Architectural Sway Points and Current US Stock Market - Weekly Blog # 611

Mike Lipper’s Monday Morning Musings

Architectural Sway Points and Current US Stock Market

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

Most of the time very tall buildings and highly valued stock prices don’t fall, but history shows that it is smart to worry about the possibility of it happening.

Buildings that are over 100 floors are largely a U.S. phenomenon. During the early days of New York’s World Trade Center, I was asked to join a luncheon club on the top floor of one of the towers. In the ride up to the club the elevator noticeably swayed. Upon arriving at the top, I could see for many miles out of the windows. I watched planes flying up the Hudson River that were below where I was standing. When pressed to join the club I commented that international clients were important to me and my business. I felt that these clients would be nervous due to the lateral movements of the elevator and the thought that they were above planes in flight. I was told not to worry as the lateral movements in the elevators would be dampened, and they were.  As the planes could clearly see the World Trade Center Towers, they wouldn’t fly too close. The increase in wind velocity from ground level to the 100th floor was anticipated by the architects, who allowed the building to sway in order to absorb the energy of the winds.

Unfortunately, as with many assurances, they did not address all risks that could befall those in the higher floors of the WTC. I had neglected to consider the landlord being the Port Authority. As its own governing body, the Port Authority did not need to abide by the stricter rules of the New York Fire Department regarding the width of the stair wells and some other fire precautions. Nor did I contemplate Boeing developing commercial aircraft capable of carrying more fuel than other airliners. Most importantly, I did not consider those planes being used as guided missiles. Nor did anyone else.

This is not the first time a structure tilted measurably. The leaning Tower of Pisa has become a teaching site in terms of soil movement, foundations, and architecture. We are now assured that tall buildings constructed after the tragedy of 9/11 will have a far lower death count and will probably remain upright.

Can we compare the attack on tall buildings and their ultimate collapse to the current US stock market? I clearly don’t know, but the life-altering experience of 9/11 causes me to wonder. Which assurances given will be proven to be somewhat faulty due to unexpected changes in conditions? As a professional investor for others, I feel compelled to consider the fall from high stock prices.

Being a numbers guy and learning from the great educational institution of the racetrack, the first thing I do is look at the long-term odds. From 1928 through 2019 there have been 92 years of data. Breaking the data into performance slices, the 30% gain for the S&P 500 Index in 2019 ranks in the top 21% for all periods. To expect similar results for 2020, or any subsequent year, is like betting on favorites at the track. It is generally not consistently a rewarding approach.

For the last decade S&P 500 Index Funds have grown at a 12.98% annualized rate. Mutual funds that did well during this period were growth oriented and had substantial investments in technology and consumer services. The worst performing funds were invested in natural resources. These trends appear to be continuing in 2020. Through Thursday, 13 of the top 25 mutual funds for the week were growth focused and 6 were technology oriented.

One of the lessons learned from the track is that good near-term performance brings more money, a bet on the continuation of the trend. At the track, the weight of money lowers the pay-off odds, which must be split among more bettors. In the investment races popularity attracts competition, as well as more scrutiny from governments and others who seek to share in the gains of investors.

One way to avoid some of the risks inherent in today’s large-cap growth stocks and funds is to re-examine small-caps and emerging markets. You could also examine a group like natural resources which has not had positive performance for a decade, with a particular focus on energy.

Question for the week: If you made a list of your fundamental investment beliefs and were forced to rank them, which of your top five could prove to be harmful due to changing of conditions?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/01/how-much-will-markets-decline-10-25-or.html

https://mikelipper.blogspot.com/2019/12/repeat-past-history-probable-or-just.html

https://mikelipper.blogspot.com/2019/12/mike-lippers-monday-morning-musings.html



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Worries: 2nd Derivative, 3rd Degree and Surprises - Weekly Blog # 553

Mike Lipper’s Monday Morning Musings

Worries: 2nd Derivative, 3rd Degree and Surprises

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

                                         

The job of the analyst and leader is to worry about the things that most others don’t worry about. The worries that most are concerned about won’t happen as imagined, but others will. As is often the case with jargon, those in the know want to protect their position by defining a situation in terms that only they understand. The concept of the second derivative is known by sports people, hunters, and drivers. In plain language, the first derivative is the speed of something moving and the second is the rate of change in that speed. When driving, we note the speed of one car overtaking another. What is of significance to avoid accidents is whether the overtaking vehicle is accelerating or decelerating. The risks of an accident happening is much greater if the overtaking vehicle slows upon passing, creating an unsafe gap between the moving vehicles.

Applying the 2nd Derivative
Quite foolishly, far too many investors believe that reported earnings will dictate future values. Foolish because in today’s world the validity of reported earnings is as accurate as the former Chinese Premier’s distrust in reported GDP numbers, thinking of them as man-made and not reflective of reality. One of the better consulting firms, the Boston Consulting Group (BGC), has published its “Value Creation Insights” on corporate activity. BGC noted that current prices include current expectations. This suggests that their clients can only raise stock prices by accelerating expectations, or for numbers-oriented people, by driving the second derivative higher than the first.

The problem facing investors today is that the current and expected 2nd derivative is negative. Through the third quarter most American companies were reporting record results driven by high profit margins. These expanding margins were the result of sales growing way above trend and by utilizing underused human and plant capacity. Part of the driving power of these results was supplied by overseas workers, customers, and facilities. Most non-US markets have recently declined. The media and others have attributed this to the current trade conflict. While this is somewhat true, I believe an equal if not greater impact is due to consumer demand slowing and higher wages being paid.

Will the Saturday Night Truce work?  
Clearly the Saturday night truce could dramatically change some of the trade issues, while creating others. While markets are likely to move this coming week, my guess is that the earliest we’ll clearly see the impact will be the following week. Although that is likely to be a knee-jerk reaction, as the details will not be forthcoming until next year. Nevertheless, as much as I would like to be wrong, I do not think that trade itself will be enough to get the first and second derivatives moving in the right direction for investors. This is the logical view.

The Absurd View
Part of the training at my two educational institutions, the racetrack and the US Marine Corps, is to always be on the alert for surprises. Some of them may be so surprising as to be considered absurd or unbelievable. In that light I suggested in last week’s blog that the US stock market could go to a new high this year. My reason for suggesting it was that in the light of the declines of the past few weeks, no one would have such foolish thoughts. Foolish me, I discounted radical swings in sentiment. Global stock markets rose last week, probably in anticipation of a favorable result. Of the 30 top movers among the 72 market price indicators, 26 were stock market indices and only four were commodity indices. Thus, one can see that changes in sentiment drove stock buyers more than they did commodity or currency players. With the Dow Jones Industrial Average gaining +5.59%, S&P 500 +4.46% and the NASDAQ composite +6.19% in the week, new highs are only +4.81%, +5.81%, and + 9.04% respectively away from their former peaks.  The absurd goes from impossible to possible and some may even say probable.

Whether or not the numbers play out as suggested, the key takeaway for investors is to expect surprises, some good. In the long run markets move on supply and demand, which may or may not be seen. However, in the short-term, changes in sentiment can make for dramatic moves.

The 3rd Degree
People need to find others to blame for their misfortunes. If they can find the culprits who did this to them the culprits can be severely punished and possibly get restitution, ensuring this problem won’t happen again. To accomplish this corrective goal requires some hearing in the court of law, or more quickly in the court of public opinion via the media. This need has been present in societies throughout history. Because the guilty can be deceptive, they need to be questioned sharply, with or without appropriate protections. If headlines are generated, the prosecuting attorney or media can go on to bigger and better things, but this will not necessarily be better for the victims.

Despite repeated trials in court or the media these offending problems continue to reappear. Why? I suggest there are two fundamental generators of these problems. The first is the so-called victim, who in these circumstances possesses bad judgment. Bad judgment is often sourced from a school or the media trying to educate quickly, but not thoroughly. A similar source may be the staffs supporting various politicians, as well as the politicians themselves.

Since the main culprits won’t acknowledge their culpability, there is a search for other perpetrators. Thus, all that serve as fiduciaries for others, as members of boards and advisers, are at risk of entering a 3rd degree chamber. Prosecutors are not interested in the number of years where things were done right, or the elements of sound judgment that didn’t work at times,  suggesting a failure to process rather than the quality of judgement. Did you know, if not, why not? Type of questions. This is exactly why when sitting on a board or working for them I ask a lot of questions, with the hope that at least the questions, if not the answers, will hopefully be remembered in the minutes.

The reason for bringing this up now is that it has been a long time since we have had a bunch of scandals. (Because of human nature I suspect malicious things happen all the time and only occasionally bubble to the surface.) Often when the economy is not performing well there is a public need to find culprits. We know that some things will surprise people and therefore there will be a need to shift blame. These issues may not come out in force until there is a recession, which will come at some point.


Question of the week: 
What do you think and are you planning to do anything about it? 


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

https://mikelipper.blogspot.com/2018/11/on-road-to-capitulation-and-recoveries.html

https://mikelipper.blogspot.com/2018/11/selectivity-over-factors-weekly-blog-551.html

https://mikelipper.blogspot.com/2018/11/history-guide-not-map-or-trap-weekly.html


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Roles in Life Rule Investment Decisions

Introduction

In studying investment managers for more than fifty years, I have learned that the roles that they have played through their lives have had an enormous influence on how they invest. What is true for the professional managers is also true for individual investors. If that is my thesis, I should apply it to myself. Thus, the following will be a form of self-analysis. The purpose of this exercise is to suggest that others should examine what in their personal history influences them as investors. Our life roles and experiences go a long way in explaining our self-imposed constraints and proclivities.

Handicapping Thoroughbred Racing


I have probably learned more about analytical thinking and careful money management from my experience at the New York race tracks than from all the classes I took at Columbia or in earning a CFA designation.

The first thing I learned was the existence of "racing luck". Despite a great deal of time and energy spent on past performance data, unaccounted things can and do happen. Thus the weight of money odds always includes the betting market's views on uncertainty or racing luck. The second thing I observed was that the betting crowd can be wrong. The most popular bet wins less than half the time and in many cases more like a third of the time. Thus, I usually have an aversion to investing in the most popular stocks or funds. The third thing I learned was that there was a better way to handle my hard-earned money.

One aspect of the first lesson mentioned above is not to feel compelled to participate in every race and to pick my opportunities. As an investor this has probably led me to favor funds that have fewer rather than a larger number of stocks. The second part of my track-induced money management course was to look for opportunities where the probabilities based on my thinking were different than the odds offered. Often I would bet on my choice for second (Place) so if my horse did come in either first or second I could still cash a ticket. Often if the favorite did not make it up to the wire at the end, when my horse did, the payoff for Place was substantial. 

Investment Lesson: Bargains are hard to discover at the track and in the market but are worth the time and effort to find.

Collegiate Fencer

As a five foot nine inch champion team member I was assigned to fencing épée. The bulk of my opponents were considerably larger than me, well into the six foot level.

Investment Lesson: I learned not to be overly concerned about being small. 

The bigger the foes, the harder they fall.

An Officer in the US Marine Corps

Here there are three lessons I learned from the USMC:

1.    Tight discipline produces first-rate results.

2.    The best defense is a good offense.

3.    Taking care of your troops and listening carefully to their reports often leads to them having the answers to difficult problems because their practical experience is far superior to field manuals of instructions.

Investment Lesson: A disciplined approach to investing is vital.
   

Simply avoiding large losses is not enough; one needs to make money to deliver against the needs of the account. Be aware one does not have to have all the answers. Many smart moves come from those with less theoretical, but more practical experience. However, one needs to take command of difficult situations even when you lack enough information.

Securities Analyst

A single financial statement in and of itself is relatively useless. Early in the game of analysis we learned to compare one company against the other, usually by numerical comparisons. The next step was to compare to price. On a statistical basis one security is cheaper than the other. This is unfortunately where a lot of analysts and investors stop. Cheaper does not always equal better. Often there are other factors including qualitative items that the market values higher than a pure statistical measure. At times a premium price is warranted.

Investment Lesson:  While numbers are very important, they are not everything.

Entrepreneur

I believe I have a tremendous advantage over many other CFAs and analysts. I started a business. At times I turned around failing products. I met a payroll and paid employees and suppliers as well as corporate taxes. Too many armchair analysts tell corporations what they should do while they themselves have never done it. Today most corporate managers do a pretty good job on what they believe to be the objective. In analyzing a company in addition to its sheer survival, one needs to understand what management believes is the objective. All too often history has shown that professional analysts make lousy business leaders. 

Investment Lesson: We should be respectful of the specific competence required in securities analysis, in business and in non-profit organization management.   

Business Consultant

Because my firm produced the most complete data on mutual funds, and to some degree on brokerage firms, I was frequently asked to consult with CEOs of various fund and other financial organizations. The real world problem was that the statistical or ‘school solution’ answer to the presenting question could not be executed for a host of reasons. The challenge just as in the Marine Corps was, “When blocked, how to go around the enemy and /or improvise with new and often on the spot solutions?” The more consulting jobs I completed, the more I came to the conclusion that the real problem was people and how they acted or will act under change of circumstances. Often the biggest problems were the CEOs who hired me; even when they recognized that they were part of the problem.

Investment Lesson: As investors: we are the biggest hurdle to better performance.  

Understanding and overcoming these limitations may be key to this exercise.  For example, I often harbor a reluctance to sell when short-term disappointment is likely. The short-term can turn into long-term, with the possible result a long period of under-performance.


Investment Manager

By the time one gets the responsibility of managing large amounts of other people's money, one should know exactly how to construct the portfolios for optimum results. Even with so-called discretionary accounts there are specified constraints and unspecified constraints. The latter is what I call the wrinkled nose syndrome. When discussing an investment or a strategy with a client or a high influencer, the nose or some other non-verbal feature indicates a weariness or disappointment.

Investment Lesson: At this point an alert manager should recognize the flashing caution light. The manager can proceed at his/her own risk, but if the particular investment strategy or single investment does not work, the manager has entered the regions of career risk.

Trustee

For those of us who have been something of a success in the investment and other businesses and want to give back to a generous society more than just cash; donating time and effort come to mind. One is often asked to become a trustee of a non-profit organization. Thus, from time to time I find myself in the position of wrinkling my nose due to perceived incomplete research. With no ‘spare time’ to speak of, I usually must decline.

Investment Lesson:  You must be as careful investing your time as you are with your capital.  

At the same time I am empathetic with the managers and their staffs who are trying to deliver expected results while staying within the specified and unspecified guide lines.

In summation

I have performed all of these roles and they have significantly influenced my investment decisions. Through this exercise I am coming to a better understanding as to what makes me tick as an investor. Perhaps each of the readers of this blog could benefit from such an exercise. Let me know what you have revealed to yourself about the impact of the roles that you have played.

_______________________

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A More Insightful Way to Characterize Funds

Guilty As Charged

I plead guilty. I plead guilty for the crime of characterizing mutual funds and their kissing cousins, hedge funds by the types of securities in their portfolios. My enablers are the fund marketing people and the lawyers. At times we are all guilty of taking the easy way out. We choose to identify people by what they look like, not what they are, or more significantly how they think. I should have known better. I forgot my race track education of calculating my betting choices after examining the characteristics of the jockey, trainer, and breeding as well as the conditions of the race and the racetrack. Shame on me.

The Talents of the Trade

Each of us has a different collection of talents. I have made a living analyzing a mass of data, organizing the data for decision making, and using that data for making decisions applying the disciplines that I learned from my educational institutions, the US Marine Corps and the aforementioned racetracks. I should have looked at the primary thought patterns of the principal decision maker for each fund. Most of the time this is the portfolio manager, but it can be the most forcible member of the investment committee, a determined marketer, or extremely rarely, the fund’s board of directors. The following are some of the ways that I identify the dominant personality of a fund and how the fund can be used most effectively in a portfolio of funds. (I manage or advise on the use of funds in a multi-fund portfolio where each fund has a separate function in contributing to the whole over the long-term.)

The Discoverer

This portfolio is full of names that are not common to most other portfolios. More often than not these names are of smaller, often newer companies. Sometimes the names are from rarely explored foreign markets. Occasionally the names are different types of securities which more often than not come from the extremes of the fixed income world. All of these securities lack significant research coverage from the usual sources of research. As an analyst I used to delight in finding companies whose president has not talked to an analyst in years. As he or she explained the company to me, I explained how analysts like me operated. Some of the most rewarding investments were in companies that had a policy of not speaking to analysts. In almost all cases the names in a Discoverer’s portfolio are difficult to analyze. When these stocks move, it is usually not due to an asset class’s popularity or the general trend of the market. Most often a Discoverer will have more strike outs than home runs. The investment results will look more like those of a venture capital portfolio, but have the advantage of offering daily liquidity. In the hands of someone with a great deal of industrial experience and a proclivity in recognizing management’s abilities, this kind of investing can be rewarding for the truly long term investor. Wealthy individuals who have a multi-generational outlook or a structured endowment for long term horizons can find a Discoverer a non-political “fellow traveler” and a good strategic fit.

The Anticipator

I use to hear this term used more frequently than now. The term was applied to managers who felt they had well-defined skills at anticipating major interest rate moves. There is still at least one fund that invests either in very short term treasuries or thirty year treasury bonds. The Anticipator has a defined view of the future and is waiting for the rest of the investing community to catch up. The trick for a successful Anticipator is not to be the first Anticipator but near to the last, just before the take off of the expected trend. At times, Bill Gross and others at PIMCO are Anticipators. To some degree this a necessity, due to its size relative to the size of the available merchandise at an inflection point. This may be a requirement for PIMCO as the world’s largest bond fund manager. Some patience is required to be a successful holder of a fund that anticipates. One can appropriately call my faith in the benefits of technology as anticipatory and not often rewarded.

The Immediate Reactor

The financial press believes that the market is full of those traders/investors who immediately react to a bit of news. They are looking for the proverbial one-handed economist who has a singular view on an event. Even the rapid-fire “macro” hedge funds don’t put their money on a single roll of the dice. Most often a substantial buy is offset by a sale or short sale, perhaps through derivatives or ETFs. Nevertheless, the Immediate Reactor does make dramatic moves quickly. The closing of the liquidity pool around a security or currency is viewed as an opportunity to get in before the bulk of the move is underway. Funds that do react well have suburb trading skills and they know how to use their size to get the best advantage. In many ways these are trading artists. Outside of occasional outsized gains, these funds can be used as an early warning device, a canary in a mine if you will.

Trend Identifier

These managers are constantly searching for minor deviations from immediate past experiences; to be one of the earlier identifiers of a change in an investible trend. For example, these trends can focus on elements of consumer spending at various price points, the popularity of products ( e.g. Blackberries and iPads), or the daily movement of a currency. In the fund arena, the rate of inflows and redemptions can be interpreted as meaningful trends. Often large funds use identification of trends to shift a small amount of their portfolio in the direction of the trend on a daily basis and more as the trend becomes more pronounced.

Trend Follower

Some managers, particularly in the commodities world, are Trend Followers. They need to separate market volatility from important market trends. These stock, bond, and commodity managers focus on large aggregates in the market place. A more modern example of this age-old technique is the use of Exchange Traded Funds. Currently there are portfolios that only own ETFs or Exchange Traded Notes (ETNs), a fixed income equivalent. Increasingly these portfolios are being used for commodities like gold and silver. Trend Followers have more faith that the trend will continue for some period of time than recent history suggests. Also aggregate trends do not allow for the investment opportunity differences among various industries, sectors and other components of the aggregates. If one does not have much faith in individual selection skills and the direction of “the market” becomes all important, Trend Following is an attractive approach.

The Resurrection Believers in Recovering Prices

As all life seems to be cyclical in terms of up and down phases, hopefully around a recognizable trend, some managers look at investments that are currently priced well below their peak levels. Excluding from this universe those stocks that were substantially over-priced given their best expectations, the resulting list of large discounts from peak can be a happy hunting ground for some investors. These investors are different from value investors who believe that today’s price represents a good value relative to today’s reality. Those that believe in recoveries believe that conditions will change. Whatever caused the unfavorable conditions, e.g. commodity prices, unpopular styles or product failures, will change. The argument goes something like this: if oil was priced at either $150 or $36 a barrel, certain properties would be perceived to be more valuable. Another variant of this strategy is when the new production comes on line, such and such will happen that will significantly change the valuation of a security. This may be considered as betting on the return of the Black Swan from Australia. History is on the side of those who believe in cycles of prices and other forms of human behavior. What is more difficult is identifying which particular cycle will change the soonest. To some degree distressed securities buyers believe in a form of financial resurrection.

Final Note

To be a good investor, one needs to know more about the intellectual motivations behind various portfolios.

____________________________________________
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