Where are We and So? - Weekly Blog # 602

Mike Lipper’s Monday Morning Musings

Where are We and So?

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

All too often those commenting on the stock market and the economy are either out of date or clueless about important changes. One of the more instructive research exercises is to review the prognostications and analysis written between September and December of 1929. While most histories focus on October 1929, few note that by December the Dow Jones Industrial Average had already returned to its October peak. This lack of understanding and its implication is similar to the six-month period after the murder of the Archduke, where troops did not start to position for open conflict until six months later. This period has been called the phony war.

As of this weekend all three of the US stock market indices are at record levels after a twelve-year climb. Currently, I don't know what this means, hopefully a subscriber or their advisor can share their wisdom on what this means for the future. My lack of clarity is based on conflicting views of the data. The averages and many diversified equity mutual funds are showing gains of over 20% year to date. While not the highest on record, these are extremely good results. The gains are more than double the long-term gains of the S&P 500, with dividends reinvested, since 1926. Typically, high valuations are caused by the sudden entry of new money from unsophisticated investors into the equity market. Due to the lack of enthusiastic volume on the upside this does not currently appear to be the case.  Additionally, there have been significant flows into fixed income funds at low interest rates. These investments could lead to total return losses when rates rise.

The other issue driving performance is the belief that better markets lie ahead. This is clearly possible, but it won't be easy. For it to happen two partially interrelated events must occur. There needs to be sufficient tariff and trade relaxations and the Chinese economy needs to begin to grow at close to prior rates. Without China's growth, global GDP growth is likely to be quite modest.

The problem facing most advanced economies is that their political leaders are focused on elections and the biggest group of voters work directly or indirectly for the goods-producing industries. (If global trade issues modify, value investors who own goods-producers may benefit). However, in the US and other advanced economies, most employees and entrepreneurs are in the enlarged and growing service sector. For political reasons, many governments are not overly friendly to this portion of the private sector

Technology can continue to spur national and international growth if government policies don't retard growth too much. However, there are a series of hurdles that must first be jumped. Technology must replace labor's repetitive work, requiring more skilled workers to run the machines and processes. This trend is already at work in retail, hospitality, and healthcare, where there are many job openings. The demand for even more jobs is likely, as customers want/demand more services. The problem is that many of those that are legally unemployed are not qualified for the openings, due to a combination of attitude and poor training at home and/or in school.

An Unhappy Solution is Possible
There is a chance that many individual and institutional investors, including Pension Plans, lose so much of their investment in private debt that they largely abandon their reliance on fixed income. They then might foolishly devote 80%+ to equities and we could then all sell into that.

On Monday we celebrate all the Veterans and their families who ever wore a uniform to protect their family, country, and way of live. Originally, the day was intended to recognize the Armistice that ended World War I. I hope that it is a reminder that it much easier to spend blood and resources than build a lasting peace.

Until we find the way to accomplish that goal, I say to my fellow US Marines, Happy Birthday. We will protect you and others until we collectively find peace.




Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/11/top-down-dictums-measured-digitally-are.html

https://mikelipper.blogspot.com/2019/10/two-questions-length-of-recession-near.html

https://mikelipper.blogspot.com/2019/10/things-are-seldom-what-they-seem-weekly.html



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Copyright © 2008 - 2019
A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

Short and Long-Term Opportunities with Risks - Weekly Blog # 593

Mike Lipper’s Monday Morning Musings

Short and Long-Term Opportunities with Risks

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

Mid-course corrections and structural changes represent both opportunities and risks. Opportunities and risks are rarely separate from each other. My process for dealing with each, travel along similar routes:

• Early, but not too early recognition. (Statistically there is not much difference from a discovery that’s too early and being labeled wrong)
• Identify the magnitude (Large to life-changing vs. time and reputation risk, which can’t be recovered)
• A research plan to narrow the number of opportunities and risks. (We can’t deal with too many variables)
• An initial plan of action (Casualty lists are full of those who were too motionless)
• Frequent adjustments to the plan. (Frequent but not too frequent, there is time needed for others to react reasonably)
• Listen to both extreme historians and futurists. (They are often the same)
• Create short-term achievable goals. (A passing grade is better than 100%, from which you can’t learn)
• Cut the losses when other opportunities appear with lower risks. (Most great discoveries/inventions are bi-products of research efforts seeking other solutions)

Subscribers could use the above principles in reviewing what comes next.

Mid-course Correction?
US stock prices since late July have violently fluctuated in a trading range, as measured by the three major stock indices.  At the lowest point they were about half-way to a normal 10% correction. As of Friday, they were within a good trading week to their former peaks, achieved in July: Dow Jones Industrial Average -2.05%, S&P 500 -1.56%, and NASDAQ Composite -2.73%. This blog is prepared for long-term investors and I am therefore not going to focus on the momentum driven traders that dominate the market these days, especially when long-term investors are nervously enjoying gains generated over the last ten years.

While the market and economies are not driven by the calendar, investors and the media tend to focus on annual returns. I am concerned that while most stock and equity fund investors have not yet reached a gain of 20% year to date, a large number have. I am wondering whether the market indices will go through their old highs with some enthusiasm, or whether they will be stuck in a price range with high volume, encouraging some equity investors to take some chips off the table and wait for the clarity they expect in November of 2020.

This is not a political judgement; one expects to see some damage from low interest rates and falling currencies. These investors should remain equity investors in stocks and funds, perhaps with some rearrangement of their choices. However, under no circumstances should they have less than 50% invested in the stock market, re-entry costs and tensions are high for taxable investors.

Fundamental Changes for Long-Term Investors
There are two very important changes that are likely to impact successful investing in the future:

• The appropriate nature of invested capital
• Fewer workers and more mouths to feed 

Adapting to the Changing Nature of Capital and Investing
The earliest identified capital included physical things like land, jewels, and weapons, etc. One could see them, and an experienced person could evaluate their worth. Thus, the earliest recorded loans were mortgages or collateral. The wonders of double entry accounting recognized an assets value as the residual of its depreciated cost. Thus, the earliest investors concentrated on collections of assets, which led to analyzing balance sheets. This may well be appropriate in a world where the physical reality of assets is well understood, but that is not the reality today and increasingly it will be less so in years to come. Over one hundred years ago JP Morgan, himself that as a banker, made loans based on a person’s character, not their collateral. Nevertheless, today we still group companies in terms of their manufactured products, while our politicians focus on manufacturing jobs and their related products.

The service sector has been more productive in the production of wealth than the manufacturing sector for some time. Matter of fact, most successful manufacturers are also good at providing service and arranging financing for their customers and themselves. I would certainly include salespeople as being service workers, both within and outside every business today. We have entered a low interest era which appears to limit profitability.  Some wonderful old companies having more physical constraints are producing well respected brands but have suffered sales and other problems leading to significant layoffs. Some of these workers will retire or leave the industry, others will go to competitors in much smaller and more specialized elements of their industry. I see this occurring in older tech, pharmaceutical, and financial companies.

For many years CEO’s have thanked their most important asset, their employees, in their annual report letter. Since recruitment has become an important responsibility of senior management, critical employees are identified as “talent”. To those who think about these things it creates a dilemma. Do we as customers continue to rely on highly respected brands, or do we seek out products and services from which organizations are supposedly attracting the best talent? We face the same question as investors, especially the choice of colleges for those with children and/or grandchildren.

As an investment manager using financial services stocks and diversified mutual funds from around the world, I deal with this problem daily. A good long-term investment in these arenas needs good portfolio managers, salespeople, and good administrators. It also needs top management who wishes to have these people and can manage them, which is not easy. The problem today is dealing with the layoffs. The Financial Times noted that trading and advisory revenues dropped 11% in the first half of 2019 for the 12 largest investment banks in the US and Europe. We have seen most of these businesses shedding people, many of which were servicing and supporting the investment and wealth management efforts, both for their own companies and external clients. The people I know are looking because they have been laid off, or because they see significant elements of decay in their shops and want a better home to practice their art. With these people I could produce the best investment team in the world, but it unfortunately won’t happen because these people aren’t capable of working well together.

I am currently focusing on a small number of turnarounds which have similar characteristics. In the past they’ve had some good performing mutual funds, good sales teams, and good administration that was largely done in house. What makes these potential turnarounds interesting is that they have retired their old management. They now have new management that is busy trying to hire the right people to run critical parts of their organization. While the companies I am looking at are publicly traded, the new top management is long-term focused and not looking to the next earnings report. Not all of them will succeed, perhaps none will. But if they don’t succeed in a reasonable time, they’ll not be able to attract the needed talent and will be forced to merge to save a limited number of jobs. Often the acquirers are not much better than the acquired, just richer. Some will be successfully turned around if they can benefit from what I see and show next.

Retirement is Necessary for Our Success in the Future
Barron’s had a cover story this week “How to Fix the Global Retirement Crisis”. It points out that in 2050 there will be more people over 65 than under in the US. Japan has already reached having 59% over 65, in the US we are at 38%.  I would suggest we need to find ways to keep able and willing people working. At the same time, we need to find humane ways to free up some of their jobs for younger workers who can do more with those jobs. Most of the time seniors are healthy and want to be active mentally and physically, if they have the financial resources to do so.

In some respects, the mutual fund industry is one of the luckiest of all industries. A substantial portion of its growth has come from external forces, usually the government looking after senior voters. In the US the federal government passed legislation which created individual retirement accounts, salary savings accounts (401k, 403b, and 457 plans), tax exempt mutual funds, and money market funds. Without these the fund industry would have been much smaller. Things are similar in other countries, but they’ve used different measures to aid their own fund industry. The leader is Australia, which mandates that 9.5% be contributed to superannuation funds, a number that is expected to rise to 12% in the future. If one combines that with a history of no recession for 28 years, future retirees can look to a sustainable retirement. Considering seniors vote more often than other age groups, one would think that the US government might address their needs.  This could even cause the interest rate of savings to rise to a level that would reduce future unemployment through sounder loans.

Investment Suggestions

1. Use the present market to clean up your portfolio of losers that are unlikely to soon return your cost.     
2. Focus new investments on companies attracting good talent.
3. Restrict brand buying to your consumer needs, not investments.
4. Be prepared for opportunities and problems.    

Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/09/excess-capital-less-equity.html

https://mikelipper.blogspot.com/2019/08/an-awkward-moment-with-frustration-not.html

https://mikelipper.blogspot.com/2019/08/short-term-recognitions-plus-longer.html



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Copyright © 2008 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

Probable Causes of Underperformance

Introduction

Most investment managers produced returns of mild single digit to mid- teens losses. Some of these managers were research-intensive managers with long histories of good results. They did not take dumb pills or drink depressing Kool-Aid on a summer eve. While they were confronted with a world where the vast majority of securities and commodities fell, they should have done better, including having some of their money in the minority of stocks that rose. What happened? I believe conditions fundamentally changed.

Lessons from the Racetrack

The first time I had to confront making bad decisions was at the racetrack when I didn’t cash winning tickets. In many ways that is when I started to learn valuable thought patterns that I applied later to investing for others and myself. In roughly the half hour between the losing race and the next one I hurriedly reviewed all of my calculations and visual inputs. I divided these into categories. In the first category were the questions did I miss changes or underestimate the importance of track or equipment changes? For example I usually noted that my horses had changes of equipment or jockeys and trainers, but I also asked, “were they being equipped with blinkers to keep them running straight and not being bothered by other horses?” Too often I did not look at these changes on all competitors which meant that I missed a poorly performing animal prior to the race that became easier to ride and guide to the finish line that was not characteristic of its past performance. (Too often investors don’t fully appreciate the changes in management of competing companies or portfolio managers.) The biggest category was the expected winning time of the race. Often if the race is slow almost any horse can win, similarly in a low performing market any investment that has a slight advantage does win. My mistake was to look at the recent track record for the race and guess which horse could run at that speed or better. In the market all too often investors look to an investment that can be spectacularly better than average. Too often one needs to look to the risks undertaken when finding such a vehicle or horse. Most of the time, a spectacular win will start with a chorus of disbelief, which could be correct. By far the biggest hurdle to handicapping or investing is to recognize that the basic conditions have changed which could be rules changes, unexpected weather, personal issues of the professionals, etc.

From an investment viewpoint, I believe 2015 experienced such cumulative changes that make many of our old approaches less useful.

What Changed?

The following are a list of important differences in 2015:

1.  The reduction of position capital at trading desks of major institutions and investment banks which are under the restraints of the Volcker Rule. Liquidity was available, but at a price and at a time of the liquidity provider’s choosing. This has led to a significant level of intraday volatility. This plays into the hands of the high frequency traders and other algorithm users picking off large scale movements. Bottom line: trading has become meaningfully more difficult and perhaps expensive in terms of full execution costs. What used to be only an equity market problem now is very much a factor in trading in US government paper and starting to be an issue for investment grade trading.

2.  The central banks’ manipulation of internal interest rates has morphed into manipulation of foreign exchange rates which are impacted by both flows into and out of the market that are not price sensitive, the values of global securities and a range of commodities.

3.  Big data comes to the Biggest Markets in a Big Way. US based managers feel comfortable having their US offices managing non-US securities. Similarly global portfolios of US securities are being effectively managed in distant offices of foreign investors. The availability of all that is known about a security instantly means that there is less opportunity to strip or dump into a market. The passage of “FD” (Full disclosure as mandated by the SEC) means the investment/trading value of published information has declined. As more institutions utilize secondary and tertiary research their value becomes discounted.

4.  “TINA” (There Is No Alternative) is not the only alternative. The investing public has globally built up their stake in money market funds and other repositories of low returns with the ability, not used yet, to rapidly reinvest. Some are using long or short positions in index ETFs or index funds. (I prefer the latter.)

5.  A growing recognition that much of government produced data needs to be questioned. In one of his first acts the new President of Argentina was to order his government to create accurate data. Another example is the former Premier of China acknowledging that its GDP was “man-made” which meant he did not trust it. 

One can take the position that one of the reasons that the Federal Reserve has had such off the mark forecasts is bad data. At a public meeting at the New Jersey Performing Arts Center (at which I am a trustee and chair of the investment committee) I asked Bill Dudley the President of the NY Federal Reserve Bank and a permanent voting member of the FOMC what additional data would he like. Bill who is a veteran numbers crunching economist at Goldman Sachs responded that he would like to know much more about the creation of the rapidly expanding student debt. He is right as student debt is the largest amount of consumer debt, greater than residential mortgages. To the extent that this debt is to be repaid colleges are going to have to produce easily employable workers who will have to postpone buying their first home and other consumer spending. An important driver of the size of student loans are the costs of food and lodging, which are often superior to their first apartment post-college, if they graduate).

6.  Many of the major economies are increasingly being driven by the service sector and not manufacturing whereas most governments and central banks have tools to spur a declining manufacturing sector. In the US it is important to focus on how US auto sales are recovering to previous heights established years ago with a smaller population. What should be noted is that in 2015 US branded cars are filling less than half of the demand. This is important because to an increasing extent a car or light truck is an electronic platform on rubber wheels. This signals that the auto (and for that matter almost all markets) have changed and our governments have not kept up. Some are conscious of this as the Bank of England has noted that there was more acquisition of service companies in 2015 than manufacturers.

7.  Target Date Funds are being questioned due to their exposure to bonds in a somewhat rising interest rate environment. This could be quite harmful to those who are about to retire when much higher interest rates and lower bond prices start to occur.

Don’t Bet on Favorites Most of the Time

I learned at the track that normal favorites win only about a third of the time, but because their betting odds have been beaten down by players pouring in the winning dollars when they do win, do not pay for the 2/3rds of the time they don’t win. That is why my bet for 2016 is for a big year up or down. My best guess is UP, for the Wall Street Journal may have taken over from Time Magazine and the former version of Businessweek with its cover pictures of success people. Saturday’s Wall Street Journal had a front page article headlined “Drab Outlook for Markets.” If the article is correct my clients don’t stand to lose a lot, but if I am correct 2016 will be anything but drab with a reasonably good chance of a better than average result. Perhaps some of the poor performing managers could produce great results in their recovery.

What Should I be addressing Next Week?

The next post of this blog will be my 400th. Are there topics I should address or would you like me to reprint any of the old posts?

As you start the New Year we wish you and your family and associates a Healthy and Happy New Year.       

________   

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