DIFFERENT IMPLICATIONS: DATA VS. TEXT - Weekly Blog # 901

 

 

 

Mike Lipper’s Monday Morning Musings

 

DIFFERENT IMPLICATIONS:

DATA VS. TEXT

 

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

 

 

School Solutions

As taught academically, the critical pivots in teaching both economics and security analysis are the numerical changes of a data series. However, as a long-term investor I am much more interested in the mood changes hinted at in textual renditions. While data precisely represents the past, text allows the reader/student to think about one or more different futures. This is why I believe philosophy or similar courses should include both economics and security analysis in their teachings.

 

Below is a brief listing of several data points describing last week (Implications italicized and discussed in parenthesis).

• Year-to-date Stock Transaction Volume: NYSE 7.11% vs NASDAQ 37.30%

(Five times greater in the younger, more speculative market, even if some of the NASDAQ is inventory swapping among dealers. Speculation normally leads to extreme up and down prices)

• Inflation Signals: The ECRI Index tracks industrial prices weekly and it normally moves gradually. Last week it rose +1.70%.

(I believe this was in response to the tariff news at the end of the week. Some market participants believe there will be industrial price increases soon).

• Participants in the AAII sample survey are increasingly worried about a down market in stocks, but others are not.

(Comparing the bullish and bearish projections of last week with those 3 weeks earlier. Bearish projections rose to 43.7% from 34.8% 3 weeks earlier. Bullish bets only rose to 34.9% from 33.6% for the same period, suggesting bears see reasons to be worried while bulls do not. Only one will be right over the next six months.)

• Equity mutual fund peer group averages +10%. Only one US Diversified Fund (USDE) peer group average has generated returns exceeding 10% year-to-date, multi-cap growth funds. Forty other peer groups have generated returns exceeding +10%, although they were less diversified.

(USDE Funds hold more assets than the other peer groups, which suggests being a holder of US equities was not a winning hand for most.)

• Investors need to be careful that the earnings reported are not accounting constructions. The London Stock Exchange Group (LSEG) and I.B.E.S. estimate that the S&P 500 Index will report a +8.3% gain for the 3rd quarter. However, they further estimate that corporate net income will rise only +6.3% for the quarter. Thus, 24% of reported earnings will be attributable to buybacks and other accounting techniques.

(Investors need to understand what they are paying 20x-earnings or more for. Hopefully, operating earnings can be repeated while earnings created through accounting cannot.)

 

Conclusions:

There are lots of reasons to be cautious. Some reserves should be considered a hedge for future down markets. However, this hedge should be viewed as a temporary buying reserve until prices more appropriately reflect the long-term value of accepting normal risk.

To aid future generations of investors as well those today, security analysis and economics need to be taught with a fuller understanding that it rests on the strength of ever-changing language.   

 

 

 

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Inputs to Implications - Weekly Blog # 797

 

Mike Lipper’s Monday Morning Musings

Inputs to Implications

 

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

 

The Use of Inputs

There is a known cure for the narcotic attraction of investing. We can’t help but view any inputs as possibly having implications for our investing deliberations. The best we can do is to quickly review the plethora of daily inputs and reject most as unimportant, or alternatively sent to Warren Buffett’s desk basket, labeled “too difficult”. With that thought in mind, the following inputs and possible implications crossed my mind this week. See how many you can reject and how few are important enough to require your further research. Alternatively, you can send me your questions.  The inputs below are in the order they reached my consciousness, not of their level of importance.

 

Inputs & Implications of August 13^th week

1.  The Value of Competition: On the surface regulators see vigorous competition as the best way to achieve the lowest price for consumers and the highest wages for workers. For the long-run sake of society, the primary value of appropriate competition is the evolvement of a sector that can sustain itself and develop useful new products and services.

 

Implications: Placing a priority on competitive prices, wages, profitability, research, and national security, will likely hurt other players in the industry. No single force seems bright enough to allow for the enthronement as a Czar to oversee the industry. History suggests that mandatory leadership does not work. The best results are achieved when those involved compete against each other and let the marketplace decide the outcome.

 

2.  Input of what is the market is saying. Most of the time there is not a single market and therefore a single market index is not that important. In an overt simplification of markets and indices, you can use the following generalization to see what each of the markets is saying.

 

The Dow Jones Industrial Average (DJIA) is the most followed by individuals getting their market views from local media and politicians. The importance of the index is its reflection of votes, not dollars.

 

The Standard & Poor’s 500 is the single most important index for investment institutions and corporate managers. The latter group is often incentivized by its own stock or industry relative to the index. Institutional investors are conscious of the flows into and out of their portfolios relative to the index. The SPX is often used as a forerunner of employment trends.

 

The NASDAQ Composite is useful in measuring the level of speculation in the market, as it generally tracks the performance of younger and somewhat smaller companies. Most speculations are based on the belief that the future of the stocks within the index are improving. That is why the index has been more volatile in recent years, with up and down tends moving faster than the other indices.

 

When discussing “the market” with someone, the first market measure they mention tells me what kind of investor they are. People see “the market” differently, and while the main elements of the market move at different rates, a good bit of the time they mostly move in the same direction.

 

3.  “Pro Inflation” input. Very few people are publicly in favor of rising prices, although their specific actions push prices higher. Truckers, autoworkers, pilots, and other Teamster’s unions are among those pushing prices higher.

 

Considering the low productivity of businesses and non-profits, a meaningful wage increase will lead to higher prices and generally worse services. The current administration’s restrictions on energy production, onshoring, the mandating of employment practices and union membership, add to inflated prices at the consumer level. The implications are that the movement of interest rates will not be enough to sufficiently bring down long-term inflation.

 

4.  Standard & Poor’s is no longer using ESG ratings in assigning credit ratings. (I wonder whether they should actually include it as a negative, reflecting the negative consequences of a company that puts social spending ahead of its obligation to bond holders, stockholders, and fellow local and national taxpayers.)

 

5.  China’s export and import numbers have declined meaningfully. Some of it is due to US government policies. Is this wise from a purely US standpoint? (It could be as disastrous as FDR’s prohibition on US companies selling petroleum to Japan in 1933, after they were precluded from the carving up of the German Asian colonies.) China’s imports of US goods are paid for from their export earnings. There is also a risk of China dumping products on the markets of our “European allies”. Implications are that the US is reverting to isolationist policies, following a war that is the preamble to the next war.

 

6.  Input: More than half of young Arabs in North Africa and the Levant are considering leaving their homes in search of better jobs. Implications: This desire is similar to those in China and many youths in the US who are also in search of well-paying jobs. This appears to be a global demographic urge. Arabs are part of this urge even though one of the stock market indices produced by Dow Jones Standard & Poor’s is labeled Islamic Technology.

 

The youths want good jobs and employers want good workers. I wonder whether it’s a global problem concerning the lack of sufficient rigor in their home, schools, or even religion? Discipline, respect for others, and following rules could be a global issue that makes future progress more difficult.

 

7.  Input- the stock markets appear to be having a bout of complacency, with the VIX declining 14.84 this week vs 17.10 the prior week, and 19.53 a year ago. We used to think of the 30 level as normal. The bond and credit markets seem concerned about risk in the near term, with the continued inversion of higher Treasury yields for 2 years vs ten or thirty years. All of them are in the 4% range.

  

Implications: Permanently higher interest rates with the level of risk about equal through the whole long period. As a student of history, I have my doubts. I suspect too many investors are focused on current conditions extrapolated to the indefinite future.

 

8.  Every large country regularly prepares for future offensive battles and defensive wars. China follows this pattern. Two indications: A Chinese national serving in the US Navy on an armed amphibious ship was caught selling photographs of critical equipment to a Chinese agent. (As a USMC Combat Cargo Officer, I served on an armed troop amphibious ship. I believe that if China attempts an opposed amphibious landing on Taiwan, it will need a number of such ships and an experienced crew, both on the ship and on landing craft.

The US has two army type forces, the regular army, and the reserves/National Guard. The Chinese have a similar set-up, with their Militia normally assigned defensive tasks. They are however receiving training in the use of drones and other more aggressive functions. This suggests the main army will have other responsibilities or will need replacements for some of their people that are wounded or killed.

 

9.  How different is the level of investment performance compared to that in the past? One thing I do each week is to look at the performance of the 25 largest long-term mutual funds. Going back to 1926 the S&P 500 grew about +9% per annum, without any deductions for expenses and transaction costs. How does that compare to fund performance?

Of the only four funds which gained between +10.08 % and +14.33%, three were passive and one active. Three fixed income funds were slightly negative. The remaining funds gained between +6.41% for a value-oriented fund and +8.66% for a large-cap growth fund. The bulk of large equity managers produced returns in the mid +7% range, which was somewhat behind the passive index before adjustments. The implication of this analysis is that it may be appropriate to use +7% as a goal for large-cap institutional money.

 

Working Conclusion

Stock Market investors are not incentivized to change their portfolios, while fixed income investors attempt to price in credit and market risks.

 

How many of the implications are real and/or likely?

The following table may help you focus.

Indication            Implication            Accurate            Important for investment  

1.    Competition

2.    Market indices

3.    Pro inflation

4.    ESG, positive or negative

5.    China

6.    Attitudes of youth

7.    Complacency & worry

8.    Preparing for war

9.    Long-term equity expectations

I'd be delighted to learn your views.  Please let me know.

  

 

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ARE WE LISTENING AS HISTORY RHYMES? - Weekly Blog # 704

 

Mike Lipper’s Monday Morning Musings

ARE WE LISTENING AS HISTORY RHYMES?

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

Pseudo Historians?

Whether we appreciate it or not, we are pseudo-historians because we store knowledge of our experiences, thoughts, or what we’ve learned from others directly or through the media. We call this “Memory”. Recall some important incident that happened to you ten years ago. If it is a pleasant memory, we delight in it and it takes up more space in our memory bank than unpleasant memories. Notice, as we get older and have more memories there is little recognition of mild events. Also notice that when discussing a specific memorial event with someone who experienced it with you, the details are somewhat different than yours. As you discuss the slightly different shared views of the past, it would not be unusual to see that you have sugar coated certain aspects. 

Welcome to the world of the historian and notice how two competent people observe the same thing differently. (My personal Queen, my wife, just reminded me that the Queen of England has said “recollections vary”.) Furthermore, most histories are written by the victors or their supporters. Typically, many are called victors for taking some small part in a victory. There are far fewer histories written from the losing side. Few want to be tagged as the reason for defeat. (I wish business schools had extensive courses on commercial failures, as they would be much more instructive than accolades not fully deserved.)

Why am I focusing on the way we learn from historical rhymes in this investment blog? Typical investors believe they have past knowledge they can use to make future decisions. I believe they are not paying sufficient attention to the past, as most investment disappointments are regularly repeated. 

Why Now in October?

One of the curses of history is tied to the seasons and sporadic rotation. Without the same cyclicality of the earth’s rotation, we humans evaluate history to understand why we are in our current condition. This coming week on October 28th & 29th, 92 years ago, became known as Black Monday and Black Tuesday. Over those two days the Dow Jones Industrial Average fell 24%, with volume reaching the unheard number of 16 million shares on Black Tuesday. As early as March 25th that year the Federal Reserve warned of excessive speculation. The stock market had been rising for 9 years and had gained 10 times its starting level. Various pundits proclaimed the stock market had reached a permanently higher plateau. (My grandfathers’ brokerage firm was preparing to retire and was closing client margin accounts.) In addition to investment speculation, the farm community was carrying excess debt due to unexpected crop price declines. (There is a debate as to whether the stock market break was the cause of the Great Depression. It potentially resulted from the loss of confidence that swept the nation, as only16% of the US population was invested in the stock market.)

What About Today?

I have little confidence in my or anyone else’s ability to regularly predict the future of markets consistently. What I attempt to do is gather relevant information that may provide clues as to the future. The following list of inputs is not an attempt to persuade, as in a “Ben Franklin sales pitch” which always has more favorable elements. The data points should be noted, but not weighed, as the unknown future is not as much a mathematical game as a psychological one. The following is my list of items that can lead to an investment decision:

Positives in favor of continued US stock Market Gains

1. For the markets to move higher, the old Dow Jones Theory requires the Dow Jones Transportation Average (DJTA) to confirm the gains of the Dow Jones Industrial Average (DJIA). In the latest week the DJIA gained 108 points and is close to a new record high. The DJTA simultaneously rose 383 points from a lower base. Railroad and trucking companies are transporting more freight out of burdened ports. Airlines are benefiting from increased domestic/international business travel and are additionally profiting from freight business diverted from ships to meet seasonal supply demand.
2. This week, investors using the New York Stock Exchange (NYSE) showed their bullishness by pushing 401 stocks to new highs vs 108 to new lows.
3. In their sample weekly survey, the American Association of Individual Investors (AAII) raised their bullish prediction to 46.9% from 37.9% the week before.
4. The market has been in a constrained trading range for more than six months. The loss of political confidence has led to a loss of investor confidence, resulting in a massive amount of uninvested cash waiting for a signal to invest.

Negatives Against Investing Now

1. Twenty-two out of 88 mutual fund investment objective averages have risen over 60% since March 23rd, 2020, most being the more popular fund categories. Historically, performance exceeding 20% per annum is unsustainable. There are two ways to correct this condition, lengthen the flat period or endure negative performance.
2. For the week, the number of new lows on the NASDAQ was 340, more than three times the number of new lows on the NYSE. Due to the relative absence of passive investors on the NASDAQ, I believe their investors are savvier than those on the NYSE, whose investors are more sensitive to volatile cash flows from passive funds and public investors.
3. The discussion of Black Monday and Tuesday, plus the length of time since the bottom in 2009, reminds me that excess speculation often leads to a market correction. The big difference between now and 1929 is the big debt bulge not covered by flows is in the government sector (federal, state, and local). Current corporate debt in unprofitable companies is also a problem. 
4. While public participation in the stock market is much higher than the 16% in 1929, it is comprised mostly of retirement accounts. In the past they have not been particularly sensitive to market moves, but growth in the lack of confidence could see dramatic changes.

Please share with me which you see first, a 50% rise or fall?  

 

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

https://mikelipper.blogspot.com/2021/10/what-is-problem-weekly-blog-702.html

https://mikelipper.blogspot.com/2021/10/the-confidence-game-weekly-blog-701.html

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Current View of 3 Past Lessons - Weekly Blog # 693

 

Mike Lipper’s Monday Morning Musings

Current View of 3 Past Lessons

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

What Little We Know About the Future

“The future” will be a series of never-ending episodes, some good, some bad. Each somewhat similar and different than the past. Analysts are a combination of historians, observers, and dreamers distinct from extrapolators. In pondering the future during a “dull market” week, I looked through three historical lenses searching for useful clues about what lies immediately ahead. Please remember my absolute right to be wrong, or perhaps worse, being half-right.

1. “The Dow Theory”

Charles Dow, the first editor of The Wall Street Journal and founder of Dow Jones in1896, spent time trying to interpret the stock market and what it foretold about the future. His analysis revealed that there were two stock markets, those of pragmatists and dreamers, using my terms. Today we might call them “value” and “growth” investors. To arrive at this conclusion he boiled down the price performance of what would become two limited indices, the Dow Jones Transportation Average and Dow Jones Industrial Average. He concluded that for the general market to have a sustained movement both averages had to move in the same direction and eventually reach their prior established peaks and troughs. One had to confirm the other’s move.

 The logic behind this view was the industrials being priced on the collective view of their future, believed only when the rails carrying their freight to customers confirmed it. We might have labeled the two indices as quality and speculation. (Some of today’s readers would not believe that the rails were the quality portion of the market. Some years earlier, Columbia University had an endowment devoted to the most prudent of all US investments-----railroad bonds!! It is worth noting that almost every significant railroad subsequently went bankrupt.)

Today, pundits still regularly comment and contrast stocks/funds that are value and growth oriented. With that in mind, it is useful to look at charts published each week on the price movement of the Dow Jones Transportation and Industrial Averages. (Both have evolved, with major changes in their composition. The Transportation Average includes airline companies, logistic companies, shipping companies, and package delivery companies. The so-called Industrial Average, in addition to including manufacturers, also includes entertainment, financial, credit card, and software producers.)

From the beginning of the current year into the middle of May, both Averages rose meaningfully. However, since then the DJIA has risen slower, being essentially flat in July and only reaching a slightly higher peak on Friday. The Transportation Average on the other hand has been falling and is now approximately 11% below its May top. Thus, as of now we have a non-confirmation of the Industrial Average Friday breakthrough. 

The May peaks in the two averages made sense as the rate of gain of the recovery topped out. This was primarily due to concerns over inflation, politics, and slowing sales resulting from shortages. While the NASDAQ also went to a record levels on Friday, on most trading days its price movement has been less ebullient than the DJIA. One of the characteristics of a top or bubble is high-volume traders going up while others lag or fall.

2. Jeremy Grantham (GMO)

Jeremy is an iconoclast thinker and portfolio manager. He has made some brilliant calls on the market and has been out of phase with markets for extended periods of time. More than a year ago he made a favorable call on the price of timber. As a member of Caltech’s investment committee, we have profited and enjoyed his performance. He is currently worried about a market bubble. Recognizing that many who attempt to read crystal balls concerning their future eat broken glass, his views are well worth considering:

• Bubbles occur when periods of very long and strong economic expansions are extrapolated into the future. (The current expansion is being fueled by government stimulus, with the advocates not identifying any termination of the expansion.)
• Much of the global expansion of the last several years has resulted from bringing low-cost labor from China and eastern Europe into production. (Unless they can cheaply be replaced with Africans, Latin Americans, and those from Southern Asia, we will suffer from wage inflation.) 
• Perceived wealth makes consumers and investors think they are wealthier than they are. While seasoned market investors understand that prices “temporarily” decline, few appreciate that housing prices can fall for a long time. In terms of future spending, housing is a worse investment than securities. (It is my personal view that we don’t own our homes, they own us. We must pay to maintain them and pay taxes on them.)
• He lists other parallels in a recent podcast and his writings.

3. My Own Experience

My first job on Wall Street was at 63 Wall Street, working at one of two very special brokerage firms. With rare exception the two firms were odd lot brokerage firms, executing share transactions of under 100 shares. Other members of the New York Stock Exchange (NYSE) found this task cumbersome in a pre-computer era. To free themselves of this burden they allowed the odd-lot broker to charge an eighth or a quarter, depending on the price of the closest qualifying trade executed by the other floor members. With their level of commission determined, the two firms competed to get orders from other firms by providing services to their customers. During this period the only record of stock prices was on Mr. Edison’s ticker tape, which was not mechanically stored. My job, along with an army of clerks, was to record the tape prices and volume for a handful of stocks useful to our brokerage firm customers, proving they got the best possible price at the time of the trade.

I learned a great deal that summer which shaped both my later career and more importantly how the real commercial world worked. Some of these insights were:

• If commissions are fixed, one competes on services that are a burden to customers.
• With the right sales attitude, it is a distinct advantage working for a limited number of professional customers in geographically close offices, rather than dealing with public customers spread around the country, if not the world.
• Internal industry competition can regulate the marketplace faster, fairer, and more insightfully than regulators.
• Develop respect and appreciation for skilled hard working people with different levels of formal education and experience.

Many years later, when assembling a financial services portfolio for family and clients, I did not limit it to brokers, banks, insurance companies and fund managers as most financial services portfolios do. I also included financial service companies with specific expertise useful to the professional market. In a recent performance review of that portfolio, some of the leaders were what I would call critical common denominator service companies with limited competition, e.g. Moody’s, Thomson Reuters, and S&P Global in personal accounts,  which have gone up multiples of our original cost.

The reason for mentioning these positions in a blog focused on what could cause the market to decline, is that almost every business is overregulated compared to other financial services businesses that are relatively lightly regulated. This is due in part to the same customer regulation that the odd-lot firms enjoyed. If some of the comments by Senator Warren and members of the current administration become law, it will make these companies less attractive investments and worse suppliers to the market.

Updates

Some of the signs of extreme inflation are possibly temporary. The runaway JOC-ECRI Industrial Price Index declined this week by 3.64% and is only up 68.27% year-to-date. I don’t know how much of the decline is from certain lumber and oil prices. Personally, I am much more concerned about service sector inflation due to rising wages. Some of this is overdone, but it is unlikely these hard-earned increases will meaningfully reverse short of a major depression.

When I talk with young people these days, they focus on trading to get rich quickly. I try to bite my tongue for I believe that investing is an art form, where each artist learns how to control their actions to reduce the probability of losses and the possibility of gains overtime. To me, trading is an inside game for professionals who believe that they have a demonstrable edge capable of overcoming expenses and taxes. Many of these young people go to or graduate from “good schools”, where they are taught and schooled, but not necessarily educated. Being schooled is what you have been taught, whereas education is what you have learned. Unfortunately, most of us only get education through our own or others’ losses. I am not worried the youth won’t get the benefits of losses, as that is almost inevitable through trading. What concerns me is that this generation will stand shoulder to shoulder with those who lived through the 1930s Depression, stoutly proclaiming “never again will I trust the market and its participants”. Some of these types of people were still at the Bank I joined after The Marine Corps in 1957. They relatively quickly past by those of us who were learning to be good analysts and not bad investors. My fear is that many of the youth today will never be good investors,  which may be the real loss resulting from the oncoming decline in markets around the world.

In Conclusion

The odds favor a major decline in the future. The issue is one of timing and we continue to learn that the duration of cycles of all sorts appears impossible to predict, but one should be prepared.

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

https://mikelipper.blogspot.com/2021/08/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/07/mike-lippers-monday-morning-musings_25.html

https://mikelipper.blogspot.com/2021/07/correcting-impression-and-gaining-some.html

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Are We Strolling the Promenade Deck of the Titanic? - Weekly Blog # 665

 

Mike Lipper’s Monday Morning Musings

Are We Strolling the Promenade Deck

of the Titanic?

Are there Parallels?

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

In the early morning of April 15th,1912 the largest ocean liner afloat sank. The ship was supposedly unsinkable, yet five days after its maiden voyage it sank, with a substantial loss of life and confidence. Are there parallels to the global stock markets? I do not know, but there are sufficient lessons that can be learned from the losses sustained almost one hundred years ago.

Parallels

Titanic 1912

As with any tragedy there were errors of both commission and omission, summarized as follows:

• Recognition of the impact of weather: Unusually warm April weather over the northern icepack detached an unexpected flow of icebergs of several miles, plus. the combination of a moonless night and glasslike seas.
• The owner’s decision to increase the speed to 24 knots (25 miles per hour) to achieve a record crossing for publicity purposes.
• An inexperienced crew properly trained for emergencies led to confusion regarding the proper off loading and fully loading of lifeboats.
• The ship was briefly turned the wrong way while the radio room crew dealt with faulty equipment as it sent out the social messages of passengers.
• The belief that four watertight compartments could keep the ship afloat, except from the top. (Six compartments were ruptured with long glancing blows below the waterline.)
• Failure to instruct and lead passengers in evacuation procedures.

The errors could essentially be summed up in terms of speed and surprises.

Concerns of Global Stock Market Parallels - 2021-?

Since the beginning of time markets have collapsed under excessive speculation, driven at high speeds with too much lose debt creation and growing social structural imbalances, needing only a surprise and an event. Some of each of these are already now present, except for “the event”. Apart from hitting an iceberg, we may already be experiencing some of the other characteristics presaging the bursting of a bubble. I hope not, but much like the lookouts on the Titanic I perceive some unexpected things ahead.

Clues

Markets depend on speculation to determine prices as it views the future and compares it to the present. This is healthy and only becomes dangerous when it gets too popular and raises prices way above a sustainable level, depriving more mundane investments of investment support. 

• This week, the stocks showing the biggest price gains were in order: solar, electric vehicles, energy, China tech, and emerging markets. 
• The biggest flows went into commodities and global stocks. High yield (formerly called “junk” bonds) rose twice as much as investment grade bonds. 
• An indication of speculation at one main street broker is the over three times as much money going into exchange traded funds (ETFs) as going into mutual funds.
• Margin debt in November set a record and is probably still rising. The banking system can earn an acceptable return leaving money at the Federal Reserve, which has opened the opportunity to other credit providers who have fewer loan-quality constraints.
• Increased volatility is usually looked at in terms of rapidly rising prices, but it also reflects sharply falling prices e.g., SPACS after mergers. This may be why the average dedicated short mutual fund gained +12.27% vs +1.52% for the average S&P 500 index fund in the latest week.
• Survey data is again found to be wanting, in this case beyond the realm of politics. The Philadelphia Federal Reserve Bank survey of Manufacturing predicted a gain of +11.8% vs +26.5% actual, not a useful navigational aide.

Debt can be used to pay for operating expenses or expand capacity. In the first case it fills a hole left by equity not used to pay for the debtor’s current operations. It is thus a substitute for equity capital but does not provide capital for expansion. Currently, most debt raised by individuals, companies and governments is not used to add people, improve productivity, or expand capacity. Thus, debt is not being used to invest in the future and its repayment will be a burden on the future, unless there is high inflation.

The CEO of the company owning the Titanic issued orders but was not in a position to see if they were quickly and efficiently carried out. Considering the difficulties the new administration is having with Congress and within its own party, one wonders about the actual results of its announced policies?

The Remaining Question

Since investors cannot avoid periodic downturns, how should they manage their portfolios? I do not know of a good cookbook type recipe answer. I suspect the multiple answers will largely be a function of your ability to withstand pressure on your invested financial, emotional, and intellectual capital. The most vulnerable will be agents managing other people’s money, who have career risk. The least pressure for the self-assured is managing your own capital, as you don’t have to endure unexpected calls on capital. Most professional managers are much more in the career risk camp. For them, the key question is the acceptable level of decline from peak and the expected time until the account fully recovers. Another question might be how much longer the capital base takes to fully reach the expected level. The successful manager’s business longevity has as much to do with his/her communication skills.

At the other extreme is the manager of her/his own capital. While no one can unseat this manager, they are at risk of doing great damage to their capital by unwisely shifting policies to accommodate current market styles. Very few investors are successful at repeatedly changing styles. I have been investing for sixty years and during that period I have been lucky enough to own positions that have risen in price by many multiples of their original cost. However, I have also had a limited number of positions that have turned out to be worthless, or close to it. The nice thing is that the mistakes lose a percentage of wealth, whereas the winners grow exponentially. This week I noticed that one of my financial services holdings quadrupled in price, although I have owned it since 1991. A good, but not spectacular 7.2% return per annum. My correct bet was that the company’s management were big shareholders and were good at what they were doing. The key to their investment success was that as their business changed, they also went through successive management changes. Technologically, the firm is a great deal different than the 1991 model, but their attention to the needs of their employees and customers is very much the same.

Conclusions

1. We cannot avoid meaningful declines; they are only a matter of time. One needs to be prepared for declines and increases that last longer than expected.
2. Patience and communication skills are of equal importance to success, as is the never-ending development of investment skills.

What Do You Think? 

 

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

https://mikelipper.blogspot.com/2021/01/contra-messages-weekly-blog-664.html

https://mikelipper.blogspot.com/2021/01/the-wisdom-of-3-wise-men-weekly-blog-663.html

https://mikelipper.blogspot.com/2021/01/anticipating-topping-us-stock-market.html

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Anticipating Topping US Stock Market for Portfolio Managers vs. Stock Pickers - Weekly Blog # 662

 

Mike Lipper’s Monday Morning Musings

Anticipating Topping US Stock Market

for Portfolio Managers vs. Stock Pickers

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

                           

                   

                           

Warning: How Markets Approach Tops

Perhaps fittingly, markets reach tops in a similar fashion to countries going to military wars. There are two phases. The first can go on for a lengthy period of a year or more, with the slow destruction of the ability to successfully fight back. The second is an immediate event, which galvanizes the opposing forces into military action. The assassination of the Archduke in WWI and the Attack on Pearl Harbor in WWII are two examples. In both cases the general population was not paying attention to the deteriorating conditions and they were truly surprised by the triggering events. Those in power were not surprised that an event could trigger hostilities and there were premature warnings if one looked for them.

With the US stock market nearer a probable peak than a bottom, I sense an oncoming peak followed by a meaningful decline. I just don’t know when, although I have a pretty good idea who will be blamed for it.

Topping Signs

The first sign is the public’s wish for a better year than the last, often expressed as a bigger gain in the US stock market. The raw gains for the Standard & Poor’s 500, with dividends reinvested, was +18.40% for 2020. A level roughly twice the long-term average of +9% to +10%. The average S&P 500 index fund, with $1.9 trillion entrusted to them, gained +17.91% with dividends reinvested and management, administrative, and transaction expenses deducted. As good as these results were, they were below the average return for US Diversified Equity Funds, a gain of +19.14% on $10.3 trillion in assets. Even with the history of a strong November and December being followed by a year producing returns of +10% or more, one should be cautious in expecting the 2021 return to be better than 2020. 

Excessive speculation with increased leverage weakens all but the strongest financial structures.  Excessive speculation is often an open invitation for enemies to embark on bold adventures (Pearl Harbor). There is no doubt we are experiencing rampart speculation, 2020 had the fastest bear market and included a record level of IPOs and an equal number of SPACs (Special Purpose Acquisition Company). In addition, 2020 saw a record level of margin debt and a new generation of inexperienced investors rapidly trading on home computers, somewhat like the “roaring twenties”. 

Accelerating inflation also weakens the defense mechanism of a society. The JOC-ECRI Industrial Price Index ended the year at +24.44%, with 81% of the weekly prices rising in the weekend edition of the WSJ. Other cracks are also visible in the economy, with landlords and their banks speculating on when and if their tenants will pay their rent. One also hears of some officially unemployed workers only willing to work off the books. Integrity is often forgone in periods of speculation and inflation.

We should not attempt to remove all speculation from the markets, as we would be killing opportunities to take risks that have paid off very well in 2020, shown in the performance of the following mutual fund averages:

Alternative Energy Funds     +92.89%

Global Science & Tech        +65.00% (C)

Science & Technology         +52.21%

Multi-Class Growth Equity    +42.89% 

(C) Canadian Information Technology stocks +80.65%

Typical Stock Pickers Play Differently

Picking stocks is an old art form encompassing both short-term gambling and long-term investing. One of the main mental attitude differences between an almost exclusive focus on picking stocks and portfolio management, is that stock pickers focus almost exclusively on the performance of individual holdings, whereas professional portfolio managers focus on the performance of the entire portfolio. This usually leads to a stock picker having a more limited number of holdings, with many driven by the same market dynamics. Many newer stock pickers are entertained by the frequent examination of price volatility, intending to hold if his/her stock prices rise relative to other immediate alternatives. The focus is often on what is happening in the market and/or in the headlines, not on the fundamentals of the company which happens to have the same name as the stock. If the stock disappoints, the player sells and either buys something else or totally withdraws from the market, until a new wave of speculation gets his/her attention. In viewing the history of stock-pickers, one is reminded of what is said about pilots “There are old and bold pilots, but there are no old bold pilots.” 

That speculation burns out many inexperienced traders is unfortunate, not only for them but also for the nation. We have reached a point where the number of new companies equals the number retiring, either voluntarily or involuntarily. Among the reasons are demographics, labor and other capital productivity, regulation at various levels, and tax rates. One of the reasons US productivity was a world leader was the birth rate of new ventures and the success of some. Among the biggest advantages a stock picker has is that he/she does not have to play and record of results is not known. If the record is self-disclosed, it may not be believed. 

The Professional Portfolio Manager Plays a Different Game

The biggest risk for most professional managers is career risk, either losing employment or reputation. Furthermore, the portfolio manager is constantly being measured against supposed peers and externally identified time periods. At times absolute and relative investment performance are paramount and at others presumed risks is critical, whereas for some accounts cash generation is most important. For example, in 2020 the same account could be a relative leader or laggard and finish the year with very acceptable results, depending on the period selected. In some cases, when an institution borrows money during a period of economic strain, cash generation or volatility is critical to making payments or maintaining credit ratings. Because of COVID and a disruptive economy, some institutions have become much more sensitive to short-term results, whereas others look at the same characteristics through a longer-term lens and see new opportunities and risks.

In contrast to the stock picker, a portfolio manager looks at each investment not only in terms of its investment merit, but also its role in creating the appropriate balance in an account in terms of risk and reward. While a stock picker would ordinarily be delighted to have every one of his/her holdings do well, a professional portfolio manager would be concerned, fearing a change in the impetus driving the market could make the portfolio a very risky vehicle. In income-oriented portfolios, the timing of flows is critical to meet payment obligations and that can put constraints on the structure of the portfolio.

Unlike the private investor, most professional portfolio managers can’t afford to be out of the market, as most outstanding performance requires ownership on key turnaround days. The best a manager can do if the market is moving differently than what is perceived to be correct long-term, is shift the relative volatility of the portfolio, with a willingness to move quickly into higher volatility when the trend is what it should be.

How are You Protecting Against Unwarranted Speculation?

• Ignore?
• Raise Cash/Short-term vehicles?
• Change Volatility?
• Prune holdings which don’t help?
• Or something Better?   

I like quoting Ben Graham, not only because of his well-earned knowledge but because of the New York Society of Securities Analysts gave me an award named after him. He is quoted as saying “the essence of investment management is the management of risk, not the management of returns.”

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

https://mikelipper.blogspot.com/2020/12/stud-poker-new-swamp-game-weekly-blog.html

https://mikelipper.blogspot.com/2020/12/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/12/searching-for-surprises-weekly-blog-659.html

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A. Michael Lipper, CFA

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IS LAST WEEK SIGNIFICANT? - Weekly Blog # 588

Mike Lipper’s Monday Morning Musings

IS LAST WEEK SIGNIFICANT?

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

There were some clues this week as to the possible future direction of the US stock market and the likely leadership for various future periods. Both the S&P 500 and the NASDAQ Composite had their single worst week of the year. I view the performance of the NASDAQ as a better predictor than either the S&P 500 or the Dow Jones Industrial Average (DJIA). The gains from the common low point of the year on January 3rd through this past Friday were: NASDAQ +23.83%, S&P 500 +19.78%, and the DJIA +16.74%. This order might be representative of the level of speculation, or at the very least the reverse order of dividend yields.

It may also be instructive to look at the number of new highs and lows for the week. The New York Stock Exchange registered 603 new highs and 250 new lows vs. the NASDAQ’s 322 new highs and 337 new lows. From this data one might conclude that this week’s decline was more a function of correcting from recent enthusiastic gains rather than representing a fundamental change in direction or future leadership.

Possible Causes for The Decline?
On July 31st the Fed’s announced that it was dropping interest rates by 25 basis points. The market was up after the announcement but turned lower during and after the news conference and then fell for the next two days. The NASDAQ had a ratio of losers to gainers of 1.91/0.73. Why? The following list might suggest some reasons:

1. Buy on the rumor and sell on the news is normal.
2. Disappointment that further interest rate declines were not identified as likely.
3. Because of the growing number of consumer and commercial credit extensions, rates should be rising to discipline the market.
4. China’s leadership is in no hurry to address trade tensions while increasing control over all elements of its society.
5. Disappointment with the two Democratic candidate television debates.

The first possible cause is a normal trading reaction. The second is mainly a concern for rate changes during the next 12 months. The third is a concern as to the depth of the next recession. The fourth and fifth causes might impact not only the next presidential election, but also the conditions during the next presidential term.

If only one of the five is important a single portfolio structure can be created. If more than one is important, it reinforces the need to subdivide one’s assets and liabilities into separate timespan portfolios, which we can help construct. For example, if one looks at various slices of the S&P 500 for the last month, the order of the four best performing slices were: S&P 500 Enhanced Value, Value, Growth and Quality. (We have maintained that value-oriented portfolios might perform relatively well coming out of the next recession. In anticipation of this, at least one manager we follow used the brutal decline in the fourth quarter of 2018 to buy some bargains and then used the first quarter of 2019 to lighten up on extended growth companies.) If one wishes to look for possible dramatic turnarounds, the worst mutual fund investment objectives this year through Thursday were the international value fund categories. They have generated average gains between 5% and 7% vs. gains between 23% and 28% for domestic growth oriented funds.

Not Market Timing
Market timing is a process that requires making three decision in a row. The first is to sell. The second is where to place the money in reserve, and the third is the new buy. The odds of making three correct decisions in a row is very difficult and only a few investors can achieve it. The biggest mistake is often made with the reserve element, as cash usually becomes too comfortable and delays re-engagement with risk. The third, which is the most difficult, is to choose something sufficiently different from the investment that was sold.

Further, market timers tend to move the whole portfolio all at once. I suggest a gradual approach, which allows for confirming that the basic view has not changed over time. One of the advantages of using mutual funds as your preferred vehicle is that it allows you to focus on changing investment characteristics, something the funds themselves are generally not set up to do. You are taking advantage of their selection skills in rapidly building a sound portfolio.

Is the Past Week Significant?
I suspect it is an appropriate time to start to move the portion of your portfolio designed to make payments over the next five years or so. For longer-term portfolios this may not be the time to make moves, particularly for those investors that have at least ten years before needing to make payments. One should definitely be judicious in making changes in legacy portfolios.

   
Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/07/chinese-emperors-learn-all-roads-lead.html

https://mikelipper.blogspot.com/2019/07/us-stock-markets-new-highs-misleading.html

https://mikelipper.blogspot.com/2019/07/twin-problems-not-enough-greed-and-too.html



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Copyright © 2008 - 2019
A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

2018 Lessons Should Be Learned - Weekly Blog # 557

Mike Lipper’s Monday Morning Musings

2018 Lessons Should Be Learned

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

                        

            

The biggest benefit from living are the lessons that could have made us healthy, wealthy, and wise. To ourselves and our loved ones the biggest losses are those lessons we could have learned and didn’t. 2018 has been a tumultuous year, but it gave us numerous opportunities to learn to improve the way we think and thus shift the odds of future results favorably.

We should have learned to reduce the use of labeling as a part of decision making, particularly in terms of labeling people with a single identity. This was brought home in 2018 in cheap polling to make political and investment decisions. Think of yourself, how many words would be appropriate to describe you as a person, as a family member, as a voter, or as an investor? We use easily descriptive labels as a short-cut to building the ultimate equation for decision making, without allowing room for contrary modifications imbedded within each level, e.g. child of, native language, health condition, source and quantity of debts and composition of assets, etc. This is not a new phenomenon, William Shakespeare’s plays often spent the first act describing or labeling the main characters and their current condition, only to change readers views by adding humor, pathos, and most of all surprises in later acts. He delivered an unexpected conclusion and a great opportunity to learn about the human condition.

Investment Lessons - Trillion Dollar Mislabel

In 2018 the media crowned Amazon, Apple, and Microsoft as candidates to reach a stock market valuation of $1 Trillion. They all used technology, operated globally, were leaders in sales for some important aspect of their business, and compared with the older industrial leaders were relatively young companies. Marketers quickly branded the three stocks along with a few others as a new investment asset class and produced highly focused investment strategies using them as a single investment. Yet they are very different, particularly in terms of their 2017 annual numbers, as shown below:

         Range of Reported 2017 Results

                                High Middle Low
Return on Equity                 49%   21%  13%
Return on Assets                 16%    7%   3%
Operating Margin                 32%   27%   2%
Revenue per employee($000)    $2,013  $841 $314
Net Income per employee($000)   $451  $126   $5
Sales Growth                     31%   23%  16%
Price/Sales                       7x    4x   3x
Price/Earnings                  218x   44x  13x

Clearly there is very little similarity among the three trillion-dollar candidates. One is the leader in four measures and the other two are both leaders in two different measures.  Each stock can be appropriate depending upon both time horizon and tolerance for volatility. Amazon is the fastest growing and its valuation assumes the rate of growth will continue indefinitely and does not discount for single man risk. It could be a worthwhile stock for very long-term time horizon investors who can take advantage of periodic volatility. A great investment for grandchildren with doting grandparents.

Apple is evolving into a quasi-annuity producer based on its store and mail order ecosystem. (While people did not realize it, the main auto companies thought they were doing the same with their annual introduction of new/improved cars and a predictable scrappage rate, which worked if the new cars were attractively priced and life-styles did not change). Apple is the only one of the three that I directly own and I’m happy to own it because its numbers and prospects are what a private company would want. Thus, I am comfortable with it today as a value-oriented holding. Microsoft is fundamentally a software manufacturer for its own devices and products of other manufactures. Because of the cyclicality of demand, it requires higher margins to carry it through changes in cycles. In recent years it has been more successful with its newer products and services. All three will benefit from “the cloud”, but there will be a shakeout in the path to the cloud and this could produce disproportionate surprises.

Market and Economic Statistical Mislabels

Even before Biblical times there were records of seasons and agricultural cycles. While there was some periodicity in their occurrence, it was chalked up to weather patterns which were in the hands of the gods and did not occur with mathematical predictability. Today we label these cycles mathematically if they drop by 10% - 20% from their prior highs. We use two continuous quarters of economic declines as a measure of recession. These mathematical measures are not connected to the cause, frequency, and duration of the poor results. In an ever-changing world I question if these measures have anything but media value. Thus, I do not believe that the stocks traded in NASDAQ are in a bear market and those listed elsewhere are not.

To me the causes of both bear markets and economic declines are man-made. Bear markets are caused by excess speculation that dries up investor reserves, either through direct commitment or through borrowings that provide the large amount of leverage used by speculators. Recent reports show that margin debt, free credit balances and short interests have been declining instead of expanding as in most speculative surges. (We can still experience stock market declines, but they are unlikely to be severe). I do not hold out the same relaxed attitude for the credit markets, as they are showing signs of speculation as new participants buy covenant-lite provisions at interest rates that are too low for the possible increases in defaults.

Economic and financial declines are the results of political and business leaders attempting to keep an aging expansion going beyond its normal life. Most US CEOs of public companies are in place for five years and most politicians are focused on their next election, typically in two to four years. In each case their rewards are very time sensitive. Their choices of action favor current stimulus rather than long-term solutions to fundamental problems, which include the integrity of education, enforcement of laws and regulations, immigration controls, health care, defense, and the development of new generations of leadership.

Thus, it is clear to me and others that there will always be bear markets, recessions, and depressions. Louis XIV recognized this with his statement “after me, the deluge”, as he weakened both the power structure by centralization and the economy by spending on continuous wars. Having written that, I echo St. Paul’s plea to avoid retribution “not now”, I believe we need to experience more unwise speculation, higher capital expenditures by business and even larger deficits before we suffer our deluge.

Two Warnings

This somewhat comforting view can be disturbed by two potential problems:

• Firstly, China’s leaders clearly see the challenge in their race to become relatively rich per capita before they become too old to work productively. Their cities need to continue to absorb those leaving rural areas of the country, which is straining under the weight of excess capacity as it transitions to more service and consumer-based jobs. This pivot must avoid reduced debt payments, particularly to government sponsored banks and to some shadow banking groups. The authorities are willing to sacrifice the underlying equity if both the banks and employment can be saved. These actions are not just of academic interest to the rest of the world. Just as countries can and do export inflation and deflation, they can export credit problems too. The way they do it is by passing risk onto external owners of credit and equity. This is already happening as China opens up to foreign investment. Some of the foreigners may be sufficiently skilled in working through Chinese bankruptcies, while others may experience serious losses that show up on their own books. This risk and the decline in the purchase of imports, or foreign branded merchandise made or assembled locally, can make China a different risk for the rest of the world, particularly the US and its multinationals.
• The second problem is that there is a significant chance that the next major economic cycle we experience after a likely recession is going to be quite different than those of the past thirty years. Consumers and businesses will accelerate their dependence on global trade. Countries can no longer afford the expense of national champions. Any place in the world where there is a perceived high margin business will be under attack. Many will be disrupted. Political leaders will eventually shift their alliances from local employment centers to national, if not international consumption bases. Some future political leader will say “We are all Consumers”. Technology and education, not schooling, will penetrate former protected positions. We will be surprised and suffer some pain as we work through these experiences. Hopefully our descendants will benefit.

December 30 Conclusion 

Monday will be the last trading day of a year and is one we would not like to re-live. But there is a slight chance we could have an explosive day in the markets on Monday. If it were to happen, a few lucky managers could claim a wining year, where most of us will have to admit that we lost some money for clients on paper in 2018. More importantly, 2018 investment performance should be looked at in comparison to the double-digit gains of 2017 and the good gains of the last ten years. More importantly, our clients should understand that occasionally we collectively can suffer losses and not lose position for better results in the future.

We wish 2019 will find our readers healthier, wealthier and wiser.

Question of the week:

How much of your portfolio is managed for a bear market, recession, and recovery?

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2018/12/cash-is-four-letter-word-weekly-blog-556.html

https://mikelipper.blogspot.com/2018/12/news-focus-may-drive-investment-success.html

https://mikelipper.blogspot.com/2018/12/investment-memory-friend-or-foe-answer.html

Did someone forward you this blog?

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.