What is Next After the Next Next? - Weekly Blog # 625

Mike Lipper’s Monday Morning Musings

What is Next After the Next Next?

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

Most people focus on the current conditions. However, as someone who has always been influenced by repetitive history, I wonder whether we are approaching a significant turning point. While I do not know, I believe it is worth pondering. Allow me to sight three events that identified turning points that changed the pursuits of individuals and nations around the world.

1. An important change in the direction of human behavior after an extended period of time. 
2. An event or a series of events that distinctly break with the past. 
3. Prominent actors primarily focusing on current problems and being oblivious of the long-term implications of their actions. Three examples are: The end of the Dark Ages in Europe, World War I, and World War II. Each example resulted from the following:

• A different kind of pivotal leadership
• A weakened old order, both politically and economically
• A relatively small invention that changed many lives
• The introduction of a period of rapid change
• People willing to participate in radical change

The end of the European Dark Ages was caused by changes initiated by Henry VIII and his daughter Queen Elizabeth, Martin Luther, fundamental scientific discoveries, and Gold from Latin America.

It was not WWI itself, but the failure of the peace in solving the political problems facing Europe and its place in the world. The development of the airplane changed the modern world, ending geographical isolation and igniting the rapid development of mass arms manufacturing and radio as political weapon.

WWII relied on political leaders inciting their populations to go to war, the development of long-range missiles, nuclear energy, and substantial improvement in medicine/hygiene.

Current Condition
During the current pandemic, many political leaders across the world have put their citizens on a war status, by limiting their movements and working conditions. They are also rapidly developing specific therapies and hopefully cures. The US and other stock markets around the world have ended an expansion driven by lenient and inexpensive credit restraints for both the private and public sectors. We entered the fastest bear market ever, in an economic and financial world measured instantaneously. Whether it is over is subject to debate.

Readers of these blogs know that I identified the March 18th low as a “stealth bottom”. It was successfully tested on March 23rd, which was lower but did not bring on new waves of selling. There are a significant number of market followers, perhaps 1/3 of the financial community, who believe a lower low is coming. They could be correct but utilizing my odds tracking experience I don’t think so.

The following statistical sample utilizes the average mutual fund performance from 3/19 to 4/16, which arrays in a pattern seen in the last bull market: Growth funds +17.27%, Core funds +14.87%, and Value funds +13.48%. The more narrowly focused funds were led by Global Science and Tech. +21.16% and Real Estate +20.46%. These were followed by mid and small-cap funds.

The leading performance of narrowly based funds is significant because they do not have the same market liquidity as the larger and more diversified funds. Investors appear to be willing to accept more risk, suggesting they may believe we have seen the bottom.

If there is going to be another major down-leg, there is lots of “dry powder around to absorb it. Money market fund assets have reached record levels, with retail investor’s cash reserves now representing 14% of their allocation. Last quarter clients of JP Morgan Investment Advisory accounts added $75 Billion in liquid reserves, while redeeming $2 Billion in long-term accounts.

Those who follow the investment management business are familiar with Howard Marks. (I have known him since he was a portfolio manager of a closed-end convertible securities fund in the early 1980s.) He has been a very successful investment manager since his early days. Recently he sold control of Oaktree Capital to Brookfield Asset Management, retaining his ownership in the company. His public intention is to raise $15 Billion in a distressed securities fund. One can read this two-ways, he may be anticipating a lower market where he can buy cheap assets, or he could be anticipating an opportunity to sell assets at higher prices.

The Next after The Next
There is a good chance the investment world will not return to “normal” once we declare victory on COVID-19. I believe this period of working from home in various forms of isolation has fundamentally changed our behavior patterns. How we live, operate, invest, shop, entertain, receive healthcare, contract for loans/insurance, and how we conduct family and other relationships. At some point we will come to the realization that we have become too fixed-asset oriented. I expect changes in shopping, education, and healthcare. Furthermore, we will become more dependent on technology for all these things, through instruments like the Apple Watch, cell phones, and other instruments not yet on the market.

As investors we may be paying less attention to physical assets and more attention to leadership, applied to our specific needs. Management will need to get out of their offices, plants, and laboratories to learn of our desires and how they can solve our problems. I expect the world of my grandchildren and great grandchildren will be quite different than they are today, creating an additional burden on me as an investment advisor. Please help with any suggestions you have. 
 


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

https://mikelipper.blogspot.com/2020/04/long-term-investors-mistakes-ahead.html

https://mikelipper.blogspot.com/2020/04/time-to-get-out-of-foxhole-weekly-blog.html

https://mikelipper.blogspot.com/2020/03/where-we-are-depends-on-where-we-have.html



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Copyright © 2008 - 2018

A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.

Cookbook Investing Doesn't Work

This is my 400^th weekly published blog post. Many thanks to my readers in the US and around the world, in particular to those who have commented or written to me over the years.

Amidst the global market uncertainty last week, my blog post “Probable Causes of Underperformance” was named one of the five Most Read Fund Manager Comments in London’s Citywire Global.  Click here  to read.

Introduction

Thus far 2016 looks and feels different than 2015. Our last two posts which were well received in the global investment community highlighted some of the changes. My friend, the Wall Street Journal’s Jason Zweig and Caltech have been researching how our brains are wired to handle the processing of information that ultimately gets translated into fear and greed. Both the financial journalist and the university acknowledge that people have difficulty dealing with uncertainty. This is particularly true when different elements trigger both the fear and opportunity tracks. We may be at such a junction now.

Misreading the Visible

Some of the items that are being misread are as follows:

1.  Size of government debt which does not include quasi-debt; e.g., actual and implied credit in mortgage markets, social security types of retirement plans and critical-to-national-interest large commercial activities, (in China they are known as State Owned Enterprises SOEs).

2.  Fund flows out of US and Japan, out of domestic stocks and corporate bonds and loans as well as Exchange Traded Funds (ETF).

3.  Declining Returns on Invested Capital (ROIC) of money center banks and major brokerage firms.

Investment Implications

1.  Aggregate government debt will rise as governments attempt to solve societal problems directly rather than through personal and corporate channels which will mean that governments will be sponsors of inflation to make fixed repayments easier.

 2.  Foreign investors have been correct about the direction of their flows into and out of Japan. This is the first time in 25 years when they have been wrong when they produced net outflows and the  Japanese market rose in double digits. I suspect the foreigners were expecting greater declines in the value of the yen. In the second half of 2015 foreign investment in US stocks and corporate bonds declined. Also the US mutual fund investor was a net redeemer of domestic portfolio funds while buying foreign portfolio funds. The net redemptions of Fixed Income funds raises the question,  “have bonds lost their place as a balancing instrument in mixed asset portfolios?”

3.  In many ways the biggest implication of 2015 and early 2016 activities of large money center banks and investment banks is the withdrawal of capital and people from the marketplace. In a world where there is probably 100,000 tradable securities, Merrill Lynch claims to follow only 3500 companies. We are already seeing a talent shift out of the large leaders to smaller financial groups including Registered Investment Advisors (RIAs). To the extent that the retail public is buying ETFs, I suspect that the economics work better for a former broker or bank advisor to use ETFs as an RIA. The market seems to recognize the problems that these large organizations are in. Goldman Sachs^* is selling at $164 per share which is very close to its tangible book value of $162. Thus the market is paying nothing for the firm’s talent and position in clients’ minds. Morgan Stanley^* is selling below tangible book. If these two firms are accurately priced then I have to wonder whether the general stock market is worth owning. If the "house" is not going to be adding to its long-term value, is it reasonable to assume that the bulk of investors will and if they don't, how much longer can the game go on?

*Held either personally or in the private financial services fund I manage                          

What are they Missing?

The desire for hard data is what drives both quantitative and fundamentally-oriented investors  and limits them to the known in building their algorithms or rules. A cookbook solution is usually created to publicize an investment method. There are two problems with this approach. The first is that I am told that the great chefs don't exactly follow a cookbook recipe as they always modify and improve what they do. The second is in the real world uncertainties are often present and could be large.

When I was a securities analyst studying new potential investments, I made a list of the things I wanted to know about an investment. Quickly the list reached on the order of 100 items. After diligent work I could get up to perhaps 50-60% of the items covered before the fear of a price moving away from the most desirous entry price occurred. Thus I had to make a decision and accept a large amount of uncertainty or go find another opportunity.  Based on the luck of time and investing in America, I had a favorable secular trend working for me so a good number of my recommendations performed well. Thus to this day I am willing to accept a level of uncertainty that would not be acceptable to “quants” and other rule book investors.

One of the major fallacies that many investors accept is that they only deal with what they think they know without regard for what they don't know; or in a Mark Twain world, what they know is wrong. Over the last year Money Market funds serving both individuals and institutions gained $16 Billion, the most of any asset class which demonstrates that their shareholders could not find suitable investments. Further, even with significant mutual fund outflows, the vast majority of fund holders continue to hold their assets in funds. To me the big uncertainty is what is on the mind of the fund holders. Why are they not being swept up in the excitement of the market place? I would suggest that there are two reasons for their current attitude. The first is a belief that for the foreseeable future funds in general are meeting their longer term needs. The second is the future is not clear enough to them to make changes.

 Another long-term trend to consider is that selling mutual funds today is far less profitable than other products like IPOs, hedge funds, private equity funds and securities. ETFs can be much more profitable when they are leveraged and frequently traded.

There is lot written about ETFs, but very little about the source of their volume on the market. What looks like general acceptance of the investment value of a particular ETF may be just the opposite. The only ones who can transact with the ETF sponsor is one or more Authorized Participants (APs).  These are market making dealers on the floor of the exchange. Many of their customers are hedge funds or other trading entities who have shorted the ETF as part of a hedged trade in which they are long. Thus they are betting that the value of the ETF will decline more than what they are long.

Bottom Line

With many stocks down over 5% and in some cases more then 10%, we could be half way to a bear market. I believe the real risk for long-term investors is not being in a position to participate in the next major upswing, whenever it appears.

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Copyright © 2008 - 2016

A. Michael Lipper, CFA,
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Contact author for limited redistribution permission.

Probable Causes of Underperformance

Introduction

Most investment managers produced returns of mild single digit to mid- teens losses. Some of these managers were research-intensive managers with long histories of good results. They did not take dumb pills or drink depressing Kool-Aid on a summer eve. While they were confronted with a world where the vast majority of securities and commodities fell, they should have done better, including having some of their money in the minority of stocks that rose. What happened? I believe conditions fundamentally changed.

Lessons from the Racetrack

The first time I had to confront making bad decisions was at the racetrack when I didn’t cash winning tickets. In many ways that is when I started to learn valuable thought patterns that I applied later to investing for others and myself. In roughly the half hour between the losing race and the next one I hurriedly reviewed all of my calculations and visual inputs. I divided these into categories. In the first category were the questions did I miss changes or underestimate the importance of track or equipment changes? For example I usually noted that my horses had changes of equipment or jockeys and trainers, but I also asked, “were they being equipped with blinkers to keep them running straight and not being bothered by other horses?” Too often I did not look at these changes on all competitors which meant that I missed a poorly performing animal prior to the race that became easier to ride and guide to the finish line that was not characteristic of its past performance. (Too often investors don’t fully appreciate the changes in management of competing companies or portfolio managers.) The biggest category was the expected winning time of the race. Often if the race is slow almost any horse can win, similarly in a low performing market any investment that has a slight advantage does win. My mistake was to look at the recent track record for the race and guess which horse could run at that speed or better. In the market all too often investors look to an investment that can be spectacularly better than average. Too often one needs to look to the risks undertaken when finding such a vehicle or horse. Most of the time, a spectacular win will start with a chorus of disbelief, which could be correct. By far the biggest hurdle to handicapping or investing is to recognize that the basic conditions have changed which could be rules changes, unexpected weather, personal issues of the professionals, etc.

From an investment viewpoint, I believe 2015 experienced such cumulative changes that make many of our old approaches less useful.

What Changed?

The following are a list of important differences in 2015:

1.  The reduction of position capital at trading desks of major institutions and investment banks which are under the restraints of the Volcker Rule. Liquidity was available, but at a price and at a time of the liquidity provider’s choosing. This has led to a significant level of intraday volatility. This plays into the hands of the high frequency traders and other algorithm users picking off large scale movements. Bottom line: trading has become meaningfully more difficult and perhaps expensive in terms of full execution costs. What used to be only an equity market problem now is very much a factor in trading in US government paper and starting to be an issue for investment grade trading.

2.  The central banks’ manipulation of internal interest rates has morphed into manipulation of foreign exchange rates which are impacted by both flows into and out of the market that are not price sensitive, the values of global securities and a range of commodities.

3.  Big data comes to the Biggest Markets in a Big Way. US based managers feel comfortable having their US offices managing non-US securities. Similarly global portfolios of US securities are being effectively managed in distant offices of foreign investors. The availability of all that is known about a security instantly means that there is less opportunity to strip or dump into a market. The passage of “FD” (Full disclosure as mandated by the SEC) means the investment/trading value of published information has declined. As more institutions utilize secondary and tertiary research their value becomes discounted.

4.  “TINA” (There Is No Alternative) is not the only alternative. The investing public has globally built up their stake in money market funds and other repositories of low returns with the ability, not used yet, to rapidly reinvest. Some are using long or short positions in index ETFs or index funds. (I prefer the latter.)

5.  A growing recognition that much of government produced data needs to be questioned. In one of his first acts the new President of Argentina was to order his government to create accurate data. Another example is the former Premier of China acknowledging that its GDP was “man-made” which meant he did not trust it. 

One can take the position that one of the reasons that the Federal Reserve has had such off the mark forecasts is bad data. At a public meeting at the New Jersey Performing Arts Center (at which I am a trustee and chair of the investment committee) I asked Bill Dudley the President of the NY Federal Reserve Bank and a permanent voting member of the FOMC what additional data would he like. Bill who is a veteran numbers crunching economist at Goldman Sachs responded that he would like to know much more about the creation of the rapidly expanding student debt. He is right as student debt is the largest amount of consumer debt, greater than residential mortgages. To the extent that this debt is to be repaid colleges are going to have to produce easily employable workers who will have to postpone buying their first home and other consumer spending. An important driver of the size of student loans are the costs of food and lodging, which are often superior to their first apartment post-college, if they graduate).

6.  Many of the major economies are increasingly being driven by the service sector and not manufacturing whereas most governments and central banks have tools to spur a declining manufacturing sector. In the US it is important to focus on how US auto sales are recovering to previous heights established years ago with a smaller population. What should be noted is that in 2015 US branded cars are filling less than half of the demand. This is important because to an increasing extent a car or light truck is an electronic platform on rubber wheels. This signals that the auto (and for that matter almost all markets) have changed and our governments have not kept up. Some are conscious of this as the Bank of England has noted that there was more acquisition of service companies in 2015 than manufacturers.

7.  Target Date Funds are being questioned due to their exposure to bonds in a somewhat rising interest rate environment. This could be quite harmful to those who are about to retire when much higher interest rates and lower bond prices start to occur.

Don’t Bet on Favorites Most of the Time

I learned at the track that normal favorites win only about a third of the time, but because their betting odds have been beaten down by players pouring in the winning dollars when they do win, do not pay for the 2/3rds of the time they don’t win. That is why my bet for 2016 is for a big year up or down. My best guess is UP, for the Wall Street Journal may have taken over from Time Magazine and the former version of Businessweek with its cover pictures of success people. Saturday’s Wall Street Journal had a front page article headlined “Drab Outlook for Markets.” If the article is correct my clients don’t stand to lose a lot, but if I am correct 2016 will be anything but drab with a reasonably good chance of a better than average result. Perhaps some of the poor performing managers could produce great results in their recovery.

What Should I be addressing Next Week?

The next post of this blog will be my 400th. Are there topics I should address or would you like me to reprint any of the old posts?

As you start the New Year we wish you and your family and associates a Healthy and Happy New Year.       

________   

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

Comment or email me a question to MikeLipper@Gmail.com.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2016

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

Winning Life with Your Retirement Capital

The greatest American horse race for three-year olds was run this past weekend, the Belmont Stakes.  As many of you may already know, I count my “misspent” youth learning to handicap (analyze) races; Belmont Park in suburban New York was one of my centers of learning. Shortly after the famed Secretariat won the race by 31 lengths and the Triple Crown in 1973, I started my firm, Lipper Analytical Services to apply some of the analytical lessons to the study of mutual funds. I was addicted to analyzing criteria to find winners.

A winning life

Some 39 years later, I realize that the process of developing a person’s retirement capital in part defines for an individual and his/her beneficiaries, whether or not one had a winning life. The accumulated retirement income in the senior portion of life will determine whether one is independent, a burden to family, a ward of the state or some combination of the three. Thus, I believe the production of retirement capital from which retirement income will flow is of critical importance to all individuals and to the society in which we live.

The defined benefit dilemma

Pension plans benefits are  obligations of the pension sponsor or employer. Obligations are treated as liabilities that are part of what the various credit rating agencies evaluate in making their credit ratings judgments. Lenders often use credit ratings to confirm their risk judgments. The level of risk is an important component in assigning an interest rate on current and future loans to the employer. Often the smaller the pension liability the lower the interest rate. Currently, employers with debt on their balance sheets may want to reduce the risks in their pension plans by favoring high quality fixed income with relatively short maturities as likely to decline the least of other investments in a down market. This judgment is based on the past and could very well be in complete opposition to a plan’s investment advisor who may believe this is the exact time to increase the plan's exposure to the risk of market forces. The dilemma for the employer is whether to rely on past history to reduce risk or to look at what appears to be an historic opportunity to buy stocks at what in the future would be recognized as great prices. My instinct is to go with the opportunity. This is not just because of my US Marine Corps training that the best defense is to attack, but also because I am familiar with another mathematically accurate analysis, utilizing "least  squares” procedures. 

"Least squares” analysis

Least squares analysis is a procedure that various analysts use to determine the best fit of a line that will be equidistant from a field of many different observation points. My concern today is that we are in a period of an unprecedented volume of inputs. I am aware that single or multiple extreme observations could for example, radically change the slope of the least squares line and produce a radically different expected growth rate. When we experience the unexpected, we are likely to experience even more unexpected results. For instance, older employees can, perhaps, take comfort from a conservative pension plan as the chances of getting the "promised" benefit is relatively good. Younger employees however might feel the opposite. Their pension provider may not have bought cheap growth assets when they were available. Thus in later years the employer may have to contribute more than normal amounts of money to offset their lower earlier returns. The question for these now aging employees becomes whether the employer can meet its pension obligations without starving the company’s future growth.

A rough rule of thumb for younger potential employees rating their future employer

I am going to suggest one analytical tool that might be used as a point of departure, though many may disagree with this approach. One of the ratios that is available on most defined benefit pension plans is the funded ratio of plan assets compared with the actuarial calculations as to what is owed over time. Many plan sponsors want to keep this ratio at or slightly below 80%. Above that level they lose some flexibility in meeting payments. A ratio below 70%, could cause credit ratings to drop. In a very simplified calculation, pension funds can show the amount of money invested in equities or other large risk featured investments. Particularly at this point of time when the stock market has been generally flat for more than ten years, sponsors who have an equity ratio approximately the same as their funding ratio are positively future oriented. They believe that they will experience growth. A risk ratio below their funding ratio suggests, perhaps for good reason, they are being cautious. Perhaps the real value of this rule of thumb is that in a second level discussion, it would show a serious interest in the long-term financial health of the prospective employer.

What choices should be included in defined contribution plans?

The various options offered in 401k, 403b, and 457 plans is something of a balancing act between paternalistic fiduciary views and the desire to let the individual saver choose from all available options permitted by various regulations. Most of the options offered come in a mutual fund format with two notable exceptions, directed brokerage accounts and various types of annuities.

The US Department of Labor has indicated the minimum of options to be offered to include a high quality, short-term fixed income fund that is often translated to be a money market mutual fund or a stable value fund. The minimum number of funds is four with at least one equity fund. At the other extreme, for awhile a number of plans offered over 200 funds from a number of providers. Studies have shown that too many choices confuse participants. Further, the history of plans is that most of the money is in relatively few funds. (I suggest that any fund that does not garner 5% of the money should be a candidate for being dropped.) Each of my plan clients is different due to the beliefs of the sponsor and the perceived needs and general investment sophistication of the workforce. In a generic sense my approach is to start with the oldest type of fund, a balanced fund, with stocks as the majority asset class and fixed income for the remainder. This fund should be used as the default alternative. Some may suggest to use target date funds for this need. My problem with these vehicles is not with their portfolios, but based on studies too many of target date fund investors don't fully understand them. If there is an effective individual advisory function at work, target date funds could be added to a moderately large list. I would like to have at least two fixed income funds, both high quality and preferably US Treasury-oriented, one short-term and one intermediate.  In addition I would add a TIPS fund. In terms of equity funds I would include a Large cap and a Small cap fund with at least one of them focused on growth. A stocking-picking fund without constraints would be a nice addition. Notice I did not label the choices as domestic or international or manager-selected global funds. These are becoming less distinctive as choices today.

Investors should have their own individual investment accounts

There are two reasons for this belief. First and foremost, the individual account can select when to accept tax consequence transactions and, at least for now, gains will be taxed at the tax advantaged capital gains rate rather than the ordinary rate that will be due when the withdrawal period begins from these savings plans. Second some of the product line extensions that I do not feel are appropriate for these fiduciary savings plans, could well be useful in an individual's own account.

Using leading equity funds

Many individuals avoid funds with large unrealized capital gains for their taxable investment accounts. In my new Reuters column,  I recently asked whether there is a penalty box for funds that have had great long-term investment performance.  The answer may have some relevance for investors and beneficiaries of retirement income.

        

  

What are your reactions?

How are you planning to overcome your retirement capital concerns?

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