Little Occurred During the Trading Week - Weekly Blog # 949

  

 

Mike Lipper’s Monday Morning Musings

 

Little Occurred During the Trading Week

 

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

 

          

 

Introspection During a Trendless Market

I have always been curious as to why so many bright investors don’t perform better overtime. These smart people often underperform the defined middle of the market as measured by major indices for extended periods! This appears to be true for both professional and individual investors over their investing lifetime.

 

One possible answer to this riddle is that market forces at every moment offer choices. Some of these choices contribute significantly to long-term results, while most choices don’t. Excluding luck, which is always an individual factor but not a continuous factor, I believe at most critical turning points the long-term correct decision is less believable to a large majority of investors.

 

Examining Our Current Choices

Don’t look at future choices in terms of which dictate buy or sell signals, which is what most do. Instead, consider the potential impact of making the wrong decision. Does this suggest that if you make the wrong choice, you will be materially worse off? A possible third choice is to temporarily increase your liquidity and wait anxiously for more information?

 

The following current choices are before us, to either engage or wait.

• Large-Cap Growth Funds – 2026 year-to-date +7.19 %, 5-year +10.25%, 10-year +16.18%.
• Small-Cap Growth Funds - 2026 year-to-date +18.80%, 5-year +4.09%, 10-year +11.85%.
• S&P 500 Yearly Growth Rate by I/B/E/S - 26Q1 29.2 %, 27Q1 14.3%, 28Q1 17.6%
• Erika McEntarffer, former BLS Commissioner Interview comments:
• Payroll data is a little hard to predict due to the change in labor supply.
• Businesses response rates are harder to reach as US business data is largely an all-volunteer endeavor, whereas in many countries it is mandatory.
• BLS staff has declined by 20% in real terms in the last 15 years.

 

Conclusions

1. Analysts and portfolio managers must look deeper than published pundit headlines.
2. The appropriate reaction to some less believable content may be to not only look deeper, but to also slowly commit reserves into developing investment strategies.
3. Diversification helps reduce the chance of large losses but also reduces the chance of large gains, which are often larger than the losses.

 

Question: what do you think?  

 

 

 

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Mike Lipper's Blog: Searching for Future Long-Term Picks: Gathering Assets, Reasons to Search - Weekly Blog # 948

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Diversification - Weekly Blog # 929

 

         

 

Mike Lipper’s Monday Morning Musings

 

Diversification

 

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

 

                                                                        

 

Preface

On a recent trip to London, Ruth and I attended a private fund and friend raising concert for the Academy of St. Martin’s in the Fields (ASMF), where Ruth is the first American trustee. The wonderful music was performed by Joshua Bell, the artistic director, and five other top-notch string musicians from the ASMF. Between the six talented musicians they played three different types of string instruments, alternating between lead and ensemble roles. The result was a successful combination of each of their talents.

 

Even when listening to a magnificent concert performance, I cannot forget my investment responsibilities. As individual musicians alternated from leading to supporting roles, it reminded me of what individual securities should do in a diversified long-term investment portfolio.

 

Application to Portfolio Management

In 1940 the SEC completed their depression-oriented reform rules. Among the last of these was the Investment Company Act of 1940, which unlike the other six regulations was not formed at their SEC headquarters. It was produced at the Mayflower Hotel in Washington by lawyers for the fund industry from Boston, New York (where the industry’s trade association was headquartered), Philadelphia, and Washington. Considering their recent experience of the market falling during the Depression, the mood of the meeting was to try reduce the chance of big future declines. The best model for that were state laws governing trust accounts, using generations of work by Boston and Philadelphia lawyers. (Even as late as the early 1960s a few Boston law firms had professional securities analysts on staff to assist in managing trust accounts.) Note, the main concern of the creators of fund regulation was the avoidance of losses. No word was spoken of making money on investments.

 

They thought the best way to reduce the chance of major losses was to limit an account’s exposure to any single investment. This led to limiting the percentage amount that funds could invest in any one stock, which usually meant no more than 5% of the voting stock at cost (not market). To this very day, most equity funds are labeled as diversified if they adhere to this principal.

 

The Problem with Voting Stock Limits

The biggest penalty paid by investors is not losses, but the absence of profits. Mutual Funds with long histories often make ten, twenty, or even more times as much on some of their holdings, which more than covers a small number of losses. Furthermore, great fortunes have been made, particularly over successive generations, in single stock portfolios or portfolios having a small number of investments.

 

For Professional Investors

The concept of risk management is critical but doing it by name or percentage of voting shares does not reduce risk, it may increase if all investments are exposed to a single concept. In the late nineteenth century professional investors considered concentration to be the best and safest way to invest. My college degree is from Columbia University, which had an endowment fully invested in railroad bonds and stocks, every single one file for bankruptcy. Today there is a risk that some participants in the “AI” surge could produce similar results by investing in too much in a good thing.

 

For publicly traded securities I suggest the biggest risks is with the stock owner and not the issuer, as they will be sellers of the stock before you do. Other risks include countries, technology, politics, and management. These can be identified as short-term and long-term factors. A possible short-term indicator is slightly more participants being bearish than bullish in the latest American Association of Individual Investors (AAII) survey of expectations for the next six months. Interestingly, the long-term indicator was Friday’s announcement by the Supreme Court, which ruled against the President’s authority to set tariffs using the International Emergency Economic Powers Act (IEEPA), which had very little to any impact on the market.

 

Bottom line, watch the musicians play and how well they work together, both with other musicians and staff, but also watch the reaction of the audience.

 

Understanding Going Global

In a recent conversation with a London-based fund manager, who in the past was almost completely invested in the US but now has a growing position in European stocks. While he has the biggest portion of his portfolio in US securities, he is very risk aware and expresses this by augmenting his portfolio with European stocks. Normally, he expects his US positions to outperform his European positions, but not in a declining market. In terms of P/E, Free Cash Flow, Dividend Yield, and other value measures, European stocks are less risky than US holdings.

 

 Another careful investor was Charlie Munger, who listed six principles to be avoided: High Financial Leverage, High Operating Leverage, Negative Cashflow, Poor Governance, High Risk of Obsolescence, No Competitive Advantage vs. a Strong Competitor.

 

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Separating: Present, Renewals, & Fulfilment - Weekly Blog # 879

 

 

 

Mike Lipper’s Monday Morning Musings

 

Separating: Present, Renewals, & Fulfilment

 

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

 

 

 

 First Priority

Determining the motivation of the client and the account’s heirs is key to understanding the performance of most investment accounts. When asking the real investment account decision-maker about the driving motivation, it is often singular even though multiple other motivations are listed. (It often takes many discussions to reach the effective truth. Over time and changing situations the driving motivations may change.)

 

With most individuals, critical decisions are based on selected discussions with highly respected individuals, which may change over time due to changing circumstances. Most often these individual decision advisers are not revealed to the “hired hands” of the portfolio manager. All too often the unofficial managers express their opinions based on their own experience, which may have little relevance to the long-term needs of the account. These accounts are effectively managed by people known and unknown to the professional manager. Thus, the crucial job for the professional is to communicate effectively with those having meaningful influence on the account. Not an easy job.

 

The Second Motivation

The owner of the account should understand that there is a second motivation operating in practically all situations. The prime motivation of the investment manager is to continue the relationship with the present controller of the account, which includes the periodic renewal of the relationship. The relationship rests primarily on the communication skills of the manager in reaching the expected satisfaction level. This is a two-part job, where the first task is setting and updating expectations. The second task is delivering the expected return and communicating the proper expectation. This is again a two-fold job, with the first task satisfying the adjusted needs of the account in absolute return terms. The next part is where many managers fall down, the artform of selecting appropriate comparisons. This is where my biases enter. I do not believe a managed account should be compared to a list of securities selected by a manager. It should instead be compared to a fund portfolio with real expenses and diversification requirements, similar to the account itself.

 

The Most Important Motivation

Most of the money in the United States is managed directly or indirectly for “retirement needs”, which has lengthened over time. “Retirement” can include the institutional needs of academic, medical, and cultural institutions. What makes these accounts challenging is the receipt of money near term to meet future needs, which may not be well-defined in the current period.

 

Currently, the biggest hurdle in managing long-term money is the new economic/financial situation, which is different from the recent past. Most of the time change moves relatively slowly, which allows the participants time to adjust their actions to the pace of change. However, there are some brief periods of even more rapid change where it is difficult to catch up and adjust to the radical changes. I believe we have entered such a period and expect to have more difficulty predicting the future. For a period, we will likely be out of step with the fundamental changes likely to occur.

 

What is Changing?

The following elements of change surfaced last week.

• Weekly S&P sector performance: S&P Finance +2.80% vs -4.01% for S&P Tech.
• Goldman Sachs will soon cut 3-5% of its Vice Presidents.
• Schroders will lay off 200 employees to refocus and improve profit margins. They will also cut their Executive Committee by half, which is 44% family owned.
• There are $3 trillion ageing and unsold private equity deals. (Retail investors are taking risks in Private Equity that exceed public investing protections.)
• The US has not seen so much restructuring in the Federal Government, Corporations, Energy, and Retail since the Depression.
• The AAII weekly sample survey’s 6-month bullish prediction is now 19.3% vs 57.3%. (The lowest I have seen, which is often wrong at turning points)
• Global financial communities are developing new instruments that can be leveraged.
• With copper and coffee commodity prices going up, I am not surprised the Fed is holding off on lowering interest rates.
• There is probably more to the reluctance in naming a bank supervisor than we know.

 

We know that history does not repeat (exactly), but it does rhyme. There is an incomplete comparison one could make with the 1930s, but I hope it isn’t so.

 

 

 

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Mike Lipper's Blog: Reality is Different than Economic/Financial Models - Weekly Blog # 878

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Mike Lipper's Blog: Recognizing Change as it Happens - Weekly Blog # 876

 

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Week in Conflict Leads to Buy List - Weekly blog # 764

Mike Lipper’s Monday Morning Musings

Week in Conflict Leads to Buy List

 

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

            

 

 

Trading Didn’t Tell Us Much 

Over-simplification: Buyers largely believe that inflation is the sole problem facing the market and the Federal Reserve will take care of it by managing short-term interest rates. As the stock market went up the first two days of the week, more shares transacted at rising prices. 

 

The next two days saw prices decline in reaction to a greater than expected fall in November retail sales. Department stores led with a more than -2.5% decline compared to an overall average decline of -0.6%, vs. an estimated decline of -0.2%. (Visits to the high-end The Mall at Short Hills in early and mid-December saw a lack of salespeople, incomplete stock, and vacant stores.) There is a second group of investors, some of which were trading and many more not. I call them Realists. 

 

Friday’s transactions were partially misleading in that over $4 trillion dollars’ worth of options came due. Options users often hedge individual securities, exchange-traded funds, and other derivatives. On Friday both the NYSE and NASDAQ traded over 5 million shares on the downside, vs. a total transaction count of 5.4 million shares on the NYSE and 5.5 million shares on the NASDAQ. (Remember, about 40% more shares were traded off the exchanges.)  1.7 million and 2.4 million shares were traded on the upside. (Thus, I am not sure how to interpret these actions, other than them giving us a clue on the size of the speculative market.)  

 

Although the believers will hopefully be right, it does not appear it will be soon. Economists have created an index of leading indicators which are still going down by about 1% per month. The believers, particularly those that are Washington oriented, focus on national numbers. They do this because it leads them to policies where they can harvest votes. The realists are more attuned to measures that track the wealth of the country and the world. This year the aggregate wealth on main street has been rising due to an inflated sample of real estate prices rising faster than public portfolio values have been declining. These people recognize their good fortune but worry about inflation and the decreasing purchase value of their currency. 

 

A leading retail-oriented broker indicated their clients have been buying mostly corporate/municipal bonds and commodities, while selling declining US government bonds. Thirty-year bonds have fallen 35%, the worst in over a century. (Never have they fallen 3 years in a row.) 

 

Commodities are finishing the year as the best asset class for a second consecutive year. Commodities are going up in price because of actual and perceived shortages, both at the industrial level and to a lesser extent at the food level. When demand drops for industrial goods in a dampening economy, some commodity prices will also drop. This is exactly what OPEC+ fears, a fall in demand.) 

 

Brokers also see a sharp increase in the purchase of tax-exempt bonds. Many of these bonds are backed by expected state and local income taxes. These revenues will likely drop when individual and corporate income drops and won’t be meaningfully offset by rising rates for political reasons.

 

Thus, in an attempt to preserve investor wealth and purchasing power, a major portion of their wealth may be exposed to rising interest rates and a decline in purchasing power. After which rates could fall if “The Fed” reduces them. It is exactly the reason I am suggesting long-term prudent investors begin investing a portion of their assets in something that was previously mostly attractive to seniors. 

 

Tactical Reserve Preparation 

This time it’s different in that capital is being temporarily retrieved from risk assets. (The length of time out of the market will be determined by changing investment and personal conditions.) Since none of us know what the future will bring, we should utilize some of our money to defend against the possibility of stagflation, which could last ten years or more. This has happened twice in the last century.  

 

The tactical reserve is best structured by buckets. One bucket being long-term oriented and another short-term. The latter would be kept in locally deposited savings accounts, money market funds, and 2 year or shorter US Treasury paper.  

 

The larger portion, or perhaps the total of the tactical reserves should be invested in Equity Income stocks, an old asset class that is slowly becoming available. For many years these investments were difficult to find due to low interest rate yields. 

 

Currently, 2-year US Treasuries are yielding 4%. In this weekend’s WSJ I was pleased to find 48 stocks out of list of the 1000 largest equities yielding above that number. My filter was common stocks yielding between 4.0 and 5.99% whose price/earnings ratio was below 15x. Every investment has risks and those with yields of 6% or more are believed by the market to have some capital risk. Also, stocks with a P/E above 15 may not have earnings approximately equal to twice the current dividend. Most of these companies regularly raise the dividend at least as much as inflation. Another helpful characteristic is a significant number of shares being held by a family or other interested parties, like some pensions, endowments, and income oriented mutual funds. 

 

While there is some portfolio diversification in the list of 48, it is not as diversified as the broad-based market indices. The largest common denominator on the list is financial companies, with a heavy collection of domestic and foreign banks, particularly Canadian. The list includes Citigroup. Real estate and utilities are also prominent. I was pleasantly surprised to see 3 fund management company stocks I own in order to participate in a growing financial services business. Furthermore, there were names of major holdings in the investment companies I own. I also found some names of stocks I should investigate for inclusion in my tactical reserve or other portfolios. 

At this point the task shifts from security selection to portfolio construction and ongoing management. As we are building a tactical reserve, we need to avoid unnecessary exposure to losses. The first rule is to reduce risks by diversification. The best way to start is to have a beginning portfolio of at least five holdings, which hopefully will grow to ten distinct holdings in time. Pick your holdings from each of the sectors - Domestic banks, foreign banks), non-bank financials, life insurance, property owners, energy providers and servicers, industrial producers of needed products, and utilities. (Some pay dividends in dollars while making their money in different currencies, including commodity aided currencies like the Canadian dollar.) Be careful to limit the maximum single holding to twenty percent of this account.  

 

When operating the account, small cash distributions should be transferred to the cash account. If the prices of the holdings drop ten percent more than the market, stop buying. If prices fall twenty percent or more, consider selling half or all the holding. 

 

Remember, these operating procedures are suggested for the tactical reserve account. A different set of rules and procedures would be more appropriate for accounts having different target dates for payments. The other important thing to remember is that the quicker an investor learns humility, the bigger the ultimate return.    

 

For long-term subscribers who will share their intended use of the list with me, I will make the list available to them.   

 

 

 

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Mike Lipper’s Blog: What does your 4.0 Profile Tell You? – Weekly Blog # 763

Mike Lipper’s Blog: Week Divided: Believers vs Investors – Weekly Blog # 762

Mike Lipper’s Blog: This Was The Week That Wasn’t – Weekly Blog # 761

 

 

 

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Two Critical Questions: - Weekly Blog # 717

 

Mike Lipper’s Monday Morning Musings

Two Critical Questions:

I.  Can Performance Replace Diversification and Create Too Much Risk?  

II.  Is January 2022 the Beginning of the Bear Market?

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

Are the Answers Linked?

The youth of today, with all their expensive schooling, are at a distinct disadvantage. They have not studied ancient history or the leaders and common people living through those periods. In their limited time, if they could study just two periods, they might find relevant answers to questions with implications for today. The development and collapse of the Roman Empire and some of the structural causes of WWI. 

As this is an investment blog, I won’t teach history in detail. The following is a list of historical topics with significant implications for today. They may help answer the two questions asked:

1. The tension between a divided Roman Senate and the leadership of the strongest state in the world.
2. The most technological roads and viaducts also helped weaken defenses.
3. The rising costs of “gifts to the people” became necessary bribes, reducing military spending.
4. While a lose collection of German tribes eventually ran over Rome, they could not agree on how to govern their conquest.
5. Compared to the cohesion of other European countries, Germany was late in unifying and did not have nearby land to grow.
6. The Holy Roman Empire, based in Vienna, was structurally weak.
7. France lost 25% of their young men in the Franco-German War, the most productive people in their country.
8. Making the loser pay for the winners’ costs through reparations failed, and in so doing ignited global inflation, leading to many autocratic governments, including the US.

The Positive and Destructive Power of Performance

(Historical Notes: In the mid-1960s, I was one of the very few securities analysts focused on what were called conglomerates. As an analyst, my research I sold to financial institutions, largely in the US, but also in the UK, Continental Europe, and Canada. Consequently, I became conscious of multi-industry companies in their countries too. My early analysis focused mostly on US auto parts and bicycle parts manufacturing companies, then gravitated to electronics companies, particularly those with defense and aircraft applications.)

From the beginning of recorded history, the danger of relying on a single or a few similar clients was clear. (Shakespeare’s “The Merchant of Venice” demonstrates the risk of a merchant’s wealth being tied up in a single voyage.) To avoid such risks, the more enterprising merchants evolved into merchant banks, with multiple clients in multiple trades. Famous Scottish trusts developed investment vehicles for the wealthy and lower classes, investing not only in voyages, but also in a wide array of stocks and bonds. They paid attention not just to investment performance, but also to the longevity of their businesses.

A handful of Boston Law firms began as custodians for the wealth of ship captains on their Asian voyages. They developed documents hoping to limit the risk of total disaster by minimizing the risk in stocks, investing the remaining assets in supposedly super-safe bonds. It was out of this colonial heritage that Boston based firms developed the first US mutual funds, utilizing their successful Balanced Funds business.

The Boston law firms had their own security analysts and portfolio managers until at least the 1960s. Their legal documents proscribed diversification rules to lower the risk of total loss during hard times. Thus, the need for diversification came into usage in the institutional asset management business and appealed to insurance companies who had similar rules.

The Problem with Two Asset Type Diversification

If the two asset types were totally uniform, one could control the risk of large losses. Losses were significantly reduced by requiring the investment of 60% in stocks and 40% in bonds, at cost. While this worked for the lawyers and their naïve clients, security selection remained a risk. Including the selection from among so-called “high-grade” stocks and bonds of different maturities and liquidity. 

Asset managers whose customers were primary interested in upside performance found the restraints too limiting, particularly during periods of inflation. To get a more appropriate measure of fund risk, I tried to group funds taking similar risks. By the end of the 1980s my firm had created over 100 separate peer groups for performance measurement purposes. There are probably an unknown number of new peer groups that would be useful today.

When I privately compare funds, I go beyond just security selection. Among the things I look for are:

• Portfolio turnover
• Whether the portfolio is collegially managed or has a single decision maker
• The size of the firm’s research effort
• Tax management
• The historical recognition of losses
• The availability of back-up people
• Trading and administrative skills available within the group

All these measures are useful in reducing investor risk. However, better relative performance in one segment can diminish the power of diversification in limiting risk.

Where Are We in 2022?

While we have only experienced three weeks of the new year, we have been confronted with a very different market and performance environment. With a lot to identify and interpret, I am using fund performance as an intermediate filter to examine what is happening. I’ve observed meaningful changes, raising questions about the normal desire to extrapolate past performance trends. I find the following significant:

1. Through Thursday, with Friday having an additional significant loss, most fund peer groups experienced single digit losses. The sole double digit loss was the e-commerce business.
2. The very few US registered mutual fund gainers have been international funds, with strength in emerging markets, commodity funds, and global energy vehicles.
3. Large-Caps have fallen less than the smaller-caps, suggesting larger-caps have earned a liquidity premium.
4. The average stock in the broad indices is down considerably more than the relevant cap-weighted index.
5. JP Morgan released a study of thematic fund performance, which was no better than the general market measures.

What Does the “Tech” Correction Mean for the Future?

(Remembering that the sole function of fluctuating markets is to produce humility in the survivors, and my assertion that I can and will be wrong, there are reasons to be concerned.) The history of peaks and bubbles shows good performance in a small minority of traded issues at the top. The good performers, in this case a limited number of large-cap tech stocks, have drained dollars out of the rest of the market.

As readers know, I view moves in the NASDAQ Composite as leadership in the entire US market. From its all-time high, the index is down 14.5%, clearly a correction. I believe the Russell 2000 is in correction as well. At some point, I guess the more senior measures will close the gap with the NASDAQ. The interesting thing is the size “off” volume at the NYSE and NASDAQ are about the same.

I have been concerned about the underlying economy showing some disturbing signs:

1. The lowest interest rates in 5000 years, until the Fed’s future small moves. The adjustable mortgage interest rate is showing some contrary trends e.g., the 3-year rate rose 12 bps this week, vs 3 bps for the 20-year.
2. Capital expenditures are being spent on supply issues rather than “greenfield” expenditures. This is indictive of a lack of confidence in the longer-term future.
3. China is having problems with a peaking workforce, although its currency is rising against the dollar.
4. The US stock market is being driven by shorter-term players, with more volume in ETFs than the more retirement oriented conventional mutual funds.
5. There is a significant trend of bank branch closures. I expect to see more retail mergers and growth in crypto-currency vehicles. The average young person has much less cash than we did at a similar age.
6. A focus-group of independents who each voted for both Biden/Obama and Trump, are concerned about crime and the way the current economy is being managed. With worries about the future, these concerns could lead to a consumer-based recession. (With rare exception, there is not a popular political leader globally, although the opposition currently lacks much support.)
7. The National Science Foundation published a report on the state of US Science & Engineering. the report shows the US losing leadership to Asia (China, Japan, and South Korea), measured in dollars expended. Considering wages are less in Asia than in the US, the Asians may be getting more for their money.

Working Conclusions

If the correction in capital-intensive Tech and Health companies accelerates, it could cause an overall decline in the stock market. Much like in the run-up to The Depression, it could cause some consumers to cut back their spending, leading to a consumer recession. It doesn’t have to happen, and the timing may be uncertain, but based on the subjects not being taught, the odds favor it. 

  

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https://mikelipper.blogspot.com/2022/01/current-causes-of-concern-weekly-blog.html

https://mikelipper.blogspot.com/2022/01/deeper-thoughts-weekly-blog-715.html

https://mikelipper.blogspot.com/2022/01/mike-lippers-monday-morning-musings.html

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