ALL INVESTORS ARE BULLISH, TIMING MAKES THE DIFFERENCE - Weekly Blog # 603

Mike Lipper’s Monday Morning Musings

ALL INVESTORS ARE BULLISH, TIMING MAKES THE DIFFERENCE

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

I often relate financial markets to horse race betting. At each point in the race there is a leader and a laggard. Their position is not important if the investor’s time period is a distant finish line. Thus, forecasts of future returns should include the length of the investor’s race. It would also be helpful to identify the near-term winners. Are they likely to be fixed income, commodities, real estate, or other asset types? 

SOME CONTRARIAN INDICATORS

Good analysts should always be looking for signs that generally accepted views and their own views could be wrong. I have found some candidates in the US marketplace that are worthy of consideration:

1. In aggregate, stocks traded on the NASDAQ have outperformed those listed on the New York Stock Exchange for the last couple of years. Generally, heavy users of NASDAQ stocks are more speculative than those trading primarily on the NYSE. Speculative stocks are driven by future projections, whereas larger NYSE companies rely more on reported results. This suggests that NASDAQ users are more likely to react to changes in sentiment than the more seasoned investors trading on the senior exchange. NASDAQ stocks have been doing better than those on the NYSE for some time, but recently the order has been reversed: 
• The ratio of new highs to lows is 2.16x for the NYSE and 1.45x for the NASDAQ
• The advance to decline volume is 3.44x vs 1.88x
2. The bond market is not only larger than the stock market, it is more risk averse. Thus, when high credit quality bonds sell at lower yields than lesser quality bonds, it is a sign of a concern for safety. In the latest week’s Barron’s, high quality bond yields dropped 14 basis points vs. 7 basis points for intermediate quality bonds. This demonstrates a willingness to trade less income (yield) for greater perceived safety.
3. A typical sign of a market top is an extreme concentration of winners. With the Dow Jones Industrial Average rising to a record 28,004 on Friday, it is worth noting that 434 of the last 1000-point gain, came from Apple.
4. The average performance for mutual funds has been way above historic rates of return for the year-to-date through Thursday night period. Below are the year-to-date average performances for selected investment categories (it’s worth noting that the averages include funds that do both better and worse than the peer averages):

    Diversified General 

        Equity Funds             Sector Oriented Funds  

    Mid Cap Growth      +28.37%  Technology      +30.55%

    Large Cap Growth    +26.53%  Global Tech     +30.11%

    Multi Cap Growth    +25.46%  Precious Metals +25.93%

    S&P Index Funds     +25.22%  Real Estate     +25.79%

                                 Industrials     +25.52%

LONGER-TERM CONSIDERATIONS

Many of the portfolios we manage are designed for longer-term beneficiaries and we therefore need to think about both finite and indefinite longer-term periods. The following is my current thinking based on what I perceive today:

1)   Yields on US Treasuries should be calibrated to perceived inflation rates, which are already imbedded in the yields. Yields are therefore a reflection of perceived future inflation rates. Currently, yields are 1.61% for two-years, 1.833% for ten-years, and 2.31% for thirty-years. I fully expect significant spikes in the latter two periods and possibly the earliest period as well, due to expanding federal deficits and weakened credit constraints on individual and institutional borrowers.

2)   China has been the leading source of world GDP growth for several years. Over the next generation, or sooner, this is likely to be less pronounced for the following three critical reasons. 

• Due to the one child policy, now abandoned, the overall population of China is scheduled to peak within 15-years.
• China’s growth engine is shifting from external to greater internal development, with more of the growth coming from a rise in the standard of living. This is likely to continue until most of the remaining seven hundred million people have moved from the farms to a more urban society. (Today, the US farm population is closer to 1% vs over 50% following the Civil War) This transition should continue to fuel the internal growth. 
• China is already wealthy as a nation, but not on a per capita basis. It therefore needs to earn foreign currency to cover its imports, which consist principally of energy and other absent raw materials. Chinese leaders recognize that an aggressive export drive might be viewed negatively by others. In the future, centrally controlled economies will likely lower tensions by balancing exports and imports. At some point India and possibly the rest of the sub-continent might be replaced by one or more African countries.

3)   Quite possibly the most difficult trend to understand is the capturing by thought leadership of digitalization over historic analog relativism. Today, most activities are increasingly driven by digital computers. The heart of computer programming is what we used to call the “nor gate”. It quickly compares one digital point to another and essentially derives right from wrong. There is no middle ground. This type of thinking has penetrated our thought process to such a degree that our political views have migrated to extreme positions, either far right or far left. Computer selection of products and services is also based on these extreme positions. Increasingly, we see investment positions being based on optimizing extreme positions. We have not yet constructed enough historic computer memory to show that extreme positions don’t last very long, in part because conditions change. The violence of both the French and Russian revolutions destroyed a few generations of more moderate and successful leadership and this concerns the history student in me. (I will shortly outline an investment approach that could allow most of us to escape the violence of extreme investing)

SURVIVING IS THE BEST INVESTMENT STRATEGY

I clearly do not know what the future will bring. Further, I am cautioning that extreme positions generally don’t work. However, I do offer a reasonable plan for our investment accounts to survive. 

The earliest attempt at human thinking was not digital, but analog. Numbers were invented later as a shorthand for reality, but not for reality itself. In the absence of digitization we could still array or rank alternatives based on a personal scale, from good to bad. (As a contrarian this is still how I rank opportunities. I have not found perfection in anything and nothing is extremely bad either.) Thus, one might call me an analog investment thinker.

I have one tremendous advantage in achieving investment survival, an advantage available to investors large or small. The advantage is building portfolios of diverse and diversified mutual funds. All too often when examining the extreme best performers in short time periods they have concentrated portfolios emphasizing a sector or type of investing. Interestingly, the lagging group also tends to emphasize sectors or investment styles. 

Each portfolio can be structured to meet account needs. The key to the selection of individual funds is the desired level of diversity. In its simplest form this could be a well-chosen short list of growth and value, plus a few middle of the road equity funds. At the extreme end of diversity it could include international funds, some concentrated on a region or method of investing, with others more regional or global. Different levels of sophisticated fixed income instruments and funds can also be added, as can funds not registered with the SEC and only available to select audiences. I do not construct portfolios to produce an overall performance record, but to satisfy a specific need.

WHAT TO DO NOW?

Since most accounts have achieved a couple years of expected performance for the ten-month period, the focus should have shifted to investment survival and maintaining reasonable performance as long as the current market upsurge lasts. Typically, our biggest dollar risks are in our most successful investments. While we are particularly fond of them, at some point they need to be pruned back or totally redeemed. Perhaps the best starting point for the scale back is the original allocation when you started investing in the name. Depending on the size of the exposure and your willingness to tolerate losing some of your gains, setting up a schedule of sales based on future prices or dates makes sense. I prefer a limited number of decision points, perhaps five or less. 

If you have positions invested in value stocks that have not participated in the current market price increase. Review them to determine the odds of being near an inflection point, or a near term price move. If you have been waiting a long time for this type of move you should probably cut back or sell the entire position, as we are late in the cycle.

If you are having difficulty executing the strategies of cutting back big winners or laggards, let us know. Hylton and I would be happy to confidentially work with you.     

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

https://mikelipper.blogspot.com/2019/11/where-are-we-and-so-weekly-blog-602.html

https://mikelipper.blogspot.com/2019/11/top-down-dictums-measured-digitally-are.html

https://mikelipper.blogspot.com/2019/10/two-questions-length-of-recession-near.html

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A. Michael Lipper, CFA

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Can You Blame Your Investment Model?

Introduction

Every moment of every trading day we are confronted with the question, “Do we buy, or sell, or just rearrange?” While one does not know exactly when the next major investment peak or bottom will be, almost all of my time should be spent on how to function between these extremes. Nonetheless, since the actual future turning points are not known, I probably should not expend a great deal of intellectual energy or emotion focusing on the search. If I have this discipline it puts me in a minority of those who make statements about the market. Perhaps my investment accounts and I are benefiting from this redirection of my emotion and mindset. Nevertheless, most of us operate in a relative performance world, my performance will be judged as how it compares with how others perform. Thus, I need to grasp how other investors, particularly institutional investors, view the market. As Hylton Phillips-Page, our firm’s VP of fund selection and I have frequent discussions with both mutual fund portfolio managers and some of their investors, I am struck that most of these chats revolve around  “the market” in general, or the price of a particular stock is expressed as a ratio of the current price to some other variable. Most of the time the managers believe they are buying and owning at some attractive discount to the larger variable. In other words they have a model which is generating a distinct benefit for their investors.

Experience as The Model

What I have learned from the Neuro-economics professors at Caltech, (where I serve as a senior trustee) is that when most are forced to make a judgment, the brain reviews its experiences. If the experiences generated pleasure it was good and thus similar situations will also be judged as good. Having been essentially a student of investing not only through my life but also of others over history where I can get some historical insight, I see a particular pattern emerging.

Most of the time prices move gradually. Often at the final run up or collapse one can divide professional investors/traders in general by age categories. Whatever driving enthusiasm is largely supported by the young, who view the then current offering as new, different, and wonderful will be the opposite of their older brethren that distrust the surge as it looks suspiciously like past problem-producing situations. Thus the more experienced players don’t participate until the parabolic price move that comes just before the turning point. Some of the more experienced players can’t stand missing out these “goodies” and need to defend themselves against the arrogance of the newly rich. (The same pattern occurs on accelerating declines to a bottom when the twin views that the world is coming to an end and/or prices fail to reflect the survival realities.)

I have noticed throughout my career that many formerly successful investors miss out on “the new thing” because the load of their experiences reminds them of past failures from over-excited enthusiasm. One of the advantages of investing through medium to large mutual fund management groups is that they often have bright analysts and portfolio managers, some with a great deal of successful experience and often, younger ones that perceive greater futures. In assembling a portfolio of mutual funds we choose some of each.

Which Past is Relevant?

To choose as the statistical base for a predictive model we have recorded human history, derived history from scientific sources in addition to yesterday’s news. I suspect we could do far worse than being guided by The Bible. It tells of seven fat years followed by seven learn years, currency manipulation by rulers, collectible and uncollectible taxes, famines, wars, disease, population growth and immigration, etc. While no one has proven that these lessons are not still applicable, we have chosen to shift to statistical measures. Most often we rely on government produced statistics. Since I have met some of the tabulators and understand how they gather data,  I have always had a jaundiced eye on their product. That is even before today’s fully expected (by me) article in the New York Times about groups of government employees developing “slow walking” strategies showing their opposition to the new Administration.

We measure our deficit, that will undoubtedly grow, as a % of our GDP which is an output measure not a wealth measure. As a matter of fact the government’s main view of the population is derived largely from aggregating tax returns. I ask how many of our readers attempt to show the largest income and the least expenses?! Further, often as people get older their wealth grows and in retirement it is their wealth not their income that motivates them.

Another source of questionable value is reported earnings of public companies. When evaluating a possible acquisition of a public company the excess assets and the operating business are separately evaluated. (I sold a data business’s operating assets, not the company and its balance sheet.)

One of the more popular valuation metrics is averaging the last ten year’s reported earnings. This is in contrast to my first lesson from Professor David Dodd, of Graham & Dodd, which was to restructure both the balance sheet and income statement to put them on a comparable basis with other companies that could have been investment candidates. Many models are based on industrial sectors as defined by either the government or a major credit rater. Over the years both IBM and Apple^* among others have been shifted from sector to sector. I suggest that if one wishes to be long or short either of these securities, it will not be because of different statistical ratios with whatever industrial sector someone places them.

^*Held personally.

We are in a New World

I am well aware the typical reason given to buy a security that is historically over-priced is, according to the salesperson, “This time is different.” To some extent that could be right today in that we have entered essentially a new phase. In the past the leading countries were growing in population and wealth. Often they were clearly technological leaders. In the United States, China, Japan, and developed Europe, the size of the work force is declining relative to their total populations and all are experiencing growth in seniors. (This may inhibit the new Administration’s ability to grow the US labor participation.)

Interesting that some have looked askance of my announcing our firm’s smallest new commitment to a fund that invests in the Middle East and Africa, because of favorable demographics, savings rates, and progress in their educational institutions. Based on current trends it is only a matter of time that Africa will house one quarter of the world’s population.

We are now living in a world where farming and manufacturing are becoming smaller relative to the growth of the service sector. (Service sector includes financial services which is experiencing growth from traditional sources but also new entrants and technologies. Unschooled farmers in Africa are daily monitoring the price of their commodities on cell phones. The fastest growth in the financial sector is in mobile finance and banking.)

The world is facing the integration of currencies, taxes, trade and military policies. One should expect that in the future we will understand the difference between schooling and useful education.

Do I Have a Model?

The simple answer is no. But I have a process to benefit and protect my investment responsibilities. First, I attempt to get our accounts to utilize the TIMEPSAN L Portfolio^® approach which addresses the importance of getting the future right. The shorter term portfolios live in the world of the present whereas the longer term portfolios are more future oriented. Since we use funds from a number of the leading investment organizations each has their own views of the future, they will change over time.

My model essentially leans on the investment lessons that have been learned over the millennia and watching what smart commercial and investment professionals do with their long-term money.

Question of the Week (or perhaps the year): What Model Drives Your Investments?  

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Copyright © 2008 - 2017

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