T.W.T.W. > Recognizing Capitulation+Risk Growth - Weekly Blog # 559

Mike Lipper’s Monday Morning Musings

T.W.T.W. > Recognizing Capitulation+Risk Growth 

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

                                                                                                                       

The Week

A long time ago on TV, on both sides of the Atlantic, there was a comic review of the current news titled “The Week That Was” or TWTW. Occasionally, news and commentary of significance are bunched into one week, as happened this past week. The items they covered may be of serious significance for 2019 and beyond.

One Day, One Week, One Month, One Year

Some of the US stock market followers can point to instances where the first day of the year market performance predicts the first week, which predicts January’s results, and in-turn forecasts the calendar year. They have some statistics to support their view. At any rate, both the first trading day of the year and the first full week of the year produced gains for the leading stock market averages. After surviving a year where only cash produced a positive rate of return of the main asset classes, one can hope that 2019’s results will have a plus sign ahead of it. With that thought in mind, the following mutual fund performance table could address the question of magnitude for 2019’s results:

  

     Mutual Fund Major Asset Class Average Performance

                      ---------------Return----------------

Fund Asset Classes    Week Ended 1/10/19  5-Year Annualized

US Diversified Equity        +6.63%             +5.80%

Sector Equity                +5.62%             +3.00%

World Equity                 +5.64%             +2.47%

All Equity                   +4.54%             +4.47%

Mixed Assets                 +3.47%             +3.65%

Domestic Long-Term Fixed Inc +0.53%             +2.11%

World Income                 +1.02%             +1.46%

Remember, the numbers above are not our predictions, they are a look at history. There were much better results over the past ten years because during this period we saw multiple expansion. The only way for the numbers above to be achieved is for further expansion of the market multiple, assuming the optimistic projections coming out of Washington. With the current size of sales forces contracting it will be difficult unless societies (governments and Private Sector) meaningfully address the growing retirement capital deficit, even assuming the optimistic projections coming out of Washington.

I recognize that absolutely none of the readers of this blog are average investors or investment managers, but there is still hope for you and your accounts to do much better. Barrons each week publishes a list of the 25 leading mutual fund performers for the week, sourcing my old firm now housed in REFINITIV. For the week, these 25 funds had gains of 19.45%-12.43%. (In eleven instances the funds had stablemates on the list.)

Attitude Changes Required?

In analyzing the 2018 results, several deeply held attitudes probably contributed to the poor results:

• Only Earnings Per Share growth counts in selection
• TINA=There Is No Alternative to equities for success.
• Demographics is destiny (without population growth no expansion is possible)
• Four interest rates hikes in 2019.
• A bear market is defined as more than 20% from peak. (Bear Markets are a sustained period of selling by Public investors.) AAII bearish sample 29% from 50% in 3 weeks. Never higher than 50%
• Capitulation requires large selling volume followed by large buying.

Three Longer-Term Considerations

1. Ken Rogoff is quoted as saying “Over the course of this year and next, the biggest economic risks will emerge in those areas where investors think recent patterns are unlikely to change.” His lists includes:

• A Growth Recession in China
• Rising Interest Rates
• Populism undermining central banks
• Higher interest rates on “safe” government bonds 

My concern is a data dependent world where the numbers are incomplete and wrong due to disruptive technology, increased under-reported transactions, poor data gathering, data expenses that are too low, “sound bite” analysis, and surprises.

2. The Historically Speaking Column in the Weekend WSJ briefly reviewed several financial panics going back to ancient Rome and government reactions to them. The column concludes “the only thing more frightening than a financial crisis can be its aftermath”. In many cases the crisis was created by leadership trying to extend a tiring expansion beyond its “normal life.” The solutions applied were an unwise attempt to prevent a repeat of the problem without recognizing the series of faulty decisions made by leadership. This included punishment of unpopular sectors and people rather than an attempt to guide better judgement and the rebuilding of appropriate reserve elements, which could have been quickly and expertly mobilized.

3. Gallop regularly measures the public’s view of the honesty and ethical standards of various occupations. Of the 20 occupations reviewed by far the highest esteem goes to Nurses. The following table shows the ranking of the professions we deal with as part of our professional lives:

Profession      %Low/Very Low   Rank out of 20

Accountants           7%               6

Journalists          34%               9

Bankers              21%              11

Lawyers              28%              14

Business Executives  32%              15

Stockbrokers         32%              16

Telemarketers        56%              18

Car salespeople      44%              19

Members of Congress  58%              20

Similar surveys are probably done in most countries. These public attitudes are probably similar worldwide and represent a major constraining force in the development of a modern financial community where we ask people to trust both our integrity and our wisdom. My fear is that during some future economic crisis the unpopularity of government will lead to an upheaval that promises more honesty and efficiency, but in the end doesn’t deliver on those promises. As bad as our current delivery system is, it will produce better results than any other long-term system. What we need to do is make it much better.

Thoughts? 

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/01/tis-season-to-be-mislead-weekly-blog-558.html

https://mikelipper.blogspot.com/2018/12/2018-lessons-should-be-learned-weekly.html

https://mikelipper.blogspot.com/2018/12/cash-is-four-letter-word-weekly-blog-556.html

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Bonds Can Hurt Retirement Capital

Introduction

Running out of money is the single biggest fear of all investors and should be of their portfolio managers and other fiduciaries. Unfortunately far too many focus on a perceived capital amount to meet their long-term funding needs. Unfortunate because they do not include allowances for taxes, inflation, and mistakes both in terms of investments and unplanned expenses. Thus their retirement or legacy needs are often understated. Because of these understatements/reasonable errors I believe payout of accumulated capital over 3% annually may lead eventually to the depletion of capital  in part or completely.

Universal Problem

There are apparently a number of perceived missing elements in every country's constitution. The global rise in populism is based on the belief that our society, in other words our government, owes each able bodied person gainful employment, and for the others some form of support. To the best of my knowledge the economic structure of no country is set up deliver on these perceived, unwritten promises. Thus this is the first big problem facing us.

Retirement Capital

However there is a second and perhaps even bigger problem that is accelerating ahead of us. Any quick review of national statistics will show that the need for retirement capital is actually growing faster than the need for jobs. To some degree the need for jobs is being addressed in the much reduced growth in population around the world, except in Africa and some parts of the Middle East. The existing unemployment and under-employment is creating a growing class of people that have little to nothing in the way of retirement capital even if they qualify for the under-funded social security.

Demographically there will be others such as the disabled and currently incarcerated who will enter the retirement stage with little or no capital. Add to these a much larger group of people entering their senior stage when they have not built sufficient retirement capital. All of these people (unlike some of the unemployed) can vote and are more likely to do so than in the past.

The risk to those who believe that they have sufficient retirement capital may be  a gross miscalculation. Eventually our societies will react to these needs. While hopefully they may make investing more profitable by lowering expenses and taxes, the odds are that governments will spend money. In some combination the money will impact taxes on (a) those that have money, (b) inflation for all, and (c) deficits which will drive interest rates up and the value of currencies down. It is these prospects plus the current low real interest rates, after inflation, which makes investing in high quality bonds risky if they have to be sold to make payments. 

Currently the Proper and Improper Use of Bonds

After a long struggle to build sufficient retirement capital with due consideration to the growing needs of present and future beneficiaries, an individual or institutional investor may wish to reduce the risk of losing meaningful amounts of retirement capital, one could properly invest in high quality bonds. This assumes that the current interest rates are above the after-tax inflation rate. Such an investor is both extremely rare and lucky. All other bond owners are speculating as to the future. 

At current interest rates adjusted for inflation and taxes it is difficult to see how bonds can be used to actually build retirement capital as distinct from maintaining it. Many if not most bond holders do so in the belief that there is less price risk in owning bonds than owning stocks or other forms of equity. Historically they are right in that most market declines bonds decline less than the stocks. Thus, I believe the proper way to look at the allocation of assets to bonds is a longer term index of fears of stocks than the VIX or other measures of short-term volatility.

Bonds Could be Worthwhile

As with all investment strategies there is a time that they are correct and other times when they are wrong. Unfortunately, I can perceive that once again interest rates will be driven so low that they can make bonds attractive to new purchasers. For those who have owned bonds for sometime, the offset is that during such a period if they have to sell their bonds the odds are the prices will be below (and perhaps significantly below) their purchase prices. There have been periods in history when purchasing high quality bonds with highly elevated yields produce in time big price appreciation benefits. My only problem with this strategy is that most of the time by the end of these market recoveries, one would have been better buying equities.

Equity Risk in Some Bonds

High yield bonds and to some extent high interest loans have been called stocks with coupons. This means while these credit instruments are called bonds and loans they have imbedded in them risk of late and/or incomplete repayment as scheduled. Unfortunately many individual and institutional investors have focused on the bond-like attributes of this kind of paper and have enjoyed the performance comparisons of high yield paper out-performing high quality bonds. Perhaps they didn't notice that in most of these periods stocks in general out-performed both high yield and high quality bonds, but they could claim that they were more conservative because they owned bonds and loans and not those risky stocks.

Spending Too Much of the Income

One of the real disadvantages of high yield paper is that most investors spend all of the interest payments as if they were from a high quality source. Note that in many periods the price performance of these assets is below the total return performance results by more than the paid interest . The missing difference is the impact of the defaults on a minority of these bonds. The major credit rating groups regularly publish their estimates of the forthcoming default rates of this asset  To the extent that investors want to spend the payments off of high yield paper, I would recommend that they put into some reserve account at least the current default estimates on the category. Often when defaults rise all of these types of paper fall to some degree in sympathy to the defaulting issues.

Bond Market Liquidity is Illusive

The liquidity in the bond market is considerably less than in the stock market which makes it difficult to sell during periods of unrest. This is particularly true in the high yield market. In one recently recorded instance that is part of a law case, the nominal bid for a bond was 65 ($0.65 per dollar of face value.) A large professional seller encountered the following situation: 60 to sell $1 million, 50 to sell $2-5 million and 31 for more. What is the worth of this account's net asset value with a nominal quote of 65?

The Problem with Bonds are the Bond Buyers

As with most things the problem with various instruments; e.g., guns or fast cars, are not inherent in the instruments themselves, but the people who use them. Utilizing Schroders^* Global Investors Study 2016 one can see individual and institutional investors bring the wrong attitudes to investing in securities and funds. The desired income broken down by location was instructive. Europeans wanted 7.9%, Asians 9.7% and those in the Americas 10.4%. One should not be surprised to learn that the Europeans in aggregate hold a higher allocation to bonds than those in America, but with an older population and more proportion of  debt than those on this side of the pond. Thus they are growing their retirement capital deficit faster as well as having higher unemployment and underemployment which helps to explain their more socialist oriented government. What is most interesting is that those surveyed thought they would live a long time in retirement. In addition, 74% thought they would live sixteen to thirty years in retirement. Contrast that image with their practice of owning particular securities 3.2 years and their advisors recommending holding for on average 4.3 years. In effect what the study is showing is that investors with a long-term need for retirement income plan to trade around five times during their retirement years. While not a perfect comparison, long-term studies of US Mutual Funds suggest those that on average trade less, perform better.

^*Held personally

Bear all of this in mind with the surge of global money going into bond funds at the same time that they are significantly under-performing the average equity fund.

US Investors May Do Better

According to the trade association for mutual funds, ICI, 60% of defined contribution assets are invested in equity funds.  With a significantly older weighted population, 54% of Individual Retirement Accounts are in equities. Roughly half of the money in these two main retirement accounts are in mutual funds. Typically defined contribution and IRA accounts don't trade much. To the extent that they don't trade and invest for longer periods of time they will build retirement capital sums. They could be augmented if the tax people allow these accounts to grow without mandatory redemptions way beyond the current 70 ½ years old.  

If the current US Administration and Congress really want to increase employment, perhaps they will focus on small companies being the largest contributors of new jobs - despite the fact that the number of publicly traded companies has dropped by 3000 over the last twenty or so years. We are down about 1/3 from our previous total.

Investment Conclusions 

At the current time, high quality bonds don't make a lot of sense for most retirement accounts. Also the average US investor, excluding currency, is likely to perform better than their European counterparts. This is particularly true if smart job generating tax programs are put into place.

__________

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Hearing and Seeing Different Investment Views

Introduction

Having just spent the last eleven days in discussions with portfolio managers, CEOs of banks and other investment experts in London plus global stock exchange leaders in meetings in Barcelona, I have been trying to find some common theme among these bright men and women. The single most common theme is the complaint,  “The world is far from perfect and getting worse with almost every bit of news.” This feeling is felt widely, which I attribute to the rise of populism on both the right and left of the political spectrum.

All Cash To Escape the Complaint

In spite of their complaints, almost no one is just sitting in all cash, which is not what I am advocating. But to own anything we must have a belief that on a relative basis at least some assets will hold value and may increase in value. Thus, we must be relatively happy about something or some things. Interestingly we don't often proclaim our happiness. Perhaps, we fear if we brag about what we own, it will be taken away from us. Many in the or around the investment community want to appear to be sophisticated so that they may join in with their lists of complaints. Rarely is any time to devoted to those investments or conditions that make them relatively happy.


There are very few portfolios that have 20% in cash. A holding of 50% in cash within a fiduciary account might be considered imprudent before a probate judge. This is not to say that we should not prepared for periodic drops of equity prices in the range of 25% and once in a twenty five year generation of 50% decline.

Bottoms Good and Bad

The reason we limit our cash accumulation is that we have studied cash hoarding by mutual funds and individuals. In many minds, cash can become too comfortable because there could always be another major drop. Off of some bottoms, the first 10 to 20% is often viewed as a rally in a bear market when it is really the easiest earnings in a bull market. Many are frequently surprised by the strength of the new market leadership. Above all we need to remember that we can and will be wrong from time to time.

Interest Rate Hike to 4%?

My readers will not be surprised that I was disappointed by the Federal Reserve’s inaction last week, including what was said by the Chairwoman. I did not expect what is analytically needed. The best result would be a single immediate jump to 4%. Many will feel my call for 4% is extreme, but they should examine the last two studies of the so-called "dot-plots" by the members of the Federal Reserve's Open Market Committee. In each case the highest rate called for was 4% or even higher in the furthest out period. If some members believe that such a rate will be called for because of economic stresses within the next two years, why not be preemptive now?

By immediately raising interest rates we will probably reduce the intensity of the bad loans being made. We will also make saving attractive to those who need to begin a life long activity of building their capital for emergencies and retirement. A careful observer should note that, as usual, the Fed is late to changes in the market place. I believe one should look at Main Street as well as Wall Street. The average interest rate being offered by a large number of banks has risen from its lowest level of 25 basis points to 30 basis points. This demonstrates to me that local banks want to attract more deposits so they can make money on more loans.

While I believe both our monetary authorities and our courts should be guided by what is appropriate for this country, there are lessons that can be useful in assessing our own problems. Some of the observers of the surge of refugees streaming into Europe are suggesting that a significant number of these people are migrants for economic reasons not for political reasons. Applying that distinction when we look at a substantial number of immigrants to the United States (including some of our original founders) we learn they came to the US for economic opportunity reasons. If we want to see growing economic opportunities in the United States we should be constructing opportunities to save and to invest, activities that the current level of interest rates do not encourage.

Come what may, investment managers will find reasons to complain and keep their investments in equity mutual funds and stocks including those in the financial services arena. Many mutual fund and other portfolios that I examine have as their largest investment sector various financial services stocks. 

Question of the week: Next week I am contemplating addressing value investing. Please let me know what aspects of value investing you would like me to address.

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Copyright © 2008 - 2015
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.