Can Stocks Move Higher if Bonds Don't?

Introduction

Unlike "data dependent" economists or media pundits, the jobs of portfolio managers and securities analysts is to attempt to make money for their clients. The past is useful in categorizing what has happened in various periods but our job is to make decisions today about what may happen in the future. The question before me today is: when the bond market is no longer rising can stocks go up in price?

Bonds Drive Stocks Since 2000

John Authers, the very perceptive columnist in the FT Weekend edition compares the performance of bonds to stocks since the prior peak in 2000.  His conclusion is that while stocks performed impressively, bonds did extraordinarily. He further points out that on the basis of inflation-adjusted returns, stocks under-performed bonds by 50%. From a shareholder's vantage point the only positive thing that various measures of quantitative easing (QE) has done is it raised the stock price level as measured by the popular indices. As a matter of fact the surge in the Federal Reserve's balance sheet caused by their bond buying is about equal to the growth in the value of the gains of the stock indices since March 2009. This would suggest that the gains in the stock market were in effect paid for by ballooning the Fed's balance sheet rather than enthusiasm for growing earnings or dividends. No wonder these market gains are called the most unloved bull market.

Bond Market Concerns

There is increasing acknowledgment that the global experiment with QE has not propelled various economies to expand. At the moment the Fed is not increasing its bond buying levels and is telegraphing future interest rate hikes. Already US rates are rising. In the last two weeks Barrons' Best Bond Yield average is up 5 basis points which is the same amount that the average of the nations' banks have raised the rate they pay on Money Market Deposit Accounts, (MMDA). Looking to 2017 one assumes that the Treasury will be issuing bonds to pay for the large or the largest infrastructure program ever by the federal government as discussed by the two main candidates.

Based on history, health, expected restructuring of one or both main parties right now it would be wise as to view the next administration as a one term occupant of the White House which could tie in with a likely recession during the term. Alternatively, according to at least one good technical market analyst a potential peak stock market will occur somewhere over the next six years.

Through the Mutual Funds Lenses

The S&P 500 with dividends reinvested is up +8.40% and the Dow Jones Industrial Average is up +8.64% for the year to date through August 11th . While the average sector fund is up +13.79%, the average US Diversified Equity fund is up only  6.33%. One can see short-term the attraction of bond funds over stock funds when "A" rated bonds are ahead by +8.56%, "BBB" funds +9.60% and High Yield (so-called Junk). +10.71%. However, if one is concerned about intermediate or longer term periods one sees a very different story. In the intermediate five year period on average only the "BBB" funds have a compound growth including their dividends over 5%. They earned 5.34% or essentially their interest payments compounded. On the other hand the average US Diversified Equity fund was up +8.42%. This suggests that over most intermediate and longer time periods stocks have outperformed bonds.

All too often market commentators take the raw net flows into mutual funds as a sign of what investors are thinking and currently supporting; e.g., putting money into fixed income funds and products. These views may prove to be incomplete and naive. At one point in time the bulk of mutual funds sales were made to individuals for long-term investment needs. Somewhere around 2/3rds went into Stock funds and the rest into Balanced and Fixed Income funds. For the most part funds were sold through salespeople or directly through the funds. Within each sale there was a built in redemption usually when the investment need was met or for some unexpected emergency. Today, I believe this type of completion is the main reason for redemptions, not dissatisfaction. What is different today is that selling forces find it more profitable and less burdensome to sell other products to retail individual investors. Thus it appears that money is moving because of dissatisfaction. This will be less of a factor going forward as most of the new money going into mutual funds is for retirement plans and a growing number of tax exempt institutions. This could lengthen the average holding period in funds.

The other misconception about fund flows is the inclusion of the transactions of Exchange Traded Funds [ETFs] and similar products as they presumably have the same kind of holders as mutual funds. For instance in the latest week some $0.6 Billion net came into the combined Equity fund base. What is more significant is that $3.6 Billion came in from two large Index funds. My guess is that most of this money is from hedge funds and other traders who are using Index funds to hedge their individual securities shorts and will sell their ETF positions once they cover their shorts. In the same week on the fixed income side $3.5 Billion went into Fixed Income ETFs, $1.3 Billion in High Yield ETFs and $1.0 Billion flowed into High Grade ETFs. (All of fund flow data is from my old firm, Lipper Inc., now part of ThomsonReuters.)

The First Question: When Interest Rates Go Up Will There be Buyers?

For some time investors in bonds and credits have been able to make money through price appreciation caused by new buyers in addition to the income generated. A period of rising rates will cause fixed income products to get lower prices. I believe there will be a meaningful reduction of flows into these products.

Second Question: Where Will the flows Go?

Long-term investors particularly retirement programs and endowments have a long-term need to generate sufficient income to meet their obligations. If they can not generate the needed funds they will seek investment vehicles elsewhere. Various forms of equity may become more attractive.

Third Question: Why Will Stock Prices Rise Significantly?

Perhaps the best answer is that very few of the market professionals believe that it will. Many of these "experts" have been wrong on Brexit and the rise of various extreme political candidates. Interesting there is relatively low risk because of the previously mentioned unloved bull market. One of the few brave commentators is James Paulson of Wells Capital Management whose latest letter is entitled "Stock investors should look a yonder" where he makes the case for a global economic bounce. He sees a bigger chance for dramatic earnings improvement outside of the US. We have been buying International Equity funds that have portfolios that have lower valued securities growing faster than many domestic funds.

Fourth Question: What is Needed for the Market Bears to be Correct?

As there have always been down markets, we have learned to expect them. Even though we have not had a major decline for sometime, we need to be watchful for such a calamity. For example in a 31 month period from March of 2000 to October of 2002, the NASDAQ Index fell some 78%. While it is interesting that today it is selling above its March 2000 level, it is instructive to note that on a year to date through July 20^th, 71% of its gain was achieved by ten stocks. And yes it took 25 years to recover from the 1929 peak. These kinds of declines have been proceeded by extended period of excess enthusiasm which we have not yet seen in at least seven or perhaps even sixteen years. Using price histories that go back hundreds of years some are looking for the next big one to drop over 50%. While this action could happen anytime, at least one technical market analyst believes it is most likely between 2018 and 2022. This somewhat ties in with the next presidential campaign which may be even more concerning than the present dance.

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Future Winners Found By One Word: Adaptive

Introduction

While securities analysts are essentially statistical historians, fortunes and reputations be they financial, business, political or military are made by change agents. Most of these changes are not self-evident initially to the change agents, but come about through seeing what is and most importantly what isn't obvious. Seeing what isn't is not enough for success. (Many of my security analyst friends are frustrated by their lack of confidence in the stock and bond markets because their valuation metrics are not working. They are not adapting to the markets structures and valuations and may miss out for a time.)

What is needed is a series of actions to create the somewhat poorly defined solution. For most of those that are called brilliantly creative, it has to do with adapting what already exists but re-purposing it for the new challenge. By definition these change agents are future-oriented and not content with merely repeating the past, no matter how cherished the past routes have been.

For lots of reasons, I believe we have entered a period when we will see new approaches to current problems. These approaches will cobble together some of the past elements with new understanding of the implications of technology.

Learning from the Military

The study of war should be about how to conduct new military operations better than the old methods. For many years the American Civil War was the classroom for the German General Staff. They studied the campaigns of Stonewall Jackson and William Tecumseh Sherman in particular. From them they adapted the concepts of maneuver and column movement. They applied these brilliantly during the first and second World Wars in Belgium, France, and Africa.

During the period between the world wars, our own US Maine Corps developed  both the Raiders doctrine and Personnel Landing Craft as well as the use of aircraft for close tactical support for frontline Marines. They were adapting some of what they themselves had studied against indigenous forces and what was present in the era, but would also be needed in the next global conflict.

Whether BREXIT Succeeds or Fails May Depend on Adaptive Approaches

The "Remain" campaign was based on the current economic factors. The "Leave" movement was based on what the English saw and didn't like.  Assuming an unfriendly divorce, the success of Leavers will depend on their ability to find new ways to make their society and economy survive and grow. Much of the Remain pitch is that the City of London, their one square mile financial district, will lose the right to "passport" their deals into the EU. In Saturday's Financial Times, Charles Leadbeater writes an article of five different scenarios for a post BREXIT era. They go from the collapsed City to London becoming the best of all major financial centers. The final one is dependent upon the people involved adapting to the situation with new technology, but in some ways also a throw back to the medieval Hanseatic League of northern, largely German Cities and London.

The Finance Minister of Luxembourg currently is warning the EU not to underestimate the UK. I believe their success will be the Brits’ ability to change the game by adapting some of the better practices and technology from around the world. As a contrarian with lots of time, I would rather be a buyer than a seller now. The new leadership is encouraging. However, as with all adaptations, there is likely to be some mistakes, but the failure to adapt is likely to be worse.

“Equity: The Film”

It is said that men traditionally resist change whereas women by nature are forced to be adaptive to change. One of the major corners of the financial community that has lagged behind the publicly traded investment houses and banks has been the Private Equity shops. Thus I am looking forward to the premier of a new movie entitled "Equity" which is about a private equity shop with a dominant  woman. The financing for the award-winning film was arranged by Candy Straight with twenty-five other professional investment women. We have known Candy since her days of heading acquisitions for a major pharmaceutical firm through a number of private equity shops and as an independent director of several mutual funds. These women are a great example of being able to adapt to difficult and challenging situations.

   

Large Cap Investments

My wife Ruth and I both have had a long term familiarity with the two corporate "Generals,” General Electric and General Motors. As a young analyst, I spent most of one year going through just about all of the major groups within GE. Ruth comes from Detroit and worked for a major auto parts supplier and raised money from the Detroit business community for the local symphony and local public television. Thus both of us have had a long term familiarity with the two "Generals.”

At one point I joked that the two should merge under the title of General Inefficiency. Clearly for many years the Generals lived in their own world and eventually lost earnings power, market share, and pride of place. But today each is in the process of evolving and adapting to both their somewhat reduced condition and also from more modern leaders.

In the past when I saw GE in a fund's portfolio (it was widely held) I treated it as an investment warehouse to store part of the portfolio until better investments could be found. GM couldn't shake the cyclical tag, and was far less owned by mutual funds, but was a comfortable holding for mutual insurance companies and trust banks. Both of the Generals evolved financial subsidiaries that traded on their parents’ credit rating and commercial relationships without outstanding success except as a recognition of their size. Both of the Generals today have evolved to somewhat smaller, but still giant, multinationals that are producing earnings on a regular basis from most of their activities. Both have benefited from adapting numerous of the business practices of overseas leaders.

Taxable Accounts Own Under 30% of US Corporate Stock

One of the characteristics of the US stock market over the last several years is that Large Cap stocks have outperformed the Mid and Smaller Cap stocks in price appreciation but not in earnings growth. Their attraction has been a throw back to the investment warehouse concept which is reinforced by superior liquidity. One of the reasons for the superior liquidity in the face of declining trading desk and floor capital is the shrinking direct participation of taxable individual accounts. In 1965, which was after my year-long research on GE, taxable accounts owned over 80% of US corporate stock. Today it is under 30%. The more, relatively small players in a marketplace, the safer it is for those in the center providing liquidity. Many of  the other Large Caps carry higher price/earnings valuations than the Generals and are equally challenged to find growing revenues. With both the Generals showing some signs of adapting to better business practices and hopefully accounting practices, their relative positions in the Mega Cap world could generate higher relative price appreciation from a historically depressed price level. The main reason that the Generals suffered the prior price declines (and in the case of GM bankruptcy) is their failure to adapt to present and future conditions.

Two Warnings

I have been stressing the need to adapt. This is not to be confused with a need to adopt. The difference is to add and modify one's own principles. Adoption is wholesale acceptance of the adopted views. This may well be the difference between a merger and an acquisition. Too often the second is one where the acquirer takes no prisoners. The acquisition is to do things the way the acquirer wants. A true merger is when both sides adapt to each other's thinking and procedures and there is a melding into a successful marriage. This is the exact opposite of the Broadway show with the title "I Love You, You’re Perfect, Now Change." The key is not capturing but working with.

The second warning is while I am optimistic for long-term investors, I am concerned by what I believe is a consideration that sidelined investors are now coming back into the market. For the first time in at least one year, many of the financial media outlets are celebrating that money is rolling into mutual funds. As usual, it would be useful to dig deeper. The entire gain in assets came from Exchange Traded Funds (ETFs). Most of that money went into a few fixed income ETFs. I believe the bulk of the ETF flow is from trading-oriented organizations. By the way, four of  the largest transaction volumes on the NYSE this week were ETFs. The money going into fixed income products now is unlikely to be long-lasting when interest rates start to rise. Thus I am warning that the inflow is likely to be found to be short-term rather than long-term investors.

Question of the Week:

What new approaches have you adapted to?

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Copyright © 2008 - 2016

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Stubborn Analysts may Become Stubborn Portfolio Managers

In last week’s post we discussed the questions that arise from examining turnover rates.  Most fund selectors are concerned about too high of a turnover rate. They are worried that these funds basically rent positions in the stock and are only in “the name” for a relatively brief period not for the longer-term profit generation from growth of the underlying issuer. Another consideration is that the costs of transactions including spreads between actual transaction prices and the pre-transaction bids eat into the profits of ownership, particularly when appropriate after-tax costs are considered.

After a series of visits over the last year with managers who have something of a value discipline (even though a few claim to have a growth orientation), it was stated that there was a risk that some turnover rates are too low. Their portfolios go for years with a number of investments that don’t work out. Often these securities do not totally collapse in price and may eventually go up to a perceived value price. What is not taken into consideration is the opportunity cost of not having winners or at least market performance during the elongated holding period.

Warren Buffett’s bad lessons

For many investors, analysts, and portfolio managers we focus on the writings of the two great names in our pantheon of analytical thought, Ben Graham and Warren Buffett. We are guided by their words, and not what they actually did or do. Many believe what Warren Buffett at Berkshire Hathaway^* stands for buying good companies at reasonable (not cheap) prices and holding them forever. Remember Buffett closed his successful hedge fund to use his own capital to buy a failing textile business at what he thought was a cheap price. (This flirtation with bankruptcy is similar to the absolute need to fire Steve Jobs from Apple^*.) Luckily for Warren soon after that experience of being an operating entrepreneur he got hooked up with Charlie Munger who taught him to buy good companies with good managers and let them manage all of their companies, except capital allocation in which he became expert. The biggest advantage that he had was that he could invest the leveraged float created by his wholly owned insurance companies. These dollars were used to buy other operating companies who had unique and strong competitive positions at currently reasonable prices. With the excess dollars he built a portfolio of investments; some proved to be short-term like airlines or high income investments that took advantage of distressed situations which would be paid back quickly if the companies survived (Goldman Sachs^*, General Electric, etc.)  In his large cap portfolio he was able to buy shares of American Express^*, Coca Cola, and Moody’s^*. He is selling Moody’s after seeing it has become a much stronger company. His relatively new two internal managers have a much more eclectic appetite and are use to higher turnover rates.

Because I don’t have the advantage of a generally growing float, wholly owned companies carried at historically low purchase prices in an investor focused book value measure; I can’t play the same game.

Mutual funds and other performance-oriented accounts are measured differently

While mutual fund marketers and regulators try to focus present and future potential investors on various time periods of 1, 5, 10 years and since inception, the daily prices of funds drive toward different time period considerations. Any given day can be a peak or bottom to an important trend which should be measured. The change of portfolio manager or investment approach could cause a reappraisal as to what are ongoing significant time periods. Most importantly of all is the relative performance of competing funds for investors’ dollars. In each period the relative performance of individual securities takes on different aspects in an overall portfolio’s performance. A stock price that is flat in a downturn is positive to performance; whereas the same flat performance is a negative in a rising market.

The classical way to teach analysts

Analysts trained academically, including through the CFA exams, or by large organizations are taught to find and promote good companies particularly with so-called moats (impenetrable competitive positions). Notice that these “good guys” are preferred regardless of price and without any significant attention to disruptions in the economy, market or sector. As analysts and portfolio managers get older the attraction to these “good guys” become greater as so many lesser lights have failed as stocks. Soon the portfolio is a collection of surviving “good guys” as the other positions have been liquidated. I am sympathetic to this condition as my personal portfolio is disproportionately invested in these collection pieces. Luckily for my clients a price/value discipline keeps both “good guys” and cheaper and hopefully more potentially promising investments in their portfolios (particularly of funds).

Most funds are managed by analysts

Most funds are managed by analysts, though in many cases they still have direct analytical responsibilities. In most cases the portfolio manager views her/himself as a super analyst and spends the bulk of their time going over and sharpening the analytical views expressed. All too often analysts stubbornly believe in their models that produced their list of  “good guys” regardless of what the current market is saying. The super-analyst-portfolio manager having the same training and attitude as his analytical staff goes along with their views and hence the portfolios take on the aspect of a collection not a vehicle addressed to the current market.

The further training of portfolio managers

I maintain that just being a good analyst is not enough to be a good portfolio manager. The PM needs to understand the current and likely future markets; this is learned by spending time with good marketing people as well as good and bad investors. The PM has to learn how to use his trading desks not only to get the correct executions, but a source of market and competitive intelligence.  All PMs should study competitive portfolios and performance, not to copy them because the student will be late. The key is to understand how the competitors reacted to presumably the same information that she/he received; given that perspective what is their likely actions in the future based on different scenarios? PMs as operating officers should be concerned with the development of analysts, traders, and administrative people including the compliance forces. The PMs should start to anticipate changes of direction for her/his own firm. Thus, I believe there is a lot more to being an effective portfolio manager than being a super analyst.

In summation

I believe that stubborn analysts can lead to stubborn portfolio managers who like a stopped clock will only be correct twice a day or once in the military. The portfolios will not be in a winning position most of the time. I worry when I see a poorly performing fund with low turnover rates that we could be experiencing one of the big, untaught, risks in portfolios: stubbornness.

How do you correct for your own stubbornness?

Please share with me for it is an ever present danger in being attracted to “good guys”

^*Some shares are owned in our financial services private fund or personal portfolios.

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