Learn from the Blame Game - Weekly Blog # 546

Mike Lipper’s Monday Morning Musings

Learn from the Blame Game

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

As is often the case, media and politicians look to blame "the guilty" for any perceived negative event. Clearly an 1100 point drop in the Dow Jones Industrial Average (DJIA) on Wednesday and Thursday was caused by bad people and their bad actions. Thus, when the bad people are found and punished for their bad actions we will avoid future problems.

Except, that means we have learned nothing from the event that will help us avoid similar problems in the future. Those who believe that only evil forces created the problem forget the only true rule of market places: The production of Humility is the only guaranteed result in the market place.

Contributing Factors 
We should have been more aware of the implications of structural changes in the fixed income, equities, and currency markets. These were regulatory changes designed to prevent the public from a government bailout of collapsing major financial institutions, while also lowering transaction costs.

1. Major Commercial and Investment Banks were required to increase their capital buffers and restrict portions of their trading and market making functions. This had twin impacts. First, liquidity was reduced in all tradeable markets, particularly in the fixed income and currency markets. Second, as this was quite profitable in most periods, it reduced the earnings power of these institutions. Thus, some market risk was shifted from the market making institutions onto the backs of investors, creating more intra-day volatility and price gaps between trades. 
2. One of the big differences between the price patterns of stocks on the listed stock exchanges and those traded over-the-counter on NASDAQ was that on the listed exchanges there was a positive responsibility on the part of the floor specialists to maintain orderly markets (In the 1987 fall at least one specialist took this obligation seriously and went broke trying to maintain an orderly market in a steep decline). As an offset to the risks involved in maintaining an orderly market, the specialist had a material information advantage to keep the book registering incoming orders. Thus, most of the time Specialists were quite profitable. Some viewed these profits as being taken from investors in higher transaction costs. To my mind, the forgone profits were worthwhile as payment for liquidity. The SEC believed this was an unfair advantage and pressured the New York Stock Exchange to effectively eliminate the Specialists. Not surprisingly, investors paid the price for the drastically out of balance pressure on non-price sensitive sales compared to those gotten by reluctant buyers last Wednesday and Thursday. We should have expected this. 
3. Daily transactions in Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs) are mostly done institutionally by managed accounts and professional traders. During the trading day these players use ETFs and particularly ETNs as part of complex transactions to offset other securities. At the end of the trading day they need to balance their positions, and with the known end of exchange trading they become even less price sensitive. Thus, the last twenty minutes of trading often encompasses the biggest price swings of the day. 
4. Most of the pundits have focused on the rise of interest rates, which have been telegraphed for some time. I believe that there were two other partially related things happening. First, the rising budget deficits expected in the US, Italy and elsewhere will create more government paper, crowding out some commercial needs and driving interest rates higher. Second, credit conditions could be peaking as the faster than expected economic expansion slows. There are signs of this with Sears and various other companies in Europe. Thus, in my opinion the issue is not primarily interest rates, but the future availability of credit capital. 
5. One of nice things about a command economy is that it may be easier to control than a multi-party led one. The central government of China is concerned about the amount of debt that has been produced in their country. It is well known that they have instructed their government-controlled banks and affiliates to cut back on debt extensions. This is not new. One of the ways the government-controlled banks reacted was to have Asset Management Companies (AMCs) take over their distressed loans. The AMCs raised a lot of capital through the Hong Kong markets and those domiciled in offshore locations. This high rate paper was purchased by what may be called "yield hogs" throughout the world. One suspects that some of these loans won't be paid back on time and in the full amount. 
6. For tax purposes, the US mutual fund year is over in October. Many equity funds in net redemption have sold some of their high-priced holdings to meet cash demands. To reduce their shareholders’ taxes, some are selling their losing positions into a declining market.

Working Conclusions:
We have experienced a somewhat normal cyclical contraction that delays normal secular growth patterns. All of the contributing factors were known for some time and thus if investors were surprised by the recent decline they are the "guilty parties" for lack of sufficient risk awareness.

In the latest American Association of Individual Investors (AAII) weekly sample survey, bullish investors dropped to 30.6% from 45.7% the prior week. One can envision the most volatile group going overboard with concern for the next six months. While no indicator has a perfect score on predictability over time, those that are wrong more often than they are right are more predictable. The AAII summary is a well-established negative (reversed) indicator.

This up and down movement lends itself well to adopting a timespan approach. I would be happy to discuss how to use this approach with a limited number of subscribers, tailored to your own needs.


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Avoiding Shallow Statistical Judgments; e.g., Last Week

Introduction

Even long-term investors like me need to pay attention to near-term information. Often I have said the critical price risks to investors are their fellow holders. At critical times the first ones to sell get materially better prices than those that follow. Early last week quick sellers did better, but paid the price later.

Trading Speed

In last week’s blog I briefly listed what many consider the 4 most crowded trades. They are: (1) Long US Dollar, (2) Short Commodity Stocks, (3) Short Emerging Market Stocks and (4)  Long US Tech Stocks. These are sizable positions relative to current marketability in large hedge funds and other trading accounts. All of these led the parade of falling prices. While one could argue about the investment merits of these positions, what was clear by being on the most crowded list is that there was limited near-term liquidity in these trades. In order to get out of the way of the falling prices, the players had to accept lower prices quickly. For some time many of us have been pointing to the shrinkage of commercial and investment banks’ capital devoted to market making activities. What we saw early is that the total dollars of the sellers overwhelmed the dollars of the buyers. (When similar markets occurred in the old days when I had a small trading desk reporting to me my instructions were to back away and let the energy of the moment exhaust itself before we entered the market at calmer prices.)  

The intensity of the selling was apparently driven by disappointments caused by statements made by the central banks of Europe and the US. Because the world is so interconnected, in a nanosecond the sellers lined up and started to compete for exit prices and volumes. Some may wish to lay additional blame beyond reduced market making capital on the current era of accelerating speed of information flow. The Economist, like some politicians, comes down squarely on both sides of the issue. It points to in an article entitled “The Creed of Speed” that reports Apple^* customers download an App every millisecond, which demonstrates the growing interconnections and thus reaction times to news. On the other hand it points out that active mutual funds have almost doubled their patience by holding stocks for almost two years, which shows a portion of the active market is taking its time on sell decisions compared with the turnover in the S&P 500 which is under one year.

^*Held personally and/or in the private financial services fund I manage

Before turning to an important cause for the rapid decline and even more rapid recovery on Friday, I will alert you as to possible future extreme intraday and single day price changes. The most popular price index and the one with the longest history is the Dow Jones Industrial Average. I should point out that on the day in 1929 when the DJIA collapsed, it fell by 13%.  Most people focus on this market break and neglect to point out that by December of that year the index rallied to its former levels, just as we saw the rally on Friday when the DJIA made up all the ground lost earlier in the week. What is critical is that in 1929 the average non- index stock did not recover to former peak levels. This lack of full market representation by most indices raises questions as to their utility for sole decision making (more on this later). Having warned you as to the utility of using an index for decision making, I should also warn you about my statistical, not investment view, as to a potentially huge one day move in the DJIA. Because the market structure has changed since 1929 and due to worsened regulation in addition to the abolition of floor specialists and reduced capital devoted to market making, I suggest that a 10 to 15% move measuring from the low to high price on a crisis day is more than possible. While this might make the news and give the pundits a lot to talk about, it may signify far less than it appears at the time.

The Real Cause for Concern

As a card carrying Chartered Financial Analyst (CFA) and someone who learned analysis at the racetrack, I have never had enough numbers. People in the global investment community use numbers to build models  of what has happened and our best guesses of the future. In truth we create statistical abstractions. I would like to have all the money that has been bet on the “best horse or stock in the race.” Not too often do we get our numbers individually wrong, more often we get the weighting of the inputs wrong. Most of the big errors come from not understanding the human equations of the managements in depth as well as the critical group of customers. In addition there is the Mark Twain quote of what will hurt us is what we know is not true. Combine this with the ever present quantity of racing luck covering the unknowable. Thus, to me the sole or main reliance on statistical measures can produce small gains and big losses, particularly losses of opportunities.

As an example I recently heard about a fund group that we think highly of losing an institutional client because the client’s consultant didn’t like that the fund group’s stock selection did not look like the average fund of that type. This is a statistical comparison, not an investment judgment. I could see redeeming the fund if an examination of its portfolio led to the conclusion that the fund managers did not have sufficient skill to pick sound investments. In this case a recent visit with both fund managers and their analysts produced the opposite conclusion.

Trading Speed vs. Sound Investing

This week’s price volatility largely shows the results of making very rapid statistical comparisons. I believe there are a very limited number of skilled artists that can play that game well consistently. For long-term investors looking to see their capital grow in the decades ahead to meet funding requirements from current needs all the way out to those who want to meet perpetual needs, I believe that they should rely on the combination of wisdom and future judgment. Wisdom is the sum total of past experience that can be learned as well as experienced. For example, the brief discussion above about the 1929 DJIA performance is part of the wisdom data bank which should include a great amount of historical inputs and personal learning, including acknowledged mistakes. The purpose of wisdom is to understand the range of what has happened. When I look through my wisdom bank, the main lessons are not from some statistical array, but from what various people through the ages accomplished in spite of identifiable mistakes and hurdles.

As important as wisdom is, investment judgment is more important. Wisdom is in effect our memory drive, where judgment is our investment plans for the future. Authors and historians make up good stories about people. Almost always they make the individual they are portraying to have a singleness of mind, knowing exactly what they want to accomplish and how they are going to do it precisely. I have yet to study such a person in reality. Judgment comes from making decisions while in motion not at the beginning. There is an expression in the US Marine Corps that it taught junior officers: in a combat situation you will never be judged on Plan A, but on Plans B,C, all the way to Plan Z. This is exactly why I divide my clients’ portfolios into sub groups.

As an entrepreneur with limited capital I had to “bet the farm” on a sole product and then on a very limited number of products, however that is not how I now invest  as a fiduciary. I put a portion of my resources in direct confrontation with selective elements of the market. Some resources are held back to add when the front line elements get tired through losses and need time to rejuvenate. Finally I try to develop specific talents that can leap frog over today’s leaders to find new ones. The key to evolving judgment is to know when to regroup. This is very strange for me to say, but I do not use investment performance as my principal decision tool. Primarily I look to whether my people judgments were correct. If I get my people judgments correct in time, stock prices will reflect it.

Proper Traits of Professional Investors

In searching for good portfolio managers and advisors of all types there are some basic characteristics for which I look. The first is the thirst for knowledge; in the modern world something new is happening every day. The next in this lawsuit-prone world is judicial temperament. Does the individual carry on his/her activity in the light of possible challenge? Does the individual know, particularly in the world of many ethical challenges, how to distinguish his or her role as an agent and as a principal? A good person can play both roles carefully. Notice I did not require mastery of various types of securities. Those are mechanical skills which lead to continual usage even when they are no longer the most suitable.

When developing the Lipper Mutual Fund Performance Analysis we said the service was for analysis not for fund selection. The funds were broken down into investment objectives of what they were trying to accomplish not what they contained. The latter was an outgrowth of how Marine Corps officers were instructed to give orders to their senior non-commissioned officers; which was to state the objective and what resources they had to accomplish the mission, not specifically how to get the job done. (This is a very different approach than saying you had to look like the rest.) In my latest endeavor, the TIMESPAN L PORTFOLIOS^®, we assign assets to specific timespans, but the instruments that can be used include mutual funds, commingled funds, separately managed accounts, individual stocks and bonds or some combination.

Question of the week: What are the chances of new index high in 2015? Will a new high be achieved in 2016?

Question of the month:  Do you react to investment tweets?

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Copyright © 2008 - 2015

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.