Reading the Future from History - Weekly Blog # 863

 

 

 

Mike Lipper’s Monday Morning Musings

 

Reading the Future from History

 

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

 

 

 

History May Suggest:

1. The American People Won the Election
2. The Recession has started

 

The Declaration of Independence was signed on August 2nd, 1776, the US Constitution was passed in 1787, and the last state (Rhode Island) ratified it in 1790. Today, Rhode Island still remains the smallest state in the Union. Thus, since the beginning of our nation the rights of our smallest state have been critical to our progress. One of the many things making the US different than other republics is The Founding Fathers fear of the tyranny of the larger states on the smaller states. Consequently, our Electoral College favors state representation over population. In the 2024 election, even though President Trump polled more votes than Vice President Harris, the House is almost evenly split, but he won 36 states and lost only 14, mostly on the coasts or major rivers.

 

This split is one reason I suggested President Trump will likely have difficulty getting much legislation easily passed through both houses, where he only has a majority of about five votes. Of the 14 major issues, only two can be accomplished through just executive orders.

 

Actually, many if not most Americans are pleased with the results of the election. An incompetent government was dismissed before it became even more intrusive and has been replaced by a new administration with untried ideas. New legislation will be delayed by a disruptive Congress and a slow-walking Deep State. Many Americans would like it if the air conditioners in D.C. did not work, fulfilling Hamilton and Madison desire that government work be part-time.

 

Recession Coming?

As someone rowing in a boat with the wind picking up and clouds darkening, you become relatively certain it will soon rain. The question is, will you get to dry land before getting really wet?

 

Evidence of an economic storm on the horizon can be summed up as follows:

1. Stock analysts have been instructed for generations that high quality bonds are more sensitive to economic changes than stocks, at least initially. Currently, yields have been going up (prices down). However, mid-quality bond prices have barely moved at all, something overseas fixed income investors are very sensitive to.
2. Most US stock prices declined this week, with just 37.7% of the stocks on the NYSE rising and only 27.6% rising on the NASDAQ. NASDAQ stocks have performed better than those on the “Big Board” for some time and are cheaper on a market to book value basis. This suggests the NASDAQ investor is a more professional investor.
3. The American Association of Individual Investors (AAII) weekly sample survey of investors indicates the bullish or bearishness sentiment of their investors for the next six months. In the last three weeks, the bullish reading has risen to 49.8% from 39.5%, while the bearish reading only went down to 28.3% from 30.9%. Market analysts believe the “public” is often wrong at turning points. With that in mind, it is interesting that the bulls gained 10.3% while the bears dropped only 2.2%.
4. The weekend WSJ tracks some 72 prices of stock indices, commodities, ETFs, and currencies. This week only 12.5% were up, with Natural Gas up a leading 5.77%. The remaining gainers all rose by less than 2%. This likely indicates sophisticated investors are nervous about what lies ahead.

 

 

Thoughts?

 

 

 

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Mike Lipper's Blog: Inflection Point: “Trump Trade” at Risk - Weekly Blog # 862

Mike Lipper's Blog: This Was the Week That Was, But Not What Was Expected - Weekly Blog # 861

Mike Lipper's Blog: Both Elections & Investments Seldom What They Seem - Weekly Blog # 860

 

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Caltech Data Heretics Go to Track for Inspiration - Weekly Blog # 632

Mike Lipper’s Monday Morning Musings

Caltech Data Heretics Go to Track for Inspiration

*Heretics are people holding opinions that are at “odds” with what is generally accepted, “odds” suggests seeking higher returns.

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

One of the luckiest occurrences of my life was being asked to join the board of Trustees at the California Institute of Technology (Caltech). Participating in board/committee meetings, as well as the informal gatherings, has been one of the great learning experiences of both my and my wife’s lives. I had not focused on the thinking process leading to the 39 Nobel Prizes awarded to Caltech scientists until this weekend. Ruth and I watched a podcast hosted by fellow trustee Rich Wolf on “The Making of The Lonely Idea”, one of several podcasts covering a few of Caltech’s scientists outlining their thinking and discoveries. On the broadcast a few realizations became clear to me:

1. Some of these great minds drew inspiration from the racetrack which is the leading source of my security analysis and investment career thinking.
2. The building blocks of our thinking rests on data, and it is often believed with religious fervor.
3. A careful analysis of the data requires a probing mindset for validation and adjustment.
4. Sound thinking must be anchored in the real world of human experience. 
5. A driving humility that accepts the reality of what is not knowable, as well as a realization of how little we individually know.

This is a particularly good weekend to focus on the investment implications of Friday’s surprising announcement of job growth in the private/commercial sectors, and a much smaller than expected rise in unemployment. The good professors at Caltech would first focus on the generation of the data that led to the burst of enthusiasm for stock prices on Friday. The enthusiasm resulted from a series of global occurrences, including China’s recovery from its shutdown and the announcement of massive US and European stimulus for their economies, to be paid largely by wealthy members for the benefit of those less fortunate.

For the purposes of this discussion I will focus on the US scene as it is the largest portion of most of our subscribers’ wealth and consumption. Nevertheless, few of us lack exposure in our investing and consumption to the influences beyond our borders. It is critical we appreciate that we are living in an incredibly fast and evolving situation as the data is flashed to us. The employment/unemployment report for “May” was for the week ended May 12th. In most months, a mid-month read is a reasonable summary glance for the entire month. However, this is not the case for this report. During May and June, the US, Europe, and Japan have been coming out of a COVID-19 lockdown. With good reason, private citizens have been reluctantly exposing themselves and their families to more contact with the outside, resulting in more people normalizing every day. Consequently, I believe the numbers for the second half of May will be materially more favorable than those of the 12th of May. With the Northeast and California coming online in June and July the employment numbers will get even better.

Humility
One of Caltech’s regular teaching lessons is that there is something to learn from every experiment, typically with more learned from those that did not deliver on their objective. (With a bunch of losing betting tickets and occasional market losses I have a reinforced need for humility.) While we never truly know what the future will hold, the breadth of today’s possible outcomes is extremely wide. In talking to people struggling to make financial plans for the fall and next year, it becomes clear that the probabilities concerning the direction of prices is currently more uncertain. Some see an initial a wave of price declines, due mostly to retail/office space rentals and the liquidation of existing finished goods inventory. This appears to be a short-term view, as almost every serious person I chat with expects prices to rise in the future. An interesting aspect of these discussions is that they initially expect the focus to be on a limited number of critical items purchased at higher prices. When asked about other prices, I am often met with “Oh, I did not think of that, but it should be added to the list”. At the end of these discussions the roster of price increases is considerably larger than the list of expected price bargains.

The key to future prices is the expected level and nature of demand. In assessing this I believe I need even more humility. The consequences of first and future waves of COVID-19, as well as geo-political considerations and habit changes, suggests that as we climb out of our foxholes people may see their lives, jobs, and homes very differently than in the past.

Financial Security
One important area of concern is the understandable desire for financial security. In our own minds we build our own fortress (prison). Until recently, many felt their jobs were the foundation of their security and this was particularly true for those who worked for large organizations. We have seen many of these employment centers “Right-sized” and many are threatened by it coming. Beyond what we earn from our labor, many count on individual and/or group investments: pensions, 401ks, 403bs, Social Security/Medicare, etc. Except for low earners, none of these are impregnable, particularly regarding high inflation. While stocks may be attractive to individual investors in the long-term, they are likely to be more volatile, with the cushions provided by floor specialists and contra-cyclical investors getting smaller. The price of gold and gold mining shares is signaling materially higher inflation. Even if the “gold bugs” are only half right, the biggest surprise to many may be the loss of purchasing power from owning “high quality” bonds.

The natural reaction to these concerns is to build ones own financial fortress, which has historically become a prison due to the lack of mobility. Stock markets in many countries are currently signaling just the opposite, with increased speculation, waves of new IPOs, and a rush into private equity, or its disguised companion private credit.

What to Do?
My investment views rests on Caltech’s practices and my track and investment experiences. Caltech’s 300 faculty and less than 2500 undergraduates, graduates, PhD, and Post Docs are always examining perceived knowledge and looking for a deeper understanding of the world as it exists. More experiments and more mistakes equal more learning, which combined with humility produces good results. Not having the breadth of Caltech, I use a twin approach. For clients and family, we build portfolios of funds, mostly equity. The portfolios use concentrated/narrowly focused funds, along with some broad-based funds. In personal accounts we occasionally add individual stocks to provide exposure to investment areas insufficiently covered in our funds. The big difference in our approach is time horizon, which when successful is for multiple generations.

Question:
Is your investment thinking evolving? If not, why not?

 

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https://mikelipper.blogspot.com/2020/05/mike-lippers-monday-morning-musings_31.html

https://mikelipper.blogspot.com/2020/05/mike-lippers-monday-morning-musings_24.html

https://mikelipper.blogspot.com/2020/05/time-to-review-investments-weekly-blog.html



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VALUE INVESTING WILL BE SUPERIOR BUT IT MAY HAPPEN AFTER THE RECESSION - Weekly Blog # 574

Mike Lipper’s Monday Morning Musings

VALUE INVESTING WILL BE SUPERIOR

BUT IT MAY HAPPEN AFTER THE RECESSION

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

Current Inputs
A few weeks ago, one of our perceptive readers asked what advice I had for his good friends that were managers of value stock portfolios. My unexplained response may have seemed nonsensical in the face of relatively poor performance compared to market. I should have explained my thinking. My reply was focused on the business of providing investment advice. I saw a short-term continuation of poor relative performance leading to less money going into these portfolios and a significant number of the managers withdrawing from the business. Lower prices often result from fewer value buyers participating in the market. Without new performance seeking money in the markets the remaining portfolio managers will need to liquidate some or eventually all their holdings. Typically, they will sell their most liquid holdings first and be forced to sell their less-liquid positions when that is all they have left. These sales will be at bargain prices for those that have the cash to take advantage, but there will be few with the cash, courage, and foresight to take advantage of these great bargains. These insightful managers will have less competition and thus they can earn premium level fees.

Recently I reviewed the performance of a large Planned-Giving Fund run by a well-known and respected manager with a recognized value bias. In looking over their performance record, it was superior for ten years, but not for shorter time periods. Just this week we were informed that a” deep-value” manager was closing his shop, as he was no longer able to produce the good returns he had generated in the past.

These inputs led me to explore the structural reason why this group of intelligent, formerly good performers, were not doing better in a market that was performing extremely well. Like many analysts who are closet history students, my search for an explanation focused on recent US financial history and recorded history from Biblical and Ancient societies.

Last Ten Years
 Because government promoted home ownership, various government subsidies and tax credits led to excessive ownership of homes by those stretched in their ability to support mortgages and the reasonable upkeep on home purchases. In some cases the buyers lied on their applications, but much more significantly lied to themselves and their families as to the predictability of their income and wealth.

In the aftermath of the mortgage crisis the government focused on the mis-selling and mis-labeling of tranches and ended up penalizing the financial industry with burdensome regulation and capital requirements. Further, Central Banks pumped money into the market in what came to be known as “quantitative easing”. This has led to a ten-year period where interest rates have been kept artificially low, depriving savers of the rates that paid them not to spend, leading to a global shortage of savings. More importantly, low rates and the availability of capital has led both commercial banks and non-bank financials to make commercial loans at interest rates which encouraged undisciplined credit extensions. Much of this money went to marginal firms for capacity expansions. This has hurt the value investor, as demonstrated by their poor investment performance compared to other investors.

Companies that value investors favor have the following characteristics:

• Strong balance sheets (under-utilized borrowing power)
• Physical assets where the current market value is larger than the depreciated book value
• Close to impregnable market penetration of good customers
• Unique and highly prized intellectual property
• Respected in-depth management
• Stable shareholder base

It takes many years if not generations to build these. The field of competition changes when marginal companies with a poor financial record and large debt can acquire even more debt at low cost. Often, when marginal companies build excess capacity they fight for market share. They do this by lowering prices, which in turn devalues the more sound companies. With a more leveraged balance sheet the marginal company can report faster earnings growth than the value focused company, at least for a while. Thus, in a period where growth is most valued, the marginals will be the more productive investments, until the next recession.

Ancient History + Human Nature
The Bible and archaeology have recorded various agricultural cycles, often tied to weather but also the expansion of crop or grazing land. Humans are driven by fear and greed. When they are in rough balance, humans tend to be both disciplined and careful. However, when either side is predominant humans tend to do extreme things and concentrate all their resources to gain more wealth/power or horde them to avoid current or future crises. When a mass of people do the same thing, like all going to one side of a boat, they can capsize the boat. That is why we have always needed recessions to correct the excesses of a prior period. I see nothing that has repealed this need and thus I expect we will have a recession at some point.

Where are We Today?
While I can’t give a date for the top of the market prior to the beginning of the next recession, nor the percent of the market gain, I can make the following observations:

1. Currently, the US stock market is being led by the NASDAQ composite, made up mostly of tech and services providers. However, this past week the stocks listed on the New York Sock Exchange had a higher percentage of gainers 77%vs. 69%. Perhaps the valuation gaps are too great - NYSE p/e 18.47x vs NASDAQ p/e 23.67x. If the rate of gain slows, perhaps yields will be more important - NYSE 2.16% vs. NASDAQ 0.99%.
2. Despite the strength of the equity market NYSE volume is flat compared to a year ago. The absence of speculative enthusiasm for listed stocks suggests there is more upside ahead.
3. While it is broadly proclaimed that the Federal Reserve won’t raise interest rates this year, this week the average interest rate offered by savings institutions rose 5 basis points to 0.65 bps. I interpret this as savings banks encouraging more deposits for them to loan out. This may support the surprise 3.1% first quarter GDP announcement. I have always believed that the Fed is a follower and not a leader on setting interest rates.
4. Each week the WSJ tracks the prices of 72 securities, currencies, and commodities. Until this week, gainers outnumbered the losers, this week they are exactly even.
5. The bond market is often more attuned to changing financial conditions. In the latest week yields on high quality bonds rose 14 bps, while the yield on intermediate credits declined 4 bps. [Prices move inversely to yields.] This suggests that bond investors are concerned about the future value of the highest quality bonds.

What to Do with Value Funds/ Managers
As a portfolio manager of portfolios of mutual funds, we invest globally in both growth and value focused funds. I expect the more growth-oriented funds to provide both more appreciation and volatility. The value-focused funds will probably go down less in poor markets. However, when interest rates go up, as I expect them to do before the next presidential inaugural, the value merchandise should do better and will receive a reasonable amount of M&A activity.

What Do You Think?  


Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/04/contrarian-observations-not-predictions.html

https://mikelipper.blogspot.com/2019/04/not-yet-peak-luck-lessons-weekly-blog.html

https://mikelipper.blogspot.com/2019/04/investing-in-quality-for-growth-or.html



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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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Bonds Can Hurt Retirement Capital

Introduction

Running out of money is the single biggest fear of all investors and should be of their portfolio managers and other fiduciaries. Unfortunately far too many focus on a perceived capital amount to meet their long-term funding needs. Unfortunate because they do not include allowances for taxes, inflation, and mistakes both in terms of investments and unplanned expenses. Thus their retirement or legacy needs are often understated. Because of these understatements/reasonable errors I believe payout of accumulated capital over 3% annually may lead eventually to the depletion of capital  in part or completely.

Universal Problem

There are apparently a number of perceived missing elements in every country's constitution. The global rise in populism is based on the belief that our society, in other words our government, owes each able bodied person gainful employment, and for the others some form of support. To the best of my knowledge the economic structure of no country is set up deliver on these perceived, unwritten promises. Thus this is the first big problem facing us.

Retirement Capital

However there is a second and perhaps even bigger problem that is accelerating ahead of us. Any quick review of national statistics will show that the need for retirement capital is actually growing faster than the need for jobs. To some degree the need for jobs is being addressed in the much reduced growth in population around the world, except in Africa and some parts of the Middle East. The existing unemployment and under-employment is creating a growing class of people that have little to nothing in the way of retirement capital even if they qualify for the under-funded social security.

Demographically there will be others such as the disabled and currently incarcerated who will enter the retirement stage with little or no capital. Add to these a much larger group of people entering their senior stage when they have not built sufficient retirement capital. All of these people (unlike some of the unemployed) can vote and are more likely to do so than in the past.

The risk to those who believe that they have sufficient retirement capital may be  a gross miscalculation. Eventually our societies will react to these needs. While hopefully they may make investing more profitable by lowering expenses and taxes, the odds are that governments will spend money. In some combination the money will impact taxes on (a) those that have money, (b) inflation for all, and (c) deficits which will drive interest rates up and the value of currencies down. It is these prospects plus the current low real interest rates, after inflation, which makes investing in high quality bonds risky if they have to be sold to make payments. 

Currently the Proper and Improper Use of Bonds

After a long struggle to build sufficient retirement capital with due consideration to the growing needs of present and future beneficiaries, an individual or institutional investor may wish to reduce the risk of losing meaningful amounts of retirement capital, one could properly invest in high quality bonds. This assumes that the current interest rates are above the after-tax inflation rate. Such an investor is both extremely rare and lucky. All other bond owners are speculating as to the future. 

At current interest rates adjusted for inflation and taxes it is difficult to see how bonds can be used to actually build retirement capital as distinct from maintaining it. Many if not most bond holders do so in the belief that there is less price risk in owning bonds than owning stocks or other forms of equity. Historically they are right in that most market declines bonds decline less than the stocks. Thus, I believe the proper way to look at the allocation of assets to bonds is a longer term index of fears of stocks than the VIX or other measures of short-term volatility.

Bonds Could be Worthwhile

As with all investment strategies there is a time that they are correct and other times when they are wrong. Unfortunately, I can perceive that once again interest rates will be driven so low that they can make bonds attractive to new purchasers. For those who have owned bonds for sometime, the offset is that during such a period if they have to sell their bonds the odds are the prices will be below (and perhaps significantly below) their purchase prices. There have been periods in history when purchasing high quality bonds with highly elevated yields produce in time big price appreciation benefits. My only problem with this strategy is that most of the time by the end of these market recoveries, one would have been better buying equities.

Equity Risk in Some Bonds

High yield bonds and to some extent high interest loans have been called stocks with coupons. This means while these credit instruments are called bonds and loans they have imbedded in them risk of late and/or incomplete repayment as scheduled. Unfortunately many individual and institutional investors have focused on the bond-like attributes of this kind of paper and have enjoyed the performance comparisons of high yield paper out-performing high quality bonds. Perhaps they didn't notice that in most of these periods stocks in general out-performed both high yield and high quality bonds, but they could claim that they were more conservative because they owned bonds and loans and not those risky stocks.

Spending Too Much of the Income

One of the real disadvantages of high yield paper is that most investors spend all of the interest payments as if they were from a high quality source. Note that in many periods the price performance of these assets is below the total return performance results by more than the paid interest . The missing difference is the impact of the defaults on a minority of these bonds. The major credit rating groups regularly publish their estimates of the forthcoming default rates of this asset  To the extent that investors want to spend the payments off of high yield paper, I would recommend that they put into some reserve account at least the current default estimates on the category. Often when defaults rise all of these types of paper fall to some degree in sympathy to the defaulting issues.

Bond Market Liquidity is Illusive

The liquidity in the bond market is considerably less than in the stock market which makes it difficult to sell during periods of unrest. This is particularly true in the high yield market. In one recently recorded instance that is part of a law case, the nominal bid for a bond was 65 ($0.65 per dollar of face value.) A large professional seller encountered the following situation: 60 to sell $1 million, 50 to sell $2-5 million and 31 for more. What is the worth of this account's net asset value with a nominal quote of 65?

The Problem with Bonds are the Bond Buyers

As with most things the problem with various instruments; e.g., guns or fast cars, are not inherent in the instruments themselves, but the people who use them. Utilizing Schroders^* Global Investors Study 2016 one can see individual and institutional investors bring the wrong attitudes to investing in securities and funds. The desired income broken down by location was instructive. Europeans wanted 7.9%, Asians 9.7% and those in the Americas 10.4%. One should not be surprised to learn that the Europeans in aggregate hold a higher allocation to bonds than those in America, but with an older population and more proportion of  debt than those on this side of the pond. Thus they are growing their retirement capital deficit faster as well as having higher unemployment and underemployment which helps to explain their more socialist oriented government. What is most interesting is that those surveyed thought they would live a long time in retirement. In addition, 74% thought they would live sixteen to thirty years in retirement. Contrast that image with their practice of owning particular securities 3.2 years and their advisors recommending holding for on average 4.3 years. In effect what the study is showing is that investors with a long-term need for retirement income plan to trade around five times during their retirement years. While not a perfect comparison, long-term studies of US Mutual Funds suggest those that on average trade less, perform better.

^*Held personally

Bear all of this in mind with the surge of global money going into bond funds at the same time that they are significantly under-performing the average equity fund.

US Investors May Do Better

According to the trade association for mutual funds, ICI, 60% of defined contribution assets are invested in equity funds.  With a significantly older weighted population, 54% of Individual Retirement Accounts are in equities. Roughly half of the money in these two main retirement accounts are in mutual funds. Typically defined contribution and IRA accounts don't trade much. To the extent that they don't trade and invest for longer periods of time they will build retirement capital sums. They could be augmented if the tax people allow these accounts to grow without mandatory redemptions way beyond the current 70 ½ years old.  

If the current US Administration and Congress really want to increase employment, perhaps they will focus on small companies being the largest contributors of new jobs - despite the fact that the number of publicly traded companies has dropped by 3000 over the last twenty or so years. We are down about 1/3 from our previous total.

Investment Conclusions 

At the current time, high quality bonds don't make a lot of sense for most retirement accounts. Also the average US investor, excluding currency, is likely to perform better than their European counterparts. This is particularly true if smart job generating tax programs are put into place.

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A. Michael Lipper, C.F.A.,
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Short and Long-Term Unseen Implications

Introduction

Being solely a contrarian is insufficient to be a competitive investor. There are instances when the majority is correct. To improve the contrarian's odds the search for seeing elements that others don't is essential.

Since the presidential election there has been a dramatic blast of enthusiasm for US stocks and a disdain for high quality bonds and emerging market securities. While the positive effects of rising interest rates have been present for a number of months, the equity acceleration began almost immediately after the election. One might be accurate in believing that all those who were so wrong about the outcome of the elections at every level were attempting to play catch-up by doubling down their bets. In both cases their views were narrow and lacked fundamental knowledge.

Early Contrarian Training

In the 1960s I was a journeyman electronics analyst. The technology to produce color television had been known since the 1940s if not before, but the projected retail cost for a set was over $1000. My analyst peers focused their time on getting up to date on all the technological advances in components for the set. Unlike them I spent time with the marketing research people of the major set producers. In turn, they were very focused on how middle market consumers were spending their money. By the mid to late 1960s, the portion of consumers’ budget devoted to auto purchases had peaked as the post WWII replacement surge had peaked.  Thus they were ready to buy their first color television at prices over $600, and some up to $1000. That perception allowed me to be early in recommending color set producers and some of their component suppliers before my more technologically-oriented competitors were waiting on new breakthroughs.

There are Two Important Elements the Enthusiasts are Missing

The people that were so wrong about the Republican surge in the election are making the same mistake again. They are taking what Donald Trump has been saying as a concrete plan for his and the party's actions, just as they misread the polls for two generations wanting an outsider to have someone to listen to them. It didn't matter whether they were on the right or the left of the political spectrum. To some extent Mr. Trump's fellow elected Republicans have not fully accepted the implications of the recent elections.

The issues for the Republicans comes down to how they will vote and how will they manage their attempts to "drain the swamp." I believe (somewhat naïvely) that the investment bulls believed explicitly in the words of the candidate and President-elect in terms of both corporate and personal taxes. One needs to remember how tax proposals become laws and regulations. The House Ways & Means committee, after what will be strenuous debate, will eventually report out a bill to the full House where there will be further debate.

Any reductions in the net tax realization of revenues will increase the size of the deficit unless one accepts dynamic scoring that suggests that tax reduction will expand tax revenues through growth. The political problem facing the Administration's desires is in the House where there are a significant number of Republican deficit hawks who probably feel that they can not get re-elected if they vote in favor of an increased deficit. It is quite possible before a tax bill can pass the full house some Democrats will need to be in favor of it. Traditionally this support is purchased with some very specific policies favored by the Democrats which the Administration would have to signal approval. Subsequently the Senate will pass it's own bill setting up a joint congressional committee to work out the differences so that both Houses can approve the legislation. Both houses' majority leaderships will appoint members to the conference committee from both parties. These will likely be their most senior tax aware members. Eventually a compromise bill will be agreed to in the small hours in the morning between as few two members and a small number of their staffs. Due to their exhaustion and some lack of familiarity of the wording of tax regulations, the committee will get help from selected lobbyists from the deepest part of the swamp  will suggest the actual language to be used.

At this point hopefully the majorities in both houses will vote to pass the tax bills on to the President for enactment. For the investment bulls to believe that they can guess both the timing and the actual impact of the legislation on specific corporations and individuals is naïve. 

In many ways the easiest part of the governing process will be the passed legislation. Particularly for the incoming Republican cabinet the much more difficult process will be the actual administration of the ensuing regulations that the multi-generational government workers will write and administer. Just look at how almost every government body is actually managed by career people from "the swamp." Good luck without substantial help from "K Street" lobbyists to guess the actual implications for various taxpayers.

The chattering classes are assuming that by a swipe of the pen the President can in the long run effectively change regulations through executive action. Regulations were initially put into place because of perceived problems; some valid problems will need to be addressed for the protection of certain groups. The tradition in government is that even when totally free market people are put in place they will drift to the bureaucratic tendencies of command and control policies. In all likelihood those that will be actually administering the regulations at the local level will believe in the command and control philosophies.

The Second Misreading

The general rise in stock prices in many markets is being taken as the public' s affirmation of the results of the election. I believe that far too many people are not looking carefully at the underlying data and drawing, at the moment, the wrong conclusions. Most of those that wanted to be labeled "the smart money" were totally convinced that the US would have its first female president. Recognizing that probably meant at best a continuation of slow growth in a market that was close to being fully priced on election eve. They were short the market or  at least a number of stocks. When they woke Wednesday morning these "investors" became traders and quickly attempted to cover their shorts in a relatively thin market at higher prices. Soon thereafter to make up for their losses they went long the stock market and short the bond market.

The faulty analysis of the US stock market, at least in part, was due to the headlines that mutual funds received substantial inflows and therefore would be heavy buyers. As usual people should carefully examine the underlying data. The quoted numbers combined traditional mutual funds with Exchange Traded Funds (ETFs). Utilizing the data from my old firm, one could see that for the month of November traditional US Diversified Equity funds had net redemptions of $+38.6 Billion  up from $+22.3 Billion in October. On the other hand for the same types of equity portfolios,  ETFs had net sales of $+33.2 Billion up from $+11.2 Billion on October. Perhaps, even more significant ETFs investing in specific sectors had net inflows of $+13.4 Billion up from net outflows in October of $-1.3 Billion.  

The significance of these divergent trend is that due to the length of time many traditional mutual fund holders have owned their funds they are approaching a period of their lives that are choosing to either becoming more conceived conservative with their money and/or their need for cash has been rising. Judging by the volatility of ETFs transactions most of the transactions are from trading entities often hedge funds or professional traders. Some of their transactions are part of "pair" trades where they take a position long or short on a specific issue, but also hedge either general market or a sector against their primary choice to reduce general market risk. Thus, the main motivations of the owners of traditional mutual funds and ETFs are in terms of likely timespans of their holdings are different. Mutual fund holders own their shares for more than four years, often for twenty, where as the ETF holder is probably focused on the month's or quarter's performance.

Thus, I do not believe that there is a general affirmation of the policies of the incoming administration at this point.

Short Term Views

It is quite possible that this last week was something of a mild turning point in the market. Each week I look at the mutual fund performance of our clients' fund positions. I compare their quintile rankings versus their perceived peers. In most periods for most funds there is relatively little movement. However, among the many funds we follow, in this week, eleven of our funds (after doing among the best in the four weeks ending December 8^th) did relatively poorly in the week ending on the 15th. On the other hand we had four funds that materially beat their four week average. What this pattern suggests is not that there were materially changes in the funds' portfolios, but that the market is questioning the very recent strength.

In a piece on the views of ten well-known investment strategists picking their favored industrial segments, eight picked financials which clearly have been doing well. As a portfolio manager of a private financial services fund, this near unanimity of opinion makes me nervous. Bob Farrell, one of the all time great market analysts was quoted in Barron’s saying, “When all the experts agree, something else is going to happen.”

Did you miss my blog last week?  Click here to read.

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Copyright © 2008 - 2016

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