redeeming the fund if an examination of its portfolio led to the conclusion that the fund managers did not have sufficient skill to pick sound investments. In this case a recent visit with both fund managers and their analysts produced the opposite conclusion.

Trading Speed vs. Sound Investing

This week’s price volatility largely shows the results of making very rapid statistical comparisons. I believe there are a very limited number of skilled artists that can play that game well consistently. For long-term investors looking to see their capital grow in the decades ahead to meet funding requirements from current needs all the way out to those who want to meet perpetual needs, I believe that they should rely on the combination of wisdom and future judgment. Wisdom is the sum total of past experience that can be learned as well as experienced. For example, the brief discussion above about the 1929 DJIA performance is part of the wisdom data bank which should include a great amount of historical inputs and personal learning, including acknowledged mistakes. The purpose of wisdom is to understand the range of what has happened. When I look through my wisdom bank, the main lessons are not from some statistical array, but from what various people through the ages accomplished in spite of identifiable mistakes and hurdles.

As important as wisdom is, investment judgment is more important. Wisdom is in effect our memory drive, where judgment is our investment plans for the future. Authors and historians make up good stories about people. Almost always they make the individual they are portraying to have a singleness of mind, knowing exactly what they want to accomplish and how they are going to do it precisely. I have yet to study such a person in reality. Judgment comes from making decisions while in motion not at the beginning. There is an expression in the US Marine Corps that it taught junior officers: in a combat situation you will never be judged on Plan A, but on Plans B,C, all the way to Plan Z. This is exactly why I divide my clients’ portfolios into sub groups.

As an entrepreneur with limited capital I had to “bet the farm” on a sole product and then on a very limited number of products, however that is not how I now invest  as a fiduciary. I put a portion of my resources in direct confrontation with selective elements of the market. Some resources are held back to add when the front line elements get tired through losses and need time to rejuvenate. Finally I try to develop specific talents that can leap frog over today’s leaders to find new ones. The key to evolving judgment is to know when to regroup. This is very strange for me to say, but I do not use investment performance as my principal decision tool. Primarily I look to whether my people judgments were correct. If I get my people judgments correct in time, stock prices will reflect it.

Proper Traits of Professional Investors

In searching for good portfolio managers and advisors of all types there are some basic characteristics for which I look. The first is the thirst for knowledge; in the modern world something new is happening every day. The next in this lawsuit-prone world is judicial temperament. Does the individual carry on his/her activity in the light of possible challenge? Does the individual know, particularly in the world of many ethical challenges, how to distinguish his or her role as an agent and as a principal? A good person can play both roles carefully. Notice I did not require mastery of various types of securities. Those are mechanical skills which lead to continual usage even when they are no longer the most suitable.

When developing the Lipper Mutual Fund Performance Analysis we said the service was for analysis not for fund selection. The funds were broken down into investment objectives of what they were trying to accomplish not what they contained. The latter was an outgrowth of how Marine Corps officers were instructed to give orders to their senior non-commissioned officers; which was to state the objective and what resources they had to accomplish the mission, not specifically how to get the job done. (This is a very different approach than saying you had to look like the rest.) In my latest endeavor, the TIMESPAN L PORTFOLIOS^®, we assign assets to specific timespans, but the instruments that can be used include mutual funds, commingled funds, separately managed accounts, individual stocks and bonds or some combination.

Question of the week: What are the chances of new index high in 2015? Will a new high be achieved in 2016?

Question of the month:  Do you react to investment tweets?

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

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

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2015

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