“Things are Seldom What They Seem” - Weekly Blog # 718

 

Mike Lipper’s Monday Morning Musings

“Things are Seldom What They Seem”

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

This is the title of a song by WS Gilbert of Gilbert & Sullivan in the operetta H.M.S. Pinafore. The title seems appropriate to thinking about investing today. In gathering research to reach my conclusion, I excluded positives that led to a bullish conclusion, but not because it’s unlikely. To the contrary, most investors tend to be optimistic, their views are documented by investment and political pundits. Consequently, another similar voice is hardly additive. Seeing potential negatives is not a popular exercise, although it’s useful in bringing balance to one’s views. To be perfectly clear, the vast bulk of my investments are invested in stocks and equity funds for the long-term, even beyond my life. I hope the majority will pay off in total return, comprised of price appreciation and growing dividends. The biggest problem today is that very few investments generate income sufficient to meet reasonable future expenses after inflation and taxes. The inability to meet current and future expenses from dividend and interest payments is a sign of a highly priced market.

Critical International Competition

Our geopolitical discussions are often based on Ukraine or China, with these conflicts placing the Western world at a disadvantage, regardless of our greater wealth. The current administration is playing checkers, where one needs to get up close to the opponent to eliminate one of the opponent’s pieces. The Russian leader appears to be an excellent chess player. The goal in chess is to capture the opposing king, using players that have different capabilities and proximity. Our Chinese competitor believes time is on their side and is building a greater level of self-sufficiency. Both appear to be capable executors of tactics and strategies based on a lifetime of work and success. By comparison, many members of our cabinet and senior staff were chosen based on their identity and political views.

Earlier this week at an investment committee meeting I mentioned that Russia had already accomplished its real mission, sponsoring disunity among European NATO members. Both German and to a lesser extent Italian business leaders wanted to maintain close relations with Russia and China. While I still believe this is the way they play global chess, there is a contrary action on the horizon. One of the main political parties in Sweden, concerned about the fluidity of Russian troop movements, wants to join NATO. With Sweden’s technological strength and good military, it could more than make up for the potential loss of Ukraine. Whether this happens or not, the mere fact that it could, is an example of “things are seldom what they seem”.

Guessing the Future is Difficult

As securities analysts, we used to say the one saving grace of weather forecasters is that they made us look good by comparison. (In terms of weather, I should point out, the less than optimum choice of the date for the Allied landings in France was a correct judgement by Ike, which differed from the German Army’s conclusion.)

Each year, the accuracy of the Congressional Budget Office’s (CBO) budget revenue projections is compared to its past record. In fiscal year 2021 the projection was too low by 15%, three times the normal error rate of 5%. Outlays were too high by 4%, twice their normal miss rate. These projections were calculated after some midcourse corrections in March. The purpose of showing these misses is another example of skilled statisticians falling to Mr. Gilbert’s song title. 

I don’t have similar numbers for analyst misses in terms of sales and earnings for the same period. My guess is the private sector error rate was equal or more than the CBO’s. My concern, particularly for high P/E stocks with double digit earnings multiples, is that errors can start “to be real numbers” This may be particularly true if one wants to invest for periods of ten years or more.

Two Different Voices

This is the season where politicians and corporate managements tell us how good things are and will be with their fourth quarter and annual earnings announcements. Actions by consumers and investors are saying something different, with consumer spending in December slightly below November. It is possible consumers shifted to earlier holiday buying due to fear of shortages, although a recent walk through The Mall at Short Hills, a ritzy shopping center, did not reveal ebullient shoppers. This suggests very little business capital was used to expand capacity vs filling out the supply chain, although there was probably some inventory building on the industrial side. 

In terms of net buying of mutual and ETF fund shares, it was dominated by the buying international funds and the redemption of domestic equity funds.

Views on a Recession

Merrill Lynch market analysts believe the quickest way to a recession is a Wall Street Crash. Jeremy Grantham, a manager that has been early but correct, put out a very dire point of view in a piece titled “LET THE WILD RUMPUS BEGIN”. He portrayed a bursting of the US Extravaganza, taking stocks, bonds, commodities, and housing down to at least their base price levels. Barron’s headlined an article “The Countdown to The Next Recession Already Has Begun”. This article pointed to rising fed rates bringing on a recession in 2024.

We May Not Be Hedged Against What We Thought 

Suppose we have a $1,000,000 portfolio invested 90% in stocks and 10% in long bonds. If any of the thoughts expressed above materialize and stocks and bonds both drop at least 10%, you now have $900,000 portfolio. While you continue to be hedged against a relative decline of one of two asset classes, you are not hedged against the loss of $100,000. If you look at the purchasing power of your money, both inflation and foreign exchange could reduce the purchasing power of your investments.

Working Conclusion

Be prepared for a difficult market that will reset values, possibly for a few years. At the same time, maintain long-term positions for future generations. They will need it, because it is possible the world will restructure in an unfavorable way, but at least they will have a start.    

  

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

https://mikelipper.blogspot.com/2022/01/two-critical-questions-weekly-blog-717.html

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

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

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A. Michael Lipper, CFA

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Are You In an Investment Bubble?

Introduction

Sales people of all types are taught the doctrine of KISS, Keep It Simple Stupid. A more urban version of this is the “elevator speech” to be used meeting a client or prospect in an elevator and designed to be delivered quickly and simply in the time the  elevator takes to go from the lobby to the floor of the intended client’s interest. Both of these approaches prize getting an intended result rather than a transmission of understanding.  

William Shakespeare, market analyst

In his masterpiece of summing up trouble, Shakespeare has the three witches in Macbeth, Act IV, Scene I intone “Double, double toil and trouble; Fire burn and cauldron bubble.” This may be the first literary introduction to a market bubble. Notice the words “double, double.” In the investment marketplaces, a requirement for a “bubble” is a phenomenon of great popularly-driven walls of money flowing into dotcoms, housing, derivatives, treasuries, and high yields. Note there is nothing wrong with any of these investments in moderation, but when they enter into the phase of double, double, or much more there is danger of being in violation of the concept of prudence by not avoiding large losses. (In handing his ruling against Harvard College in 1830, Judge Putnam intoned the famous “Prudent Man Rule” which required a trustee or fiduciary to do those things that other men of intelligence and prudence did with their own money.”)  This ruling created a peer-related legal concept of prudence. By definition, if there are large holdings in a security or sector, when they go down there is limited demand for the falling securities which will lead to even greater declines.

Camp followers or market followers

In many European wars the armies were closely followed by a bunch of women; some of these were the wives of the soldiers, others pursued a more professional type of transient relationship. The wives were interested in the long-term, the second group were more interested in the action of the moment. I see a parallel to the second group in some of the emerging trends today.

This week the MacArthur Foundation recognized Professor Colin Camerer from the California Institute of Technology for a genius award. I am a Caltech Trustee, thus my wife Ruth and I know and prize Professor Camerer for his leadership of a group of graduate and post-doctoral students who finished their work at other universities. Their combined study that linked blood flows in the brain to financial decisions showed that sophisticated risk-taking investors rather than neophytes were more likely to get caught up in playing bubbles. (Two well known brains who lost a great amount of their wealth in past bubbles were Sir Isaac Newton and Winston Churchill.) When I read about Colin’s success I wrote that the victims were in effect playing the old market ploy of the 'greater fool theory'. My good friend and regular Wall Street Journal columnist Jason Zweig had the same conclusion. The greater fool theory works on the basis of buying and holding an investment at a price that is disassociated from reasonable value on the basis that there will be a bigger fool who will pay an even higher price. Essentially these “fools” are letting the market make their decisions for them on the belief they can identify the ultimate fool. (Not themselves, of course.) It didn’t work with tulips or any of the other previous investment bubbles.

Where is this present bubble?

Over this past week and on a recent trip to London I was made aware of investment managers who on the basis of their back-tested data make the claim that they can produce better than market results due to their timing and selection of market sector skills through the use of Exchange Traded Funds (ETFs). As with other vehicles which can be driven too fast, ETFs are based on a safer, older model that had a more prosaic basis. Having given up on selection skills in picking managers or securities, many financial institutions are opting to closely match the market through low-cost index funds. (Unless the profits on securities loans or smart intraday trading are particularly adroit, the fees charged most of the time mean that the index vehicle comes close to matching the reported index return, but rarely produces the exact return of the index.) The merchandisers of securities recognized that using an index in a publicly traded security opened up opportunities for them to generate commissions, spreads, arbitrage opportunities and margin interest and thus became advocates of ETFs (Bubble, double bubble). Further, hedge funds found a safer vehicle to short against the risks in their long positions.

KISS and Elevator Speeches seem to be working. Each week I look at the net flows into ETFs and mutual funds as produced by my old firm now known as Lipper, Inc. In these reports the volatility of the dollar flows into and occasionally out of ETFs are larger than mutual funds even though the total size of the fast growing ETF business is considerably smaller than the mutual fund business. This is beginning to feel like the players of the day are increasingly playing the greater fool theory. I don’t know how long this phase of the game can last.

The revenge for 2008

Diversification became the buzz word for safety in many financial institutions. The assumption is that if one is invested in a number of different asset classes and sectors one can’t lose it all at the same time. This belief was based on a mathematical model that showed traditionally different market sectors were not particularly well correlated. However in 2008 almost every stock and bond around the world went down, except for treasuries and some small markets not usually held by foreigners. The spread of correlations collapsed.  In reaction to this painful experience many chose to play the market in a risk on/risk off fashion. For a lot of these players the ideal vehicle was and is today, ETFs. (double, double bubble).   

A study of history may suggest that we are in the midst of a Hegelian Synthesis where one trend creates an opposite trend and prominence of one over the other reverses. We may be heading back into a market of security selection not index trends.

The lessons of George Washington

One of the lessons from this weekend for Ruth and I with some good friends came from the dedication of a national library for the study of the first President. In the dedication of the library at Mount Vernon, the well known author David McCullough said George Washington had no better than a sixth grade education, but his library and his letters showed that he learned a lot. His first military battles were defeats but he learned to be a brilliant tactician using maneuver and surprise that my Marine Corps text books value so highly. He was a great leader of men getting his troops to stay with his ragtag army when their enlistments were up and farming season was looming. He stopped a potential army take-over in its tracks by just addressing the troops. Of all his manifold skills the greatest of them all was his leadership.

Applying General Washington’s leadership to your portfolio

How do you avoid the group think that is surging through the use of ETFs and other index-hugging approaches? George Washington was not afraid to try different things. He found and led other generals who were more trained in the arts of war than he. He kept his eye on his strategic goals and did not focus only on tactical moves. He endured the loneliness of command well. In the context of today’s investing world this means picking securities and managers who are different and that are focused on the strategic goals of the account to deliver funding when needed.

Are you strong enough in your investment beliefs to escape indexing a major portion of your investment responsibilities? Share your views with me privately or publicly.

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.