Twin Problems: Not Enough Excitement and Too Many Fears - Weekly Blog # 584

Mike Lipper’s Monday Morning Musings

Twin Problems: Not Enough Excitement and Too Many Fears

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

Stock Markets Don’t Confirm New Highs 
On the Wednesday before the July 4th US Independence Day Holiday, the US stock market indices reached new highs on low volume. On the next trading day, in a shortened session, there was no enthusiastic follow through. Is the very slight decline is a symptom of a self-correcting advance that likely curtails a significant enthusiastic response in volume? Greed is now not overcoming the sense of ennui or complacency. Those not fully participating have lots of fears, like:

• The timing and nature of a stock market reaction to the oncoming recession?
• Unattractive political leadership choices
• Global strategic issues  

These considerations and others were on my mind over the last four weeks when my wife and I visited London, Dublin, Melbourne, Uluru, and Sydney, where I talked with investment professionals and other investors.

Lessons from Uluru
Most investment types are very quick to adjust their thinking to the headlines of the day. As a brother of a US Marine Corps Reconnaissance veteran from the Korean War and my own search for appropriate long-shots, I wonder whether the right questions are being asked? In some ways the visit to Uluru helped crystalize my concerns, which made me re-think what I saw in London, Melbourne, and Sydney.

Uluru is in a desert in the Northwest Territories, in the middle of Australia. It celebrates the Aboriginal worship of the massive rock formations sacred to them. In Uluru we found a good regional airport, a bunch of modern hotels, a fleet of tour buses and crowds of tourists, both from Australia and from around the world, with a focus on tours from Japan. Hotel reservations were difficult to obtain and the entire commercial scene was an enormous bet that tourists will continue to descend on Uluru for a long-time into the future. In a somewhat similar fashion, visits to London and Sydney, as well as my experience walking around New York City, one can’t help but be impressed by the huge amount of permanent capital being invested in the continued growth of mid to high price tourism around the world.

Excess Expansions Bring Tears
I have often said that if one cuts into a securities analyst a historian will bleed. I have started to question whether this global outpouring of capital into hotels is somewhat like the gold rushes in the US, Canada, Australia, and South Africa? There were similar surges in the building of  the transcontinental railroads in the 19th century and the over 300 automobile manufacturing companies competing in US and other countries in the 20th century. Closer to the present, one could look to the “Dot-Com” and sub-prime periods for phases of euphoria.

Demand Failures
There are many ways to look at these expansions and collapses. Most attention has been directed at what proved to be unsound financial arrangements, which in some cases were fraudulent, but in all cases were the result of bad judgement. Many of the dreams of the “Dot Coms” have subsequently been delivered, but by different groups with largely overseas resources. The biggest problem for the owners of over mortgaged homes was that momentary supply exceeded demand. To me, a more important issue was the failure of demand or substitute demand. Where could the talents involved have been utilized? Where could the workers and their families have found paying jobs?

Financial Services Clues
I pay particular attention to the Financial Services businesses, where almost all the participants in this global industry are trying to present themselves as Technology companies that happen to be dealing with financial matters. I wonder if this is similar to GE and many large industrial manufacturers in the 1950s, who began divisions to be in either Atomic Energy or Computers. Currently, Financials are competing with Tech companies for both experienced and inexperienced credentialed employees. They are paying Silicon Valley wages and are trying to manage these freer spirits in a more regimented company. In the academic world, are we producing too many people to find long-term employment in Fin Tech? On Friday, the only major group to go up in price was Financials, a rare occurrence. The thinking behind this rise was that good employment numbers suggest the postponement of the expected drop in interest rates by the Fed and many Financials would gain due to level or higher interest rates.

Low Rates Produce Long-Term Troubles
Paradoxically, lower interest rates are not favorable long-term for the economy. Low rates encourage the issuance of lower quality credit loans or the renewing of loans of deteriorating borrowers. Furthermore, the lower the rates the less power the central banks have to step in and prevent major financial failures. Perhaps the most negative implication of low interest rates is that it does not address the globally growing size of the retirement capital deficit in a world when people are living longer and more expensively.

Question of the week:
Do you see excessive expansions?


   
Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/06/reduce-investment-mistakes-with-deeper.html

https://mikelipper.blogspot.com/2019/06/our-investment-mistake-is-in-labeling.html

https://mikelipper.blogspot.com/2019/06/mike-lippers-monday-morning-musings.html



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Could the “Stress Test” be a Big Trap?

Beginning Monday and perhaps lasting for a week, savers and investors will look forward to the publication of the results of a series of stress tests on the 19 largest domestic financial institutions as to their safety and soundness of their capital. While I do not know the details of the measurement of these tests, the absolute reliance on them seems to me like a dance at the “Mad Hatter’s Tea Party.” In my book MONEYWISE, I identify one of the causes of risk of loss of permanent capital is unanticipated events. These warnings were written in 2007 before both the recognition of the sub-prime mortgage collapse and the recognition of various Ponzi schemes, most of all Bernie Madoff’s. In these cases there were numbers trending in the expected direction and the future was expected to follow predicted patterns.

I hope that I am wrong about the statistical stress tests being applied by the government and that in the near term future, all of the financial institutions tested with their present or augmented capital prove to be safe and sound. As humans, as well as many animals, are conscious (or more likely unconscious) odds makers, the odds on the outcome of the tests are somewhat less than completely perfect.

The intent of the tests is to supposedly give us comfort in continuing to leave our capital with these institutions and perhaps more importantly be willing to advance additional capital in the form of deposits, loans, various forms of equity, and counter-party risk assumptions. This exercise is similar to, but not identical, with an acquisition study. In one way or another I have participated on both sides of the acquisition mating dance. Only at the first level of these discussions are the various numbers significant. Additional scenarios are often produced as variants of the original data. These are similar to the stress tests we are all awaiting. However, in an acquisition exercise there are many other analyses performed. Perhaps the single most important analysis is to evaluate management, to determine how much of the past was created by the leadership rather than the environment, and what is management’s expected roles in the future. The 19 financial institutions are all in competitive businesses among themselves as well as other domestic and global competitors. As an odds-maker, I put the probability of significant changes of price and other terms of trade as almost a certainty. (Unless the government will attempt to put into place monopolistic pricing discipline, under some other name, to protect its investment in these financial institutions.) There are many other elements to a good acquisition analysis. There remains one more critical screen and that is trust.

Both financial and intellectual frauds often start as business in the late stages of expansion to make up for earlier, smaller losses. The frauds are expected to be short lived by the perpetrators until assets are returned in full with interest, or when various market share or sales targets are met. Most frauds are begun by previously honest individuals or organizations. I am not suggesting any of the 19 institutions are doing anything fraudulent. However, I wonder if the stress test is leaving enough of a cushion to keep each of the 19 in a safe and sound condition if there has been undiscovered fraud committed by employees or customers/counter-parties. The odds of such occurrences are favorable; the frauds have not been discovered yet, and the people committing the fraud in some aspects may have superior data systems knowledge and capabilities than each of the 19.

The bottom line as a manager of a financial services fund: I look forward to the coming week and the enthusiasm generated by the expected results. However, I am willing to bet a year to three years from now that we will discover that the stress test failed to identify the specific stress that one or more of the financial institutions will go through. For the others that are addicted to investing in stocks and bonds of financial service companies, they may wish to widen their selections and include both large and smaller companies.

Let the games begin this week.