What We Should Have Been Watching? - Weekly Blog # 903

 

 

 

Mike Lipper’s Monday Morning Musings

 

What We Should Have Been Watching?

 

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

 

 

 

Lessons from the racetrack and life

At any given time, humans tend to congregate around what is most important to them or what is going to happen. These topics are labeled favorites, both at the track and by psychologists. On any given day at the track favorites win a minority of the races. More importantly, when favorites win the payoffs are relatively small, as the winnings must be shared with a large number who have reached the same conclusion.  Thus, backing the favorite is a low return game.

 

The problem in going with the less popular is their winning ratio is lower, as most people bet on the favorites. Thus, in terms of frequency, favorite betting wins.

 

There is a more rewarding goal, winning more money over time with less frequency but higher returns. This is the choice I learned at the track and apply to investing in securities.

 

This Week as an Example

Using the public media and limited public conversation, their favorite investment topic was the speech by Fed Chair Jerome Powell at Woods Hole, the implication of which was a cut in short-term interest rates. While most investors believe these are probably the most important questions to be asked, I believe there are more important questions with higher, longer-term implications. These can be grouped under labels of concentration and valuation.

 

Concentration

Much has been written about the amount of money invested in seven or ten largely technology/financial stocks. One study shows that the ten most popular stocks in the S&P 500 represent 38% of the total value of the entire index. On average, the ten largest market caps in the index between 1880 and 2010 represented only 24%. However, I question the math or source because railroads represented 63% of the stock market in 1881.

 

This observation is of particular interest to me as a graduate of Columbia College. Around 1880 Columbia had an endowment account restricted to investment in the most secure stocks. You guessed it, lawyers restricted the investments to railroads!! This particular endowment was to be spent on bricks for the campus. Thus, for many years all of Columbia’s buildings were brick faced.

 

There were many important implications that should have been drawn from this case, especially since every single railroad went into bankruptcy years later. However, if you had included political analysis along with legal analysis it was obvious railroads had become too powerful in the country.

 

In terms of political analysis and understanding how the US works politically, people should read a new 856-page book written by Bruce Ellig, a good friend of ours. The title of the book is “What You Should Know about the 47 US Presidents”. The book devotes a chapter to each President, covering the most important laws and regulations of his term. Included in the book is information about the President’s life and personal activities.

 

Valuations

John Auters of Bloomberg believes “valuations are extreme”. Prices in terms of sales, earnings, book value, and dividends are at a stretching point. In a recent survey of intuitional managers, 91% believe the US market is overvalued and 49% believe emerging markets are undervalued. Some 60 years ago I worked for a research-director who believed shipments of boxes were a good economic indicator. They probably still are, and that is why I took notice that they were down -5% in the second quarter.

 

With the federal government pushing to let retail investors participate in private capital transactions, particularly private equity, the health of the market for these longer-term, illiquid investments, could impact the listed market. There are approximately 3100 positions in private capital firms that are unsold. Their retail owners may not see the level of distributions they were expecting, which could unfortunately increase the volume of listed securities to be sold.

 

Long-Term Horizons:

 In the long run equity investing can generate very attractive returns. A dollar invested in the 1870 equity market by the 25th of July would be worth $32,240 in nominal dollars before taxes this year.

 

 As often said, history does not repeat but often rhymes. There are a number of parallels with the market crash of August 1929 to November 1936, and the economic depression that followed from February 1937 to February 1945, which will be discussed in upcoming blogs.

 

 

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Analyst Calendar: Preparation for 2026 - Weekly Blog # 895

 

 

Mike Lipper’s Monday Morning Musings

 

Analyst Calendar: Preparation for 2026

 

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

                             

 

 

Analysts should attempt to get ahead of the stock market. Starting next Tuesday, we are entering the second half of 2025. Using the performance of Large-Cap US Diversified Mutual Funds as a broad indicator of the experience of US investors, the first quarter of 2025 was relatively strong, but April’s second half was weak. Perhaps it was due to concerns about taxes, tariffs, and international turmoil. The Market slumped into June, then recovered through the final four weeks of the quarter, bringing average performance back to mid-single digit gains, with half in the last week, despite a 9% decline in the value of the dollar. Not a great foundation for the continuation of two 20% gaining years.

 

Starting next week, analysts will quietly begin gathering their thoughts on preparing forecasts for the next calendar year. For the most part they will not have the benefit of the proclaimed or quietly guided company estimates. The estimate for 2026 will be more difficult than prior years. Not only will there be comparisons of two 20% plus years, but it is also unclear what taxes, tariffs, and the value of the US dollar are likely to be. There are two other quandaries that should be addressed. We have entered a period where there is a shortage of necessary talent at companies. For tech companies there is a struggle to find AI personnel at prices approaching Wall Street levels. Industrial and service companies have approximately 400,000 open positions, despite many announcing plans to lay-off workers. To some degree, this speaks to the quality of present workers and their attitudes.

 

Another concern is the level of IPOs threatening private equity portfolios with unattractive opportunities to sell some of their holdings. These sales are necessary to raise sufficient cash to pay the dividends expected by present holders and retail buyers. Private markets could contract quickly, constricting private securities firms. An investment trend is normally near the end of its popularity when it becomes dependent on retail buyers.

 

The answers to these questions may not be determined in the third quarter. Even though the fourth quarter is the second highest selling period of the year, it may not provide quick answers for marketing forces expected to produce results.

 

It is possible the market may be saved through efforts in the unofficial “fifth quarter”, which can deliver either surprisingly good numbers or poor ones, setting up a splurge in the first quarter of 2026. These will rely on the increasingly popular “adjusted” sales and earnings per share numbers created through skilled accounting approaches. These are often approved by the firms’ accountants and are not objected to by the regulators.

 

The problem with this exercise is that it makes the following year more difficult for analysts and investors to understand the base for the real earnings power of the company next year.

 

Buyers be thoughtful.

 

 

 

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Understanding the Universe May Help - Weekly Blog # 842

                   

 

Mike Lipper’s Monday Morning Musings

 

Understanding the Universe May Help

 

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

 

 

 

How can High Growth Stocks Co-Habitat with Flat Value stocks? 

Well-known commentators have recognized that stocks with radically different investments attractions can co-habitat without the more enthusiastic followers driving out less ebullient investors. Although from time-to-time the dominant species kill off weaker ones. 

 

As is often the case, earth bound investors have too limited a view. My exposure to the Jet Propulsion Laboratory managed by Caltech suggests a broader view, including other planets and similar elements. So far, we have not found any planetary bodies possessing a similar atmosphere to earth, so war between them seems unlikely. 

 

This suggests to me that growth and value can co-exist. The high price to earnings for extreme growth is neither a threat nor an inducement to own single digit p/e stocks. Extreme growth “planets” will move to their own rhythm and will not usually be impacted by value-oriented bodies, despite attempts at colonization.  

 

To show the difference we can look at the current year-to-date investment performance of two funds managed by Vanguard.  Their S&P 500 index fund has gained +15.51% this year, while their Total Bond II Institutional fund has fallen -0.20% for the same period. The S&P 500 has fellow travelers like the NASDAQ Composite, with a +18.65% return. The performance gap between the S&P 500 and the NASDAQ may be closing. This past week saw stocks on “The “Big Board” decline 44% vs 53% for the NASDAQ. 

 

Trading liquidity could be a contributor, with small and mid-cap stocks dropping for the past 13 weeks. Another factor could be the lack of dividends.  The 30 stocks in the Dow Jones Industrial Average (DJIA) have 3 non-dividend payers, or 10%. There are twice as many non-dividend payers in the Dow Jones Transportation Index, with one-third less positions, representing 30%. 

 

Market Structures are Changing   

Large Multi-Product/Service Financial firms have reacted to the slowdown in their revenue growth by forcing their various product/services silos to work to expand the firms’ sales base. Their model is similar to department stores which are closing or becoming depots for orders placed online. Another issue is good department store salespeople believing the customers are theirs, not the stores.

 

One attraction for sales teams leaving “wire houses” is Raymond James’* belief that customers belong to the brokers, not to their firms. They offer three alternative ways to join Raymond James. I believe there is a natural peak of good customers for every trade, after which new efforts will lead to lower margins.

 (*) Designates a position either owned by customers and/or personal accounts.  

 

An example of a smart move is Morningstar’s sale of their TAMP business, which recognizes that the number of fund distribution points is shrinking. 

 

T. Rowe Price stated in their mid-year outlook that the risk of recession is now lower. That is possible, but history suggests the higher securities prices go for a narrow segment of the general market, the more risks rise. 

 

Other Brief Comments and Observations 

The US and China agree that they prefer seniors stay in the countryside rather than come into the cities. They also both want more babies produced. The rich country replacement rate is currently 1.5% vs. a neutral rate of 2.1%.  

 

In a period where national productivity is low, the idea of creating holidays like Juneteenth and Labor Day looks politically motivated. Each day of lower productivity increases the risk that lower income jobs will be replaced by machines that can work 24/7, 365 days a year. 

 

Institutional investment sentiment was lower in June than May and April. Currently, 53% of the surveyed institutions believe a recession is not expected for the next 18 months. (I suspect there is a bias at work in their projections. Many, if not most of the respondents are primarily employees rather than owners of their businesses.) 

 

The big four accounting firms are laying people off. 

 

There is a somewhat useful Walmart Recession index of future risk, which increases when store sales are higher than the movement of their stock price.      

 

The standing military in Russia, Ukraine, and China are finding that they are not properly equipped to accomplish their mission. They point to corruption as the cause. (I suggest corruption is something of global problem. Perhaps Dr Spock or his replacement can solve the issue during an intergalactic conflict.) 

 

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Investment Markets are Fragmenting - Weekly Blog # 839

 

         

Mike Lipper’s Monday Morning Musings

 

Investment Markets are Fragmenting

Flows Going to Potentially Higher Risk

 

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

   

       

   

Why the Fragmentation?

The answer is simple, salespeople make money by getting investors to make investment choices. At the institutional level commissions have totally disappeared, and the same largely applies at the retail level too. However, “vigorish” is alive and well, just with different names for spreads, underwriting fees, and management fees. Passive clients may decide at some future point that management fees are not worth it.

 

A valuable client is one that is actively investing and directly or indirectly aiding in getting new active clients.  The value of a client occurs either through the flow of new money or the reallocation of the portfolio. The marketing agent is consequently a bit of a worrier when communicating with clients. Furthermore, there is a desire to introduce new investment ideas, particularly new types of securities or new investment markets. The marketer will often present him or herself, or their firm, as more knowledgeable than the client. Thus, the marketer can dominate the client more than they expect.

 

Performing Better with More Risk

What follows is a brief discussion of current possible ploys that might be suggested. In truth these ideas might be sound if executed when not so popular. If peers already hold positions in the new play, their length of time to the eventual peak and subsequent major decline is shorter.

 

There are a very limited number of investors who have trading skills, and that does not include me. Most successful investors hold a relatively small number of holdings for many years. These are the types of investors who own Berkshire Hathaway with the goal of transferring assets to heirs after they are gone. (I am one.)

 

Until perhaps this week, James Mackintosh a Wall Street Journal columnist, noted that “Four giant tech stocks added more market value than all other stocks in the S&P 500 for the last month.” I suspect many investors were enticed to buy those four stocks. Unfortunately for them, the only class of stocks to rise for the week ended Thursday were small caps. regardless of growth, core, or value orientation.

 

Many individual and institutional investors have portfolios consisting of stocks listed on the NYSE, usually with dividends. These investors might be enticed to invest in NASDAQ listed stocks due to the greater number of tech stocks. There is a belief that most short-term NASDAQ traders are better than those playing on the big board. In the latest week only 23% of NYSE volume fell, compared to 42% on NASDAQ.

 

The fastest growing asset class today is Private Investments, either individually or through funds. As is often the case, the biggest risk is not the issuer, but other holders. The sponsors of private debt and equity do not have an obligation to buy back securities, except at the terminal date. The secondary market is very limited, and prices favor professional dealers.

 

Jaime Dimon, CEO and Chair of JP Morgan Chase is worried about inevitable investment mistakes in the privates. Although he does not see a structural problem, I think there potentially is one for two reasons.

1. These securities are being sold to individual investors. When the public loses money, they often complain to the media and members of congress who are always pro regulation.
2. There are very few pension funds still operating. Many have promised fixed returns to government employees, which includes teachers. For years these plans have used interest rates much lower than current rates, many of which have been bought from insurance companies. I believe some insurance companies will go bankrupt if interest rates stay at current levels or go higher, with the retirement burden falling on taxpayers. Politicians are probably better at getting the feds to change regulations. A guaranteed payment funded by a variable (market) sensitive vehicle is dangerous.

 

What are Your Thoughts?

 

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Faulty Decision Processes at Change Points - Weekly Blog # 607

Mike Lipper’s Monday Morning Musings

Faulty Decision Processes at Change Points

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

On the surface stock owners are expecting seasonal presents----unless they have already received them. By Friday morning media headlines were mostly good and had set up a favorable 2020, unless one looks deeper. Frequently, I reference a chart in the Weekend Wall Street Journal that measures the change in the current prices of stocks, commodities, currencies and other investments. This week 65 of 72 prices rose, suggesting some form of inflation is mounting. The numbers hawk in me saw a possible problem, as we normally see positive category price changes in the 31-42 range. (The seven falling prices were: S&P 500 Real Estate, Natural Gas, Lean Hogs, Yen, S&P 500 Telecom, US Dollar, and corn). The out of normal price behavior made me think about the benchmarks that investors use to guide their decisions.

The most prevalent sales pitch in moving investors into or out of securities is a short comparison of two alternatives. If “A” is larger than “B”, “A” is a buy. This assumes the measure is relevant to the needs of the investor and most importantly, the relationship between A and B is reasonably constant and meaningful. Currently, the price of gold mining stocks is going up, yet the price of gold is flat. One could say that this is compensation for the plentiful risks in mining. Alternatively, some stock buyers expect gold to become more valuable due to the fall in the dollar. Regardless of the reason, the market for physical gold is not sharing the same enthusiasm. Perhaps the comparison is faulty, as one alternative represents a view of future attractiveness and the other a measure of current value. This dichotomy suggests that simple statistical comparisons need to be understood more fully.

As someone who’s developed a large number of open and closed-end fund indices, I question whether many benchmarks are relevant in making decisions as to the future value of investments. This week my old firm noticed that two mutual fund categories, equity income and utilities, were getting net inflows, while other equity categories were not. Some buyers, perhaps spurred on by their wealth managers or other investment advisers, were attracted to these two investment categories because of their comparatively high dividend yields and/or lower volatility. In our investment management practice we rarely use funds from either category. If some of our accounts need current income we use higher yielding funds, but not the highest. Furthermore, we prefer to use funds growing earnings and cash flows that pay higher dividends. A few growth and income funds have delivered both rising dividends and capital appreciation for years, which over time has given investors a better return than either Equity Income funds or Utility funds.

There were two recent articles in The Financial Times that I believed should have been tied together. The first, based on Morgan Stanley research, was titled “Investors Braced for Low-return Decade after years of Robust Growth”. The article compares the last ten years to the last thirty years and estimates that current investment performance is below both. Initially, I felt they’d failed to adjust for inflation and currency depreciation.

A few pages later there was a news article about the rapid movement in the location of magnetic north. It has been moving for 500 years, causing navigators on land, sea, and in space to adjust their navigational instruments. To me, the second article reflects the reality of change and should also be required before we apply benchmarks. The world of medicine adjusts for changes in height, weight, and other characteristics when it compares modern people to those in the past. Popular stock and bond market indices should also be adjusted and consider both the world we live in and what the future might hold. “Political scientists” that use pooling data to predict attitudes and voting preferences also need to adjust their slicing and dicing of the population and the way they collect data, which will be between expensive and very expensive.

A Barron’s panel of experts have concluded that the S&P 500 will rise 4.1% in 2020. The precision is breathtaking, but if you actually believe the number wouldn’t it be prudent to sell now and wait for a better re-entry point, likely to occur in most years? (This applies to tax-exempt and not tax-deferred investors).

Alternatively, a contrarian indicator is the number of puts vs. calls traded on the S&P 100. Last week the ratio was close to three times normal. While buy and hold investors in aggregate have a better record than traders, those in derivative markets and on NASDAQ are better short term. I believe we will remain in a sentiment driven trading market for a while longer, which could be emotionally trying for investors. However, those who are steadfast will likely accomplish most of their realistic long-term goals.

Please privately share what you think with me, as my crystal bowl is unusually cloudy.



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https://mikelipper.blogspot.com/2019/12/investors-are-worrying-about-wrong.html

https://mikelipper.blogspot.com/2019/11/contrarian-stock-and-bond-fund-choices.html

https://mikelipper.blogspot.com/2019/11/mike-lippers-monday-morning-musings-all.html



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Sentiments Approaching Reversal Points - Weekly Blog # 589

Mike Lipper’s Monday Morning Musings

Sentiments Approaching Reversal Points

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

In the near future US stock market sentiment will approaching a reversal point.

Handicapping the US Stock Market
The art of picking winning bets at the racetrack is called handicapping. The betting goal is the same for long-term investors, to have more money at the end than when you started. Note, unlike baseball it is not the number of wins vs. loses. Both handicappers and investors recognize they will be wrong a percentage of the time, but in both cases success is measured by the number of dollars remaining at the end of the game, suggesting that in order to cover the losses gains will need to be larger. As the portion of the wins must be bigger than the average win, most successful investing involves a streak of contrarian thinking.  With that in mind I’ve laid out my view of the current level of the stock market.

As of August 9th, the three major stock market indices have declined modestly from their recent record levels. (S&P 500 -3.54%, DJIA -3.92% and NASDAQ -4.45%) None of these are even near a -10% correction, a -20% bear market, or a generational decline of -50%. Even including the worst week of the year, the three indices are up between +15.87% and +23.14% from the lows generated on January 3rd. However, the weekly survey of sample members of the American Association of Individual Investors (AAII) shows that only 22% are bullish for the next six months, with 48% being bearish. These percentages are historically extreme. A somewhat more nuanced view is expressed by bond and bond fund investors that also indicates caution. For the week ended Friday, yields on a Barron’s list of high-grade corporate bonds yields fell 11 basis points vs. only 4 bps for a similar list of intermediate credits. (Remember, a fall in yield means prices rose, indicating increasing demand.) During the trading week ended Thursday, General US Treasury Bond funds rose +2.25%, while the average High Yield fund declined -0.48%. It’s interesting that in a week where the Fed lowered interest rates by 25bps, the flight to safety pushed US Treasuries higher. 

Like Charlie Munger and Warren Buffett I am not a big fan of book value as a measure of operating success, although it is somewhat useful as a gross comparative measure. Comparing last week’s market to book value with those of a year ago, the DJIA declined very slightly, while the S&P 500 is the same as a year ago. Thus, the market is not grossly overpriced despite second quarter earnings being flat. According to analysts, the current quarter is expected to show a 1-2% decline that will be made up in the fourth quarter.

However, there is still reason to be concerned. On a year to date basis mutual funds have gained 2-3 times their average rate of gain for the last five years. Additionally, they are producing gains that are higher than their very long-term rates of return. Funds limited to the largest stocks, both within the US and abroad, have gained +14.47% year-to-date on average, compared to their five-year average return of +5.77%. Multi-cap Funds, a group of funds without a size limit which often has some large caps, were up +13.74% year-to-date and +5.32% for the past five years. Funds focused mostly on US holdings did somewhat better than those invested abroad due to having more tech holdings and the long-term rise in the dollar.

Short-Term Investment Thinking
Just as the betting results on the most favored racehorses is not great because they rarely produce enough betting winners to cover losses, I am betting against both the AAII crowd and the buyers of US Treasuries. I would also not be surprised if 2019 ends with high single-digit equity gains. In most of our managed accounts I would not disturb the highly selected funds in our portfolios.

Caution: Healthcare Could Look Like Financial Services in the Future
Over my professional investment life the Financial Services business has been quite good to me and my family. However,  the average rates of return have not been as good as they were in prior decades. Looking at the structure of these businesses today, while the numbers are larger the number of people and firms have shrunk. The number of publicly traded firms has been cut in half. The rates of return are also smaller than what they were years ago. Perhaps the single best measure of the decline is that fewer sons and daughters of successful professionals and successful investors want to enter these businesses. In sum, I believe the percentage returns are smaller than those of past decades for most investors. There is a very real risk that the same trend will govern the Healthcare Industry.

As with the Financial Services business, the Healthcare business is already highly regulated by the government and it is likely to become more so. In both cases the purpose of government regulation is to make care available, better, and cheaper for the public. I have twin fears that it won’t happen. The first is a story in Sunday’s New York Times about an individual who went to Mexico for a knee operation  paid for by a generous employer funded insurance plan. This is just another example of what is now called medical tourism, in this case to lower costs. Non-US citizens, both the very wealthy and the very poor, are entering the US for healthcare services they can’t get at home. For many years US residents have been traveling to other countries to get medical treatments not been approved here. These trips, along with the number of Canadians in our hospitals, demonstrate that patients will travel to get what they believe to be better or cheaper medical care. They may or may not get it.

What has likely caused the increase in medical tourism is the combination of increased regulation and the limiting of profit making of doctors, hospitals, insurance companies, pharmaceutical companies and all their suppliers and servicers. As an investor, as well as portfolio consultant to a hospital, I have looked at their financials. The good ones are reasonably profitable, but increasingly many are not and therefore  one needs to look beyond the dollars of profit. The first ratio to consider is profit relative to investment. Perhaps more important, is their perceived ability to pay dividends to their owners. For the most part these organizations feel compelled to reinvest their so-called profit into their activities. In many ways I do not consider retained earnings as current profits, because as an outside investor I can’t spend it.

As someone who has a large family dependent upon me to pay some or all their medical bills, including insurance, I would appreciate lower medical costs. It is important to understand that insurance is temporary risk shifting, favoring long periods of paying premiums directly or through the workspace. In the end my real desire is for others to have the lowest costs, but I want the best care for my family and the best often includes the new best drug or procedure. My fear is that as we restrict profitability in the healthcare system we won’t get the lifesaving or life betterment new drug or procedure quickly enough.

Just as we are well served in the financial services businesses by an appropriate level of profit, we need to ensure that the healthcare system can do its job of making our lives better.   


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

https://mikelipper.blogspot.com/2019/08/is-last-week-significant-weekly-blog-588.html

https://mikelipper.blogspot.com/2019/07/chinese-emperors-learn-all-roads-lead.html

https://mikelipper.blogspot.com/2019/07/us-stock-markets-new-highs-misleading.html



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Use Simple or Complex Mixes of Tactics and Strategies to Attain Investment Success.

Introduction

The global stock markets are probably not priced with a lot of bargains. High quality, fixed income markets are full of fears. All markets including commodities and real estate are likely to be more volatile for the next couple of years than what we have recently experienced. If you disagree leave the worrying to the rest of us.

Our concern is based on the volatility that won’t be constrained and lead to panic-driven major disruptions. Since we don’t know what our next investment voyages will be like, we should examine our navigational tools. In our lives we know from our own or observed experiences that frequent changes rarely produce optimum results and in many cases deplete resources substantially. Thus the key to using the appropriate tools is the discipline to use them correctly and even when periodically they produce sub-optimum near-term results. Nevertheless there may be times when changing tools makes sense. Usually the best time to make switches is whenever a tool is too successful and not when it is underperforming. This reliance on intelligent discipline is one of the may lessons that I learned in the US Marine Corps.

Our basic four investment philosophical tools are:

1.   Reliance on Simplistic Approaches

2.   Recognition of Complexity

3.   Goal focused Strategies

4.   Timely Tactical moves

Simple

A study of most very successful individual investors appears to demonstrate that large wealth is generated by investing in ownership of equity, usually very concentrated to the point of a single investment.  It takes an unusual person that can tolerate the cyclicality involved in a single or even a highly concentrated portfolio. This cyclicality produces too much trauma for most. So they start to diversify. The problem with diversifying is that almost every day a new potential threat to one’s wealth shows up, particularly in the media. The standard risk control measure for new risks is to add some new protective investment. Over time this approach leads to a large number of investments.

In the modern world, people and institutions seek comfort in becoming part of the masses and either directly or indirectly index their portfolios. The thinking behind this is that all of these investors can’t be wrong, but equally they can’t be as right as the successful wealth-builders. Other simple philosophies are to only invest in highly credit rated stocks and bonds which produce similar upside and downside results. It is like someone who goes to the racetrack to bet on winning horses, so they bet on almost every horse in the race. Quite often they will have a winning ticket, but most of the time the money received will not pay for all the losing tickets. The nice part of simple moves is that they do not require additional thinking or analyzing.

Recognizing Complexity

There are no two people exactly alike. Even my twin grandsons, not only are they different, but they strive to be different. While each market has on the surface similar characteristics of prior market cycles, there are enough differences so the past is a bit instructive but not totally predictive. I believe that each portfolio and investor are different than others. One of the risks that some investors face in dealing with live managers and brokers as well as the so-called robo advisors is that at times one’s needs and preferences are not utilized in portfolios. One of the ways I recommend dealing with this is to divide an investment portfolio in terms of expected payouts. I start often with four timespan portfolios.

Each portfolio can be selective in terms of levels of aggressiveness/conservative as well as many other selection functions. Because consultants want to deliver the past to clients, they ask about the dispersion of performance within a manager’s book of business. To the extent that there is little dispersion, there is little attention as to the differences between people and institutions. All 401(k), pension plans, endowments, and families are different and deserved to be  treated that way. However, there is an expense to managing complexity. The difference is similar to buying off the rack versus custom produced and fitted clothes. Each has its place, but overtime the old rule of getting what you pay for generally works.

Goal Focused Strategies

Almost every physical and investment trip has bends and turns with occasional reversals. Those who successfully complete their trip do so because they have a navigational tool of an effective compass. We all understand that prices go down as well as up. While there are relatively few complete wipeouts, we have seen 90% declines in leveraged, highly speculative stocks in the 1960s and the 1930s. These are rarities. Most general stock market declines in a single generation are on the 50% variety. Within each rolling ten year period there is a 25% fall, and often within a ten year period there are three years of greater than 10% decline. Strategies should recognize the downside potentials, but also be aware and positioned for the upside.

Since 1926 the general stock market has on an annual basis gained in the range of 9%. We have experienced gains of three or four times the average and have seen a number of concentrated funds with speculative holdings post annual gains of over 100%.

Some may feel that because the number of publicly traded stocks is down by a factor of 50%, the institutionalization of trading, and the growth of index funds that past upsides will be curtailed. I would argue eventually the reverse. Periods of extreme concentration as we have been in, lead to lack of focus on securities that are not part of the highly valued concentrated portfolios particularly in the market capitalization weighted indices.

A very important point in assessing long-term investing is the power of reinvesting cash distributions (interest, dividends, and capital distributions). The great Sidney Homer, the long term head of Salomon Brothers fixed income research pointed out that for the long term bond investor there are three returns of cash over the life of the bond:  (a) proceeds from maturities, (b) current interest coupon payments, (c) and interest on interest.

Most people don’t fully appreciate that the third element produces the most cash. For example a bond with a 4% coupon held for a twenty year maturity will receive 100% of its issue price, 80% of its issue price for twenty years in interest payments, and if they can reinvest the interest payments at the same 4% for the period they will receive 119% of the issue price. The message here is that by buying and holding solid bonds and reinvesting the income, the return to the investor is larger than most believe. The key is not spending the interest and reinvesting it at a similar rate as the initial issue. (If you sense a certain rhythm to this approach it is worth noting Mr. Homer’s parents were both professional classical musicians.)

The interest on interest example is actually more powerful in investing dividend stocks and funds. Today they are many solid equity companies who are yielding 2% to 3% that over the next twenty years are likely to raise their current dividends at least at the rate of inflation, if not higher. Many of these stocks’ twenty year dividends will be higher than a 4% coupon on a high quality bond. Both many dividend paying stocks and all mutual funds have reinvestment mechanisms, so the equity investor does not have to look for current income opportunities the way the bond investor does. I am biased, but I believe the reinvestment potential through good mutual funds is better than many individual stocks. The US and UK regulators do not value the reinvestment mechanism in their assessment of the value to investors. Dividend paying stocks and mutual funds could represent a significant part of endowments and individuals long term portfolio segments.

Timely Tactical Moves

The first thing is to determine is whether the investor has trading skills. Can they recognize the difference between intra day and daily volatility vs. a meaningful change in price trends? There are some that believe that they posses this skill and a few may. It is very definitely an art form that requires the right personality approaches with extreme discipline.

Others attempt to be anticipatory and get ahead of new trends. As someone that has been known to be premature, too soon is often equivalent of being wrong. At times one may have to concede that one is premature and reposition for closer to fruition trends.

Contrarians can identify where they think the crowd is wrong and take a contrary view. Most of the time these moves don’t have much price risk as the market doesn’t believe in them.

My Dilemma

My dilemma is to find the correct communications with potential clients as to which of these tools should be used with all or a portion of their accounts. Any thoughts would be appreciated.

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A. Michael Lipper, CFA

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Investment Journeys with Worries

Introduction

Investing is similar to a journey or a voyage. We start from a known location usually expressed as a sum of money and we set sail for unknown futures, some short-term and some long-term including possibly some beyond the time we personally are onboard, but our money is. The wise investment traveler before he, she, or they get started consults the known histories or charts and they scan the horizon looking for possible dangers. Only time will tell whether some of the perceived dangers are real. Some will be mirages or just shadows. And some will not be foreseen and surprise us.

If one wants to survive the voyage one should begin to catalog the beginning dangers and add to them as time and travel produce new ones. In many respects this is the job of the investment managers, at least in my opinion. The way I categorize the dangers is by the most likely time frames when they can do the most danger.

Near-Term Worries:  Sudden Sentiment Switches

At this very moment the biggest worry is that many investors have left the comfort of fundamental investing and economics. Notice how much of the punditry is based on the outcome of political analysis. These “authorities”  including many portfolio managers and analysts as well as salespeople are proclaiming their analysis of various political decisions and even more absurdly, their outcomes on security prices. 

Many of these predictions were brilliant, that is they were brilliantly wrong about recent political events, but even more wrong about the significance of their outcomes. It is true we have recognized that the main drivers to securities prices for almost a year have been changes in sentiment, however there have been very few of these pundits who have been correct; to use a betting term, the "daily double" (which is difficult to win) of getting various political decisions right as well as their significance. The risk to market prices is that when the "experts" are proving wrong in one or both directions; for instance large, one- sided positions are quickly reversed creating high intraday volatility and bouts of illiquidity. If against historic odds the overwhelming opinions of the experts prove out, there will likely be far less movement because the more active players are in a favorable position.

While I can not accurately predict the future, my instinct from my handicapping racetrack days is to bet against the favorites. That way I have more upside and less downside than following the crowd.  Thus, I suggest that long-term investors not get shook out by bouts of volatility and perhaps take advantage of them when they occur  - as they surely will. This will be true for just about all asset classes that have substantial followings.

Bonds Can Hurt Stocks

This week in The Wall Street Journal  there was the headline "Bonds Flash Warning Signs." The Journal was reacting to the continued and accelerating purchases of bond funds. We have seen the same pattern in many markets around the world. Both individuals and institutions are desperate to attempt to close the gap in their retirement capital in their chase for yield. 

I have often said that if one cuts the wrist of a security analyst, a historian will bleed. While I try to learn from my and others' historical mistakes, it appears that most investors and markets do not. The postmortems on the last major global financial crisis ending in 2009 blamed the underwriters and credit rating agencies. In many cases they did not cover themselves with glory. But there were two other parties that contributed heavily to the crisis: the political structure including the central banks and the buyers themselves. The buyers bought into varying levels of residential mortgages without an understanding that house prices could decline. Again the buyers did this in many markets. Have we entered a similar situation about ten years later?

The fearsome drive for yield can be seen this week in the 3.28% yield on what Barron's called the best bonds, meaning high quality. This yield is in the same range of a number of sound dividend-paying stocks. Over time many of these stocks have a long history of every year or so raising their dividends. Currently the dividend increases are equal to or exceed the common perception of inflation. Thus, over time the income from owning some stocks will be bigger than from owning high quality bonds. Having mentioned inflation one should look at the probable price movements of bonds and stocks during periods of inflation. (Almost all central banks have been trying to increase the rate of inflation in their countries.) Since bond interest payments are meant to be fixed and dividends on stocks do rise periodically, it stands to reason that bond prices during an inflationary period will decline until maturity and stock prices rise.

I wonder when the media, politicians, and "strike-suit" lawyers will look for culprits to the mis-selling of bonds into unsophisticated senior citizen accounts. These actions can be helpful to the financial community which may be dealing with illiquidity issues that at least by rumor threaten various counter parties.

To the extent that the bond buying phase continues it could lend itself to bigger fraud instances due to the available leverage opportunities.

Long-Term Worries: The Absence of "Middle Men"

In the history of organizational changes we seem to play accordion, going through periods of contraction and expansion. Almost every industry or group of people start with an increasing number of players which reach a phase of competitive destruction which shreds the weaker players. Often the surviving stronger players concentrate their resources on what they do well and outsource small, difficult, and time consuming functions to others. Thus a group of small, agile, and tightly-managed middlemen evolve. At some point, particularly when the majors sense that they are slowing down, they choose to capture or in some cases recapture the functions that have been the job of the middlemen. We have seen this pattern in almost every industry; airlines, autos, chemicals, financial, retail, etc. On the surface the large acquirers reduce their external expenses and secure some skills that weren't within their base. I have personally seen trading, investing, underwriting, research and money management go through these consolidations. 

I suggest that in time this consolidation of the supply chain will work against many of the mammoth players. While there is a good history of large companies in development of major products and services, most of the startling new products and services are incubated in small, agile companies. Many of these are run by entrepreneurs who work many long hours at low current pay. Small companies have less fringe benefits than their acquirers, which is compensated for by sharing in the proceeds of the buyout. Once the entrepreneur and his/her staff are in their big new homes, their lives and incentives become different and often lead to lower productivity and certainly less risk taking. I suspect that this is one of the reasons that US productivity has declined.

Over a twenty year period the number of publicly traded companies is down by about half. While there have been a limited number mega mergers, most acquisitions have been of large companies acquiring  mid and small companies. A number of savvy portfolio managers have recognized these trends and have specialized in mid-cap investing. In the US they may have less luck than in the past because there are fewer publicly traded mid cap companies.

As usual when there is a need, the markets provide  solutions. There are two trends to answer these needs. The first is that more worthwhile companies are staying private avoiding all the hassles of being public. In some cases they go through the intermediate step of working with and through a private equity group to their eventual mega buyout or IPO. 

A second solution is found in the missing creativity of middlemen in the US, which is increasingly being supplied by activities overseas, both in the developed and the developing world.

I view this evolution as somewhat worrisome, events won't be as smooth as they were in the past and it will cause the larger companies to slow down their growth and/or in some cases see a more halting progress pattern. I am also worried about the skill level of the managers in the major corporations to manage all the elements of the previous middlemen successfully. They are different.

Question: What are your systemic worries?

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A. Michael Lipper, CFA

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Contact author for limited redistribution permission.