Investment Markets are Fragmenting - Weekly Blog # 839

 

         

Mike Lipper’s Monday Morning Musings

 

Investment Markets are Fragmenting

Flows Going to Potentially Higher Risk

 

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

   

       

   

Why the Fragmentation?

The answer is simple, salespeople make money by getting investors to make investment choices. At the institutional level commissions have totally disappeared, and the same largely applies at the retail level too. However, “vigorish” is alive and well, just with different names for spreads, underwriting fees, and management fees. Passive clients may decide at some future point that management fees are not worth it.

 

A valuable client is one that is actively investing and directly or indirectly aiding in getting new active clients.  The value of a client occurs either through the flow of new money or the reallocation of the portfolio. The marketing agent is consequently a bit of a worrier when communicating with clients. Furthermore, there is a desire to introduce new investment ideas, particularly new types of securities or new investment markets. The marketer will often present him or herself, or their firm, as more knowledgeable than the client. Thus, the marketer can dominate the client more than they expect.

 

Performing Better with More Risk

What follows is a brief discussion of current possible ploys that might be suggested. In truth these ideas might be sound if executed when not so popular. If peers already hold positions in the new play, their length of time to the eventual peak and subsequent major decline is shorter.

 

There are a very limited number of investors who have trading skills, and that does not include me. Most successful investors hold a relatively small number of holdings for many years. These are the types of investors who own Berkshire Hathaway with the goal of transferring assets to heirs after they are gone. (I am one.)

 

Until perhaps this week, James Mackintosh a Wall Street Journal columnist, noted that “Four giant tech stocks added more market value than all other stocks in the S&P 500 for the last month.” I suspect many investors were enticed to buy those four stocks. Unfortunately for them, the only class of stocks to rise for the week ended Thursday were small caps. regardless of growth, core, or value orientation.

 

Many individual and institutional investors have portfolios consisting of stocks listed on the NYSE, usually with dividends. These investors might be enticed to invest in NASDAQ listed stocks due to the greater number of tech stocks. There is a belief that most short-term NASDAQ traders are better than those playing on the big board. In the latest week only 23% of NYSE volume fell, compared to 42% on NASDAQ.

 

The fastest growing asset class today is Private Investments, either individually or through funds. As is often the case, the biggest risk is not the issuer, but other holders. The sponsors of private debt and equity do not have an obligation to buy back securities, except at the terminal date. The secondary market is very limited, and prices favor professional dealers.

 

Jaime Dimon, CEO and Chair of JP Morgan Chase is worried about inevitable investment mistakes in the privates. Although he does not see a structural problem, I think there potentially is one for two reasons.

1. These securities are being sold to individual investors. When the public loses money, they often complain to the media and members of congress who are always pro regulation.
2. There are very few pension funds still operating. Many have promised fixed returns to government employees, which includes teachers. For years these plans have used interest rates much lower than current rates, many of which have been bought from insurance companies. I believe some insurance companies will go bankrupt if interest rates stay at current levels or go higher, with the retirement burden falling on taxpayers. Politicians are probably better at getting the feds to change regulations. A guaranteed payment funded by a variable (market) sensitive vehicle is dangerous.

 

What are Your Thoughts?

 

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Current View of 3 Past Lessons - Weekly Blog # 693

 

Mike Lipper’s Monday Morning Musings

Current View of 3 Past Lessons

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

What Little We Know About the Future

“The future” will be a series of never-ending episodes, some good, some bad. Each somewhat similar and different than the past. Analysts are a combination of historians, observers, and dreamers distinct from extrapolators. In pondering the future during a “dull market” week, I looked through three historical lenses searching for useful clues about what lies immediately ahead. Please remember my absolute right to be wrong, or perhaps worse, being half-right.

1. “The Dow Theory”

Charles Dow, the first editor of The Wall Street Journal and founder of Dow Jones in1896, spent time trying to interpret the stock market and what it foretold about the future. His analysis revealed that there were two stock markets, those of pragmatists and dreamers, using my terms. Today we might call them “value” and “growth” investors. To arrive at this conclusion he boiled down the price performance of what would become two limited indices, the Dow Jones Transportation Average and Dow Jones Industrial Average. He concluded that for the general market to have a sustained movement both averages had to move in the same direction and eventually reach their prior established peaks and troughs. One had to confirm the other’s move.

 The logic behind this view was the industrials being priced on the collective view of their future, believed only when the rails carrying their freight to customers confirmed it. We might have labeled the two indices as quality and speculation. (Some of today’s readers would not believe that the rails were the quality portion of the market. Some years earlier, Columbia University had an endowment devoted to the most prudent of all US investments-----railroad bonds!! It is worth noting that almost every significant railroad subsequently went bankrupt.)

Today, pundits still regularly comment and contrast stocks/funds that are value and growth oriented. With that in mind, it is useful to look at charts published each week on the price movement of the Dow Jones Transportation and Industrial Averages. (Both have evolved, with major changes in their composition. The Transportation Average includes airline companies, logistic companies, shipping companies, and package delivery companies. The so-called Industrial Average, in addition to including manufacturers, also includes entertainment, financial, credit card, and software producers.)

From the beginning of the current year into the middle of May, both Averages rose meaningfully. However, since then the DJIA has risen slower, being essentially flat in July and only reaching a slightly higher peak on Friday. The Transportation Average on the other hand has been falling and is now approximately 11% below its May top. Thus, as of now we have a non-confirmation of the Industrial Average Friday breakthrough. 

The May peaks in the two averages made sense as the rate of gain of the recovery topped out. This was primarily due to concerns over inflation, politics, and slowing sales resulting from shortages. While the NASDAQ also went to a record levels on Friday, on most trading days its price movement has been less ebullient than the DJIA. One of the characteristics of a top or bubble is high-volume traders going up while others lag or fall.

2. Jeremy Grantham (GMO)

Jeremy is an iconoclast thinker and portfolio manager. He has made some brilliant calls on the market and has been out of phase with markets for extended periods of time. More than a year ago he made a favorable call on the price of timber. As a member of Caltech’s investment committee, we have profited and enjoyed his performance. He is currently worried about a market bubble. Recognizing that many who attempt to read crystal balls concerning their future eat broken glass, his views are well worth considering:

• Bubbles occur when periods of very long and strong economic expansions are extrapolated into the future. (The current expansion is being fueled by government stimulus, with the advocates not identifying any termination of the expansion.)
• Much of the global expansion of the last several years has resulted from bringing low-cost labor from China and eastern Europe into production. (Unless they can cheaply be replaced with Africans, Latin Americans, and those from Southern Asia, we will suffer from wage inflation.) 
• Perceived wealth makes consumers and investors think they are wealthier than they are. While seasoned market investors understand that prices “temporarily” decline, few appreciate that housing prices can fall for a long time. In terms of future spending, housing is a worse investment than securities. (It is my personal view that we don’t own our homes, they own us. We must pay to maintain them and pay taxes on them.)
• He lists other parallels in a recent podcast and his writings.

3. My Own Experience

My first job on Wall Street was at 63 Wall Street, working at one of two very special brokerage firms. With rare exception the two firms were odd lot brokerage firms, executing share transactions of under 100 shares. Other members of the New York Stock Exchange (NYSE) found this task cumbersome in a pre-computer era. To free themselves of this burden they allowed the odd-lot broker to charge an eighth or a quarter, depending on the price of the closest qualifying trade executed by the other floor members. With their level of commission determined, the two firms competed to get orders from other firms by providing services to their customers. During this period the only record of stock prices was on Mr. Edison’s ticker tape, which was not mechanically stored. My job, along with an army of clerks, was to record the tape prices and volume for a handful of stocks useful to our brokerage firm customers, proving they got the best possible price at the time of the trade.

I learned a great deal that summer which shaped both my later career and more importantly how the real commercial world worked. Some of these insights were:

• If commissions are fixed, one competes on services that are a burden to customers.
• With the right sales attitude, it is a distinct advantage working for a limited number of professional customers in geographically close offices, rather than dealing with public customers spread around the country, if not the world.
• Internal industry competition can regulate the marketplace faster, fairer, and more insightfully than regulators.
• Develop respect and appreciation for skilled hard working people with different levels of formal education and experience.

Many years later, when assembling a financial services portfolio for family and clients, I did not limit it to brokers, banks, insurance companies and fund managers as most financial services portfolios do. I also included financial service companies with specific expertise useful to the professional market. In a recent performance review of that portfolio, some of the leaders were what I would call critical common denominator service companies with limited competition, e.g. Moody’s, Thomson Reuters, and S&P Global in personal accounts,  which have gone up multiples of our original cost.

The reason for mentioning these positions in a blog focused on what could cause the market to decline, is that almost every business is overregulated compared to other financial services businesses that are relatively lightly regulated. This is due in part to the same customer regulation that the odd-lot firms enjoyed. If some of the comments by Senator Warren and members of the current administration become law, it will make these companies less attractive investments and worse suppliers to the market.

Updates

Some of the signs of extreme inflation are possibly temporary. The runaway JOC-ECRI Industrial Price Index declined this week by 3.64% and is only up 68.27% year-to-date. I don’t know how much of the decline is from certain lumber and oil prices. Personally, I am much more concerned about service sector inflation due to rising wages. Some of this is overdone, but it is unlikely these hard-earned increases will meaningfully reverse short of a major depression.

When I talk with young people these days, they focus on trading to get rich quickly. I try to bite my tongue for I believe that investing is an art form, where each artist learns how to control their actions to reduce the probability of losses and the possibility of gains overtime. To me, trading is an inside game for professionals who believe that they have a demonstrable edge capable of overcoming expenses and taxes. Many of these young people go to or graduate from “good schools”, where they are taught and schooled, but not necessarily educated. Being schooled is what you have been taught, whereas education is what you have learned. Unfortunately, most of us only get education through our own or others’ losses. I am not worried the youth won’t get the benefits of losses, as that is almost inevitable through trading. What concerns me is that this generation will stand shoulder to shoulder with those who lived through the 1930s Depression, stoutly proclaiming “never again will I trust the market and its participants”. Some of these types of people were still at the Bank I joined after The Marine Corps in 1957. They relatively quickly past by those of us who were learning to be good analysts and not bad investors. My fear is that many of the youth today will never be good investors,  which may be the real loss resulting from the oncoming decline in markets around the world.

In Conclusion

The odds favor a major decline in the future. The issue is one of timing and we continue to learn that the duration of cycles of all sorts appears impossible to predict, but one should be prepared.

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

https://mikelipper.blogspot.com/2021/08/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/07/mike-lippers-monday-morning-musings_25.html

https://mikelipper.blogspot.com/2021/07/correcting-impression-and-gaining-some.html

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Anticipating Topping US Stock Market for Portfolio Managers vs. Stock Pickers - Weekly Blog # 662

 

Mike Lipper’s Monday Morning Musings

Anticipating Topping US Stock Market

for Portfolio Managers vs. Stock Pickers

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

                           

                   

                           

Warning: How Markets Approach Tops

Perhaps fittingly, markets reach tops in a similar fashion to countries going to military wars. There are two phases. The first can go on for a lengthy period of a year or more, with the slow destruction of the ability to successfully fight back. The second is an immediate event, which galvanizes the opposing forces into military action. The assassination of the Archduke in WWI and the Attack on Pearl Harbor in WWII are two examples. In both cases the general population was not paying attention to the deteriorating conditions and they were truly surprised by the triggering events. Those in power were not surprised that an event could trigger hostilities and there were premature warnings if one looked for them.

With the US stock market nearer a probable peak than a bottom, I sense an oncoming peak followed by a meaningful decline. I just don’t know when, although I have a pretty good idea who will be blamed for it.

Topping Signs

The first sign is the public’s wish for a better year than the last, often expressed as a bigger gain in the US stock market. The raw gains for the Standard & Poor’s 500, with dividends reinvested, was +18.40% for 2020. A level roughly twice the long-term average of +9% to +10%. The average S&P 500 index fund, with $1.9 trillion entrusted to them, gained +17.91% with dividends reinvested and management, administrative, and transaction expenses deducted. As good as these results were, they were below the average return for US Diversified Equity Funds, a gain of +19.14% on $10.3 trillion in assets. Even with the history of a strong November and December being followed by a year producing returns of +10% or more, one should be cautious in expecting the 2021 return to be better than 2020. 

Excessive speculation with increased leverage weakens all but the strongest financial structures.  Excessive speculation is often an open invitation for enemies to embark on bold adventures (Pearl Harbor). There is no doubt we are experiencing rampart speculation, 2020 had the fastest bear market and included a record level of IPOs and an equal number of SPACs (Special Purpose Acquisition Company). In addition, 2020 saw a record level of margin debt and a new generation of inexperienced investors rapidly trading on home computers, somewhat like the “roaring twenties”. 

Accelerating inflation also weakens the defense mechanism of a society. The JOC-ECRI Industrial Price Index ended the year at +24.44%, with 81% of the weekly prices rising in the weekend edition of the WSJ. Other cracks are also visible in the economy, with landlords and their banks speculating on when and if their tenants will pay their rent. One also hears of some officially unemployed workers only willing to work off the books. Integrity is often forgone in periods of speculation and inflation.

We should not attempt to remove all speculation from the markets, as we would be killing opportunities to take risks that have paid off very well in 2020, shown in the performance of the following mutual fund averages:

Alternative Energy Funds     +92.89%

Global Science & Tech        +65.00% (C)

Science & Technology         +52.21%

Multi-Class Growth Equity    +42.89% 

(C) Canadian Information Technology stocks +80.65%

Typical Stock Pickers Play Differently

Picking stocks is an old art form encompassing both short-term gambling and long-term investing. One of the main mental attitude differences between an almost exclusive focus on picking stocks and portfolio management, is that stock pickers focus almost exclusively on the performance of individual holdings, whereas professional portfolio managers focus on the performance of the entire portfolio. This usually leads to a stock picker having a more limited number of holdings, with many driven by the same market dynamics. Many newer stock pickers are entertained by the frequent examination of price volatility, intending to hold if his/her stock prices rise relative to other immediate alternatives. The focus is often on what is happening in the market and/or in the headlines, not on the fundamentals of the company which happens to have the same name as the stock. If the stock disappoints, the player sells and either buys something else or totally withdraws from the market, until a new wave of speculation gets his/her attention. In viewing the history of stock-pickers, one is reminded of what is said about pilots “There are old and bold pilots, but there are no old bold pilots.” 

That speculation burns out many inexperienced traders is unfortunate, not only for them but also for the nation. We have reached a point where the number of new companies equals the number retiring, either voluntarily or involuntarily. Among the reasons are demographics, labor and other capital productivity, regulation at various levels, and tax rates. One of the reasons US productivity was a world leader was the birth rate of new ventures and the success of some. Among the biggest advantages a stock picker has is that he/she does not have to play and record of results is not known. If the record is self-disclosed, it may not be believed. 

The Professional Portfolio Manager Plays a Different Game

The biggest risk for most professional managers is career risk, either losing employment or reputation. Furthermore, the portfolio manager is constantly being measured against supposed peers and externally identified time periods. At times absolute and relative investment performance are paramount and at others presumed risks is critical, whereas for some accounts cash generation is most important. For example, in 2020 the same account could be a relative leader or laggard and finish the year with very acceptable results, depending on the period selected. In some cases, when an institution borrows money during a period of economic strain, cash generation or volatility is critical to making payments or maintaining credit ratings. Because of COVID and a disruptive economy, some institutions have become much more sensitive to short-term results, whereas others look at the same characteristics through a longer-term lens and see new opportunities and risks.

In contrast to the stock picker, a portfolio manager looks at each investment not only in terms of its investment merit, but also its role in creating the appropriate balance in an account in terms of risk and reward. While a stock picker would ordinarily be delighted to have every one of his/her holdings do well, a professional portfolio manager would be concerned, fearing a change in the impetus driving the market could make the portfolio a very risky vehicle. In income-oriented portfolios, the timing of flows is critical to meet payment obligations and that can put constraints on the structure of the portfolio.

Unlike the private investor, most professional portfolio managers can’t afford to be out of the market, as most outstanding performance requires ownership on key turnaround days. The best a manager can do if the market is moving differently than what is perceived to be correct long-term, is shift the relative volatility of the portfolio, with a willingness to move quickly into higher volatility when the trend is what it should be.

How are You Protecting Against Unwarranted Speculation?

• Ignore?
• Raise Cash/Short-term vehicles?
• Change Volatility?
• Prune holdings which don’t help?
• Or something Better?   

I like quoting Ben Graham, not only because of his well-earned knowledge but because of the New York Society of Securities Analysts gave me an award named after him. He is quoted as saying “the essence of investment management is the management of risk, not the management of returns.”

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

https://mikelipper.blogspot.com/2020/12/stud-poker-new-swamp-game-weekly-blog.html

https://mikelipper.blogspot.com/2020/12/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/12/searching-for-surprises-weekly-blog-659.html

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

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The Ultimate Contrarian Advice: Don’t Follow Buffett to the Peak

Introduction

Regular readers of these posts already know that I have been examining the evidence that we are close to going hyperbolic on the way to a high peak. The good news is that we are not there yet. The bad news is that I see the potential extremes that could cause more than a normal decline.

The leader of the band

In the wonderful musical play and movie The Music Man, the promoter/instrument salesman/conductor mesmerized a conservative small town in the Midwest of the United States and convinced it to purchase expensive musical instruments and uniforms. In some ways Warren Buffett could be the Music Man for the next peak, not because of his ukulele playing, but people want to believe and follow him.

The Berkshire Hathaway calendar (BRK)

Each year on the first Saturday of March BRK releases its annual report. As a shareholder and a manager of a fund that owns these shares, and like many others, I read the report online on Saturday to prepare my thinking for Berkshire’s conclave and annual meeting the first Saturday of May in Omaha. (This is always entertaining to see the mix of retail and institutional questions asked of Mr. Buffett and Charlie Munger over five hours.) In reading this year’s letter I was struck by how, in a gentle Midwest almost “aw shucks” approach, Warren Buffett was laying the groundwork again for a big pitch to get others to follow his thinking with their own investments.

What is missing for the run up to the peak?

While every major peak is somewhat different from the others, many of them appear to promise great gains quickly.  In an over-simplification, these peaks are based on the intense belief that great wealth will be bestowed on the investors who believe in the presumed future. These are not value focused investors who believe that they are buying securities at a discount from today’s worth. They are growth investors, and they are not actively buying today.

For my analytical sins I attend many company analyst meetings either in person or electronically. As I commented earlier this week to the CEO of a major financial institution who I have known for more than 20 years, almost all of the analysts’ questions were focused on the last reported quarter with some implications for the current quarter. A great deal of attention was paid to the likely buyback of common stock by the sell-side analysts. There were no questions about “blue-skying” the future (in effect what long-term investors are paying management to produce successfully). Since most of the companies I follow intensively are in the financial services business, their current stock market multiples are low, which indicates the lack of future growth that might command higher valuations. (More on the dangers of small numbers later.)

This is exactly why the Buffett letter is so important. If one analyzes Berkshire Hathaway carefully and adds up its insurance businesses and its financial stock holdings plus its finance companies as well as possibly including its debt dependent railroad and utility operations, one could say that BRK is mostly a financial services investment. Nevertheless, Warren writes in terms of the future including a comment about one hundred years in the future. In last week’s post where I was linking Warren Buffet and George Washington as growth investors, some did not see the connection. George Washington believed in changing the productivity of his assets through technology (the five-sided threshing barn), the distillery (to upgrade his grain growing) and raw land purchases in a number of more western colonies. Buffett is a believer in the increase in productivity, including lowering his operating and financing costs for a number of Berkshire’s operating and security investments. We will see whether his always entertaining annual meeting ignites investors to search for growth.

Applying even relatively modest growth to future earnings would lower the current perception of market price/earnings ratios. Once that happens there may be a renewed search for growth investors. If this happens quickly, we could see such a rapid price advance that chartists would describe the prices as having gone parabolic, which is what happened to the run-ups to other great peaks.

More excitement is needed!

We are currently in a small number world. Often the numbers that are discussed in the financial media are small, usually a few percentage points or smaller. That is not going to drive the animal instincts of the investors who are sitting with too much tied up in cash and fixed income instruments to fear losing out on a great opportunity to make a lot of money. So the numbers have to change. In effect, we will need to breakthrough the expectation boundary. That can happen.

If it happens, what’s the risk?

The risk of large losses from subsequent price declines will be due to not taking to heart the conservative portfolio management principles that Warren Buffett and Charlie Munger have been preaching and following for years. Some of those enjoying what could be a meteoric rise will be wary but will be looking for signals of the top in the wrong places. They will be looking at the companies, political structures and/or the economy.  As Minsky believed, they should be focusing on long periods of stability and quick periods of instability. John Mauldin quotes from a study from a number of years ago by Professor Chichlinisky from Columbia University on endogenous uncertainty which suggests that market declines are ignited by movements within the market itself not caused by outside events. A good trader will spot a sell order that is too big for the market causing the dealers to back away from current prices which in turn will bring in lower prices and more sellers. As we live in a global market, the unexpected seller could come from a small Norwegian fishing village as what happened in the last real estate paper collapse.

Bottom line

The conditions for a major blow off of higher prices are not generally present today. But watch out when brokers start pushing growth and then watch for changes in the market structure.

Please drop me a line and let me know how you see the current market and the future potential for large gains.

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