When, Not If - Weekly Blog # 527

The Next Recession

Recently, two very senior operating officers of significant organizations asked for my outlook on the next recession. I am very sympathetic to their quest for guidance, as it will immediately impact their day to day decisions which are trending quite positive. Taking the advantage of being an interested observer without operating responsibilities, I replied with some certainty that a recession was on the way.

The real question was when, not if. To be honest, I don’t know. Predicting the timing of a recession with operating precision is similar to the task of identifying when a volcano on the Big Island in Hawaii will erupt, or when “The Big One” (massive earthquake) will hit. One of the techniques in the USMC is to identify the potential for trouble rather than exercise the arrogance of solely predicting.

Why am I confident that there will be a recession? Because throughout the history of humans there have been cycles of alternating relative calm and crises, with some of these being caused by changes in weather. In the world of markets and economies the main stimuli for cycles are human behavior. The causes usually start with the word “over”: Over-building, over-capacity, over-borrowing, over-hiring and other terms for over expansion, or if you will over-expansion.

In explaining the falling apple, Sir Isaac Newton identified the physical laws of gravity. He believed they and other physical phenomena were put in place by “The Watchmaker in the Sky,” or God.  Perhaps there is a similar force that periodically corrects for errors in human risk management behavior. Having established, at least for me, the certainty of periodic recessions, the more difficult task is predicting the timing. I must admit that I fall back to the lessons of both the race track and highly valued stock prices, plus the power of envy.

Most people individually are quite bright and make reasonable decisions. However, when we enter “the crowd” our innate insecurity draws us to popular views which become ours. These are then reinforced by something psychologists call “confirmation bias.” Substituting Newton’s watchmaker with an eternal “bookie,” the greater the power of the confirmation bias the greater the odds that it is wrong. Thus, as noted in last week’s blog, with the large, learned, financial institutions’ belief that the next recession is three to five years away, it is an intelligent bet to make against the crowd. (A much more difficult bet to make wisely is which side of the over/under challenge to accept. Right now the odds favor the next recession coming more quickly than in three to five years, but there have been very long streaks in history which could give the “over” bettors some comfort.)


Risks of Fraud and Mistakes

Thus far, I have just focused on the normal tug of war between greed and fear. There are two other indefinite variables. The first is the surfacing of a large fraud from a respected place. A careful study of humans reveals that at almost all times there is a level of fraud. Sometimes the fraud includes intellectual fraud along with criminal fraud. One of the characteristics of the period before a recession is the pace of activity accelerating and the public scramble for attaining wealth being top of mind. Thus, the time spent on careful underwriting risks is shortened and the envy for wealth is heightened.

The second variable is the frequency of mistakes. During these volatile periods small errors occur in transactions more frequently, caused by too little time and too little experience, by both buyers and sellers. This accelerated pace often leads to big mistakes by important people and major organizations. In the post-mortems after failures, the repeated question is often how these very bright, accomplished people could make these mistakes? The answer appears to be the rapidity of the times demanded it. 
 
Economic recessions and market cycles have been necessary to correct for human excesses. Thus, in the long-run they are cyclical in nature, but do not change secular trends.  Long-term portfolios should be diversified across both cyclical and secular patterns. A 50/50 balance between the two is a useful starting point in portfolio construction because it prevents over concentration on the intermediate and long-term investing.


Two Significant Pivots

1.  Tactical Pivot

This week’s fund performance displayed a significant change. Prior to last week there were a limited number of equity gainers concentrated around the production and use of cell phones. Globally, growth-focused funds were just about the only asset class to show gains. In the week ended June 7th there was a dramatic change. Value-oriented funds joined Growth funds in generating positive results year to date. Their gains in the week turned many of these funds to gainers for the year. The bigger turnarounds were experienced by Base Metal Commodity funds +4.85%, Basic Materials funds +3.41% and the already positive for the year Consumer Services funds +3.73%. One could interpret these results as an indication that a further cycle expansion became likelier last week.

2.  Strategic Pivot

For a considerable length of time mutual fund investors have been net buyers of non-domestic equity funds. This focus on non-domestic equity funds is clouded by the way the vast majority of international funds display their portfolios. Most funds rely on portfolio statements from their custodians. Where a corporation is legally domiciled is important to a custodian as a source of local law and taxation. This information is much less important to investors than where companies are making their sales and pre-tax operating profits. The mismatch is clearly seen when it appears that the majority of US foreign investment is in European entities. While this is legally true, it is not helpful as to where our foreign funds expect to make their money.

Most large companies are multinational in scope. This is particularly true of companies domiciled in the UK, Germany, Sweden, and the Netherlands. To the extent that these companies are showing growth it is coming largely from Asia. This makes sense on both demographic and savings trends. The leading middle class growing countries are China, India, and Indonesia. They have populations that are in the early stages of acquiring the goods and services that more developed countries produce, either at home or in their overseas facilities. This is the reason that we are investing for our clients in Asian-oriented funds for the long run.


Asian Play

This weekend we are seeing American political leadership following investors pivoting toward Asia, which is causing distress for many Europeans, even though they are also significant Asian investors. The Asian play is not geographically limited to the Asian continent. Latin America, Canada, Africa, and the Middle East are junior partners to the growing power bases in Asia.


Belmont Stakes Implications and Lessons

I look for useful implications from everything that happens as I’m always willing to learn, even if at times reluctantly. The running of the 150th Belmont Stakes, which was won by Justify with Gronkowski in second place, was just such a learning experience.

Implications

Did you notice the silks worn by the winning jockey or the crowded picture in the Winners Circle? The winning colors are those of one of the three syndicates that own Justify, the winner. They belong to the China Horse Club, a group of some 200 Chinese investors. I am guessing that an old friend and retired good investment manager was probably not surprised that this group was part of the winning combination. He recently pointed out that after a lifetime of collecting selective Chinese art, the prices for such pieces has skyrocketed as Chinese buyers attempt to repatriate their art by becoming the dominant buyers. I suspect we will see more Chinese money buying into racing and more importantly breeding opportunities to meet both nationalistic and long term investment needs. (One of the real power centers in Hong Kong is the Happy Valley Racetrack.)

The other two owners are equally interesting. WinStar Farms is another syndicate, whose leader has the corporate title of president, suggesting that it is being managed with more of a corporate philosophy than just the skills of a bunch of enthusiasts.

The third owner is perhaps the most interesting of all. It is the family office of the famous, or infamous depending on your political views, George Soros. Disregarding politics, the office’s investment approach is sound. It buys into some of the best thoroughbred breeding stock and regularly sells off many of the resultant yearlings, with advantageous tax benefits. Not surprisingly, the manager of this operation is the tax manager. This is one of the ways the wealthy, who want to remain rich, employ intelligent risk management techniques. In this case it sold off the racing earnings of Justify and retained the breeding rights. At this point the colt’s racing earnings, including the Belmont win, is $3.7 million. However, the ownership has sold off most of the breeding rights for $60 million.

The investment implication highlighted by Justify’s ownership structure is that the world is moving toward more professional management of assets and liabilities and away from pure family control.


The Betting Lesson

A reported 90,000 people were at the track on Saturday and many others bet largely through electronic means. As much as I scanned the entries, I could not find a substantial reason, other than racing luck, that Justify was not clearly the best horse in the race. However, my discipline would not let me make an odds-on bet where the amount won would be less than the amount wagered. (I do this in my investing portfolio when buying good long-term stocks.) The colt did win and paid off $3.60 for a $2.00 Win bet, or after returning the $2.00 bet realized a gain of $1.60. I am reasonably certain that this was not a good return for the risk of being wrong. If one considered the winning position for Justify and then selected the second best colt, one might have bet on Gronkowski for Place. In fact, he came in second from trailing behind until late in the race. One would have won $13.80 or a gain of $11.80 for a $2.00 bet, or over seven times more than the winner.

The critical investment lesson to learn: Picking winners is not as productive as balancing the risks and rewards of investing.
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Investors Need to be Wrong to be Right – Weekly Blog # 515

Introduction

Investing is an art not a science. In science the search is for a repeatable answer under every identified condition. As strong as it may seem to many, the search is not in the end the largest performance number. The search is the delivery of the required funds to meet the accepted needs of the beneficiaries; be they institutions or individuals investing within the realms of prudence. Thus, the investment manager’s primary function is to aid in the feeling of the well-being of the beneficiary. According to a recent report on happiness as applied to nations, well-being is based on income, healthy life expectancy, social support, freedom, trust, and generosity. It is far easier to contribute to well-being through sound investing. I believe our clients hire us to provide sound investments for them in order to accomplish their well-being. Thus far I have been able to deliver. But much of this is not based on the certainty of math and science that I learned in school and university, but as a handicapper at the New York racetracks. From an investment standpoint what I learned at the track that is useful can be summarized as follows:

1.  The objective is not to win every race but to finish the day as a winner (including expenses).

2.  Don’t bet on every race, there could even be days when no bets are made as the payoff odds are not appropriate to the probabilities foreseen.

3.  Occasionally the most popular bet is logical in terms of expected results, but the payoffs are too low because it doesn’t take into consideration what can be called “racing luck.” At these times it could make sense to invest in the second or third most logical horse if they are being offered at reasonable odds for second or third place and turn into larger money makers if racing luck overcomes the favorite. This is a good bet as favorites rarely win, even half the time.

4.  After concluding the most logical result, the real analysis begins, which is how much should be bet on this horse in this race? Weighting one’s bets can make the difference of a nice win vs loss record and walking away as a winner for the day.

5.  Accepting that I was wrong an uncomfortable number of times, but learning from the experience by re-examining both my analysis and how I handled my money and to a lesser degree my expenses.

Thus, I believe that, like other investors, I will be wrong in terms of market direction, sectors, “factors” and selections. To defend our beneficiaries’ interests I have adopted a policy of having a number of different bets at the same time, but with the recognition that unlike at the track where races end, the investment process continues through many cyclical periods.

“Goldilocks” May Be Leaving

Liz Ann Sonders of Charles Schwab among others is raising concerns about the future. After all, for at least nine years it has been somewhat easy to ride the secular rise in the US stock market. (Shorter periods for other stock markets.) This issue brings up a number of questions: evidence of impending change and what should be the correct investment policy going forward. In terms of evidence of impending change there are two important elements:  flows into stocks are from traders not investors and credits may be mispriced leading to fixed income not providing stable values. This week some in the press for the first time are heralding significant flows into the equity market from “funds”, which shows the Public is buying the current conditions. The truth, according to Thomson Reuters’ Lipper Inc., is that $20.4 Billion came in net, but $18.7 Billion went into domestic oriented ETFs with $8.2 Billion going into the SPDR S&P 500 and $3.1 Billion into PowerShares (Invesco*) QQQ. Both of these are favorites of hedge funds and other traders. In numerous cases ETFs and ETNs are being used by these players as substitutes for futures which are more expensive. I am noting that a number of investors have sold short some ETFs that represent over 10% of their assets and in at least one case over 100%. What may be more disturbing is that a number of independent investment advisors and a number of advisors working through brokerage firms are managing discretionary accounts exclusively in ETFs/ETNs. Some of these are probably good, but I suspect many do not have any successful background in market trends, sectors, “factors” and the selection of individual securities. They may be, along with others, contributing to a much higher turnover rate in ETF/ETN portfolios than conventional mutual funds.

*Invesco is held in a private Financial services fund and personal accounts that I manage.

Credit Concerns

Remember that most significant stock market declines begin after a period of fixed income market declines. Through March 15th most bond funds are showing a slightly negative total return, which includes both their income and their market movement. The only domestic groups that are not negative are loan participation funds, some specialized credit vehicles, and ultra short maturity funds. I don’t know when the next recession will commence, but I expect it will be within this first term of the President. I do know that during a recession bankruptcies and other financial difficulties occur and they are not being priced into the market. Institutional term loans are being priced at only 3.2% above prime corporates, compared with 3.1 % before the crisis that began in 2007-8. Further, while banks have much more capital than they did before the last crisis, their book of derivatives is somewhat higher.

In a talk at a Futures conference last week, my old friend Tom Russo, formerly General Counsel to Lehman Brothers, mentioned that when a counter-party believes it was duped, the entire class may be considered illegal as an auditor will have difficulty claiming the asset is worth 100 cents on the dollar. He said, according to the Financial Times, that “when you owe a little bit you call your bank - when you owe a lot you call your lawyer. “A good bit of derivatives are directly or indirectly financed through the credit market.

What Should Investors Be Doing Now?

There is no special reason for long-term investment policy to be changed as long as it contemplates that there will be periodic market declines. This is similar to money that is invested in what we label Legacy and Endowment Timespan L Portfolios®. For those with a shorter focus of at least five years, they should be making two lists of equities and equity managers.

The first list should be of items that at higher prices would become risky if the general stock market rises at a rapid rate. (There is some chance of this happening as new money rushes in on the basis of buy-the-dip or FOMO fear of missing out.) The risk is that such a surge most often leads to a major fall, which could lead to structural changes. The second list should be labeled “Hopefully not to be used, but probably will be.” It is a list of sound companies and managers who may be slightly damaged in a decline but will survive and prosper. Both of these lists should have names and prices scaled to avoid emotional price reactions. Five or ten price points could be prudent.
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