Danger Ahead, New High Stock Market: Is Capital Preservation with Appreciation the Answer? Weekly Blog # 514

Introduction

At the end of February I was about to suggest that both the high and low for the year 2018 were in place. If either price was violated it would be troublesome. After the first nine days in March I am getting much more concerned about a breakout above the January highs.

Why are Higher Prices Dangerous?

Perhaps I am jumping to the wrong conclusions, but for many the 400 point rise of the Dow Jones Industrial Average on Friday can be chalked up to volatility, but others may see it as a successful test of the February lows. (I would have preferred a lower test with more volume of trading and statements of discouragements.) But the realist needs to accept reality, not wait for the perfect. There is a good chance that others will see it as a successful test, encouraging buyers with significant power to return and drive the next upward move. Using the very volatile sample by the AAII, 45.2% of their surveyed members are now neutral, which is higher than both their bullish and bearish members. This is a rapid change from just three weeks ago where the neutral tally was 32.6%. In the recent week the top 25 performing mutual funds had gains between +7.77% and +6.07%. All but one of these were growth oriented and or specifically science & tech oriented. 

Thomson Reuters tallies analysts’ earnings estimates and in their latest report the analysts expect the S&P600 Small Caps to have earnings growth for this year of +24.1%  compared with +19.45% for the S&P 500 and +37.67% for the Russell 2000. Both the fund performance leaders and earnings estimates are based on a belief that the future is going to be good, led by positive future developments in terms of technology, politics, and economics. (Perhaps they will be correct.)

After nine years of rising markets, I have been on the lookout for signs of an inevitable market decline. In terms of magnitude of decline a normal cyclical decline is in the range of 25%. These happen normally once within a decade. Not too many people are psychologically wiped out in these declines and usually return to the stock market within a few years after the decline.

A much more serious fall, that is often labeled a collapse, happens infrequently, normally once a generation and is generally in the range of 50% from the peak and has investors leaving the marketplace never to return, This type of fall is in the passing on their distrust of the market to the next generation. The individual and societal losses from these collapses are relatively small compared to the forgone profits from the recoveries, which impacts the rest of their lives and often also the next generation’s. As both a fiduciary and an investor I would like to avoid these results. I attempt to do this with an eye on a number of different market histories.

The major traumatic collapses start with apparently successful investing, that not only turns a small amount of money into a larger amount of money but inflates the investor’s belief in their own investment skills. Often this confidence leads to the use of borrowed money in the forms of margin or derivatives. A speculative fever takes over the crowd, while they recognize there is some risk their confidence is such that they can get out without large losses.

The driver of these “animal instincts” is based on an unshakeable view of the future. These speculative markets are driven by sentiment, not researched fundamental investing. This is why I am paying more attention to measures of sentiment, along with attention to internal financial calculations.  One of the fuels of a major top is the sucking into the market of all or most of the available cash.

Assuming the US and perhaps other markets pierce their former highs, the various pundits, including non-professionals, will proclaim that those not participating are stupid. They have never studied handicapping at the racetrack where in each race there is likely to be at least one horse with a good, very current record receiving a disproportionate amount of the betting money. This is the favorite of the crowd, no different than the current market where leading funds are heavily invested in a select group of multinational tech companies. At the track, while the favorites do win at short odds, they don’t win enough money to cover the losing bets the majority of the time.

I am concerned that over the next year or so too many investors, including those institutions that are de-risking, will get sucked into the market. My fear is not for them alone after their disappointment of losses from the next peak, but for the opportunity losses in a future recovery. Unfortunately in our society these are the losses that are socialized for the rest of us to pay.

What are the Signs to Watch?

Currently, the most visible largely speculative source of flows into and out of the market are the Exchange Traded Funds (ETFs). Much of the current activity in these securities is by traders, often at hedge funds, who are using ETFs rather than more expensive derivatives. In the last week, while the larger mutual fund industry had a small net inflow due to net purchases of non-domestic funds ($2Billion), ETFs had a net outflow of $12.6 Billion with $10.3 Billion in one ETF invested in the S&P 500. This is a sign of a trading market that has lots of speculation occurring.

The second item to watch for soon is mutual fund advertisements heralding their ten-year performance results, which had been trailing more current periods. It is easy to look good from a bottom in March of 2009.  These market efforts could bring a lot of unsophisticated money into the stock market, which will entice the so called sophisticated players to trade the market on the way up convinced that they can get out in time.

What can a Wise Investor Do?

In an over simplification, portfolio strategies can be divided into two buckets: Capital Preservation and Capital Appreciation. For some of our clients, particularly those who have worked hard for their money, their primary concern is capital preservation. This is particularly difficult today if one is concerned about after inflation and after tax earnings. Around the world, governments in theory are sponsoring inflation as a way to create jobs, by ballooning the income of businesses and individuals. What they are actually doing but not discussing is lowering the purchasing power of the loans that they are repaying. This is a continuation of a trend, as governments since their beginnings have debased their currency as a way to payback less value than what they received. 

To the capital owner and the individual, inflation is another form of taxation. In the current environment income taxes are not the only source of pain. Because of the recent changes in the US tax code, I believe we will see an aggregate increase in fees, tariffs, sales and use taxes, as well as various forms of value added taxes. If the job of capital preservation is to maintain the purchasing power of capital, it must earn more than inflation, all taxes, and other distributions. I suggest that in the current market, high quality bonds can’t produce the necessary income. (That is why in our TIMESPAN L Portfolios® we should only have fixed income in the Operational Portfolio.)

At this juncture, until we see much higher real interest rates, the best suggestion is high quality stocks whose yields are in the range of the ten year treasury and have a history of periodically raising dividends roughly in line with inflation. One would like to find dividend payout ratios below 50% of earnings, if possible. In truth that is going to be difficult to do with appropriate diversification.

As a practical matter many accounts are going to have to dip into the capital appreciation bucket. In selecting funds or stocks I would array them based on a guess of how many years into the future the particular issuer will pay a dividend that would qualify for inclusion in the capital preservation bucket. In some cases this may be in only a few years. In others, like with Berkshire Hathaway* and Amazon, the indefinite future may be too short. In these cases the willingness to periodically sell off some of the appreciation to fund the preservation bucket could allow the position to be in the portfolio.

* Owned in both a financial sector fund and personal accounts that I manage

<b>Questions of the week:

What portions of your portfolio do you consider Capital Preservation and Capital Appreciation? Do you expect to change these based on market cycles?  

A More Insightful Way to Characterize Funds

Guilty As Charged

I plead guilty. I plead guilty for the crime of characterizing mutual funds and their kissing cousins, hedge funds by the types of securities in their portfolios. My enablers are the fund marketing people and the lawyers. At times we are all guilty of taking the easy way out. We choose to identify people by what they look like, not what they are, or more significantly how they think. I should have known better. I forgot my race track education of calculating my betting choices after examining the characteristics of the jockey, trainer, and breeding as well as the conditions of the race and the racetrack. Shame on me.

The Talents of the Trade

Each of us has a different collection of talents. I have made a living analyzing a mass of data, organizing the data for decision making, and using that data for making decisions applying the disciplines that I learned from my educational institutions, the US Marine Corps and the aforementioned racetracks. I should have looked at the primary thought patterns of the principal decision maker for each fund. Most of the time this is the portfolio manager, but it can be the most forcible member of the investment committee, a determined marketer, or extremely rarely, the fund’s board of directors. The following are some of the ways that I identify the dominant personality of a fund and how the fund can be used most effectively in a portfolio of funds. (I manage or advise on the use of funds in a multi-fund portfolio where each fund has a separate function in contributing to the whole over the long-term.)

The Discoverer

This portfolio is full of names that are not common to most other portfolios. More often than not these names are of smaller, often newer companies. Sometimes the names are from rarely explored foreign markets. Occasionally the names are different types of securities which more often than not come from the extremes of the fixed income world. All of these securities lack significant research coverage from the usual sources of research. As an analyst I used to delight in finding companies whose president has not talked to an analyst in years. As he or she explained the company to me, I explained how analysts like me operated. Some of the most rewarding investments were in companies that had a policy of not speaking to analysts. In almost all cases the names in a Discoverer’s portfolio are difficult to analyze. When these stocks move, it is usually not due to an asset class’s popularity or the general trend of the market. Most often a Discoverer will have more strike outs than home runs. The investment results will look more like those of a venture capital portfolio, but have the advantage of offering daily liquidity. In the hands of someone with a great deal of industrial experience and a proclivity in recognizing management’s abilities, this kind of investing can be rewarding for the truly long term investor. Wealthy individuals who have a multi-generational outlook or a structured endowment for long term horizons can find a Discoverer a non-political “fellow traveler” and a good strategic fit.

The Anticipator

I use to hear this term used more frequently than now. The term was applied to managers who felt they had well-defined skills at anticipating major interest rate moves. There is still at least one fund that invests either in very short term treasuries or thirty year treasury bonds. The Anticipator has a defined view of the future and is waiting for the rest of the investing community to catch up. The trick for a successful Anticipator is not to be the first Anticipator but near to the last, just before the take off of the expected trend. At times, Bill Gross and others at PIMCO are Anticipators. To some degree this a necessity, due to its size relative to the size of the available merchandise at an inflection point. This may be a requirement for PIMCO as the world’s largest bond fund manager. Some patience is required to be a successful holder of a fund that anticipates. One can appropriately call my faith in the benefits of technology as anticipatory and not often rewarded.

The Immediate Reactor

The financial press believes that the market is full of those traders/investors who immediately react to a bit of news. They are looking for the proverbial one-handed economist who has a singular view on an event. Even the rapid-fire “macro” hedge funds don’t put their money on a single roll of the dice. Most often a substantial buy is offset by a sale or short sale, perhaps through derivatives or ETFs. Nevertheless, the Immediate Reactor does make dramatic moves quickly. The closing of the liquidity pool around a security or currency is viewed as an opportunity to get in before the bulk of the move is underway. Funds that do react well have suburb trading skills and they know how to use their size to get the best advantage. In many ways these are trading artists. Outside of occasional outsized gains, these funds can be used as an early warning device, a canary in a mine if you will.

Trend Identifier

These managers are constantly searching for minor deviations from immediate past experiences; to be one of the earlier identifiers of a change in an investible trend. For example, these trends can focus on elements of consumer spending at various price points, the popularity of products ( e.g. Blackberries and iPads), or the daily movement of a currency. In the fund arena, the rate of inflows and redemptions can be interpreted as meaningful trends. Often large funds use identification of trends to shift a small amount of their portfolio in the direction of the trend on a daily basis and more as the trend becomes more pronounced.

Trend Follower

Some managers, particularly in the commodities world, are Trend Followers. They need to separate market volatility from important market trends. These stock, bond, and commodity managers focus on large aggregates in the market place. A more modern example of this age-old technique is the use of Exchange Traded Funds. Currently there are portfolios that only own ETFs or Exchange Traded Notes (ETNs), a fixed income equivalent. Increasingly these portfolios are being used for commodities like gold and silver. Trend Followers have more faith that the trend will continue for some period of time than recent history suggests. Also aggregate trends do not allow for the investment opportunity differences among various industries, sectors and other components of the aggregates. If one does not have much faith in individual selection skills and the direction of “the market” becomes all important, Trend Following is an attractive approach.

The Resurrection Believers in Recovering Prices

As all life seems to be cyclical in terms of up and down phases, hopefully around a recognizable trend, some managers look at investments that are currently priced well below their peak levels. Excluding from this universe those stocks that were substantially over-priced given their best expectations, the resulting list of large discounts from peak can be a happy hunting ground for some investors. These investors are different from value investors who believe that today’s price represents a good value relative to today’s reality. Those that believe in recoveries believe that conditions will change. Whatever caused the unfavorable conditions, e.g. commodity prices, unpopular styles or product failures, will change. The argument goes something like this: if oil was priced at either $150 or $36 a barrel, certain properties would be perceived to be more valuable. Another variant of this strategy is when the new production comes on line, such and such will happen that will significantly change the valuation of a security. This may be considered as betting on the return of the Black Swan from Australia. History is on the side of those who believe in cycles of prices and other forms of human behavior. What is more difficult is identifying which particular cycle will change the soonest. To some degree distressed securities buyers believe in a form of financial resurrection.

Final Note

To be a good investor, one needs to know more about the intellectual motivations behind various portfolios.

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