This Week’s Implications for Our Investment Future - Weekly Blog # 668

 

Mike Lipper’s Monday Morning Musings

This Week’s Implications for Our Investment Future

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

Late-Stage Markey Surges

Through Thursday, the average US Diversified Equity Fund rose +2.49%. While not followed closely beyond the mutual fund business, it should be. The total assets of these diversified funds at the end of January were $ 10.7 trillion, compared to $16.2 trillion in all equity funds. These are the aggregate investment decisions of the largest group of individuals and institutions, distinct from measures developed by publishers.

Each week I look at the performance of 18 different types of diversified equity funds, which excludes more narrowly based specialty funds. Two observations of this week’s performance are:

1. This week’s performance is unsustainable. If annualized, the performance would be almost 260% for the year. 
2. Within the largest macro fund category, S&P 500 Index Funds gained +1.20% and ranked 17th out of 18.

These observations are like what I have seen or read about in the late stages of a “bull” market. In most markets, the performance for S&P 500 Index funds rank in the middle to top of their macro group. The reason for this is that they are low turnover portfolios, with no cash holding them back in rising markets.

Late-Stage Leaders

If the +2.49% gains for US Diversified Equity Funds is unsustainable, then look at the other four leading investment averages:

    China Region           +5.29%

    Equity Leverage        +5.10%

    Global Science & Tech  +4.22%

    Small Cap Growth       +4.04%

(Remember, these numbers are averages, several funds had substantially greater than average gains.)

Other Late-Stage Observations

• Contrarian indicators include an 8% increase in bullish sentiment for the American Association of Individual Investors (AAII) weekly survey, which now stands at 45.5%.
• 81% of Wall Street Journal prices rose this week. 
• Both the New York Stock Exchange (NYSE) and NASDAQ reported a 6% drop in short sales. (The reason a drop in short sales is viewed as a negative is that short sales need to be closed by a purchase, which adds to volume.)
• Market analysts become nervous or at least suspicious when formerly visible trades are hidden. 47.2% of equity trading-volume was not on the publicly traded stock exchanges. While this may lead to some investors getting better prices, it raises questions as to the validity of reported prices. This is not reassuring in highly speculative, volatile markets.

Possible Investment Implications Learned from the Impeachment Hearings with a look at History.

As much as possible, the following observations are intended to help make the investment decisions that will impact future investment performance. Words spoken by elected and unelected politicians are like hourly or daily temperature readings, good for conversations but not to be taken seriously when setting and executing long term investment policies. Actions have longer-term implications for historical purposes and provide some factual inputs in understanding what happened. Far more important are the reactions to actions, usually not by the original actor. 

The following is a historical example of this principle. The Imperial Government of Japan attacked the US naval and airfield installations in Pearl Harbor on December 7th, 1941.  The attack was timed with similar attacks in Asia to establish a “Co-Prosperity” Asian region, with Japan as its supreme leader. The attack on the US was designed to prevent a well-armed US from coming to the aid of the Asian countries being invaded. They were successful in destroying our aging battleships. (For the only time in recorded history, the US aircraft carriers were out at sea alone.) This was the deed, but the key to the future was the reaction. 

FDR used the attack to declare war on Japan, as was expected. But in addition, he declared war on Germany and the axis allies, which was not expected. (FDR did not want to be considered a President Wilson, who entered WWI two years late and changed the history of Europe, Russia, and WWII. He was conscious that his cousin, Theodore Roosevelt, had won a Nobel Peace Prize for settling the war between Imperial Russia and Japan. Later, he split the presidential vote in the US, which elected Woodrow Wilson as a minority President.) FDR resisted entering the War with Germany for two years, as it would have been unpopular in the US and would have added to the problems of his mismanagement of the economy, which resulted in the longest and deepest depression in US history.

What the Japanese did not count on, was the attack on Pearl Harbor and the saving of our aircraft carriers giving FDR’s the political power to galvanize the US. It enabled him to fight both a World War and push through various social moves which had not been possible beforehand. Regardless of how one feels abut my narrative, there is no question that the reaction to the attack on Pearl Harbor was much different than the Japanese had intended.

Could We Be in a Similar Position Now?

Some have suggested that the new administration is the most politically left leaning group since FDR. The staffing of the Cabinet and administrative functions with former Obama people is like FDR’s brain trust. To see the ambition of the current leadership, read the proposed Antitrust Merger Standards, which would allow the government to decide on all future mergers. (This is a backdoor way to establish an “industrial policy”, which numerous countries have thankfully tried, removing a lot of vital competition in the global market. Another example of the ambition of some in Washington can be seen in the “reconciliation budget” proposal from the Financial Services Committee in The House. It has a current spending plan of $38 Billion and would reach $72.9 Billion by 2031. (I would like to learn how much our taxes will have to rise for this relatively small desire of the party.)

The President Could Be Saved from Himself

Just as reactions to an action can be contrary to the expressed wishes of the actor, so too can the current actions of the President and The Speaker of the House. We are seeing them both play to their own majorities, but they are driving away more of the middle in the process. Considering both of their elections had smaller pluralities than expected, the House Leader is now the only person in her role to lose two impeachments, which could have been won if better managed. The President appears to be creating more unemployment, more businesses closings, and a reduction in the level of education at all levels. We will have to see if any foreign government does anything meaningful we want.

If Not, is a Long Recovery a Prospect?

Without meaningful political changes, an FDR length depression could occur. Right now, I believe most worried investors are still treating the current phase as a cyclical depression that should be complete within four years. That is what I am doing, but it could be a lot longer and I am not prepared for that.

Question of the Week: What is the worst for which you are prepared? 

Did you miss my blog last week? Click here to read.

https://mikelipper.blogspot.com/2021/02/adjust-investment-tools-for-next-phase.html

https://mikelipper.blogspot.com/2021/01/is-gamestop-missing-event-weekly-blog.html

https://mikelipper.blogspot.com/2021/01/are-we-strolling-promenade-deck-of.html

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Caution Ahead: Emotional Turns Likely - Elections and Coronavirus - Weekly Blog # 644

 

Mike Lipper’s Monday Morning Musings

Caution Ahead:

Emotional Turns Likely-Elections and Coronavirus

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

When the battlefield is quiet, expect to be attacked, is a lesson from the US Marine Corps. For bullish equity investors the low volume of August trading should signal a need to expect change. The most dangerous short-term change is one spurred on by emotions, rapidly bringing into action holders of excess cash or large equity holdings.

The calendar provides two events that could quickly galvanize emotional responses, the forthcoming US election and reports of successful vaccines/therapeutic COVID-19 treatments. Both could mobilize a large amount of almost instant trading from thrilled and disappointed investors. Based on a lifelong study of turning points, I suggest caution on the part of investors who believe in rusty or non-existent trading skills. Furthermore, very soon after the announcement a counter trend could appear, reducing the size of the initial pop and in some cases completely reversing it. As more information becomes available, the implications of the announced event will often become clearer. Even if further information reinforces the initial announcement, the length of time varies before complete utilization becomes evident. Thus, investors will have time to calmly adjust their holdings. 

Profitable courses of action build on some factors present before the headline event, while others will have little to no future impact. Some will advise you of the critical present factors supporting the future event, I am not so privileged. All I can do is briefly list some of the factors that might support the trends post the announcement, including the subsequent reversal moves:

• The biggest investment news of the week was the changing of the components of the Dow Jones Industrial Average (DJIA) and the reweighting of Apple*. The current producer of this most senior of US stock indices is S&P Indices, owned by Standard & Poor’s, who consults with some of the editors of The Wall Street Journal when making changes. On Monday they will delete Exxon Mobil, Pfizer, and Raytheon Technology, adding Sales Force, AMGEN, and Honeywell. In addition, on the same day the weight of Apple in the index will be reduced due to Apple’s four for one stock split. It will be replaced as the company with the heaviest weight in the index by United Health.

Because of the dominance of Dow Jones through its wires and publications, most investors tend to believe that the DJIA measures the US stock market. That a thirty-stock market price weighted index is “the market” with its’ 30 stocks and not the S&P 500, the Russell 3000 or the Wilshire, with its original 5000 stocks, shows the power of the media. Clearly, global indices have even more components. Nevertheless, the DJIA has done a reasonable job of tracking high-priced US stocks. Part of its success is due to dropping components when their outlook appears to be slowing. (Some components comeback into the index after a large merger.)

While most market followers will continue to use the DJIA as a market measure, I will not for the next twelve months. While statisticians will link the new components and the reduced weight of Apple, I believe they have created a new measure. After one year I will see the level of correlation with the S&P 500 and if the gap is close, I will return to using it as a measure. Once again, the editors may have done a good job of changing the components to represent our economy. Over the more than one hundred years of its existence, they have done a good job of switching the emphasis from consumer products, to industrials, to tech and then to high-tech.

(*) Owned in personal accounts

• Record high prices achieved this week for both the S&P 500 and the NASDAQ Composite confirms the view that the American Association of Individual Investors (AAII) sample survey of market direction for the next six months is a contrarian  indicator. For the first time in many weeks the leading bearish prediction fell below an extreme reading of 40%. 
• 79% of the WSJ’s weekly prices rose. This may reflect some shortages, but it also reflects merchants trying to increase prices to make up for forgone profits. Despite many learned economists being quite sanguine on inflation, I expect the Fed to get and exceed its desired 2% inflation target.
• Unfortunately, I expect layoffs will rise for a while. The Russell 2000’s second quarter estimated revenues dropped -19%, with earnings dropping -99.1 %. This indicates to me that smaller companies have kept their staffs to preserve their hard to get employees. So far, third quarter revenues have not risen much. There is a good chance that instead of preserving the work force the focus will shift to preserving the firm. I suspect private firm closings indicate a similar trend.
• The bond market is moving contrary to the stock market. Of thirty-one fixed income mutual funds investment objectives, only twelve gained for the week and they were equity tinged high-yield or pro inflation vehicles. The maturity yield curve tightened, with maturities of more than two years rising.
• There may be more longevity to the current market than appears. Typically, markets don’t peak until they exhaust all available cash and there is a lot of cash on the sidelines today. In addition, there is a lot of capacity to increase margin borrowing.  Remember, margin can be used to support short sales, as well as the more popular long purchases.

Working Conclusions:

• Trading oriented accounts should be prepared to make lots of small moves and be willing to reverse direction when appropriate.
• Capital appreciation accounts should look for bargains by being contrary.
• Capital preservation accounts need to recast their portfolio in one or more other currencies to determine their risk of only evaluating their accounts in dollars. European investments may look attractive for “value” oriented accounts and Asian investments could be attractive for long-term growth investors. Multi-generational investors should develop an understanding of the long-term outlook for selected investments in Africa and the Middle East.

Share your reactions and thoughts with us. 

     

Did you miss my blog last week? Click here to read.

https://mikelipper.blogspot.com/2020/08/mike-lippers-monday-morning-musings_23.html

https://mikelipper.blogspot.com/2020/08/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/08/rotating-leadership-likely-on-horizon.html

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Data Driven Reactions Dangerous - Weekly Blog # 633

Mike Lipper’s Monday Morning Musings

Data Driven Reactions Dangerous

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

Starting with the unemployment statistics published on the next to last Friday of the month, we have experienced whipsaws for the seven trading days since then, impacting stock prices by approx. 10% from top to bottom. Both the extreme highs and lows were “gut” reactions to the perception of what the numbers signified.

Employment Surge
Each month the federal government announces the level of employment and unemployment based on the week closest to the middle of the month. In this case it was released before the Friday morning opening the week ended May12th. What surprised many people, particularly those who were bearish, was that the number of people employed actually rose instead of declined.

US stocks prices surged and if investors understood when and how these numbers were constructed they should not have been surprised. First, throughout the month of May and into June, various business in largely non-coastal states were reopening, bringing back some of their workers. (The number continued to grow, at least through this last week.) Second, there was a relatively slight change in the classification adjustment as to which people were reported as employed.

The announcement came on a Friday morning, often a low volume trading day during warmer weather. It was probably exaggerated by many of the active traders sheltering at home or beginning a three-day weekend. Furthermore, since March 23rd many stock prices have risen materially. Bank of America (Merrill Lynch) published the Farrell Sentiment Indicator, named after their former great market analyst, showing this rise being the most “hated” rise in history. (The indicator is based on surveyed six month market projections over the prior ten weeks by the American Association of Individual Investors.) Consequently, it was not surprising to believe there were a lot of short sellers. Opening prices jumped and we suspect many purchases were made to close short sales and limit loses, either voluntarily or involuntarily.

Spike in COVID-19 Numbers
On the following Monday, higher numbers of victims of the Coronavirus were announced. The number of tests jumped as did the overall number within hospitals, although few noticed. Furthermore, as various communities open-up from lockdowns, one suspects more people will be tested and quite possibly contract the plague.

Appropriate Investment, Not Trading Reactions
Careful analysis of both announcements should have led one to conclude that first was positive and the second negative, but not to the extremes the market took each impulse. More importantly, the history of market investing for long-term investors is that they are not swayed from their focus on meeting their long-term goals. Unfortunately, a reverse in market direction is often an excuse to plow reserves back into the very investments that created prior losses, doubling down on the prior mistake instead of shifting into sounder investments. Before accepting the results of various statistics you should understand how and why they are constructed the way they are.

We find the same needs beyond investing, as illustrated by the following:

1. In most communities the entry age to grammar schools is calendar based, often with September 30th being the cut off. (Some parents, believing their youngsters are not as mature as they should be to enter school, keep them out and place them in school the following year, giving them a competitive advantage academically, socially, or athletically.)
2. COVID-19 reports end on Saturday, as some communities view the Sunday data as being unreliable. (Interesting, I found the same unreliability when I started to collect and measure mutual fund performance in the 1960s. We could not call back a number of east coast funds on Friday and question their net asset values and dividend data. Thus, we ended our week on Thursday, which is still the practice.
3. For marketing purposes, all thoroughbred horses officially have their birthday on January 1st. One of the elements used to help pick winners in the most difficult maiden races of two-year old’s, was to attempt to find out when they were actually born. In absence of that data the size of the colts and fillies was a clue, as young horses grow bigger with age.  

What is the Market doing?
In the table below you can see that we are going through three somewhat different markets, as captured by various indices. One could assign labels to the three indices in an oversimplification, based on the primary drivers of each: NASDAQ (Seasoned Speculators), S&P 500 (Large investors, particularly with limited research staff), Dow Jones Industrial Average (Media, retail investors, and active traders)

         Date of    % Change   % Change
Index  2020 High   to 6/13    for Week   2020
DJIA     Feb 12     -13.35%     -5.55%   -10.28
S&P500   Feb 19     -10.18%     -4.78%    -5.86
NASDAQ   June 10     -4.31%     -2.30%    +6.87

By losing less the NASDAQ beats the DJIA, although at some point the gap may close.

Another set of year to date data through Thursday is the performance of the three leading mutual fund sector averages:  Global Tech +9.48%, Domestic Tech (largely domestic) +6.66%, and Precious Metals +6.37%.  Large Cap Growth funds +4.42% and Convertible Securities funds +4.26% were also leaders.

An Unheralded Way to look at National Data
As evident to all our readers that I pour over all sorts of data to help me think through the investment problems of our clients. The ensuing discussion looks at our economy in a very different way for analytical purposes, not to begin a discussion as to individual and national priorities. The data quoted is from Wikipedia and covers federal data through 2019 and state/local data through 2015. If the combination of federal, state, and local government data provided to and for our people was done by private enterprises, economists would label it as services activity. There is probably no single recipient of these services that approves of how the combined expenditures of federal, state, and local governments are spent. Nevertheless, out politicians believe that enough people approve of each item, although for the most part we have not been asked.

The math includes not only those items paid for by income taxes, but also sales and use fees. (Thus, the cost of your drivers’ license, registrations, admissions to parks, and utility fees are included.) In fiscal 2019 the Federal government reportedly spent $7.3 trillion (34% of GDP). States spent $3.7 trillion and local authorities $1.9 trillion, for a combined total of $12.9 trillion out of a GDP of $21.4 trillion, suggesting the combined governments are spending about $39 thousand per person in this country. You can dispute the accuracy of the numbers and adjust for the very likely increase in governments spending in this year of lockdowns without meaningful government lay-offs. Any number between $20,000 and $50,000 per person is a large number, assuming the working poor brings in $20,000. The average working person has become middle class. Those with children and other non-workers are not doing badly either, compared to people all over the world. This is not to say we have developed an efficient system to provide critical services to all our inhabitants.

These issues will only become more binding in the future and have been with us for a long time. Since 1990 the Federal portion of total spending has grown at a rate of 4.6% per annum and taxes at 4.3%. I suspect State and local spending has grown faster, but taxes and fees have probably risen close to the same level.

The growing gap of spending vs. revenue generation cannot continue forever. As a corporate stock owner, I wonder whether these concerns will lead to lower profit margins and dividend growth.

We need to get some of our best minds to work on this.

 

Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/06/caltech-data-heretics-go-to-track-for.html

https://mikelipper.blogspot.com/2020/05/mike-lippers-monday-morning-musings_24.html

https://mikelipper.blogspot.com/2020/05/time-to-review-investments-weekly-blog.html



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AML@Lipperadvising.com

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A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.

Learning is the Key to My Investing

Introduction

You are probably a recipient of lots of uncorrelated information and impressions. I am as well, but because of my obsession of always thinking about investing for clients I try to find investment inputs to almost everything that comes my way.  Most often I attempt to see available information, in other words inputs that others don't see.

My sense of this past week is that we are transitioning into more dynamic markets and there are growing forces that will stampede equity markets. Thus I am maintaining my market prediction that some time within 2015 we will see a + 20% to -20% or both movement in equity markets.

Lessons from weather

As beauty is in the eye of the beholder, the impact of weather is very much influenced by location and preparation. When I finished last week's blog, in the greater New York area we were dealing with excited announcements of a forthcoming blizzard. (Quite possibly the loudness of the warnings of an incoming multi-foot blizzard was due to the underreporting in 2012 of the oncoming storm "Sandy" when we lost electrical power for two weeks and New York had a particular subway inoperative for a year after the storm hit.)

When last week’s “storm” deposited only a smattering of inches of snow, many within NYC were upset with the closing of schools, offices, and subway lines. For some, if there was not the severe impact predicted, it was like it didn't happen. For those at the eastern-end of Long Island and much of New England the multiple feet of snow was a very different story. Even Nantucket, a summer home for the rich and famous lost all boat and plane connections to the mainland along with loss of electric and communications.

Because the airlines were fearful of a blizzard, they cancelled many flights (including our own) for what would have been the second major day of the storm as they were repositioning their planes to safer spots. Luckily for us our travel agent was able to secure two seats on one of the last flights out of Newark Airport.  Afterward, East Coast to West Coast travel was suspended for a considerable time.

I believe that there are numerous investment lessons one could learn from this and many major storms:

1. Location of persons and assets is critical to risk exposure.

2. Uncertainty is normal and we mislead ourselves believing in a high degree of certainty, particularly when expressed in finite numbers.

3. While the "official' forecasts displayed a range of possible outcomes, the media and their brothers/sisters in the political structure focused only on the most draconian possibilities.

4. In the right environment,  people panic.

5.  Recovery is normal after severity.

We will see whether the storm predicted for today and tomorrow in New York, New Jersey and New England will be real.

Misreading economic forecasts and data

During the last week, the Director of the Congressional Budget Office testified to Congress on the Budget and Economic Outlook: 2015 to 2025. There was little commentary within the investment sandbox because he did not see rising deficits until 2018. However, to those considering our TimeSpan L Portfolios ^TM approach, the forecast is relevant to the third segment, the Endowment Portfolio, which is designed for investing from five to fifteen years. I have less confidence in the Director’s numbers than I do in his projections as to what will cause the deficit to rise. His four key factors were:

 
1. Retirement of the Baby-Boom generation (most however, won't be able to leave economic production)

2. Expansion of federal subsidies for health insurance

3. Increasing health care cost per beneficiary. (means greater longevity)

4. Rising interest rates on federal debt

My US Marine Corps heritage and concerns about worldwide threats make me wonder how we can avoid a major increase in military and related spending.

Further we live in a dynamic global society where change is accelerating. One example can testify to some of these changes. According to the Financial Times, in 1960 GM was the most profitable US company with earnings of $7.6 Billion. In 2013 Apple^* was the leader with $37 Billion. (If one annualizes Apple’s current quarter's rate the profits would double for its current fiscal year.)  To me if one works the numbers, the profit per employee is staggeringly different; $12,666 for GM in 1960 and $399,568 for Apple in 2013. Part of the profit growth is that while both companies are global, Apple is getting much higher profit production than GM. Thus, I am seriously questioning the CBO's future estimates. I would be much more comfortable with a wide range of estimates, with some recognition of the level of uncertainty.  (I hope I learned from the blizzard last week, that the same storm, or passage of time, could give me the different snow fall results from Boston to New York.)

^*Owned personally or by the private financial services fund I manage

Fund investors and traders are not waiting for clarity in 2015

The following data points show different attitudes:

1.  In the week ending January 29^th, US fund investors added $8.9 Billion to Fixed-Income and $3.1 Billion to non-Domestic Equity funds while withdrawing a little from Domestic Stock funds. On a performance basis, the average International fund on a year-to-date was up 1.75% as the only General Equity fund to rise. (A number of Specialized or Sector funds also rose.) Bond funds are continuing to show good performance this year led by General US Treasury funds and Corporate Bond funds.

2.  One of the ways to measure bearishness is to calculate the ratio of the size of short sales to the average daily trading volume. I pay particular attention to this ratio for the more speculatively priced NASDAQ traded stocks. In the last reported period, the ratio was 6.54 days, up +27.9% from the prior reporting period. While this indicator is expressing a bearish point of view, it also identifies the level of potential buying that must come into the market to collect or cover bets. If the short ratio gets to be large, one could see a sudden spike rally.

The Super Bowl is different in 2015

While I have watched and attended  numerous Super Bowls, this one is going to be very different for me. In the past I hoped the officials made good calls on contentious plays and I hoped that the television commercials would produce added volumes for the advertisers and earnings for their shareholders. Like a professional sports game with poor officiating, in the investment arena a sound game plan can lose. The single most important contributor to the sport's revenue is the various television contracts, each collectively bargained contract determines how much will go to the players and their retirement needs.

This year I can concentrate on the playing skills of the two superb teams with quite different tactics and strategies.  The reason for the change is that after 20 years of good performance and service I resigned as investor advisor for the defined contribution plans of the National Football League and the NFL Players Association.

Question of the Week: I appreciate what you have shared with me in the past. Are there particular current items that you follow that determine your long-term strategy?

__________    

Comment or email me a question to MikeLipper@Gmail.com .

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Watch Energy and Guns on the Trip to the Peak

Introduction

Unlike drones and more like electrocardiogram plots, investments rarely go in straight lines but undulate; frequently reversing directions which is normal.  As has been stated in my past posts, I believe that our current journey will take us to peak equity prices. Unlike Irving Fisher’s comment in 1929, I do not believe that when we reach the peak in the future that we will achieve a permanent price plateau. After the peak, there will be a measurable decline whose fall will in part be a function as to how extended the rise is above a reasonable value base. Beyond the decline we will also have future rises to other peaks.

This seesaw pattern is why I am a firm believer in subdividing one’s portfolio into time horizon and perhaps other components to protect the ability to accomplish the majority of one’s investment goals.

Signposts

No two market cycles behave exactly alike. Nevertheless, there are a number of indicators that I watch and compare with previous cycles. One of the best contrarian indicators is bond prices. A decline in bond prices is caused by the current owners not wanting to own their existing merchandise and/or refusing to buy newly offered bonds. This will lead to the need for higher yields both for the existing and new offerings. The year 2013 was the first in many that prices of bonds and the performance of bond mutual funds declined, which in turn led to bond fund redemptions. When stock prices drop some of their owners may flee the fall and buy into bonds and bond mutual funds. This is not happening now.

A second important indicator is commodity prices. At any given moment the quantity of a commodity in the hands of buyers and sellers available for immediate shipment including movements from or to warehouses fluctuates. New production from newly planted crops, new mines, and new refinery and smelting capacities will not be available immediately. Rarely will new supply come to market at prices lower than current prices. Thus, falling commodity prices are both a sign of reduced demand and expectations. These lowered expectations, along with regulatory changes, are the reasons why major Wall Street brokerage firms are exiting the commodity brokerage and dealing businesses. (This reduction in commodity capacity at some point will lead to shortages and strong commodity prices but not now.)

A third current indicator and a very volatile one is the level of stock trading. The folk law of “The Street” is that as the first trading week predicts January activity which in turn is a good, but not perfect guide for the year. The thinking behind these views used to be based on when Wall Street bonuses were paid out, but in a more modern era of a shrinking financial community, the new flows are expected to come from defined benefit and defined contribution retirement funds which would have just received their cash contributions. For whatever reason, including weather or market volume, this last week was lackluster and most prices moved very little. Some of this sleepy behavior could be attributed to a strong December and a way-above-expectations 2013. On a purely technical basis the ratio of shares sold short to the average trading volume theoretically generates the number of trading days that would be needed for the shorts to purchase enough stock to cancel out their short position. With the NASDAQ market producing much better returns than the other organized markets, some shorting, hedging, or tax management activities were done in December. This year the short ratio of the number of trading days needed to cover declined approximately 21% from the prior month to 3.79 days. This has the potential impact of fewer shares being needed to cover and therefore less demand.

Sages

One of the many blessings I have is that I know a number of very thoughtful and accomplished people. Some of them share their views in writing with others. Two in particular have said or written pieces of particular interest at this time. Jason Zweig in The Wall Street Journal (subscription may be required) suggested that we were not in a bubble. He described a bubble as similar to the South Sea Bubble of 1720 based on the presumed ability to become the principal trading partner between Europe and the New World. This is the bubble that sucked in, as prior posts have mentioned, Sir Isaac Newton. In the bubble some investors temporarily made ten times their initial purchase in the unlikely event that they got in early and sold at the top quickly.  I agree that I do not see a bubble on today’s scene, but this does not reduce the risk of an eventual meaningful decline.

The second sage that I (and a lot of others) pay attention to is Byron Wien. Each year for many years he comes up with a list of ten possible surprises. While these are clearly not meant to be viewed as predictions, he believes that his surprises have better than a 50% chance of occurring while other people would not give them more than a 33% chance. A good example is his prediction that the price of West Texas Intermediate crude would exceed $110 a barrel. He is correct that others would find this to be a surprise. A recent panel of investment “experts” were almost unanimous with predictions of $80-90. All of these people are more expert than I on the price of oil and energy in general. However, in the search to find sources of capital to invest it has occurred to me that large portions of capital invested in energy are good sources for re-circulating capital.

The energy trap

As global GDP grows there is little question that the use of energy will grow with (it if not ahead), as people become greater users of energy as they get wealthier. Therefore I do not doubt the long-term demand side of the equation. What I am doing is to raise the question of excess supply and flat to falling prices. There is no question as to the increase in US production benefiting from horizontal drilling for oil and gas. Hardly a day goes by that the US or other countries’ claims of large reservoirs of gas are being published. The costs to develop all of this production are very large. For political reasons almost every government is adding to the operating costs structure. One of the better global investment managers that I know is a great believer in the capital cycle which in its essence is that building too much capacity too quickly will lead to lower prices. I raise this concern as a potential problem for those with large energy holdings on a longer-term basis.

In my model if you have at least three time horizon components to your portfolio, I would:

1. Utilize rising prices this year to reduce some of my equity commitment for your shortest-term portfolio.
2. For the intermediate portfolio I would recognize the cyclical nature of the market and be upgrading the quality of my holdings in both the stock and bond elements. You will suffer less when the decline hits.
3. For the truly long-term portion I would keep focused on likely future markets when you intend to convert your securities holdings to spending requirements.

Guns can shoot down asset allocation.

The past year has been difficult for many who practice the art of asset allocation. For those who use domestic and international equities and debt, plus commodities, real estate, venture capital and private equity there were too many negative or single digit returns, particularly if these investments were housed in a hedge fund or a fund of hedge funds. Smart asset allocation works well if a patient investor will allow the various cycles to work out to the advantage of a long-term relationship. However, I fear the normal cycles will be interrupted.

President Ronald Reagan noted that every war that the US got into happened when others presumed the US was weak and lacked political will. The black flags flying over Ramadi and Fallujah, two cities in Iraq that US Marines and others fought hard for and managed well for the inhabitants is the latest instance of weak US reaction to a significant threat to the World. Syria and Libya are other elements of concern. As an accidental offset, Iran may become somewhat less of a problem as it may fear that it is being surrounded by battle-trained Sunni warriors. Russia, China, and a good bit of Europe and Africa may become unstable due to these conflicts and our collective lack of response.

Perhaps, some additional reserves are warranted in our investment portfolios. What do you think? 

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The Temptation to Go Short

There appears to be general agreement that a bottom in the stock market indexes was achieved on or about March 9, 2009. April was a strong month, and in some cases showed the kind of progress one sees in what we used to think was a “normal" year. May, and the first few weeks in June, showed additional progress, but at a slower rate. The penultimate week in June showed some weakness. Now we have just two days to see whether we will have a trading rally for the late institutions trying to get rid of too much cash, and trading desks attempting to square their positions.

The popular press (if that term is meaningful anymore), is developing an expectation gap. Very few new jobs have been created by the government’s stimulus. Auto sales have not picked up since the intervention. Interest rates are low, which in many respects shows the lack of solid loan demand. Though somewhat counter-intuitive, many would consider moderately rising rates a plus.

Could we see another test of the recent lows? The answer is yes. But that is not the right question. The correct question is, “What are the odds that we have seen the bottom for most stocks in 2009?” My guess is that there is a better than a 75% chance that we have seen the bottom for most stocks. There is a new symbol for this bottom, “VL.” This suggests that we have already seen something of a “V” bottom coming off the March lows, to be followed by dull, relatively flat movements of most prices. (Within the horizontal portion of the “L” there is plenty of opportunity for trading successes.) Some believe this flat, range bound, market could last for a long time. One might say “VL” stands for very long.

In the face of these observations, why do I believe, in general, shorting it is now unwise for most investors? Often, the study of mutual funds provides answers to larger investment questions. The mutual fund industry is competitive always within its own market, but has grown by entering other providers’ markets; money market, tax exempts, and bank loans are just three examples. Many in the fund business feared the “retailization” of hedge funds (the decline of hedge fund minimum investment requirements) might cause mutual funds to lose customers. The counter attack by the fund industry was led by the so-called 130/30 funds. These funds invest 100% of their assets on the long side and with the use of leverage (often margin) allocate 30% on the short side. Other funds, also willing to bet on declines at least of the markets, if not civilizations, are available.

My old firm, once Lipper Analytical Services, now known as Lipper, Inc., created an investment classification called “Dedicated Short Bias Funds” as a peer group for the 130/30 and other funds betting, at least in part, on a decline. Setting up this peer group worked well. In 2008, and again in the first quarter of 2009, Dedicated Short Biased funds were the best performers (and often the only profitable funds on average) in the diversified US equity fund super-group. As I have often stated, fund performance is cyclical, driven by the highest mathematical power, within a large universe, of reversion to the mean. (Both the leaders and the laggards move in the direction of the middle of the array, often way beyond the point of becoming the new leader or laggard).

I doubt that there will be a meaningful reversal of the performance and rank of the average Dedicated Short Biased fund for the first half and second quarter of 2009. In both periods, these funds are the only classification within the U.S. Diversified Fund super group which shows negative results. Their current fund declines of over -20%, is larger than any other fund in the super group on the upside. (A number are getting close to a 20% gain for the first half.) Further, I believe it is too early to see a counter-reversal for the short sellers.

Thus my considered judgment for investors, not traders, is: this is not the time to go short.