Could the Biggest Risk Be Confirmation Bias? - Weekly Blog # 564

Mike Lipper’s Monday Morning Musings

Could the Biggest Risk Be Confirmation Bias?

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

                                                               


Have we entered a phase that will lead to substantial losses and mixed opportunities? This comes back to my perennial question of why so many bright professional and other investors wind up with substantial losses and missed opportunities. I have posed the question of whether there is some malfunctioning in our investment brains to Caltech professors studying neuro-economics. The best answer I have heard is that judgement is derived by comparing inputs with past memories. Apparently, when we are presented with a new element we compare it to past elements. If it matches closely to what is in our memory, we see it as confirming our views from the past, re-assuring us as to the correctness of that view. This process is labeled confirmation bias.

Earning Recession Confirmation Bias at Work?
Arbor Research & Trading, utilizing data published in The Wall Street Journal from Bloomberg, displayed the frequency of forecasting an “earning recession” by various T.V. business news channels. It showed that the forecast was much more prevalent on CNBC than Bloomberg and was not mentioned materially by Fox Business. One suspects that those who tend to support Democrats largely view their business news through CNBC, with perhaps some clarification from Bloomberg. Others, often with more money to invest, get more of their news and views from Fox Business. Each camp goes to their likely source for conformation of their views.

“Contradictory Data Confound Economists”
This was the headline in a Wall Street Journal (WSJ) weekend edition article. Economists that either work for the government or academia tend to focus on time series captured by long-term government workers. Marketers and investors tend to be more comfortable with data that is accessed through the private sector. In an over simplification, data supplied through government sources is currently showing signs of deceleration in the US economy, whereas commercially produced data continues to see an expansion. Is Confirmation Bias at work?

Stock Market Data Shows Continuing Recovery and Faith in the Future
Every weekend the WSJ compares the last reading of the week with that from a year ago, for the Dow Jones Industrial Average (DJIA), Standard & Poor’s 500 (S&P) and the NASDAQ Composite (NASDAQ). The price recovery for the indices, measured against their all-time highs established in August through October of 2018, continues. The DJIA is only down -3.65%, the S&P 500 down -5.48% and the NASDAQ -8.52%. Looking at these declines from peak levels, one might be surprised to learn that for the latest 12 months and the next 12 months,  the NASDAQ has the highest P/E valuation and the DJIA the lowest, which is the opposite of their performance rank. In a gross simplification, this suggests that the future is perceived as being better for the NASDAQ and its technology/growth-oriented stocks than the industrial and consumer focused DJIA. This opinion is buttressed by the current market performance of diversified equity funds. The S&P 500 has more growth than the DJIA and has a lower industrial weighting.

For the calendar year through last Thursday afternoon, 61% of US diversified equity fund averages gained more than the low-cost, fully invested, S&P 500 Index fund average. Active managers, despite the handicap of higher expenses and the burden of cash, were selecting equities that were more attractively priced than the S&P 500.

The Untold Story About Dividends and their Price Value.
The yields on the three indices are 2.3% for the DJIA, 2.0% for the S&P 500 and 1.09% for the NASDAQ. While the yield numbers are small relative to earnings and market movements, they play a real role in declining markets and may well be one of the reasons the DJIA has declined less than the S&P 500. The key is the growth rate of dividend payments. For example, in our private financial services fund we hold shares in Moody’s. This  week the company raised its dividend by 14% despite announcing cyclically declining earnings. They have a history of raising dividends each year. While the current yield is below 2%, the yield at our cost is over 10%. Even though the stock has risen 8x its original cost, the tax impact is a multiple of the dividend. As it would be one of the last positions sold for the more senior holders, there is a reluctance to sell before other positions are liquidated. It is my impression that tax-paying investors in stocks in both the DJIA and S&P have held some of their holdings longer than many investors in NASDAQ stocks, so they probably turnover their portfolio at a slower rate. Thus, in down markets there is a slight tendency for the more senior holdings to fall less than the newer ones. This in-turn may reduce their daily volatility.

How to Reduce Confirmation Bias?
While there is no perfect person except your special person, mere mortals have weaknesses, including the inability to totally research problems completely. Divide inputs between those that have a good record of success and those that are more wrong than right. Both should be listened to and studied. Recognize that it is exceedingly rare for people and their actions to be correct more than 2/3rds of the time and certainly any record of 75% should be disbelieved. But also pay attention to negative indicators, they may be correct 1/3rd of the time and quite possibly at least 10% of the time. These ratios are point of time oriented, whereas many of our decisions deal with a continuing process, such as dollar cost averaging, building a position in an important investment or deleveraging a portfolio. During such a process one can change the rate of engagement, pause it, or even temporarily reverse direction. The key is to be correct on balance with your money, not just with the number of right vs. wrong decisions. And most importantly, to learn about your own process, particularly when mistakes are made.

Questions of the week: 
What have you learned about your confirmation bias?
What have you learned about investing in 2017-2018? 
 


 Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/02/some-retire-while-others-sense.html

https://mikelipper.blogspot.com/2019/02/should-reputations-have-sell-date.html

https://mikelipper.blogspot.com/2019/01/excessive-security-risks-weekly-blog-561.html




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Four Investment Quandaries for 2013+

·       Debt, a four letter word

·       Killing off the Individual Equities Investor

·       Asset Allocation: Correlations?

·       Learn from today’s investors

Investment analysis is like a narcotic or a very difficulty habit to kick.  At the beginning of the week, I may not have an idea about what I will post the following Sunday night.  Though I am exposed to a myriad of communications, in many ways the most valuable inputs are the conversations I have with investors and investment professionals.  This week I will focus on four suggestive thoughts, or quandaries for 2013.

The worst four letter word

Growing up I was told that it wasn’t nice to use certain four letter words like F*@k or S*#t. What my Mother never told me was the worst four letter word of all; a word that has bedeviled mankind for centuries. That great economist William Shakespeare put the following words into Polonius’s mouth, giving guidance to his son Laertes, “Neither a borrower nor a lender be.” The four letter word is debt.

There are three essential problems with debt. The first is that it must be paid back, often at inconvenient times. The second is the additional payment of interest, which can be either fixed at the time of the loan or flexible, but each is based on the assumption that the rate is high enough to pay the lender to forgo spending and has a sufficient risk premium that is an accurate gauge of the odds on getting repaid in full and on time. The issue here is what appears to be the appropriate lending rate at the beginning of the period may not be the right rate at the end of the period when conditions have changed. The third problem is collateral that in theory guarantees to the lender that he will get his money back in full and on time. Securities can often provide the margin for a loan. Of course, if the securities go down in price the value of the collateral may become less than the size of the loan. Some upstanding people, companies, and nations have been able to borrow based on their good names. J.P. Morgan is reported to have said that he loaned money on the basis of a man’s character. There is a problem with this as fittingly portrayed by Shakespeare again, in “The Merchant of Venice,” in the legally sanctioned, but inhumane attempt to collect on the collateral on a defaulted loan.

The main purpose of debt is time-shifting. The borrowers want an asset that at present they cannot pay for, and the lenders are willing to delay their own spending if they get paid for this indulgence. Unfortunately what has become the custom is that new debt is raised to pay off expiring debt. The question facing both the borrowers and the lenders is what is the optimum level of debt that can be added on top of a given level of assets? This is called debt capacity. It is usually calculated on the basis of assets and/or income that are not encumbered by other debt. What is usually done for nations is to compare their outstanding debt, most often without concern for future debts, to the their Gross Domestic Product or GDP. This number is the estimated annual generation of goods and services within the country. (Two weeks ago, I blogged on the approach of looking to a more complete analysis of both the assets and liabilities for the US.) Nevertheless I will stay with the convention of looking at a nation’s debts as a ratio of its GDP. Europe’s deficit as a unit is now 131% of its GDP. China has a 120% ratio, all of Asia excluding Japan is 104%. (Hong Kong 275%, Singapore 137%, Malaysia 117%, Indonesia 33%) These reported ratios include personal and corporate debt as well as sovereign debt. Thus globally there is too much debt. 
 

In the US, as is often the case, the private segments of the economy are moving differently than the government sector. The private sector is deleveraging its debt structure whereas the federal government is adding to its debt by issuing bonds that are largely being purchased by the Federal Reserve System to neutralize their impact on the level of interest rates. The combination of the private sector deleveraging and the Fed’s increased borrowings leaves the US debt level, according to one source, at 62% of the GDP which is down slightly from prior readings. 

Translating the economic figures into the bond market, the following three facts are of interest:

1.    Some Investment Grade (corporate) debt is yielding less than some sovereign debt. This would indicate that the market believes that corporates are safer than some nations. One possible reason for this is that Europe, with 7% of the global population,  spends 50% of global social spending.

2.    The yield on the S&P 500 is higher than an index of BAA bonds. Again, the market is suggesting that lower investment grade credits are safer than dividends on the S&P 500 stocks. At the same time this represents an unusual opportunity to view large cap stocks as a more productive source of current income than investment grade bonds.

3.    We may not be out of the sub-prime mortgage mess. The Federal Housing Administration (FHA), is by far the largest guarantor of conventional mortgages. Not only does it already in effect own a number of defaulted mortgages, but there is pressure from Congress and the Administration for the FHA to loosen its underwriting standards. Only a significant recovery in house price and possible individual incomes will bail out the taxpayer liability.

“Who killed Cock Robin”

The somewhat shotgun wedding of the New York Stock Exchange and IntercontinentalExchange (ICE) publicly demonstrates the fact that while derivative trading particularly not based on stocks is very profitable for an exchange (and therefore broker/dealers), trading in individual stocks is not. As an analyst and owner of brokerage firm stocks, for some time I have taken the position that listed equity agency business for brokerage firms is not profitable. Try to get a brokerage account opened to buy 100 shares a quarter of General Motors. What you will quickly find in a broker (if one will talk to you at all), he or she will attempt to sell to you some complex structured product or a high fee fund or possibly introduce you to using a margin account (interest bearing and securities loan revenues). This reaction by the peddlers of our business has been successful in discouraging individual investors from buying and holding individual stocks. Thus, the title to this section, “Who killed Cock Robin” is an English nursery rhyme, but the real killer of interest on the part of individual stocks is the regulatory agencies, particularly the US Securities and Exchange Commission (SEC). In 1968 the Commission forced the beginning of the end of fixed-rate brokerage commissions, which were totally replaced in 1975. Prior to those dates there was a vibrant and useful retail research and individual sales business by brokerage firms. Institutions received tons of reasonably high-quality research and other services from “Wall Street.” Continuing this trend of not understanding the impacts of its actions, the SEC permitted multiple locations where a trade could take place which denuded the central marketplace’s liquidity. Carrying this approach further, the substitutions of penny decimals for fractional prices made professional traders withdraw their capital from the marketplace. The way all markets work is that there has to be a perceived profit potential for the professional participants to play. Without the professionals in the game the market will shrink in size and its use as an important economic indicator will be vastly reduced.

I do not mean to be negative on the announced deal, because the holders of my private financial services fund and I benefited. Our holding in NASDAQ OMX rose 3% on the day of the announcement. My guess, the thinking is that NASDAQ itself may be in a merger situation or that the change in control of the NYSE means that it will be a less fierce competitor for new listings and daily trading. While this may benefit my fellow investors and me, it won’t do anything positive for the individual investor and could hurt.

Is asset allocation really about correlation?

At this time of year, institutional investment committees have meetings to decide on the appropriate mix of assets for their portfolio responsibilities. Historically this was a decision made for them in that the initial funds in both the US and UK were balanced funds with a reasonably fixed percentage in bonds and stocks. Balanced Funds and their modernized versions are still an important part of the mutual fund business. The whole excitement about asset allocation was generated by a flawed study of corporate pension funds that showed that funds with a higher percentage in equities did better. For the most part there were only two asset class accounts, bonds and stocks. Later on other classes were added in terms of venture capital, private equity, international securities, commodities, gold, timber and various forms of real estate. Then 2008 came along, with the exception of US Treasury Bonds all the other asset classes declined and often in roughly the same percentage declines.

My approach to this question is first to have an opinion as to how closely the correlations of the asset classes will be over time. Using US mutual fund investment objective averages over ten or more years, most fall within 100-200 basis points in terms of annual returns which suggests to me that on a long term basis it is difficult to pick winning asset classes.

Jason Zwieg’s latest piece in the Wall Street Journal on a young 107 year-young investor and manager, Irving Kahn, takes a different point of view. At his age he is invested approximately 50% in well-researched global small caps and the rest in cash. I have worked with Irving for many years on analyst society activities. He and his late wife Ruth were on an analyst trip with my wife Ruth and me in Italy more than 25 years ago. They both set a blistering pace which was a challenge for us younger types to keep up. Out of all of these experiences, I have developed a real respect for his acumen; besides he is one of the very few people alive that remembers my grandfather’s Wall Street firm. If the committees have Irving’s research skills, I would approve of their allocation if not some other forward looking approach was warranted. We should be watching and listening.

Learn from today’s investors

Most individuals do not have CFA certificates or have logged more than 50 years as an investor, but we can learn from what they are doing as shown in the following examples:

1.    As already indicated, on a personal level they are paying off their debts. If one disregards student loans, consumer debts are declining. Savings as calculated by the government is rising a bit. Individuals are slowly, but I believe surely are going through their own austerity program particularly in terms of being more astute shoppers.

2.    While retirement flows are continuing to benefit from 401(k) and similar salary savings plans, the purchase of mutual funds for individual retirement accounts through directly marketed mutual funds is well off  peak gross sales. This may be in response to investors' own actual or feared employment picture. Possibly they are using what would have gone into their IRAs to reduce their debts or to improve their homes for a future sale.

3.    The most intriguing demographic trend of all is that there is a substantial increase in the number of singles. In many cases these are, according to Gary D. Halbert, white women who have made the decisions at least temporarily to forgo Children and Marriage.

The young appear to be worried about their future and they should be. Our debt burden and less than wise investing will make their lives more difficult. However, after worrying in American fashion, they will find innovative ways to improve their condition. This is one of the major differences between Americans and Europeans.

You can’t agree with everything I have said.  Please discuss your thoughts with me by reply email.

I hope on Tuesday you can relax with family and friends, not worry about these quandaries and that the rest of the week won’t be too eventful.

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Unpopular, Unconventional, Painful and Disruptive

Unpopular, Unconventional, Painful and Disruptive is not the name of the new hot law firm. The title is a summation of some of my "out of the box" thinking flying home from a too-brief visit to an offsite board meeting of the California Institute of Technology and a visit to PIMCO, the world's largest bond manager.

"The New Normal"

One of the reasons bond managers think in terms of secular trends is that at times they invest, rather than trade, bonds with long maturities. While those who buy stocks should be thinking in terms of long to infinite time periods, many of them focus on much shorter periods; e.g., quarters, twelve months, five or ten years - certainly not thirty years. That is why understanding bond managers is important to equity investors.

In meetings held by senior PIMCO investment people with a group of Caltech trustees, PIMCO focused on an expected period of prolonged very low interest rates. They also shared their opinion that the various stimulus moves by leading central banks and governments will not lead to effective de-leveraging. I got the distinct impression that these moves would prolong the valley of low employment and a decline in the developed world's standard of living, while many of the emerging countries enjoy rising standards of living. A further examination for the sluggish response to the various government actions reveals that in the US, 71% of GDP comes from consumer spending with 47% of that total spent on services and only 24% on goods. As services are time perishable, the old pump-priming techniques of the 1930s don't work as well.

Re-thinking

If the present generalized approach is only going to prolong the problems, why not stop banging our heads against the stone wall and let the natural correction forces operate? In other words, let rapid de-leveraging happen through a normal bankruptcy cycle. During bankruptcies, various contracts can be abrogated. I would carry the process further by removing various constraints and restrictions in government policies that are no longer valid. What should come out of a bankruptcy is a new beginning with an enthusiastic attitude. Unfortunately, only 42% of the American public believes that hard work leads to success as indicated in a recent Wall Street Journal article. This attitude must change.

 

The whole idea of re-thinking past dictates of government is accelerating. I recently attended a conference organized by the Museum of American Finance at the New York Stock Exchange. The focus of the conference was how to restore individual investors' confidence in the equity market. For some time I have maintained that the regulatory pressure to lower transaction costs is a significant contributor to the problem. When commissions and spreads were large, retail salespeople sold stocks and provided other investment services to the public. As their remuneration rapidly diminished, salespeople gravitated to higher commission products such as hedge funds and structured securities. The chair of the NYSE recognized that the switch from quoting prices in fractions to decimals, including sub-pennies, has reduced the attractiveness of selling stocks as a business. I find it interesting that there are news accounts that the SEC is considering a test of a return to the use of fractions. If the SEC can see itself reversing some of its past policies, there may be hope that other government bodies can re-examine their past actions to become more pro growth.

One of the most rigid congregations in the world is the scientific community. Scientists regularly make pronouncements of various laws and theories. This weekend my wife Ruth and I listened to leaders that supervised the work at JPL (Jet Propulsion Laboratory, an affiliate of Caltech) of the Mars landing of  "Curiosity." Each manager described some of the various scientific beliefs and budget constraints to carry out the mission. This remarkable success is viewed around the world not just as a success of Caltech/JPL or of the US, but of mankind as part of its conquest of knowledge beyond our earth. I hope this achievement and the continuing reports back from Curiosity will lead to a greater understanding of what we are capable of doing with our collected talents. We can achieve growth by re-thinking our various constraints.

Investment implications

The markets ahead can be painful either on a prolonged basis with current government policies or more painful but of shorter duration if we allow normal "animal instincts" to operate. In terms of investment policies, in most cases I would not want to own government bonds. I believe the risk premium will rise and stocks will do better than bonds in general. In terms of stock selections, I favor disruptive companies that can take advantage of significant structural changes in our various market places.

What disruptive securities do you own?

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