Contrarian Bets and other Risks - Weekly Blog # 597

Mike Lipper’s Monday Morning Musings

Contrarian Bets and other Risks

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

A good bit of the reported sentiment suggests we are entering a significant market decline, followed shortly by a recession. To the extent that these opinions represent the popular view, my training at the New York racetracks suggests a contrarian view. The popular view is driven by a two day, eight-hundred-point decline in the DJIA, or an approximately 3% change compared to a frequent daily movement of about 1%.

There are two statistical measures that are also pointing down. These have often been wrong in terms of the direction of the US stock market for the ensuing six months, as indicated below:

• American Association of Individual Investors (AAII) surveys a sample of its membership each week to determine if they are bullish, neutral, or bearish on the US stock market. Extreme views are those values above 40% or under 20%. This latest week, Bullish sentiment was 21% and Bearish 39%. Three weeks ago, showing how volatile these views can be, the Bulls represented 35% and the Bears 28%.
• The buyers of Put and Call options are very focused on the near-term and when the Puts (bets on stock prices declining) reach historically extreme levels, they become contrarian indicators. Last week the ratio of puts to calls on the S&P 100 Index was 236 to 100. Similarly, the overall ratio of puts to calls was an above normal 73 to 100, normal is 60/100.

Longer-Term Risks
I previously noted that one of the most successful corporate pension funds moved out of equities years ago after they produced a 20% annual gain. They thought the result was unusual because it was between 2 and 3 times their actuarial assumption, suggesting they should withdraw from equities until the following year.

There are hardly any two-year periods with two back-to-back +20% gaining years. As of the end of the first nine months of 2019 there were 14 mutual fund investment objective averages producing +20% or more returns. Of these, the two biggest gainers in the last ten years on an annualized compound growth basis were  Large Cap Growth +13.37% and Multi-Cap Growth +13.21%. I suspect that the average fund in those two categories was loaded with what we used to label FAANG stocks (These averages with the leading performers are clearly doing a lot better than +20%).

Perhaps even more instructive is that the leading investment objective average for the last ten years was Health/Biotech Funds, which rose +15.41% but gained only +6.2% in the first nine months of this year. (For those who are going to be judged by their performance over the next five years it may be prudent to reduce exposure to managers that have produced +20% gains this year, with the understanding that these reserves will be recommitted to equities near the end of the next recession.)

There are other risks beyond staying too long with oversized winners. The biggest one has two names, prediction risk and execution risk. Most future projections are linear in nature and tend to be top-down, starting with aggregate demand or top-line revenues. Sports gives us two examples where this doesn’t work.

While I used to manage the National Football League-NFL Players Association Defined Contribution Plan, I do not claim to be a football analyst. However, I suspect more touchdowns are earned by broken plays than those illustrated on chalk boards in training camps. One of the great heavyweight boxers used to say that plans evaporate the moment your opponent hits you in the face. Far too many analysts and investors take future guidance from a company as a somewhat guaranteed plan. To me, I try to focus on the execution risks of any plan. I try to get some understanding as to what could go wrong and most importantly who will fix it. What I learned in the US Marines was that officers issue the orders of a plan, but enlisted men (particularly the corporals and sergeants) accomplished the missions, regardless of what is on paper. That is why in looking at operating companies I like to have an idea of who the supervisors, directors, and department heads are. With funds, while the portfolio managers are important, the key decisions are in effect often made by the analysts, traders, marketers, salespeople, administrators and occasionally the chief investment officer. These are the people who will execute the reality and are critical in our decision-making process.

One final set of risks bearing down on the current investment process comes with the initials ESG (Environment, Social, and Governance). This is not the appropriate vehicle to discuss the validity of the arguments for and against these tenants. My concern is that beneficiaries will suffer because insufficient attention is paid to prediction and execution risks. Below is a list of past predictions in terms of climate change which have already proven to be wrong:

          Year   Prediction

• 1966 - Oil gone in ten years
• 1970 - Ice age by 2000
• 1976 - Scientific consensus of planet cooling, famines imminent
• 1977 - Department of Energy says oil will peak in the 1990s
• 1988 - Maldives islands will be underwater by 2018
• 1988 - World’s leading climate expert predicts lower Manhattan underwater by 2018
• 1989 - Rising sea levels will obliterate nations if nothing is done by 2000
• 2005 - Fifty million climate refugees by 2020

Source: Calafia Beach Pundit quoting Mark Perry’s blog

While most of us are occasionally wrong in our own predictions, we need to understand the basis for forming the prediction.

The Biggest Risk to Fixed Income Investors
Having just questioned the process of predicting, I call to your attention a presentation made by Theresa Gullo, Assistant Director for Budget Analysis of the Congressional Budget Office to the National Association of State Budget Officers on “The Long-Term Budget Outlook”. The bottom line is that the CBO estimates that there is a two-thirds chance that federal debt will be between 71% and 175% of GDP in 2039. The two biggest culprits are major health care programs and net interest. Of the major developed countries, the only two running a surplus are South Korea and Russia. It seems likely to me that that many governments will increase their efforts to overcome the drawdown from innovation by materially increasing the global rate of inflation. This raises the potential of insufficient funding to satisfy fixed income beneficiary needs. 



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/09/mixed-near-term-after-recession.html

https://mikelipper.blogspot.com/2019/09/capital-cycles-changing-weekly-blog-595.html

https://mikelipper.blogspot.com/2019/09/concentrate-or-diversify-2-questions.html



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A. Michael Lipper, CFA

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Individual Investors Should Worry Professionals

Introduction

When I became a professional securities analyst in the 1960s there was a trend to have two separate research and marketing efforts of brokerage firms. A traditional effort to serve individual investors was joined by a second, and higher paid effort to serve institutional investors. Around the cyclical movements of the stock market, individuals and institutions invested differently and each fed off the other's transactions. Institutions were able to buy what they thought were cheap stocks from supposedly unsophisticated individual owners and sell into them when individuals were not well enough informed. Interesting this dichotomy did not work to the disadvantage of the individual investors as much as it may have seemed. Individual investors were not only net buyers, but for the most part long-term investors that often facilitated the more rapid turnover of the so-called professional investors.

This relationship is no longer the case. Because of the decision of the US government to introduce price competition in brokerage commissions (which led to a price war) the profitability of directly serving the individual long-term investor declined meaningfully. Today try to get a “full service” retail brokerage representative to be interested in opening an account to handle the sporadic purchase of a hundred shares of a NYSE traded securities. If the broker can’t get the customer to open a margin account, buy new issues, trade over-the -counter securities or place decision making judgment in a managed account or a packaged product or possibly an automated relationship with a call center, chances are he/she will not be interested in the relationship with the perspective customer. Only the alternatives just suggested are profitable for the firm and the individual broker. Thus relatively few individuals are directly active in today’s stock market. They are investors through their employers’ defined contribution plans, land stock purchase plans, and or mutual funds/variable annuities or in some cases stock options.

The plain truth on most days, particularly in the summer months, almost all the transactions come through various institutional channels. The market has become largely a game of professionals competing against each other for research and trades. In some respects the market has become more susceptible to sudden volatility within the trading day as the professionals in this interconnected world react to each incremental research element and price change. Thus, a different sort of market analysis is required to avoid being at a competitive disadvantage.

The Players

Exchange-Traded Funds (ETFs), and Exchange Traded Notes (ETNs), while relative small in terms of assets as compared with other institutions,  are selectively quite large in the intra-day markets. While the regulators believed that when they permitted the creation of these vehicles in the US and a number of other markets, that individual investors would benefit from their low cost and trading efficiency, they really created trading vehicles for fast trading professional investors including hedge funds, market makers, managed accounts of investment advisors, central banks (Tokyo), and other institutional players.

In many weeks the aggregate net transactions in ETFs is larger than those of conventional mutual funds, even though their assets are less than half of the assets of mutual funds. While there are thousands of ETF transactions in a given week, the vast majority of transactions are in a couple of products that professionals are using to invest or hedge with or without margin type leverage. According to my old firm, Lipper, Inc., for the week ending Wednesday there was $6.7 Billion in net purchases of equity ETFs; $4.4 Billion went into PowerShares QQQ Trust EFI, invested in the 100 largest NASDAQ stocks, and $1.2 Billion into the iShares Core MSCI EAFE Index fund or about 5.65% of that fund’s total net assets. This left approximately $100 million for net purchases of all other equity ETFs.

A similar pattern was present on the taxable fixed income side which had total net purchases in the week of $1.2 Billion, with $1.1 Billion into two funds, iShares 20+Year Treasury Bond ETF, and iShares Core Total U.S. Bond Market ETF.

All four of these funds could be used to fulfill the short-term trading needs of institutions. To get a feel as to how important the trading is in these products, one should look at the extreme volatility of the major stock and bond indices in the last ten minutes of a trading day as the Authorized Participants (APs) try to even up their trading books. On some days in the last few minutes the stock indices can move close to 1/3 of the daily price moves for the whole day up to 3:30. Sometimes some of the transactions in ETFs are on the short side. In October of 2016 the size of the short interest was at a record level on the SPDR S&P500 ETF. Currently it is at the lowest level in more than a year. Obviously some trading institutions were shorting due to their views on the US Election. They may have viewed this as a hedge against some long positions or it could have not been paired against other holdings.

Mutual Funds are Evolving

There is also something happening in conventional mutual fund transactions. Despite a current period of relatively good fund performance, funds are experiencing net redemptions. A careful analysis will reveal that this is not a signal of disappointment. Most of the redemptions are coming out of the Large Cap Growth and Growth and Income funds that were the major receivers of decades of inflows driven by commissioned sales people. The basic investment pitch to potential owners of funds was to provide retirement capital and to a lesser degree educational funding. On an actuarial basis a good bit of these redemptions are completions fulfilling their intended purposes. In prior decades we would not have seen net redemptions because the normal completions would have been offset by new sales of funds, except selling funds to individuals is far less profitable than it has been in part because the sale freezes the money in place for a number of years due to anti-churning rules and commissions on funds are no longer the highest level available to the salesperson.

There is another important trend that takes mutual fund dollars out of the US marketplace. While domestic funds in the week had net redemptions of $4.6 Billion, non- domestic funds had net sales of $2.6 Billion. This is understandable on two levels. The Financial Times data shows that there are eighteen national stock markets it tracks. Eight had gains of between twenty and twenty-six percent and only one of these (NASDAQ) was in the US. The IMF is forecasting only India and China will have GDP gains of more than 5%.

Chart Readers

All three of the major US stock market indices, Dow Jones Industrial Average, Standard & Poor's 500, and the NASDAQ composite started last week with a price upward gap. Often price gaps get filled before a major move occurs. In addition the NASDAQ composite daily price chart shows a reversal pattern called a “Head & Shoulders” which might be predicting a decline. As part of the market’s function to promote humility, this index is now rising near its former peak. The technical market analysts at Merrill Lynch stated that if the index breaks out on the upside it would be a failed Head & Shoulder pattern that is quite bullish. As usual there is an “on the other side” market research team at Charles Schwab that suggests that we should be prepared for a summer pull back.

Investment Conclusions

One of the reasons I came up with the TIMESPAN Lipper Portfolios® is to address this kind of situation, The second of the two portfolios, the Replenishment Portfolio, has a function of replenishing the Operating Portfolio which is designed to meet payment needs near term, or about  two years. The Replenishment Portfolio expects that over a market cycle it will be called to replenish the operating funds. This assumes that over a cycle (which typically takes four to seven years) there will be at least one down market. With this in mind Replenishment Portfolios should be examining their liquidity positions . This will be easier if they are in open end mutual funds that are not expected to “gate” or temporarily restrict redemptions in cash. In some cases large redemptions will be met with in-kind transfers. In most cases the transferred securities will be relatively easily sold.

The other two portfolios, Endowment and Legacy should not be disturbed. However if there was a serious decline one might want to switch. My data and consulting client, the late and great Sir John Templeton instructed to switch into better bargains when available.

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Picking Winners and Avoiding Losers: Thanksgiving Lessons

A good analyst and a better investor learn from what they are exposed to in their life experiences. We are all interested in picking winners and particularly in avoiding losers. In the US on Thursday, we celebrated Thanksgiving. This official holiday is similar to other harvest holidays celebrated in many countries that have developed from an agrarian base. Within the US, the holiday is an occasion to watch traditional American football games, either in person, on a television or on a computer screen. Immediately after the holiday is the somewhat official beginning of Christmas and Chanukah shopping season both in stores and Online.

As family and friends gather, often there are opportunities to acknowledge what we are grateful for; forgiving those that have disappointed us, but not forgetting the lessons learned.

Weather impacts

In New Jersey and some parts of New York and other states, one of the things that we are thankful for is that we have begun recovering from the recent visit of the super storm Sandy. Some of us were just inconvenienced by the loss of power for a period of days into weeks. Others have lost their homes in part or in total to the combinations of the hurricane followed by a “nor’easter” snowstorm, and in some cases resultant fires. The physical, emotional and financial damage is starting to be more fully understood. Whatever the immediate size of the financial loss, by current estimate the money spent on rebuilding, and in many cases new construction, will be larger than the financial losses sustained. These expenditures on housing, infrastructure and shoreline development will occur over a couple of years, as much concerted planning is needed to avoid some of the ravages of future storms. My guess is that the infrastructure and the rebuilding spending will initially focus on an attempt to restore what was in the impacted area first. There is likely a second phase that may occur as people start to take a long-term view. Much of New York, Boston, Hong Kong, Singapore and elsewhere are built on reclaimed land from nearby oceans and rivers. There are people who believe that within the next 100-300 years these lands will be subject to waters rising five feet, which would flood LaGuardia Airport in Queens and Logan Airport in Boston for example. If these fears are acted upon, the indirect costs of Sandy will be huge.

The national media has heavily focused on the impact of Sandy and has largely ignored the weather event that will probably create a larger loss, the devastating drought that is affecting all or parts of 17 Midwest and Western states. The drought is expected to intensify through the winter. While the US is probably the most productive country in the world, there is some possibility that we will have food shortages and suffer some inflationary pressure, particularly intense on the less well-off. A related issue to the food shortage potential is the actual substantial curtailment of barge traffic along the Mississippi River. Due to government water conservation policy, the Missouri River, which is fed in part by dams, and in turn feeds the Mississippi, has not be receiving its full bountiful supply of water since last week. The barges with their deep bottoms that won’t be able to go downriver carry some $7 billion worth of commodities, coal and other products, much of which feeds US export markets. 

Two weekend analytical observations

As long time readers of my posts know, I usually comment upon my visits to a nearby high-end shopping mall during the Thanksgiving weekend. This time I visited the shopping center twice; once on so-called Black Friday and again on Sunday. In contrast to years ago, I was able to find parking spaces. On Sunday I parked where we normally park during the week, not a good sign for retail sales. One of the reasons that parking was relatively easy was that there were fewer cars with New York license plates. In the past, the difference between New York and New Jersey sales taxes drove New Yorkers to shop for more expensive items into New Jersey. (A new very large mall has recently opened that is much closer to New York City which could have attracted the tax conscious shopper.)  Walking in the mall was relatively easy with very few crowded locations; the Apple store being one. Judging by what people were carrying, there were more lookers than shoppers. Some high-end stores changed their merchandise mix toward lower price point merchandise, one being Tiffany. This tactic did not seem to attract many of the well-dressed shoppers that had taken great pains to look attractive. The price and tax conscious high-end shoppers were not enthused by what they were being offered. The two walking tours however, don’t tell us how much shopping is being done Online. I will watch whether the regular FedEx and UPS truck deliveries on our block are delayed from their normal delivery times and if they seem to be heavily laden. At this point, if I had to make a judgment, I'd say that this won’t be a great season for high-end retail shops.

The second observation is that there is much to learn from watching National Football League* games on Thanksgiving Day. I have long stated that my two great learning experiences were my active duty service in the US Marine Corps and my hours at various New York race tracks, trying to wager successfully and avoid too many losses. The study of past performance and other factors which I followed were called handicapping, which focused on how changing conditions would affect the results of future races. One of the techniques that I used in reviewing past performance was to look for consistent, hopefully improving, patterns. Many times these encouraging patterns were interrupted by inconsistent behavior. If there were only one or very few inconsistent results, I followed the approach of excluding the inconsistent results and believing that if the conditions were similar to the races where the results were consistent, to believe that the next race the horse was more likely than not to return to its trend of consistent results. Long before the leading Football teams acknowledged that they had hired statisticians as revealed in an article by Judy Battista in Sunday’s New York Times, I was applying this technique while enjoying watching various professional football games. On Thanksgiving Thursday, there were two games where this kind of analysis was useful. In the first game, a grudge match between the New York Jets and the New England Patriots, the final score of 49 (New England) to 19 (Jets) was misleading in terms of a comparison of the potential value of the teams in securing future victories. As is often the case, God is in the details. In the first quarter neither team scored. In the second half, the Jets scored 19 points vs. 14 for New England. However, in the second quarter through a series of interceptions and fumbles, New England scored 35 points, including three touchdowns in about one minute! From my handicapping viewpoint, what happened to the Jets is the equivalent of a jockey dropping his whip or a saddle slipping badly, which led me to exclude the second quarter as indicative of future performance. Applying this approach to selecting funds (and to some degree individual securities), I would be more interested at the right price (odds) backing the Jets than the Patriots. When I apply this to funds, I am willing to throw out the results of 2008, particularly if by early 2010 the fund had recovered from its 2008 loss. Thus one might say that I can be forgiving.

The second game put the Texans from Houston against the Detroit Lions. Detroit traditionally has a game on Thanksgiving Day, for in a much earlier time it could not get a local field to play on for a normal weekend game after the holiday; so a tradition began with the Lions playing this game on Thanksgiving. The Lions traditionally have a poor Win-Loss record. This year’s game was against the Texans who had the best record for the season in professional football of 9 wins and 1 loss. Remarkably at the end of regulation period, the two teams were tied at 31 points apiece and so they had to play in an overtime period. At our Thanksgiving dinner there were relatives from Michigan. The Lady of the House, who had suffered through many football games in Michigan, assured us who were watching the game that the Lions would find some way to lose, which they did. She was not forgetting the team’s past problems. In similar fashion, a fund or manager that consistently disappoints is not likely to rise up for a sustained period.

* I have the honor and privilege to work on the National Football League/Players Association defined contribution plans.

Applications for the care and feeding of investment managers

As we are all humans, we should learn to forgive them, as this is good for own mental health.  Even the “programmers” that control the inputs to quantitative funds are human, and therefore one should allow for some mistakes. The key is the duration and explanation for the shortfalls from our expectations. However, I firmly believe that performance results are not the key to future results but rather a starting point to raise our understanding as to the past, current and future conditions when a manager can produce consistent results for a while.    

Now it is your turn to share:

What are you thankful for?

For what are you willing to forgive investment professionals?

What should we forget?

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