Selectivity over Factors - Weekly Blog # 551

Mike Lipper’s Monday Morning Musings

Selectivity over Factors

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

We are entering a new phase where successful investing will be different than successful litigation and gatekeeper buying. The classic way to judge the strength of a civil law case is to follow past precedents. The same reliance on history carries the day with most institutional gate keepers and investment advisers. Their standard phrase is “Past Performance does Not Guaranty Future Results”. Nevertheless, soon after delivering this dictum they mouth such and such factor or manager has the following good record compared to other records, except when things change.

I believe that underneath the volatility we have seen in 2018 we are seeing greater dispersion in the returns of factors and mutual fund classifications. This ranges from pseudo mathematical certainty to the art form of selectivity. Increasingly the differences in performance are more important than the similarities. Another way to look at it is that instead of looking at any giving picture two dimensionally, we search for a third or perhaps other dimensions. This leads to different views being developed by different observers. The more successful observers will be much more valued than those who are just model makers until the next changes in the investment picture.

POSIBLY BIGGEST CHANGE IN 100 YEARS
Practically all of those who have been schooled in Liberal Arts courses believe that it is the government’s function to stimulate the economy out of a recession. From this requirement it follows that it is the government’s responsibility to control the economy. Modern governments, whether elected or command controlled, translate that into job creation. Increasingly, leaders are becoming frustrated with their inability to get their economies (people) to comply with their desires. Part of their problem is that their favorite handmaiden, the central bank, has not been as effective as desired. The institution that studies the central banks with the most detail is perhaps The Bank for International Settlements (BIS). The head of the BIS’s Economics-Research Department is quoted as saying “politicians have come to rely on central banks to stimulate growth since the (financial) crisis.” Yet, with very rare exception, constituent economies have produced below normal historic results. Central banks/governments have kept short-term interest rates below the levels needed to cover  non-paying loans, whose interest rates are too low. A still greater penalty has been levied on economies by the misallocation of resources during recessions. Far too many people continued to be employed by failing organizations kept alive during the recession, instead of transferring that human capital to sustainable activities. In the face of these challenges some governments have reduced administrative burdens and tax levels, but this will probably only have a modest impact. The more people and businesses recognize that central powers are attempting to manipulate them, the lower their confidence in their own ability to build their own futures.

As is often the case, I am fulfilling the function of the prudent analyst gazing at the various futures ahead. Clearly I am ahead of the current thinking of those in power and most of their opposition. Nevertheless, I am beginning to ponder the impact of an appropriate investment strategy in response to the relative ineffectiveness of the top/down thinking of the central powers. The following topics should be explored by those charged with the responsibility to make payments to multi-generational beneficiaries:

1. Will the coming recession be largely caused by cyclical or structural causes? If largely cyclical, we have been there before. We know how to play that game, which is mostly based on sell/hold/buy decisions in the same securities. If structural problems are the main cause of the recession, the decision process centers around which areas and instruments should be employed and which should be abandoned.
2. What is the probable length of the recession? Typically, a cyclical recession is quicker because prices can adapt quickly. A structural recession involves the transfer of productive resources from one sector and location to another. This raises the question as to how quickly critical employees can be found and trained, not only in manufacturing but also in sales and service roles.
3. What will be the new measure of success in the post-recession recovery period?
4. How much of our economic and personal lives will be disrupted by technology applications? There are some that have concerns about the world of Big Data and its impact on individuals. Due to internal security concerns China will be the leader in that world, even more so than Saudi Arabia was in a world run on oil.
5. In a recession, particularly one caused by structural factors, corporate and personal defaults will likely be higher for credit instruments than for underwritten bonds. However, with the shrinkage of the number of brokerage firms and commercial banks, who will do the underwriting? It may be easier to distribute credit instruments directly to pockets of wealth rather than through a syndicated underwriting of bonds. (In the latest week, focusing only on financial organizations, two  yields tightened and six widened.)

SHORT-TERM POSITIVE
As mentioned in past blogs, market analysts believe that significant price moves are unlikely if there are price gaps between trades, particularly when comparing price ranges day to day. Gaps in price charts need to be filled before a sustained move is likely. Of the three main stock market indices, two had price gaps filled by declining prices this week. There are only six weeks left in this calendar year to avoid breaking a fifty-year rule, that bonds and the S&P 500 do not decline in the same year. Bonds are off this year. The only fixed income funds positive on the taxable side are Ultra Short Obligations, Short Investment Grade Bonds, High Yields, Short US Governments and Money Market Funds. With only the US Diversified Equity Funds macro group being positive, the only way to avoid breaking the fifty-year rule is for there to be a pretty broad stock price increase in the next six weeks. Because no one expects it, there is a chance that we could even reach record levels by year-end.

A MAJOR WORRY FOR GRANDCHILDREN
In the weekend edition of the Financial Times there is a three-page article about the opening-up of some of the secrecy surrounding the long-term outlook for the US military. What becomes very clear in the article is that the current administration is worried about the growing technological skill of the Chinese. It is quite conceivable that at some point in the future the Chinese military establishment could surpass the US capability to an extent that could be extremely upsetting to the US. (I firmly believe that this is a more important concern for this administration than the loss of manufacturing jobs in the US.)


Question of the week: 
What actions are you contemplating based on the changes you foresee?


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

https://mikelipper.blogspot.com/2018/11/history-guide-not-map-or-trap-weekly.html

https://mikelipper.blogspot.com/2018/11/things-are-seldom-what-they-seem-weekly.html

https://mikelipper.blogspot.com/2018/10/we-are-in-training-exercise-weekly-blog.html


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A. Michael Lipper, CFA

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Next Rise Needed for Peak

Introduction

Last week's post hinted that this week I would discuss where are we on the track to a major peak, an issue that I have been concerned about for some time. History suggests that those who use a crystal ball to predict the future are often forced to eat crushed glass. I certainly doubt most people's ability to predict the future with any accuracy. I do not claim any special powers or intelligence. What I do believe is useful is to cogitate about what can happen in the future that is not a mere extrapolation of a current trend.

Fear of loss of opportunity

The way people write about the large losses suffered from major declines is wrong or at best incomplete. There are two missing pieces. The first is what families talk about in terms of foreclosed leveraged loans which transfers property; i.e., the family farm or business. For me the second loss (which is both more difficult to measure and much more important in the end) is the loss of opportunity to make very cheap purchases of property, businesses, and securities. Based on the past, purchases made in distressed periods have yielded capital appreciation of three to one hundred times original capital. Throughout recorded history, burnt investors, often hurt by intellectual or legal frauds swear “never again.” They won't believe in any positive view of the future. We are already seeing investors, particularly younger investors, pulling back.  With this so-called risk revulsion as a prospect, I am focused on a track to be wary of the next market peak.


Watch for these signs

A sharp, narrowly focused big rally that will dramatically change the individual participation in the market is almost a requirement for a generational peak. Peaks need to suck in all or almost all available capital. They do this on the basis that despite an immediate strong upsurge, that further large price gains are a certainty. We have not yet had this precursor, but we could be setting it up starting with this week.

After 205 trading days without as much as a 5% general correction, we did get one by early February. This last week saw a  relatively low volume rally that regained almost all of the decline. The gain in the week was impressive. Perhaps impressive enough for people to extrapolate that 2014 could produce the kinds of remarkable gains that 2013 did. (Our own private financial services fund, as did some others approximately, produced a 40% gross gain. We have warned our holders that this type of gain is not expected to be repeated again in the near future.)

Volatility and dispersion

How could we put up some spectacular numbers that would excite people to override their natural caution? The answer is in two technical market words, volatility and dispersion. The mathematical definition of volatility deals with the amount of price movement that is different than some trend line. The popular press tends to only refer to volatility on the downside. The kind of exciting upside market price movement that will need to occur to suck lots of money into the market will not be called volatility, but genius. What will cause this kind of movement? That will be dispersion. The market is moving away from the high correlation market that took almost all stock prices down five years ago. What is happening now is that the relatively little volume being transacted today is away from the large secure stocks even though one could make the case that large caps and their supposedly large liquidity is the safest place for institutional investors today who are conscious of the age of the current bull market run. We are seeing most of the volume being done in social media-related securities widely defined. (In some cases these are the re-birthed "TMT" names, technology, media and telecommunications.) Just contemplate that Apple^* has a market capitalization exceeding Exxon. Listen up at your next cocktail party when the conversation moves from "Bridgegate" to the stock market, count the number of times Apple, Google^*, Twitter, and Facebook  are brought up relative to Exxon. Then judge by looking  at the outer ring  around the conversation and guess what they will be buying and selling soon. One of the reasons individual stocks can skyrocket is an increasing number of insistent buyers are overwhelming the market with buy market orders not terribly concerned about their going-in price because the rewards will be so large.

This kind of action can, and to some degree is, happening in selected currency, commodity, and bond markets which are deemed to be professional arenas. These can be reinforcing a bullish stock market. Much has been written about the smaller than normal interest rate spread between high quality and high interest paying paper. One of the reasons Moody's^* went to a new high this week was the increase in high yield offerings expected in both the US and Europe, which will require credit ratings. And this is where the reinforcement to the equity market comes into the picture. Moody's recognizes that historically low expected default rates will make high yield (low quality) bonds more attractive for purchase. Whether these new bonds are part of a refinancing scheme that lowers interest rates and extends maturities or are totally new to the bond market, the mere successful offerings in the bond market tend to make the issuers’ stock price rise. (This kind of reaction has penalized high quality stock funds compared to those which invest in lower quality or marginal companies.)

^*Stocks owned by me personally, by the private financial services fund I manage, or both.

Haywire

Markets collapse not because of immediate economic conditions, but from rumors or news of unexpected occurrences; e.g., the assassination of the Archduke Franz Ferdinand that was the proximate cause of the beginning of World War I. Clearly I do not know what event will stampede the market decline after a meteoric rise. But I have a possible one to think about. The present Chinese dynasty is very conscious of collapses of prior dynasties; they also think in longer terms than most of the world's political leaders and even some far-sighted military leaders. China is building for periods way beyond  the current expected terms of office. They want to restore China's place in the world to be number one. Along the route a lot can go wrong unexpectedly. Some problem dealing with China in rumor or reality could be the equivalent of that relatively minor shot in the decaying days of the Austro-Hungarian Empire.

What are the sorts of unexpected things you think could cause some future collapse or you don't think there will ever again be a major collapse? Please let me know.

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