Pick Your Bias and Selective Data Will Support - Weekly Blog # 630

Mike Lipper’s Monday Morning Musings

Pick Your Bias and Selective Data Will Support

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

Different investment horizons favor different inputs. One can be reassured that I regularly search through lots of data as inputs to making investment decisions.  There currently appears to be a tug of war between the inputs that please bulls and bears.  We manage money utilizing different investment horizons and what I am seeing may be useful to our subscribers.

Short-Term
Positives:

1. The “fear index” for short-term trading is slowly falling, currently reading 28 compared to 32 and 36 respectively for the last two weeks. However, it is still elevated compared to last year’s 16.
2. The S&P/Dow Jones roster of global stock market indexes shows 29 of 32 rising.
3. A list of weekly prices that includes various domestic equity price indicators, commodities, and currencies, shows 79% rising. 

Negatives:

1. Taxable bond fund net sales, while still positive, fell a bit. (This is viewed as a negative indicator, much like the old net odd-lot transactions being right for a while, but wrong at most turning points, often confirming them.)
2. A relatively low level of overall stock transactions possibly suggests that some traders and investors are starting their low-volume summer vacations. (The absence of high-volume market followers indicates a lack confirmation signals.)

Many active equity Mutual Funds focus only on their long-term investment objectives and are not very sensitive to changes in market direction, or even the direction of flows into or out of their funds. The first quarter, plus a glance at April, was an interesting petri dish. We did a small confidential survey of a limited number of active stock funds in some of our client accounts, which showed the following results:

1. Half of the funds enjoyed positive net contributions.
2. Approximately 30% owned 200+ names, 50% had 50-100, and 20% held below 25 names.
3. Remember, February saw a high point and March a low point for this cycle, but only 20% chose to make dramatic changes to their portfolios. In each case they actively reduced some risky positions, but generally replaced them with the same number of names.
4. Most of the funds used their existing holdings to allocate new money to and used them as a source for redemption proceeds. Thus, they stayed within their expected portfolio envelopes.

The useful observation from the small survey is that many active funds are worth a premium management fee and should be used as long-term vehicles to meet long-term needs, not short-term instruments to play the market.

Intermediate Term

1. Many international or global funds view the world from a European perspective, based on the size of the market and value of the assets listed on their stock exchanges. Companies in Europe were the first to become multinational, beginning with their investments in the Americas. Today, Europeans are much more dependent on both their imports and exports with Asia and Africa, than US companies. Thus, when US investors buy into a European multinational they are buying into China, etc.
2. Over 60% of Asian trade now remains within Asia. From a trading and investment perspective, Asia is becoming as integrated as Europe, without the bother of an overall government. Today, Asian economies are almost fully recovered from the Coronavirus, whereas the US and Europe are not.
3. The Baltic Dry Cargo Index is rising and is currently slightly less than half of last year’s level, which I take as an indicator of the Asian recovery.

Longer-Term – The Major Concern, the “New Normal(s)”
We are handicapped in our thinking by out of date ways of assembling and characterizing our data. For example, we separate governmental activities from services provided, but don’t identify total government wages and service revenues buried in goods manufacturing. Thus, much of business and the whole political structure is coming to a gunfight with a rusty knife. The “new normal” will likely force some corrections. Our job as investors is to be a bit early to these changes. As usual, the change agent will be uncomfortable prices.

The first wave of COVID-19 has wiped out many family’s cash savings and put many domestic governments, educational institutions, and critical non-profits in jeopardy. In addition, it has added to our unemployment and increased the swelling group of young people looking for jobs. At the other extreme, because of travel restrictions and working from home, some businesses have increased their cash levels. This has also occurred for some wealthy families.

Our political leaders have a long-term view, all the way to early November, and are focused on goods manufacturing employment in a half dozen states. This is where their problem lies, it is not where the bulk of the people are. Local and state governments provide many services to their citizens/voters and I fully expect almost all to institute fees for the services provided, substantially raising them above what they already charge, possibly with a poverty discount. Rainy-day reserves will need to be quickly restored before additional waves of this plaque hit. It will likely include a reasonable reserve for future plagues in this overcrowded globe. (It is quite possible, due to neglect or political patronage, that some of these services can be outsourced to more automated and friendlier companies.)

Bottom line, the cost of government will be going up
The average 5-year return for diversified equity mutual funds through Thursday night was 5.13%, with the average domestic and international fixed income fund earning less than 3%. I doubt that most employers are earning much higher on their retirement responsibilities. This suggests they are not earning their cost of capital, regardless of what they say, and is the reason they have not been expanding in the US. Additionally, while many companies already charge for services after the initial sale, many do not, or charge prices that are too low to cover costs.

I expect prices charged by business, like those of government, will rise in the future. Others have doubted this because of the large number of unemployed, but some at the low end will be employed at wages below the cost to automate. Unfortunately, this period of “go to shelter” has exposed many middle management types in the post 40-year age group who were good enough with full employment, but are now no longer needed. These are nice and good people and some will find employment at considerably lower wages, or take on entrepreneurial risks themselves.

There are upsides to these views. First, people at all levels will learn to budget both their time and money. We are already seeing the personal savings rate rising, but this is initially used to pay back debt. Further, while automation will reduce some jobs, technology will create many more as it addresses existing and new problems.

I expect prior to the end of the next Presidential term to see inflation in the 3-7% range and interest rates perhaps 2% higher, with average equity returns 1-2% higher than interest rates. This should be a good long-term return for stocks and stock funds. A predictor of rising inflation is that gold mining stocks are rising but the metal price is flat. The latter is discounting the future value of gold after significant costs.

Working Conclusion:
In each problem there is at least one or more opportunity, if we are smart and flexible. Investors with these capabilities should see opportunities a bit earlier.   



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The Age of Investing

Introduction

Some people believe that age is a common denominator. The great fallacy of Target Date Funds is that age is a shorthand for the level of investment risk an individual should take. There are many other measures and some more important than others in terms of individuals; e.g., assets including intangibles, liabilities including contingencies, mental and physical health as well as others. All of these factors should be viewed through the filter of one’s gene pool. With that thought in mind I learned separately of the recent birthday celebration of a 108 year old matriarch and the death of my senior cousin at 88. The matriarch is of a large family and is the mother of a smart and aggressive woman I knew as the senior director in terms of service of at least one volatile public company. Because of popular governance approaches there was a move to remove her as a director without any real acknowledgement of her remarkable gene pool, which to my mind is concentrating on form over substance and overlooking her contributions to the younger senior executives on the board. The 20 year spread between the live matriarch and my recently passed cousin suggests to me when I counsel 401(k) plans for current employees and their need for retirement funding I also must consider the uncertainty of the length of their life span, medical conditions and end of life medical expenses. I have great respect for actuaries and their ability to reasonably predict length of life of large masses of people for life insurance purposes, however I am extremely skeptical of their ability to predict any specific person’s date of death. 

My cousin was a lawyer and businessman as well as a long-time investor particularly in above-average yielding stocks which he shared with members of the family and others on a pro bono basis. I have a different model, which is to copy or exceed the life of a certain leading name investment manager who was close in age to the matriarch and was actively trading for himself and others paying a fee until a few days before his death. My somewhat facetious thought is that the pros normally outlive the amateurs.

Time horizon investing

Some of the readers of this post are responsible, at least in part, for investing for extremely young children, grandchildren, or great grandchildren. With that responsibility in mind I would suggest that some attention should be paid to time horizons beyond a century, possibly 120 years. (This comes from the trustee of Caltech who recommended the issuance of 100 year bonds because I could see the need for insurance companies and families for this kind of paper. On a historic basis I like to pay, not to receive, low interest rates.) To sharpen the focus on the future, based on lot of current experience, many young people do not get their first professional job with above-substance pay until age 25 and are forced into uneconomic retirement at 65, and then live to 120. The ratio of work-based earnings for 40 years compared to 80 years living off of savings (theirs, or others) including transfer payments is 3/1. I know of very few investment portfolios that can produce triples with certainty.

Three depressions

I am not about to discuss past or future economic depressions. I just want to focus on three rates of change that are currently way below the actuarial norms. In order of sluggishness to normal change, they are: population growth, savings rate and the dividend yields. Except in Islamic and a few other cultures, fewer children are being born. In part this is due to the recognition of improved medical conditions so fewer children die in childbirth. The use of contraceptive devices, and some additional recognition of economic uncertainties also affect birthrates. On the one hand, fewer children mathematically raise average income per person, reduce the size of consumer markets, and could create a shortage of workers or warriors.

The low savings rate is due to two factors. First, the ability to save is being crunched by expenses rising faster than incomes and second, the interest rates available to many are too low to attract their money into the savings system. One of the reasons I pour over the weekly edition of Barron’s is for its statistical section. In this week there is a monthly table of the dividend yield on the Dow Jones Industrial Average for the last ten years. At the end of January 2014, the yield was 2.14% which was the second lowest (2.01% in January of 2004 was lowest). There were other months that were lower, but most of the time the yields were higher. Obviously, the dividend yield is not in and of itself attractive enough to explain the record price for the DJIA. (The high at the beginning of the month was 16530.94 which compares with the monthly low of 6547.05 in March of 2009 when the yield was 4.31 %.) The explanations for this almost 1000 point increase in the averages are three.

• First, dividends have increased because earnings have grown.
• Second, there has been significant repurchases of the shares outstanding for the older companies in the average.
• Third, the stock market should be future focused discounting what the average dollar of investment sees.

Tying age and data together

For those who attempt to provide long-term solutions for individual or institutional investors the measurement process has shifted to a total reinvested return mentality which is the way my old firm started to report to fund boards, management, investors, and the media. This in turn means that we have all become much more price sensitive. With current historically low yields there is little price protection afforded by yields. If a market is dropping a “normal” down market of 20%, I believe a current yield would have to be close to 10% to cut the decline in half.

The rosy future is dependent on smart youth.

Last week a panel of Caltech trustees met with approximately 100 graduate and undergraduate students out of perhaps a total student body of under 2500 who were interested in exploring entering the financial community with firms like Goldman Sachs recruiting on campus. As one might expect, my fellow trustees (all who are active within the financial sector) were encouraging, I raised issues for them to think about. (I am willing to discuss my view or send my notes to our subscribers.) The key question for some of the Ph.D. students is should they continue with their efforts on developing new products with a seven-to-ten year time horizon for a possible big pay off or go into the financial community for more near-term rewards? I am finding that this is a question that my nephew at Carnegie Mellon is dealing with; he is a bright young man who already has patents registered and is attracting the attention of some leading professors. Somewhat younger, I also have a grandson at Bucknell who is an engineering major and is trying to get the right internship to learn how productive engineering is. As long as the youth of the world are attempting to make things that will help our progress, we have good reason to be positive for long-term investing for the next 100 years.

Filling the age gap

Tonight was the Super Bowl XLVIII. For the first time our National Anthem was sung by a world famous opera singer, Renee Fleming. I am very proud to report that she engaged the New Jersey Symphony Orchestra to accompany her. (Ruth, my wife, is the Co-Chair of the NJSO.) She is addressing the chronic problem of classic musical audiences, that they are aging and orchestras are working very hard to bring in more of the young to invest their time and eventually their hard-earned money in support of classical music. From an investment point of view this can be important. There is a clear relationship between math, science, and therefore investing, and perhaps improving each with an understanding and appreciation of classical music.

I think Ms. Fleming sang wonderfully!

_____________________     

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IN THE LAND OF RE

My text today focuses on “RE.” One might think of this prefix as returning to past times of glory or relearning past lessons. With all due respect to various writers of imaginary kingdoms and a number of sermons, my thoughts are on the return of capital (employed) and the return on investment.

Starting with the most controversial application of “RE,” the biggest long-term risk is reflation. (Some may use the term re-inflation.) Many governments around the world are incurring debts at current levels of interest to cover their deficit spending, as well as the new manipulation entitled “stimulus spending.” In either case by inflating the value of the currency they will be paying back the debt with devalued currency. Further, higher prices for goods and services will increase the level of taxes paid. With some exceptions (e.g. social security payments and the value of some deductions), income taxes will rise. Prices for property, whether real estate or other forms of equity, will rise to offset the decline in the value of the currency. Part of the danger coming from inflation is that the increase is built into the cost structure of tradable goods and services as well as various forms of property. Eventually after prices rise above their real value based on their utility function, prices will decline, often rapidly, which can lead to various stresses including bankruptcies. For these and other reasons, I believe governments, including our own, will reflate by putting too much credit and money into the system.

Out of the fear of such future occurrences of inflation, in many accounts I use Treasury Inflation Protected Securities (TIPS). I recommend at least some TIPS in every balanced account of stocks and bonds. If interest income provides most of the living expenses and charitable gifts, the portion invested long-term in TIPS should approach the level of interest income generated from high quality bonds. Even in the case of a large commitment to stocks, some holdings in TIPS may act as the “canary in the mine,” a very sensitive indicator of future perceived inflation. There is one major drawback to the use of TIPS in a tax-paying account: the calculated incremental rise in the value of the debt (which is how inflation is accounted for at maturity) will be taxed each year even though the investor did not receive the income in the year charged. While the risk of rising inflation is very real over time, the tax-related issues are such that investors should consult with their investment manager and their tax accountant.

The second “RE” is “releveraging” or the opposite of the more popularly-used term deleveraging. On an overall global basis, incomes can not grow faster than the sales of products and services unless the commodity is in permanent short supply, (which doesn’t often last long), or when leverage is applied. There are two types of leverage, operating and financial. These are detailed in my book MONEY WISE. Operating leverage occurs when sales grow at a faster rate than costs. Often operating leverage occurs when there is a high break-even point due to capital employed. This desired attribute is called a rising operating margin. Often “growth” stock investors look for increasing operating margins with the hope that this growth will be sustained. Until sales and distribution costs, as well as prices, turn unfavorable, growth is a winner. Very few companies can actually maintain rising operating margins for long periods of time in a competitive world.

The second form of leveraging is financial leveraging; buying additional productive capacity through the use of debt. For this to work the interest rate paid on the debt needs to be below the operating margin. Debt also needs to be repaid or refinanced, so the ability to generate sufficient cash to repay the debt is very important. “Value” investors often focus on stocks and bonds of a company that can pay off their debt quickly and substitute operating earnings in place of interest payments. Often this focus leads to only looking at companies that the markets perceive as being distressed. “Value” investors see productive use of financial leverage as looking at free cash flow, net of the interest and principal of debt service. In other words, they are saying, “To get us out of the hole, we will add back in debt service spending that they believe will be declining.”

The next “RE” is reviewing the facts beneath the surface. Let me suggest two very different examples of facts, that when reviewed will suggest a difference from the popular view. The first is the report that a number of large commercial banks are both profitable in the first two months of the year and that they are increasing their loans. Many potential borrowers from banks, such as corporations, tax-free institutions, and some individuals, have obtained lines of credit for future borrowings. In a period where cash is becoming king, some are now tapping into these lines because they are fearful that the money will not be available when they have a real need for capital. These loans are being taken down by the borrower while the lender records an increase in lending. In some cases the borrowers have no immediate need for the money and turn around and invest it in short-term, high-quality paper (e.g. US Agency or commercial paper). From a macro viewpoint, this is not a stimulus-oriented use of capital. I do not know what proportion of the increase in lending and bank profits are due to this type of activity, but this is an example of looking underneath the headlines in press releases.

The second area to review is more difficult to identify. I am beginning to sense that the long- term trend of substituting machinery for human labor may be decelerating. With new capital equipment costs high, and the abundance of highly motivated, intelligent people who will work at much lower wages and fringes than in the past, we can see changes. One is already seeing former business people driving cars, trucks and buses which in the past sat idle for the lack of drivers. A number of unemployed people have entered the market for services, either as part-time employees of established businesses or franchises, or are becoming entrepreneurs. I am told that there are many commission-only jobs available, some will be filled by enthusiastic people who never in the past were directly involved with sales. I am not privy to whether these people are listed as unemployed or underemployed. Government statistics are always behind in measuring changes in the structure of the economy and that may be why I don’t have statistics to back up my view.

The final “Re” for this session is relearning. As children, many of us were required to save a portion of our meager allowance each week. Some of us tried to install this concept with our own children. Many families from other parts of the world, particularly Asia, are prodigious savers. From an overall economic standpoint, our government is trying very hard to get people to spend now and even incur more debt. This “logic” holds that with consumption in the neighborhood of 70% of GDP, this spending will jump-start the economy. As often the case with politicians facing elections, this is very short-sighted. Consumption spending without saving is like treading water: surviving for now, but not leading to a rescue. In pure economic terms savings leads to a much higher multiplier effect than consuming. As savings grow, it will build up in the financial system, though whether that will be in the formal banking system is another question. Eventually the small savings will filter into the investment stream, which over time, will direct it to a high return on investment (with risk of loss very much in mind). If we can get the savings rate in this country up to 10%, which produces (after the current “delay”) annual returns anywhere from 6-12%, we will be giving our next generation the financial means, and more important the discipline, to deal with the huge debt needed to cover the excessive spending done while we were, theoretically, in the driver’s seat.

For the Greater Good: Frugality vs. Stimulus, T.A.R.P. and Foreclosure Relief

In this Sunday’s New York Times, Cornell Professor Robert H. Frank wrote an article entitled “Go Ahead and Save. Let The Government Spend,” in which he discussed whether taxpayers should resist spending their last dollar and let the government spend through the stimulus package, TARP and similar programs including the expected foreclosure relief package. In the article, Professor Frank referred to the John Maynard Keynes essay, the “Paradox of Thrift,” which argued that increasing individuals’ savings rates has the effect of reducing aggregate demand, and because of the negative multiplier effect, actually reduces personal income. Over the past seventy years many academics and politicians have used this analysis to conclude that government should stimulate a declining economy with grants. Keynes would individually have us spend our last dollar to lift the economy. In the Times article, Prof. Frank disagrees, “Taxpayers shouldn’t feel bad for putting their own savings first.” He stresses that personal savings find their way into the financial system, usually through some form of deposits. These deposits will force banks to compete for good loans by lowering interest rates which helps some existing borrowers as well as new borrowers.

I agree with the thesis that we should let the Government spend our money first, whether it provides optimum benefit to the economy or not. However, there are two stronger arguments that Professor Frank could have made. The first has to do with the contrast between the multiplier on consumer goods and services purchases as opposed to the multiplier on capital goods purchases. The largest part of consumer spending is for immediate or near-term consumption, which pays for the human labor already expended. Compare this impact to spending on capital-producing investments, such as mining or manufacturing, which may produce much larger revenues and earnings in the future. Those who favor immediate satisfaction by spending today are following the same pattern of over-spending and under-saving that is one of the causes of our current calamity. In effect, this is a consumption based philosophy that does not look to the needs of the future. In contrast, savings that support capital production does grow the size of the pie.

In order to make wise capital expenditures, business people assume various contingencies when building their calculations for cost of capital and expected returns on their capital, including sweat equity. I believe that from an economic measure, the return on private capital spending is materially higher than consumption expenditures. Thus, we should all be increasing our savings for the long-term benefit of the economy.

The second reason we should encourage savings is that frugality has its own reward. In my recent book Money Wise, I suggest that the second most important way to convert riches into wealth is by controlling expenditures. If your goal is to increase your savings from the current 5% to 9%, you will need to find the other 4%. You will do this by either expanding your gross income or finding some expenses you can do without, or can delay. In other words you will become a much more efficient purchaser. This more efficient mind set will stay with you for a much longer period of time than will the pleasure of consumption, and thus will have a more lasting benefit to you, yours and your charitable endeavors.