This week’s Dichotomy/Bifocals Needed - Weekly Blog # 932

 

 

 

Mike Lipper’s Monday Morning Musings

 

This week’s Dichotomy/Bifocals Needed

 

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

 

 

 

1 week = 1 month, or 1 or more years

From this investor’s viewpoint, the previous five trading days could be seen as a great dichotomy. Seventy seven percent of NYSE stock prices declined and 66% of NASDAQ stocks. Additionally, the US dollar rose in price to 100.362 on Friday from 97.70 on Thursday!!

 

The stock price decline was supported by a sharply increased bearish reading in the American Association of Individual Investors (AAII) sample survey looking 6-months ahead, which rose to 46.4% from 35.5% the prior week. There was only a slight fall in the bullish six-month prediction which fell to 31.9% from 33.1% the prior week. Large publicly traded companies continued to report little to no hiring to offset those retiring.

 

One might have thought that worries about inflation would have had more impact, with the ECRI industrial price indicator rising to 130.99% from 126% the prior week. The index was up 9.59% for the last 12 months, but that didn’t seem to retard the jump in the dollar on Friday.

 

If one listened to the advocates of The President, the move in Friday’s dollar pointed to good times ahead. Other factors they mentioned were part of the reason the majority sold stocks this week, including on the last day of the week. We therefore have a dichotomy, which is a condition that can’t last or perhaps requires a different analysis?

 

The correct analysis is a condition that possibly occurs to seniors. That is the need to get corrective eyewear (glasses or implants). Perhaps we need to use one set of lenses for short distances and one for long or perhaps use bifocals.

 

We could be drawing close to the time when we will know whether the short-term optimistic view or the longer-term more pessimistic view followed by optimism is correct.

 

Watch the S&P 500

There are four major US stock market indices quoted in the press. The Dow Jones Industrial Average (DJIA) consists of just 30 stocks weighted by their stock prices, whereast he Standard & Poor’s 500 is weighted by market capitalization. The NASDAQ Composite is also capitalization weighted of about 500 stocks, although some stocks don’t have public records for five and ten years. The Russell 2000 Index is small-cap focused and suffers from a significant number of companies reporting losses. For analytical and investment purposes, most large financial institutions use the S&P 500 Index.

 

The S&P 500 Index closed at 6,632 on Friday, the lowest price in over four months. Market analysts believe a further decline of more than 3% will make a near-term market rise above its former high of 7,002 difficult for an extended period. The reason for this is, many of the investors who bought stocks before the decline will try to breakeven on the way up, making progress slow. 

 

Question: What do you think?

 

 

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Mike Lipper's Blog: Premature: Buying Program to Begin Soon? - Weekly Blog # 931

Mike Lipper's Blog: Expectations Changing? - Weekly Blog # 930

Mike Lipper's Blog: Diversification - Weekly Blog # 929

 

 

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Do Current Prices Lead Future Markets? - Weekly Blog # 926

 

 

 

Mike Lipper’s Monday Morning Musings

 

Do Current Prices Lead Future Markets?

 

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

 

 

Lessons From the Weatherperson

With condolences to too many in the US and Europe this weekend, no snow came down in Summit, New Jersey today. The purpose of mentioning this is not to gloat, because we will have our share of bad weather in the future. The purpose is to remind all of the lack of certainty in predictions, and to remind all that the real value of weather-people is making professional investors look good!

 

I have one advantage in the securities analysis game, another title for predictions. My advantage is I learned analysis at the New York racetracks. The first thing was to read the situation, which included the conditions of each race and many other details. The purpose of this exercise was to eliminate races that were difficult to analyze. For example, younger horses with little to no experience, or a clear standout quoted at very small odds. Remember, my prime objective was to leave the track with more money than when I arrived, after expenses. A goal only a minority achieved each day. (This led to never wagering all on any given race and having enough money to get home. Thus, I am not fully committed in my current portfolio.)

 

The next task was to compare the records of the horses, which usually produced horses with the most wins or fastest times. This exercise normally produced a list with the smallest betting-odds, and they would generally be excluded because the payoffs were relatively small. So much so that they would not even cover prior or future losses. (This is like coming to a highly favored stock in a late market phase)

 

With all these eliminations, what is left? What I found at the track and later at my desk were bits of information in public view, suggesting that on a given day a horse could do well and beat the more popular favorite. (This was and still is my current hunting ground for investments.)

 

The Big Advantage

There is a big long-term advantage in selecting investments over picking horses at the track. When the day at the track is over, the game restarts the next time you enter the track. With investing in securities your investment progress passes through a number of phases. I find it easier to pick securities, which will have more up phases than down. The big advantage is that after an up phase there is more at risk than what you initially put in. If there are subsequent up phases, your returns are the product of your initial investment plus the return on other people’s money. A study of the returns of successful people captures this compounding impact. 

 

Applying The Track’s Principles Today

Enthusiasm is the enemy of finding current bargains. Most long-term investors, if they don’t get punished by high expenses, taxes, and selling large portions of their wealth quickly, have a good record of growing capital. However, if they get sucked into the market when most are enthusiastic about its progress, they become victims when enthusiasm shifts. The greater the number of transactions the greater chance they will not only have poor returns but will lack the capital and the guts to buy when securities are cheap.

 

The 2026 Shift

One month is hardly conclusive that markets around the world are expecting a different game, but the S&P 600 Small Cap Index led most other US stock indices with a gain of +5.61% in January. (If that rate of monthly gains were to continue throughout the year, the annual gain would be over 100%)

 

By comparison, if a January S&P 500 Index gain of +1.45% continued for a year it would produce another double-digit return. The problem is that it results in a four-year period of double-digit returns. (I suspect the doubling of one of the small cap indices is more likely than a four-year period of double-digit gains in the S&P 500 Index. Goldman Sachs calculated that if only 1% of the capital invested in the S&P 500 moved to the S&P 600, it would raise the latter’s price by 37%.) For perspective, of the 105 Mutual fund peer group averages, only 8 were up double digits.

 

Now To The Real World

In the last 3 weeks the usually slow moving ECRI Industrial Price Index came alive with successive weekly readings of 131.20, 126.28, and 117.67. The gain over all of last year was +11.50%. The three biggest price-increases this week in The Wall Street Journal were Natural Gas +20.64%, ULSD (diesel fuel) +12.16%, and Crude +6.78%. (I wonder what the present Fed and the probable new Chairman after May will do.)

 

There are lot of other worrisome statics out there. In a recent report Michael Roberts listed some 17 economic return elements that are worth looking at. I have selected just a few of them for you to digest.

1. Healthcare and social services generated more than 100% of net payroll gains in 2025. Top decile earners now account for about 45% of total consumption. (These top decile earners won’t be the beneficiaries of the tax changes in ’26.)
2. Softer demand for luxury goods suggests financial stress is beginning to move up the ladder.
3. Layoffs have reached recessionary levels and wage growth continues to slow.
4. Creditors are increasingly unwilling to lend at historically low real yields.
5. A recent PWC survey of 4000 global CEOs found that confidence in revenue growth had fallen to a five-year low.

 

Next Two Years

Odds are, the next two years will be anything but smooth. The key to surviving this troubled period is maintaining capital in diverse financial and other assets. Gather as many resourceful people as possible into your circle. Stay alert and get comfortable with change. Lastly, share your thoughts with us.  

 

 

 

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Mike Lipper's Blog: Failed Expectations: Do Details Count? Zig-Zag Flips - Weekly Blog # 925

Mike Lipper's Blog: Is This The Week That Ends Instability? - Weekly Blog # 924

Mike Lipper's Blog: How Much Longer Can We Avoid Thinking About the Long-Term? - Weekly Blog # 923 

 

 

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Do You Believe Congratulations Are in Order? - Weekly Blog # 706

 

Mike Lipper’s Monday Morning Musings

Do You Believe Congratulations Are in Order?

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

Interpreting US Stock Market

Various US stock indices reached record levels last week. Does this indicate a new “bull market” or a new phase in an old one? Based on recorded history, the choice is not based largely on one’s political views, but on long-term earnings trends, dividends, and how they will be priced. While the precise answer for any future date is uncertain, the specific date is irreversible. Our job as risk managers is to guess the correct strategy today, although most long-term investors are somewhat reluctant to make major changes. 

Some investors weigh losing any significant money to the market or taxes as much more important than the write-down of inventory prices. Investors should adjust the importance of these factors in making tactical and strategic decisions. Absent these hurdles, investment decisions should be based on odds and penalties. 

Odds should be based on selected histories. For example, at the racetrack one tends to place more confidence in a horse that has developed a consistent pattern around the track. This is relatively easy to do with securities, as prices normally have a cyclical pattern. The more difficult decision is assessing the penalty for being wrong. This decision becomes easier if a specific portfolio structure is introduced, as discussed below:

Burn Rate Portfolio

In addition to anticipated future payments we should set aside a reserve for unexpected non-market related contingencies. The sum-total should be put in what insurance companies call, a “side pocket”. The critical question is how long a period of unfortunate markets the side pocket should cover before the main investment portfolio once again produces wealth for future needs. As mentioned last week, history does not exactly repeat, but rhymes. Apart from a grossly mismanaged recession in the early 1930s, most recessions end in three to five years. One might therefore want to use a five-year plan.

In today’s investment environment, one should not put the entire “burn rate portfolio” in cash. Inflation will erode the purchasing power of the dollar relative to the currencies of countries supplying our needed products and services. The most critical rule for the reserve account is being liquid. Some of the money may be needed in five working days, some within a month, and almost all within a quarter. 

Depending on the size of the account, I would be inclined to invest 50% in well-diversified, conservatively valued equities, or well-chosen mutual funds. The bulk of the remainder should be invested in high-quality corporate bonds, with maturities spread over the next five years. A relatively small amount should be invested in a retail US Treasury Money Market fund. The most important next step is to create a separate side pocket from your investments accounts.

Investment Accounts

In today’s environment the only portion of the account not invested in equities is a timed buying reserve. The key is to invest this cash out of the market, reconstructing a different buying reserve at least annually. Within the diversified investment account, one should have some market price sensitive stocks, usually selected from cyclicals. Another portion, depending upon the comfort level of the investor, should be invested in time sensitive investments, often secular and explosive growers. 

We cannot avoid being international consumers and investors today. Bear in mind that the general history of wealthy investors is to choose some investments less influenced by local governments. Within the investment account there is room to invest both aggressively and conservatively through individual equities and or mutual funds. (Because of my background of globally following fund and fund like vehicles, I rely more on funds.)

Brief Comments of Interest

• The Chinese government has proved it can mobilize the civilian portion of its economy for war, if needed.
• Judging by changing price/earnings ratios, stocks within the DJIA are more cyclical than those in the NASDAQ composite.
• Growth and value stocks within the S&P 500 have performed about the same year-to-date, 30.4% vs. 31.2%.
• A president of a long-term, low turnover fund stated that his fund’s performance of 20%+ was “not good enough”. Our analysis suggests 20% is difficult to repeat every year.

The following groups of stocks are up from their 2011 lows: S&P 500, Russell 2000, Russell Growth, Russell Value, MSCI World ex USA Small Caps, Consumer Discretionary, Consumer Staples, Financials, Health Care, and Materials.

The only three stock sector mutual fund indices generating performance over 30% in 2021 are: Lipper Financial Services +39.72%, Lipper Global Natural Resources +33.25%, and Lipper Real Estate +30.49%. Among the commodities funds the winners were: Energy Funds +84.16, Specialty Funds +44.27%, Base Metals Funds +32.22%, and General Funds +31.45%.

Four observations from T. Rowe Price:

• The Delta variant spread appears to have peaked
• Corporate and government debt levels are elevated
• Chinese regulatory actions have likely peaked
• The Baltic Dry Index recently dropped from its precipitous rise 

Of the 25 best performing funds for the week, there were 13 small caps. Additionally, 31 of the 32 S&P Dow Jones global indices were up for the week.

Question of the Week: Any changes in strategies contemplated? 

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

https://mikelipper.blogspot.com/2021/10/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/10/are-we-listening-as-history-is.html

https://mikelipper.blogspot.com/2021/10/guessing-what-too-quiet-stock-markets.html

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“New Normal” Unlikely to be a Repeat - Weekly Blog # 635

Mike Lipper’s Monday Morning Musings

“New Normal” Unlikely to be a Repeat

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

Analysts love history, believing the future will be a repeat of the past. Almost every force for change today is itself changing. There is so much changing that there is a great temptation to retreat to cash or a central value index. Quite probably, the least realistic and useful diagram for the future is a straight line. However, there are a series of mathematical manipulations that may be useful in identifying the multiple “New Normals” we will go through.

I believe it was in the second year of algebra that we were introduced to simultaneous equations. In these equations each formula has a different unknown, requiring each to be solved before completing the entire equation. There were other useful exercises that could also be helpful in our search for an investment strategy. The first, which was mislabeled as geometry rather than logic, was proving theorems. In that exercise we segregated math formulas between those that supported the theorem and those that did not. The correct solutions were based on the logic displayed, not the number of pros and cons. Perhaps the most useful math we learned was the math dealing with circles and semi-circles. I believe that learning to think in circular patterns is much more representative of the reality of human (market) behavior.

Where We Are is More Important Than How Far We’ve Traveled
Utilizing the two-sided balance sheet approach, I will divide the current inputs between those I perceive as positive for long term investing in equities and stock funds vs. those that increase the risks of losing money.

Positives
In analyzing data we look for indicators that on balance successfully predict the future. Positive indicators are normally correct more than half the time. However, what is even more valuable are the rare negative indicators. On a contrarian basis they are correct more than 75% of the time.

1. One of the best negative indicators is the sample survey of the American Association of Individual Investors (AAII). In the latest week, for the second week in a row, the survey is increasingly bearish, 48.9% and 47.8% respectively. A more normal three-part distribution has numbers in the thirties, as it was three weeks ago when it was 38.1%. Rarely do the weekly readings go over 40% and it is extremely rare for any choice to exceed 50% for the six-month outlook. 
2. Private clients at a large US brokerage firm bought equities for the first time in eleven weeks.
3. Individual investors are not constantly wrong, although they tend to make up their minds slowly and consequently tend to be wrong at turning points. (Data is no longer corrected on transactions below 100 shares, so we can no longer use the odd-lot theory.) If we look at total flows, we see net purchases of $11.3 billion for fixed income securities and funds, including $2.6 billion going into TIPS and $5 billion net outflows from Equity. These flows are forcing the prices of fixed income products up and their yields down. This reflects market action and is not a predictor of future interest rates.
4. We appear to be in two different markets at the same time. The daily stock price chart for the NASDAQ Composite is in an uptrend and has been establishing new highs. The other two main market index price charts look to be forming a temporary top, despite 24% of the S&P 500 being invested in FAANG stocks plus Microsoft. In 2013 the same stocks represented 9% of the index.
5. Rising freight volume carried in trucks is expanding, leading to capacity expansion.

Negatives

1. The Citigroup Panic/Euphoria Model is predicting a bearish period one year away.
2. Investors are pouring money into fixed income, even though there is a long-term expectation for higher interest rates driven by inflation. One example of this is a repeated issue of a 100-year bond from Austria, a country without a particularly bullish outlook. A pitch used to sell very long bonds is that it avoids having to make more frequent decisions, which can be wrong!!!
3. Some US investors are investing outside the US or the dollar. Of the 25 best performing mutual funds this week, 16 were precious metals funds (gold), 3 were emerging markets funds, 2 were China Region funds, 2 were India funds, and only 2 were invested in domestic small caps. Except for the precious metals group, the individual holdings in the other 9 funds appear more important that a sector bet.
4. The VIX indicator of worry is selling at twice last year’s rate.
5. Friday’s volume rose, which is not normal in the summer months, revealing interesting results that need to be further examined. The stock of T. Rowe Price lost 7.62% for the week, even though it published good results. On Friday, Janus Henderson had a market volume of 10.66 million shares, where the normal volume is 1-2 million shares.

Conclusions

1. We should not expect some clear straight-line news any time soon. That is not to say various pundits will not extoll these points of view, but on careful examination the precision of their views will come into question.
2. Despite what various political leaders state, we live in an increasingly integrated world and that is a net good thing, although it has a price, among other difficulties.
3. At today’s prices we are being paid to take long-term equity risk and are not being compensated similarly for fixed income risk taking.
4. We should focus on the announcement of capital expenditures in order to see how much is being invested in new products and new distribution, or see if it is being used to lower existing costs.

What Do You Think?   

 

Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/06/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/06/data-driven-reactions-dangerous-weekly.html

https://mikelipper.blogspot.com/2020/06/caltech-data-heretics-go-to-track-for.html



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Emotional Preparations for the Next Markets Using Top/Down and Bottom/Up Thinking

Introduction

To some degree we are similar to a group like teenagers enjoying our first kiss. This communication skill has set us up to be exposed to other kisses. Turning to our social, political, and investment lives we are regularly being planted with kisses. Unfortunately those kisses are from those who wish us to part with our approval, votes and money. As they besiege us with kisses as translated from their sales training exercises “Keeping It Simple Stupid” (KISS).

I am particularly turned off by oversimplified presentations or sound bites by various sales types, be they be politicians, salespeople, and especially client portfolio managers and other types from wealth management organizations. It is normally a mistake to interrupt them as they have to go back to their opening line and repeat their pitch. Don’t ask too many detailed questions. By the time one gets to the third level of questions or cross examinations they are out of their depths. The good ones will stop there and change the subject to more familiar topics. The others will guess which “solutions” can be amusing but have little lasting value. Nevertheless, these presenters do have worthwhile value. They are excellent at summarization and generating memorable quotes.

Before I select a mutual fund for my clients I need to spend time with the fund's primary portfolio manager. I ask lots of questions, some they may have not addressed before. The purpose of the exercise is to assure me that the portfolio manager, perhaps aided by analysts, knows more than I do and has some different views than I do. I buy funds when it is clear to me that they bring materially added value. Often these portfolio managers are not as memorable or glib compared with their professional presenters. I still remember spending close to two hours with a well performing fund manager peppering him with lots of questions. At the end of the time allotted I looked at my list of questions and did not have any answers to my questions. What was clear: I did not understand him well enough other than to appreciate his good record. Subsequently when as all good managers do, he had some less than stellar performance, he left the large fund group with a couple of accounts as it became clear that the group was only interested in good performance not the reasons for it. It took many years for me to return to this particular shop. On return the new group of portfolio managers were good communicators of their bottoms up  analysis.

The Necessary Three Inputs

One of the better market analysts that I know is asking his clients to be emotionally ready and to be prepared to act in the future when the markets become much more cyclical with major changes of direction.

In order to prepare for these changes I believe a good investor will need three inputs. The first is understanding the “big picture” scenarios of the top/downers. The second are the contrary indications from the bottom/uppers. The third is an individual risk management levels for different components of one’s entire investment and career portfolio. In this stew one will need to be judicious in what one eats and when, without the tempting need to consume all that is “on offer.”

Top/Down Stock Market Views

Charles Schwab’s team is expecting a pull back from current levels. This is overdue in that the S&P500 has not had a 5% decline in over a year. The only strategy in using elements in the “500” to decline in the second quarter was the S&P500 High Beta sub index. It was the second highest performer in the twelve months through June which clearly demonstrates the rotational or cyclical nature of the market. The level of enthusiasm does not yet fulfill a prerequisite for a major top; the American Association of Individual Investors' (AAII) consensus in its weekly survey had a bullish jump to 35.5% from 28.2% the prior week and a bearish count of 25.8% from 29.6%. Clearly most participants have a neutral view. This and other sentiment indicators are worth watching at least as coincident measures and when they go to extremes as contradictory signals.

Bottom Up Inputs

Contrary to popular views of many of the various pundits, mutual funds are beating “the market.” Each week my old firm, now known as Lipper Inc., an affiliate of Thomson Reuters, tracks fund performances of mutual funds around the world. For investors in SEC registered funds, it divides its list into various investment objectives. In the latest week it is tracking 69 equity oriented fund objectives. For the year to date period ending Thursday the average performance in each equity oriented fund investment objective was better than the performance of the average S&P500 fund in 39 investment objectives or 56% of the universe.

In the US Diversified Equity (USDE) group there were five better performing objectives, four were growth funds of various market capitalization levels. There were 9 sector objective winners, in addition  25  of out 26 world equity fund objectives were also winners.

The latter is not surprising as fund investors and their advisors have been buying non domestic funds for over a year while their older and more long-term fund holders were completing their USDE voyages to meet educational, retirement and estate needs. What is interesting and historically surprising is in the same year to date period there are 27 fixed income investment objectives with fluctuating net asset values. Every one of these averages were positive. One of these, the Emerging Market Local Currency average (with a gain of 11.45%) did barely beat out the S&P500 gain of 11.39%.  Often when stocks go up, bond and other fixed income securities decline in price.

An Important Breakout Despite Clues of a So-Called “Likely” Pullback

Some of the leading technical market analysts are pointing to the fact that both the S&P500 and the NASDAQ Composite have twice broken out on the upside with gaps. These are usually filled in before there is an extended move. This is underpinning to the belief that a pull back is likely.

A reversal to the reversal may be imminent. In the backing and filling of the NASDAQ composite index, NASDAQ created a classic “head and shoulders” reversal pattern which often presages a reversal of the former pattern, which was rising. However, instead of declining, the index is rising - if it continues for a little bit more it could create a reversal to the prior reversal pattern and predict an important breakout for the NASDAQ. This is of great interest to small cap and technology investors and could stimulate even greater enthusiasm for their holdings.

The level of naivety expressed by much of the various talking heads about the changes in US regulations and taxes is a bit breathtaking. If Congress is instituting the changes it is likely that the bill will be hundreds of pages long. If that is not daunting enough, the number of pages of specifics including contradictions will be a multiple of the legislative documents. For instance the controversial and badly drafted Dodd Frank Act (DFA) was 848 pages and the subsequent regulations totaled 22,000 or a ratio of 25 pages of regulations for each page that was finally passed into law. Remember currently the bulk of the employees that will administer these regulations are not sympathetic to the current US Administration. Further, when the new laws and regulations come before the Supreme Court or possibly the lower courts, they will review the testimony given to the relevant Congressional committees.

Thus, when and if we get a major piece of “tax reform” enacted, my fear is that the amount of taxes that my clients and I will pay will go up not down as the reductions of deductions and permissible expenses will cancel out any tax rate reductions.

Emotional Preparations

First I accept that I will not perfectly predict the peak or the beginnings of a major decline. Hopefully I won’t be too premature or too late. My primary defense mechanism is my TIMESPAN L Portfolio^® philosophy where I can expect to be able to be defensive in certain parts of our holdings and are willing to continue to hold other parts having our large gains converted into significant unrealized losses. One can accept these unhappy results if there is sufficient capital (largely cash) in the operating component. Without scaring them too much, I try to get clients to do the same. I accept a certain amount of substantial career risk and position myself to be able to pick up bargains during the chaos.

__________

Question of the week: How are you emotionally preparing for future economic and market declines?  They will certainly occur, perhaps sooner than expected.

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Beware of Wrong Identities

Introduction

Identifying items that are identical to each other is at the base as to how we learn in the western world. As children we are asked what images are the same as other images. Later on we learn that the values derived from a particular equation are the same as the values derived from another equation, and labeled an identity. Many of today’s college and graduates students learn about investing in forty or fifty minute classes in an academic institution rather than in the marketplace. Thus, it is no wonder that many professional investors and so-called sophisticated investors use identities or labels in finding investment solutions in marketplaces that are always changing. Therefore, it is not surprising that far too many investors will continue to suffer from simplistic, quick, applications of identity labels.

Historical Precedent

This post is being written on the last weekend in June, 2017. Forty-four years ago I first published the weekly Lipper Mutual Fund Performance Analysis. At the time my brother owned the Databank and had been publishing since 1968. There was a large balloon payment due to my brother for my acquiring the Databank. What does this have to do with today’s misapplication of identities?

Going back to the 1930s there were reports on the performance of mutual funds. (None of those reports that were published in those periods exist today.) The commercial purpose of these were to help salespeople in their marketing efforts to sell funds. In the case of my brother’s firm, it was to find outstanding managers to manage separate accounts.

These efforts created a central identity. However, I saw something quite different. I saw first a need on the part of the independent directors of funds to have an accurate, timely, independent source of fund performance analysis covering multiple time periods from very short-term to quite long-term periods. The second and eventually larger user of these analyses were the senior management of fund groups to help them manage the portfolio managers and funds under their command. 

The reason for highlighting the multiple time periods sprang from my experience as an investor, which was based on the thought that one never really understood an investment until one could observe its performance in both down markets and other periods of sub-par performance. Thus, some forty years ago I took what was a then standard identity set and delved deeper into it to get more useful knowledge and applications.

The Current Picture

The nexus of the academics getting interested in the market, perhaps to augment their own income, and the rapid development of fast computers with prodigious memory, the price actions in many marketplaces were translated into mathematical equations. Just as the written word, a published equation takes on the aura of an absolute truth and a sense of inevitability. Currently there is a great deal of money invested in published index matching vehicles. That none of these measures were ever designed to be prudently managed portfolios (which had various liquidity, payment needs, and regulatory constraints as well as expenses) was ignored. Little to no attention was made to the commercial motivations of the index publisher.

This week, the Fortune 500 double issue was published. In the US, the first index-like investment vehicle which started in the 1930s was based on the forty largest companies by sales on the Fortune list at that time. It was perhaps a coincidence that half of the forty were on the Dow Jones Industrial Average and half in what evolved to be the S&P 500. No one seemed to focus on the need of Time Inc, the publisher of Fortune to sell advertising. It was a given that the larger the company’s sales, the more likely the larger its advertising budget.

The original Dow Jones average was to record the dollar value change of leading stock prices or in today’s lexicon, volatility. Publishing the more volatile prices had the greater the likelihood that their newsletter and eventually their newspaper would get paying readers. The NASDAQ indices was designed to focus some attention on the Over-The-Counter market which was not represented in the DJIA. NASDAQ wanted more listings. 

Except for the sales culture, professional investors increasingly found that the published indices were not as useful in the more recent markets. This has led to the production of passive indices based on market capitalization, products produced (energy), legal domicile, largest stock market activity, earnings, dividends, etc. These are often called smart beta or factor based. From my standpoint they are an improvement, but in many cases these are using the wrong identities at the moment.

Information Technology Sectors

Charles Schwab & Co., has addressed the concerns that the soaring tech sector stock price performance is sending a reminder of the “dot com” peak of 2000 and subsequent collapse. The data that they show is persuasive that while the tech group has done well it is more soundly-based than in 2000. What I found of great investment interest in the data was that the tech companies in the S&P500  had net profit margins of 17.8% and a price to sales ratio of 4.5x. Both the Mid-caps in the S&P 400 and the Small-caps in the S&P 600 tech sectors had margins in the 3% range and price to sales of 1.4x. As an investor the way I look at these data points, I wonder how much of the lager tech companies are benefiting from materially lower tax rates due to their more global activities. If and when net tax realizations become lower, the Mid and Small caps should rise relative to Large caps. Perhaps more significant is the major disparity in the price to sales ratios. With all other things being equal, which they almost never are, the prices of Mid and Small caps are much easier for acquirers.

If one were going to select on the basis of statistical factors alone, I would, at the moment, be more interested at tax rates paid and price to sales ratios than market capitalizations. The Federal Reserve Board  has come up with their own factors to approve the capital spending of large banks which could well lead to useful factor investing which can be summarized as follows:

• Credit and counterparts risk

• Liquidity risk

• Operational risk

• Information technology risk

• Trading activities market risk

• Interest rate risk

• Strategic risk

• Model risk

• Reputational, fiduciary and business conduct risk

As all the banks passed their recent exams, we know it is possible to do so.

Shrinking Number of Small Caps

I was delighted to see that my old friend Jason Zweig had a front page column in the weekend edition of The Wall Street Journal on the shrinking number of publicly traded Small-caps. He felt that with an aggregate universe that is half what it was in the past that it would be difficult to beat the index by active Small-cap managers. I don’t like to disagree with someone as well read and knowledgeable as Jason, but I do and it ties into my concerns about identity or label investing.

First, I am under the impression that about one quarter of the stocks in the Russell 2000 are not currently making money. Over time some of these will disappear. Next the job of an active portfolio manager is not to use a pre-determined list with given weights. One of the key tools of an active manager is weighting. In some cases the heavier weights in a portfolio are caused by better than average performance of individual issues, but in some cases it is the manager not the market that makes the weighting decisions. Timing of purchases and sales can make a big difference. The best way to beat an index is to get out of the index. This can be done by owning issues before they go into an index either in their pre-IPO life or at the instance of a successful underwriting. Finally what particularly appeals to me is if the organization is appropriately knowledgeable is to judiciously add some right-sized international issues.

  

Is Indexing Peaking?

The problem with sticking to an identity is that we live and invest in a dynamic world. For an extended period of time the individual security price trends were closely correlated. As with any universe there comes a “Minsky Moment” when greater dispersion takes place. One then wants to be long the winners, some of the Large-cap tech stocks, and short the energy stocks at the moment. I find it of interest that the leading performance of the average Large-cap Growth fund on a year to date basis is so great that now for the first time in five years Large Cap Growth funds are beating the S&P500 index funds for five years. I don’t know how long this will last or it will be led by the best performing sector as of now, Science and Tech. What I do know is that all performance is cyclical.  

Looking for the next Winners

Going back to the rationale I used while publishing the Lipper Mutual Fund Performance Analysis, my recommendation is to focus some of your research time on those managers and funds that are clearly out of step. Understand which tunes they are marching to and be prepared to change your attitude when the big band starts to follow their lead. Remember the identity or label that you wish, first a survivor and second an occasional winner.

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A. Michael Lipper, CFA

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