Introduction
What
should be normal for an investor and particularly for a portfolio manager of
other people’s money after a particularly good investment performance, one
should question what can go wrong. Traditionally, September is the worst
performing month of the year. Not only was it a positive month in 2017, but
most of our advised accounts produced better than their individual performance
benchmarks. Since
we utilize fixed income funds, both bond and money market funds as buffers to
equity fund performance, most of our accounts are benchmarked against the
Lipper Balanced Fund Index which is reported daily in The Wall Street Journal. The
long-term record of that index is to produce returns between 5% and 10% with
most of the time in the 7%-8% range and these are the normalized expectations
for this benchmark. We need to keep in
mind that that past performance is no indication of future performance, and
that investing includes the possibility of loss of principal.
Some of our clients’ investments were in mutual
funds that gained over 20% and a few in the 30% range. These funds were
invested internationally and/or invested in the top five stocks in the S&P
500 or their international equivalents. As we manage diversified portfolios we
also own funds that did not do as well as the top performers.
I mention these results as a prelude to my
natural caution; I am casting around as to what can go wrong.
What should be normal for an investor and
particularly for a portfolio manager of other people’s money after a
particularly good investment performance, one should question what can go
wrong. Traditionally, September is the worst performing month of the year. Not
only was it a positive month in 2017, but most of our advised accounts produced
better than their individual performance benchmarks. In the first 9 months of
2017 we are producing returns at two to three times normal long-term annual expectations.
We have invested some of our clients’ money in mutual funds that have gains of
over 20% and a few in the 30% range. Following what should be the normal
reaction after such results I am casting around as to what can go wrong.
A lot can go wrong. At the moment the
three most prominent concerns all have a political base. As a classically
trained securities analyst, I normally
ignore the political world, in part I have observed that contrary to most people’s
logic, news follows the market rather than the other way around. For example
the so-called Trump Bump actually started in July of 2016, not at the election time. One reason
for generally ignoring the shifting currents of the political world is that I
am a securities analyst, more comfortable with financial statements and
operating conditions than attempting to be a political analyst.
Nevertheless the three biggest risks to
stock portfolios emanate from political decisions. Remember that Bernie Baruch
when testifying before the US Congress was defending himself and his
transactions that were labeled speculative. Reminding the Members of the
derivation of the verb ‘to speculate’ was to see far (into the future).
Recognizing that I may be wrong about any one or all three political risks, I
will discuss each in order. The order chosen is in the probability of happening
and the inverse order of magnitude of potential risk.
Risk
#1: Top Potential Casualties
Politicians strive much more for power
than policy. In a capitalistic society there is almost always conflict between
political power and the power of money. Often it is hidden but rarely is it not
present. The battleground between the opposing forces is public awareness which
is in control of selecting the levers that make our society progress. The
following is an incomplete list of industries that the federal government
curtailed through various measures since the aftermath of our very destructive
Civil War, in roughly historical order. After identifying the industry or
company in parenthesis are the government actions.
Railroads (Interstate Commerce Commission
on tariffs); Life Insurance (licensing by individual states); Banking (Federal
Reserve and Federal Deposit Insurance Corp.); Steel (tariffs and labor
disputes); Standard Oil (trust busting); AT&T (breakup) and commercial airlines
(deregulation). I am not suggesting that some of these actions weren’t in
response to public concerns, but in these cases the net results were to force
the companies to drastically change their ways which may or may not have helped
the public more than it hurt them.
As a very powerful Speaker of the US House
of Representatives once stated, “All politics is local.” In most communities
the movers and shakers typically are a small group with a lead the following
sectors: Banking, Newspapers, Auto or Farm Equipment dealers, Doctors,
Insurance Agents, Retail trade and Real Estate. If a number of these feel
threatened by new types of competition, they have an easy access to their
political leaders in Washington - particularly when their regular political
campaign contributions are remembered.
Today the five largest market
capitalization stocks in the Standard & Pours’ 500 are increasingly being
looked at as threats to the established
commercial and therefore political order. The five are Apple*,
Facebook, Amazon, and the two classes of
Alphabet (Google). Their combined market cap is $ 2.9 Trillion or in the
same region as the annual incremental addition to the US national deficit.
Clearly their very market successes create envy, both in the financial markets
and public sentiment. Much more important in my mind is each of the leaders can
be seen as an unintended threat to the cabal that runs our political structures
on both sides of the aisle. I will very briefly identify the threats that can
be conceived:
*Held
personally
Apple is encouraging communications at
numerous different levels which is destroying land line phone companies, local
newspapers, and local financial institutions. Facebook in the last US election
was the source of both valuable and manipulated news.
Alphabet (Google) is the ultimate supplier
of “authoritative” information putting our teachers and professors to shame.
Amazon has just about destroyed the local
book store and is seriously hurting the retail trade. Its very success has
driven its stock prices up at a greater rate than the rest of the stocks in the
S&P500, accounting for perhaps 25% of this year’s gains in some measures.
It also is one of the reasons that active managers who own more of these and
similar stocks are outperforming the identified indexers as well as the closet
indexers. European governments have been among the first to try and corral
these companies and could reduce their residents’ use of these products (which
has happened in China.)
I don’t know how the political power class
will attempt to rein in the power of the new uses of technology, but they may
only be as successful as the Luddites in delaying the march of automation.
While at the moment I am worried and expect the rumors or actual governmental
moves to force a give up of some of the large stock price gains, I am betting
that these companies’ lobbying and other efforts will blunt any serious
moves. However, my tolerance is perhaps
at the 33% level. If your level of tolerance is less, be aware of the perceived
risk.
Risk #
2: Repatriation: Pandora’s Box
Be prepared for disappointing results from
the temporary repatriation tax holiday. Politicians and to some degree central
bankers are steps behind investors and corporations in their recognition that
we are in a post-national world. A good bit of the foreign earnings of US
corporations has been generated from sales of products and services to non-US
residents. To the extent that the foreign branches and subsidiaries have paid for their US capital and research
services, the foreign activities represent potential spin off candidates. This
is the case for a number of multi-nationals.
If they fall for the tax trap and bring
all of the foreign earned capital back to the US, they are probably good
candidates for sale as they don’t believe in their own future particularly if
the bulk of the repatriation goes to buy-backs which helps the existing
management and hurts future owners.
Often when we invest in a foreign to the
US fund, we are investing in foreign multi-nationals. This is similar to when
non-US residents invest in our funds. In truth all over the world, most large
financial institutions invest in large caps globally. They assume that the
companies will be managed to achieve the highest prudent return long-term, not
to solve local tax issues to reduce the size of unwise deficits. It may take
awhile for the politicians to recognize that investors have felt the need to
defend themselves from their own local governments, at least by diversifying
into different legal and tax jurisdictions. Whether we like it or not we have
entered a post-national world. One can expect the politicians to fight it and
try to refocus investors on their home market, but it won’t work unless they
encourage the locals to make their market the most attractive in the world.
This probably won’t happen, unless we drastically shrink the size of government
and regulation.
The risk is that when repatriation for
sound reasons does not produce the flow of money into the US that the politicians
were expecting, the politicians won’t see that they are the crux of the
problem. Most likely they will wish to penalize international investing, which
will be counterproductive and hopefully won’t last too long.
Risk # 3: Lessons from French and Russian Revolutions
The overall theme of recent elections in
India, Great Brittan, US, France, Germany, and possibly Japan and Catalonia is
that voters are angry as to their current position and want change. Many, if
not most, of the current leaders were seen as change agents to solve the
perceived deep problems. However, the problems are indeed deep and have been
growing for forty to eighty years, Thus, they won’t be solved quickly in all
likelihood. That is where the risk comes to the surface and the fearful lessons
from the French and Russian revolutions. In each case the initial uprooting
was led by a middle class leader who was attempting to fix the old system. It
didn’t happen fast enough and there was some mismanagement of resources due to inexperience. In a short time the awakened masses lost
patience. The mob or perhaps an organized crowd consumed the change agents and became enthralled with more radical
leaders. For forty years I have been expecting a wave of change agents which
could have come from either the right or left. If they can’t produce quickly,
they will be replaced. The replacement can come from either extreme, but
almost certainly will be extreme. This threat can only be headed off if the
change agents get some quick early victories and start to come up with some
extreme approaches themselves to head off more extreme approaches of the new
radicals.
Question:
What are the three political risks ahead
of us?
__________
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A. Michael Lipper, CFA
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