STEALTH BOTTOM? and Other Considerations - Weekly Blog # 621

Mike Lipper’s Monday Morning Musings

STEALTH BOTTOM? and Other Considerations

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

         

Sector Selections?
Better Yields 
Market Structure Changes Implications?
Early 2021 Patterns
         

DID WE HAVE A STEALTH BOTTOM ON WEDNESDAY 3/18?
Is it possible the pundits did not recognize that we achieved the low for this “correction” cycle? Somewhat usual, I am asking the question that others don’t. First, to me “correction” is a term that should be applied to a down market attempting to correct a former structural weak up market. The US stock market likely would have gone down regardless of the surprise of the novel Coronavirus. Briefly, the causes were:

• China changing from being export led to domestic demand focused.
• The US market over valuing earnings per share, rather than focusing on operating earnings or GAAP net income.
• Excessive commercial and individual lending that was outside of the established banking and credit institution channels.

It was only a matter of time before a market that assumed its long expansion would continue unabated. The virus and its policy reactions showed collectively that the emperors of the world were all lacking the advertised “new clothes”

Two weeks ago, I prematurely thought that the market’s search for a bottom had been reached, although I warned it would be tested and the test could come at lower or higher prices. On Wednesday March 18th we had a substantial jump in NYSE volume. The VIX  index  jumped to 84, compared to 12 the year before. The daily low wiped out all gains achieved since the day the current administration was elected.

For the 3/18 low to be recognized as the low for this phase, it is likely that at least one more attempt to set a new low will occur and it didn’t happen on Thursday or Friday. Both the volume and VIX retreated. News chatter has also improved from both China and the District of Columbia.

At this point in time I am of the working view that we have probably reached a bottom, addressing the excessive elements mentioned. What the bottom does not contemplate is the structural changes to investment policies going forward. At least they are not currently clear to me. Consequently, I am beginning a very wide scan of the future, looking to the 2021-2025 period. The rest of this blog will hopefully generate responses from our very perceptive subscribers, with their contributions either for or against attribution.

SECTOR SELECTIONS
I have maintained that looking through the lens of more than 200 different fund categories, both registered with the SEC and other domiciles, I can see the daily work of some of the brightest investment people in the world. As many of them do not publish their views on a timely basis, I let the performance of their portfolios speak for them, supplemented by periodic publication of their portfolios and occasional conversations with a limited number of them. As a contrarian, the first place to look are the fund classifications that are doing poorly. Are they providing essential products and services, but are priced or delivered incorrectly?

The first two fund categories are globally priced but delivered locally. They are doing particularly poorly now, both in terms of fund performance and in their markets globally. The first is real estate, where all of their international, global and domestic fund categories are performing near or at the bottom. Their buildings do not seem appropriate for the increasing number of people that have or will have limited mobility. Furthermore, their pricing may have to change from being an estate asset, to being used for life or health use instead.

The second major global fund classification suffering are the energy producers and deliverers. In the future we will need more, not less energy as a key replacement for human labor and comfort in a climate challenged world. While consumers of energy will eventually pay for the whole chain of services through direct charges and taxes, they leave others to finance the system and thus have little optionality.

With the expected changes in both the automobile and real estate sectors, they should gain more influence and share the risks of what is delivered. That means they should become equity owners as well as consumers. Some movement in this direction will let the marketplace become more efficient in terms of pricing, including an investment in long-term delivery. This will become obvious when more people recognize that in our lifetimes, we are renters of assets, both short and long-term, and our control ownership dies with us.

For those who want to participate in future development, nothing is better than air. I am not focusing on the hot air produced by politicians and other sales types, or passenger travel. The current requirement to work from home emphasizes the importance of communication and package delivery. The physical and financial limitations of pipes and wires are likely to reduce their importance in the new world. Telecommunications will become our way to make our work, safety, and entertainment more efficient. The management of telecommunications has been tied in the past to the financing and rate setting of the public utility model. Ultimately, consumers pay for telecommunication services through a number of different prices and taxes. To the point consumers do not recognize the all-in cost of what they are getting, that should change. (This may lead to smaller governments at all levels.)

The second and largely unexplored investment opportunity of the future is drone package delivery by air. We are already using drones for both package delivery and crowd identification/control, particularly since the virus crisis. (Loudspeaker equipped drones are being used in an attempt to disperse crowds and direct them. They are also being used to patrol various locations.) We need to establish a grid system for drones that allows them to travel safely and efficiently, as well as instituting other regulations. One should expect weightier deliveries with appropriate policing. I wonder when drones will  carry robots to finish the delivery, or perhaps do some of the on-sight work. There should ways for us equity types to participate in this innovation.

The advocates at Matthews Asia have put forth an interesting view. Can China, now that it no longer has any new cases of the Coronavirus being reported from Wuhan, a city of 11 million, be a good place to invest for a globally diversified portfolio? There is evidence as to the power of a command economy. Large companies are loaning money to their smaller suppliers. Apple has all its Chinese retail stores open, distinct from their stores in the rest of the world. An interesting headline from the Financial Times shows that Apple is not alone, “Volvo’s China plants almost back to pre-shutdown levels.”

BETTER YIELDS
Over the last couple of years, few if any individuals or institutions could pay their increasing bills from the interest or dividends available in the US market. This may be changing. We may be returning to an old model where equity dividends were larger than those of high-grade bonds.

Each week Barron’s produces a Best Grade Bond yields index and this week the index read 4.01%. (That is the highest I remember in a number of years.) In the same issue there was an article that highlighted the following yields from large financial institutions: J.P. Morgan Chase 4.2%, Morgan Stanley 4.5%, M&T 4.2%, and US Bank 5.1%. I believe all of these are owned by Berkshire Hathaway, which I also own along with J.P. Morgan and Morgan Stanley. More importantly, these yields are below the Barron’s index of intermediate grade bonds (5.37%), which have a higher yield due to their perception of having less safety. In that article they also show the banks, with what they calculate as their stressed price/earnings ratios: J.P. Morgan at 22.2x, down to 10.1% and Morgan Stanley with an earnings power calculation assuming large credit defaults. I do not suggest these companies for your investment, but to show that there are corporate yields higher than high grade bonds.

If any of our subscribers own or are contemplating municipal bonds, I would be happy to discuss the risks that have led to their sharp price declines.

MARKET STRUCTURE IMPLICATIONS
A perpetual warning that should be given to all investors in publicly traded stocks and bonds, is that companies and holders share the same name, but not necessarily the same path of progress and value. The day-to-day price of securities is a function of its owners, particularly those who are selling. The sellers are transacting to meet their own needs and desire for liquidity, as well as to partake in other opportunities that may or may not be competitive with the stock’s name. In the past, most cities and towns had street level walk in brokerage offices and registered representatives to handle customer originated ideas. Their somewhat safer house recommendations have been replaced by packaged products like pensions, 401-k or similar products, and mutual funds.

The upstairs broker or website producer is now a registered investment adviser, or perhaps should be. They wish to have the customers either legally or actually become a discretionary account. Some of these advisors are really quite talented, but others are not. Many of these accounts perceive that they invest as major institutions do, but do not really understand the needs of the institutions. One way or another, they and others have been heavily invested in the Dow Jones Industrial Average (DJIA). Interesting because the DJIA was the worst performer of the three popular US stock indices on the way up to the peak, as well as the worst of the three on the way down. This is interesting because the junior in terms of age and repute, the NASDAQ Composite, was the best in both directions. The NASDAQ voluntary market makers provide the least liquidity of the three markets. In the latest week, 88% of the stocks listed on the NYSE fell, while only 74% of those on NASDAQ declined. More aggressive institutions and individuals are prominent investors in the outgrowth of the OTC market. This suggests that the herd instinct of the public and their less than market sophisticated advisers were panicking last week, which is one of the characteristics of a turnaround.

EARLY PLANS FOR 2021-2025
I have for sometime taken the view that the sales and earnings reported for the current year have little value in making investment judgments for 2021-2025, the shortest period I normally focus on. As this blog is already quite long, I will outline briefly the initial part of my thinking in building an investment plan for the future. For this purpose, I will just focus on the political input.

I believe in a fan approach to the unknown of taking two extreme positions. In this case I assume one party takes total control of the White House and both houses of Congress and list their priorities. Next take the other side. If you have more difficulty with the second, you haven’t been paying attention and are letting your political leanings influence your analysis at a cost to the performance of your investments. Beneath the surface, both parties are now badly fragmented and being held together for the sake of the election, primarily in the House and somewhat less in the Senate. The day after the 2020 election is over the campaign for 2024 begins in earnest, with a high probability that there will be two different candidates for president. As a practical matter, whomever wins the various elections will probably need to give ground to the “special interests”, often represented by their former colleagues. Furthermore, the challenges that will dictate the record of the office holders will be surprises like Covid-19 and changes in governments and other powers around the world.

I will pay attention to the political competition which is a “parlor game” for the media, but I am more interested in the likely changes in supply and demand for products and services. I would appreciate any thoughts from subscribers, as far too few people are thinking about the future constructively. 



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/03/searching-for-bottom-understanding-and.html

https://mikelipper.blogspot.com/2020/03/searching-for-bottom-and-plan-weekly.html

https://mikelipper.blogspot.com/2020/03/should-changes-in-markets-change-your.html



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Bonds Equal Risks

Introduction

In all of the PIMCO/Bill Gross excitement and speculation about what money will stay and what will go where, no one is asking whether some or all of the money should exit the bond arena. By self-appointment I am asking the question both as a professional investment manager and a member of a number of significant investment committees. There seems to be a fundamental belief that once serious investment money is devoted to bonds one can change managers, durations and credits, but the allocation to bonds is almost sacrosanct. I believe as Socrates believed, "The unexamined life is not worth living." My proclivity is, almost child like, always asking why.

The classic reasons to own bonds

Bonds are a contract to pay interest and principal in a timely fashion. Thus no uncertainty about the future. Bonds provide income which can be spent or reinvested (particularly in open-end mutual funds). Historically bond prices move inversely to stock prices. Bond prices rarely go down.

The Siren pull of Bonds is Global

Ever since the bottom of the stock market, if not before, individual investors and many institutional investors have been adding to their bond holdings at a much faster rate than the appreciating equity holdings. I see this rush throughout the mutual fund world in almost every country that has a sizable bond fund market. While the rush is understandable for those who suffered equity losses by selling in the decline or seeing their wealth on paper shrink, nevertheless, I find any stampede a bit scary.

While I don't often agree with the SEC, I was heartened to read what SEC Commissioner Daniel Gallagher said in a speech to the Securities Traders Association in reference to the $10 trillion US corporate bond market. Commissioner Gallagher said "It clearly looks like a bubble." He indicated that roughly one quarter of the total is owned directly by retail investors and 73% of the $3.2 trillion of outstanding municipal debt is owned by "small investors." I don't know whether the Commissioner's numbers include bonds owned directly in open and closed end funds, defined contribution plans and variable annuities. My sense is that direct and indirect holdings of debt issues represent ownership of over half by individuals. He felt that in their chase for yield they did not stop to understand the risks of what they owned.

Commissioner Gallagher made another important point which was in 2008 the average daily trading was $1.04 trillion and in 2013 dropped to $ 809 billion. I believe trading has constricted even more in 2014 due to government regulations restricting the size of inventories that major banks and broker/dealers can own in their market making activities. Greater demand and smaller capital bases are likely to lead to an increase in bond price volatility.

On a temporary basis, Money Market funds appear to be a resting place. Weekly numbers on flows into Money Market funds seem to be growing at a rapid rate this week through Wednesday, according to Lipper, Inc. my old firm. I find this encouraging on two fronts.

First, the former owners of PIMCO funds may be reassessing where they should invest. (I would hope that they will reduce their bond investment.) Second, investors have not been scared off in using Money Market funds despite the SEC's misguided attempts to prevent a run on these funds. (They actually made a run much more likely, I fear.)

What are the risks in bonds?

The first risk is that high-quality bonds can go down in price. Over the last 15 years the Barclays Bond Market Index fund on a capital basis fell in six years or 40% of the time. Please note that this calculation is ignoring the income produced. Unfortunately, most bond investors utilize the income produced for their spending needs. They are ignoring the fact that with long maturities issues, the reinvestment of the interest in the then current interest rate market can produce more capital than the eventual return of their principal when it matures. A slightly less foreboding view can be had at looking at the last 40 quarters for the Vanguard Intermediate Term Investment Grade fund where it declined on a total reinvested basis 12 times or 30% of the time.

Second, the potential gains of investing in high quality paper is not going to be large enough to restore the starting capital of a balanced account with at least 50% in general equities.

Third, there isn't much if any room for interest rates to decline and therefore add to the value of existing bonds. At some point the manipulation by the major Central Banks can not ignore the misallocation of capital to higher credit risk issuers which will lead to lenders demanding higher rates. My guess is that this will happen sooner than the governments are expecting.

Fourth, the traditional concept behind a balanced fund is that when stocks periodically decline, bond prices will rise as governments will force interest rates down. In a major way this can not happen now. Bond prices and stock prices instead of being inversely correlated will move in the same direction, but at different momentums.

Fifth, the bond investor craves certainty. However, we are living in an uncertain world. I believe that we are going to be surprised by one or more changes listed:

·       Inflation

·       Tax Realizations

·       Contracts abrogated by courts and governments

·       Unforeseen crises which change cash flows

Sixth, a popular measure of risk is, how much can I lose? With bonds there is, perhaps, for an investment manager, a bigger risk. Bonds are essentially contracts and they are expected to perform in a specified manner. If they don't for any of the identified elements listed above, the expectational gap could endanger career risk for the manager.

The weakness of "My Word is My Bond"

I grew up in a world where stock exchanges were run by their member communities which enforced personal verbal contracts. You did not have to like the counter-party to a trade but you believed that the counter-party was good for his or her contract. The community would not tolerate any breaking of the contract. Under the current environment I hope and believe that my word is taken as acceptable. With what is happening today I don't know that I would have the same reliance on someone's else’s bond!

N.B.

Note that this post is solely devoted to bonds. For our readers who are much more interested in stocks, I will, on request, be willing to share a portion of my September report on our private financial services fund which comments on three holdings of current interest.
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The Need to BUY Now

Introduction

I have a belief that for the moment we are in a melt up phase which is short of the type of parabolic explosion that signifies a generational top. Further, I believe that in general we have moved from a fairly valued stock market and are on the way toward a fully valued market. Thus, I have been focusing on reducing the opportunities to take large risks of losing substantial capital. I have not, however, devoted as much space in these posts to all the different types of risks there are out there. The quotable Howard Marks of Oaktree Capital, a long-time user of our performance data, has produced another one of his great letters where he has enumerated 24 risks which show the breadth of ways to lose significant chunks of capital.

Nevertheless, a number of professional investment managers feel compelled to buy some positions now. Some may be sensing a “bandwagon” surge on the part of their clients to more fully participate in the melt up. Others have picked up my view to look for unconventional investments. Still others have devoted too much effort on avoiding losses over the years and now need some new winners. These feelings need to be corralled under a term similar to the one that earlier drove investors into the market which was TINA (“There Is No Alternative”) to assuming risk and enter the market. The new term suggested by Howard Marks is FOMO (“Fear of Missing Out”).

A buy a day

I believe that on any given day that there is a security someplace in this world that represents a real bargain. However, to paraphrase Jason Zweig’s excellent interview with Charlie Munger in this weekend’s The Wall Street Journal, one must recognize the extent of one’s circle of competence and not stray beyond it. Further, Mr. Munger has said that patience is needed. He has gone through a period of years without adding a new name to his roster of investments. Charlie’s innate wisdom may be greater than mine, but I am willing to suggest areas that professional investors should examine as long as they are within their own circle of competence.

Framework for seeking new names

My preferred search procedure rests on my introduced Lipper Time Span Portfolio concept. This concept rests on four independent portfolios which may contain funds or individual securities. The four time spans are the Operational Portfolio to provide the next two years of funding. The Replenishment Portfolio which is designed to renew the funding capability of the Operational Portfolio within five or so years. The Endowment Portfolio is to cover the currently identified longer-term needs of the major beneficiaries. The fourth and ultimate portfolio is the Legacy Portfolio which is to produce capital for spending beyond the grantor or initial investor. Typically the Endowment Portfolio is to cover a time span of more than ten years or beyond the competence of the existing investing decision makers; while the Legacy Portfolio, if desired and well managed could be, in effect, a perpetual portfolio.

With the time spans in mind, I find it useful to make some general predictions of the currently likely investment environments in each of the four time spans recognizing the old quote of “Humans Plan and God Laughs.”

At this point in time I believe that the Operational Portfolio will struggle with below historic interest rates which at very best may reach double current rates.

The Replenishment Portfolio should expect at least one major market melt down of at least of 25% and if the current melt up goes parabolic, 50% or possibly more.

Assuming that the market is in a form of recovery by the time the Replenishment Portfolio has done its job, the Endowment Portfolio should be moving up in a cyclical fashion over its life, averaging an inflation adjusted return on equity for stocks and a “real” rate of return similar to returns on capital employed by the general economy. The Legacy Portfolio will largely be driven by the disruptive forces unleashed by technological and sociological changes.

While I would prefer to focus on the longer-term portfolios, my investment management friends and I need to perform well with the first two portfolios or we won’t be given the opportunity to direct the two other portfolios.

Looking for short-term winners

If we were in “normal” times with interest rates tied to credit concerns and inflation, high quality short-term paper would be earning in the 4-5% range which could easily acquit the funding requirement. The so-called riskless investment in US Treasuries can’t do it. My suggestion is to research within your circle of competence the following unconventional thoughts:

1.     In August there were a number of currencies which gained 1% which could be of interest; Norwegian Krone +1.42%, Malaysian Ringget + 1.39%, South Korean Won +1.37%, Brazilian Real +1.24%, and Mexican Peso +1.01%.

2.     Very selected Commodities; Cotton +5.89%, Natural Gas +4.75%, and Aluminum +4.74%, all for the month of August. I would not recommend Livestock +11.45% gain year-to-date or shorting its corollary, Grains -11.28% year-to-date.

3.     Not immediately but in time, one should also select, high quality municipal bonds which are likely see their interest rates go up when newly issued. The banking authorities have ruled that these issues can no longer be counted as High Quality Liquid Assets (HQLA) for bank reserves' calculations. Combine this news and the fact that banks are being forced to cut back on their trading desk’s Muni positions. This means that there will be fewer buyers of this paper particularly at a time that the US needs to dramatically improve its physical and educational infrastructure. Demand for financing will force interest rates up.

4.     Bank loans recently shunned because of fears of a recession may well be priced attractively if we are entering a slow down, not a recession.

Searches for the Replenishment Portfolio

The next five years or so are likely to be difficult for portfolio managers. The melt up momentum will drive a lot of stock prices higher, but one needs to be careful with some biotech and new small companies being priced generously. Focusing on firms which are spending their excess funds wisely to build competitive advantages might be prudent.

Because we believe in the rising capabilities found in many emerging markets we have a number of investments in these kinds of funds for our Endowment and Legacy Portfolios, but I would not be adding them into the Replenishment Portfolio now as these stocks have led in seven of the last ten and half years.  Most of the flows into this sector come from institutionally-driven ETFs (Exchange Traded Funds) which added $3.5 billion in August compared to the much larger and more conservative mutual funds which added only $1.8 billion. Our financial services private fund is doing better recently by not being burdened by deposit-oriented banks.

Question of the week

Where are you finding stocks to buy for the short term (five years)?

__________

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Copyright © 2008 - 2014

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