Excess Capital + Less Equity Opportunities + Political Fears + Psychographics = Rate Inversion? - Weekly Blog # 592

Mike Lipper’s Monday Morning Musings

Excess Capital + Less Equity Opportunities + Political Fears + Psychographics = Interest Rate Inversion?

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

The extra day in the Labor Day weekend allows us time to think about the above thought equation. The factors listed are more important than the reaction to short-term yields being higher than long-term yields. There will ultimately be the inevitable recession of unknown date. Since the beginning of recorded financial history there have been periodic recessions to wipe out excessive risk taking. Currently, I see a limited amount of excessive risk assumption, mostly in unsound credit extensions and trading leverage. While these are important, they are probably insufficient to generate a broad economic recession. Nevertheless, the factors listed are significant enough to cause a disruption of some magnitude and length.

Excess Capital
The investment markets, particularly in the US, have produced returns at a higher rate than the growth of the underlying economy. One of the lessons from both human and animal history is that too much success leads to failure through over-supply. Sir Isaac Newton viewed the laws of physics as the tools of the Watchmaker in the sky. Thus, the laws of gravity were immutable and it is also probably true regarding the returns on invested capital. Compared to the US return on capital at its last peak in 2006 the current reading is lower, even though the size of the capital base is much larger. This suggests the law of large numbers is at work, making it difficult to sustain high rates when the base rises. Publicly-traded companies recognize this, and don’t want to have an extra-large pile of cash on hand, making them the target of a raid. Their three-fold approach to this dilemma is to raise their cash dividend by at least the perceived rate of inflation (creating a quasi “growth bond”), make acquisitions for cash (often overseas), and buy back stock.

Those who sold their shares back to the company received cash, which should have been reinvested into equities to maintain their stock/bond ratio. The size of buy-backs in 2019 appear to be smaller than those in 2018, making the chore of reinvesting more difficult. The enthusiasm for seemingly attractive stocks is less this year, resulting in cash building up in both institutional and individual investors portfolios. Because the cash build up was reinvested in short term paper while awaiting better (lower) prices, it increased the willingness to pay higher yields.

Less Equity Opportunities
The number of publicly traded stocks in the US has been falling for many years, resulting in about half the number of companies surviving. New enterprises are staying private longer, due to investments from private equity groups. Foreign companies have also been active buyers of both publicly traded and  private companies. Private equity managers have raised considerable amounts which need to be invested each year, further reducing opportunities and generally raising prices. This alone can make a market more vulnerable to a shock.

Investors may believe that they are well diversified, but they are probably not as diversified as they believe. Mutual funds are a good representation of how investors manage their money. With the smaller number of opportunities available, we are seeing the leading positions in the largest fund categories, like S&P 500 Funds, Global Funds and International Funds being dominated by the same large tech companies. Each of these funds has a few to over half its ten largest stock holdings represented in the twelve largest tech-oriented firms. If one includes the largest users or suppliers, the tech exposure probably represents the single largest driver of the funds’ performance.

Political Fears
The speeches and political commentary in numerous countries, including the US, is frightening some investors away from their long-term responsibilities. Many of these investors have seen  confiscatory taxes, capital controls (exporting capital) and limiting profitability in their lifetimes. The US looks more favorable to some than their home country, so cash is flowing into the US dollar. Some or most of this cash is going into short-term instruments, which is pushing up short rates.

Within the US, the presidential primary season has been a scene where each potential candidate seems to be trying to be more left oriented than the others. For those with capital and long-term responsibilities there does not appear to be a single large safe home for investment, leading to an increase in international investing. Traditionally, one invests outside of one’s home country for opportunities not found within it, but some of today’s international investors are seeking safety or at least a different set of circumstances or projected time frames. Thus, one can see a heavily US oriented portfolio being hedged with some Asian/Chinese positions. The hope being that the hedged elements do relatively badly, meaning that the US holdings on balance do well. This reminds me of a quote from John F. Kennedy in the latest Marathon Global Investment Review: “Change is the law of life. And those who look only to the past or present are sure to miss the future.”

Psychographics
How the global population feels towards “things” and people is one of the key change agents in the demand for products, services, and investments. An interesting article in The Wall Street Journal (WSJ) this week indicated that young people in China and I believe in Japan are taking on debt for products and services, mirroring the behavior of those in the US and other western countries. In both Chinese and Japanese societies saving was a paramount goal to provide for future healthcare and retirement. This generation seems to spend their pay entirely on purchases and the repayment of consumer debts. They are setting up permanent households later and having fewer children, leading to an expansion in the number of financial intermediaries, rather than providers of mortgages and long-term investments. These changes are modifying the slope and nature of the yield curve, favoring short-term borrowing funded by longer-term capital.

One of the areas of specific interest is the use and ownership of autos and related vehicles. With the building of mega cities that have reasonable public transportation supplemented by ride-sharing, there is a smaller need for private autos and the financing to support them. All of these changes shorten the time horizon of an increasing portion of the population, not only changing the structure of yield curve, but the political attitudes concerning what is important. Increasingly, societies are sacrificing the future for the present, ignoring JFK’s admonishment mentioned above. Bear in mind, he was the first young president of the US.

Interest Rate Inversion?
In my mind there is no doubt that we will have a recession during the next five years. In the post-mortem examination of the predictive elements, some may claim that notice was given when short rates were for some period higher than long rates. Because of the changing conditions for money I would note the inversion, but not place too much faith on in its predictive skills

Investment Conclusions

1. Prune the portfolio of those holdings currently trading at a loss, whose prospects are not exciting.
2. Reduce all levels of debt.
3. Slowly start a recovery portfolio that is quite different than the present one.
4. Consider some exposure to value investing, but separate value into mispriced stocks and bonds vs. deep value plays. The latter will be selling at discounts of 25% or more from current value, with control in weak or feeble hands.
5. Look to the more distant future. One place to look is this week’s Bloomberg Businessweek entitled “The Elements”. The magazine suggests some unexpected winners and losers from the commercialization of the lesser known chemical elements, but patience will likely be required. 

Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/08/an-awkward-moment-with-frustration-not.html

https://mikelipper.blogspot.com/2019/08/short-term-recognitions-plus-longer.html

https://mikelipper.blogspot.com/2019/08/sentiments-approaching-reversal-points.html



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How to Send Your Investment Dollars Overseas

More and more money is leaving home. The flight is caused by unhappiness at what is happening in this country, if not outright fear as to the long term value of our hard earned capital. What many Americans fail to realize is that there is hardly a truly popular government any place. To some this desire to obtain capital escape is a new urge, but the truth is that wealthy individuals and families have been exporting their investment capital for centuries. The earliest investors to send their money across borders were the wealthy from small, often but not always, wealthy countries. The two leading countries that were slow to export an important part of their wealth were the Americans and the Japanese. In our case there was some foreign investment in the late 19th and early 20th centuries, (I believe that my grandfather’s brokerage firm had not only foreign customers, but some US investors investing overseas through his facilities). From the time I was a trainee in the vault of a New York bank counting foreign stock certificates that backed the American Depository Receipts some 50 years ago, I was interested in investing in foreign securities. While I have owned individual foreign stocks in the UK, Canada, Australia, Netherlands, and France, I found a sounder way to invest. With total bias, the better way to invest is through internationally-oriented mutual funds.

GLOBAL FUNDS OR INTERNATIONAL FUNDS?

For those who are novice investors the best choices are global funds that mix at their discretion, US and foreign holdings. In truth, today most large capitalization funds almost anywhere in the world are global funds. In many cases at least half of the earnings growth driving their performance is generated by foreign-based affiliates or exports. But for those of us who believe that we have the right mix of investment managers, a dedicated international fund is the right tool. For those of us who are more demanding, a number of different international funds are needed.

FOUR APPROACHES TO OVERSEAS INVESTING

Recently I was present when a large domestic investor was hearing the seductive call to invest overseas. Sitting through three presentations of separate account international managers, I realized that the analysis leading to their decision should have been similar as to what I do in selecting international funds for portfolios of largely domestic funds.

PARTICIPATE IN THE MARKET

The first approach entails asking the question, “What does the international investment bring to the account?" The simplest desire, and the one that can not be assured, is better performance than the existing portfolio. To me the first step is how the new investment integrates with the existing investments. Some portfolios are essentially participators in the general economic conditions. Most of the satisfactory investments for this need are index huggers, or if you prefer, closet indexers. Some prefer actual index funds trading off potentially advantageous stock selection for lower fees. In truth, the portfolio manager of this product can be located anyplace where there is electricity for his/her index modeling computer.

TILTING THE ALLOCATION

A second approach is a country and/or sector allocator. In this case there is a willingness to move away from the central tendency of the index. As practiced by the activists, there may be a willingness to eliminate some countries or sectors. Others have an operating rule to underweight or overweight a country or a sector by 50%. For the most part these managers use publicly known trends. Their skills of mixing and matching can be practiced from any location where air travel can easily bring in foreign salesman or commentators.

PICKING STYLE

The third approach is to have a global point of view. Often this is described in terms of growth (of earnings) or value (a discount from intrinsic value). Various studies show that from time to time either growth or value produce better results. As the investment game is now global, it is my point of view that growth or value leadership (or for that matter most sector leadership) follows a similar path in the domestic market as it does in various international markets. Therefore, we try to match the style inclinations of the international portfolio managers with those that dominate the domestic portfolio. As international investing is inherently more expensive, I reserve the domestic portfolios for minor style changes if I do not have the ability to meaningfully shift cash flows. In this third approach one is counting on the allocation skills of the portfolio manager. If one wants to participate in the leading edge and willing to be part of the “bleeding edge,” then the activist should be located in the flow of information. While today we can do a lot from a central location like my intergalactic world headquarters in Summit, New Jersey, there is a belief particularly by clients and some consultants, that closer to the action listening posts are better. (Notice that most of these are in cities with good restaurants.) There is some risk that the listeners are primarily getting their inputs from these restaurants, golf clubs, and in certain places, the American Clubs. The listeners may not have their ear really to the local ground. For example, in none of the recent manager presentations or six month reports did I hear anything about wide scale loss of faith in the European Union. On August 27, in my previously mentioned global world headquarters, I read that only 42% of Europeans say they trust the European Union, and this is down 6% in the last six months. In addition, “fewer than half of Europe’s citizens see their country’s membership in the EU as a positive thing….” as reported in EurActiv. I do not find this poll as a positive indicator unless I want to put on my contrarian hat. If I do this hat trick my investors should be warned.

STOCK SELECTION

The fourth approach and the one that I generally favor is one where individual stock selection is the critical talent of the portfolio manager. To my mind they have to know as much about the companies they invest in as the leaders in the various local communities. These managers should regularly attend important weddings and funerals; speak and understand the local dialects as well as be able to prepare local foods. In other words, they should have gone, or are, local. Having a string of offices around the world would help if they are offering investments beyond a single market. These should be primarily research offices not sales offices. There is a risk to this marriage with the locals similar to the risk of working with industry analysts. While from time to time they may advocate a sale, rarely will they advocate complete retreat and closing the office. Thus in this fourth approach there is a purchase bias which must be recognized.

We use all four approaches depending upon the needs of the account. Notice in no case did we focus on performance. My approach is that performance is at best an introduction to a manager and may well be poorly timed after a period of good performance.

As this blog is an instrument of a global community, I am curious whether you will share your thoughts on international fund and manager selection.

I hope next week to devote this blog to a view as to the direction of the domestic market that appears to be wallowing in fear and unhappiness. Any thoughts would be most welcome.

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