Stocks Are Not Concerns of Contrarians; Structure & Debt Are - Weekly Blog # 510.

Introduction

I attempt to learn every single day. Further, as a disciple of betting on racehorses, I am always searching for the potentially successful contrarian bet. Contrarians perceive potential future developments different than the crowd. Thus, they almost always are premature and often wrong. However, since contrarians by definition have fewer followers when they are wrong (or too premature) losses are relatively small.

Normal Stock Markets Decline

Anyone that has studied the laws of gravity or were a ground-crunching US Marine, is used to a long march up a hill or a stock chart followed an accelerating decline. We should have expected it because of the length of the past performance streak.

For the last ten years earnings growth has been declining and most of the time operating earnings have been growing in the mid-single digit range. On the other hand, due to the central banks/governments’ manipulation of interest rates, risk assets mainly stocks, attracted inflows. Using the average US Diversified Equity Mutual Fund  investment performance for periods ending at the end of January produced the following results:

Average US Diversified Equity Fund Performance

Period Length	% Total Reinvested Return
One Year	+21.34%
Two Year	+ 20.96%
Three Year	+ 11.12%
Five Year	+ 12.53%
Ten Year	+   8.12%

Any follower of statistical streaks, e.g., Super Bowl winners, election victories, or rainy days would doubt the continuation of a streak. Despite the Atlanta Fed’s latest forecast of GDP 2018 growth of 5.4%, streaks end  often to the disbelief of the crowd.

First Contrarian Concern

The stock market structure  has changed and some very successful people are betting on further changes.

A strategist at JP Morgan* has noted that there has been massive redemptions by commodity trading advisors and risk parity pools. Charles Schwab* has noted massive unwinding of “short vol” and other positions to meet margin calls. In the latest week, according to my old firm, conventional equity mutual funds had net redemptions of $3.1 Billion and equity ETFs had net redemptions of $ 20.8 Billion. While there may be some double counting in these observations, what is clear to me is that the trading community reacted much more and faster than the longer-term investment community. (We can discuss privately whether we are seeing modern day Sir Issac Newtons at work.)

From a longer term point of view I am much more concerned in watching three of our most prominent investment leaders adding dramatically new (to them) investment activities. Goldman Sachs* going into consumer small loan business through Marcus. Black Rock announcing that it wishes to raise $10 Billion to permanently invest in long-term minority positions similar to Warren Buffett and Charlie Munger at Berkshire Hathaway* and some of their other holdings. Blackstone becoming the 55% partner in ThomsonReuters* financial services, currently managed by Reuters.

*Owned in a private financial services fund or in personal accounts

Each of these may make sense, but requires the use of talents that they may not have already.

What is much more significant to me as a stock market investor is that they are saying that their existing businesses are insufficient to produce enough of the expected profits.  When a crowd moves to a different casino table or shrinks around a trading post on the floor of a stock exchange, one has to wonder whether these bright people are saying something very fundamental to which we should be paying attention.

Second Contrarian Concern

One of the reasons for the victory in the last Super Bowl was the winner had better defenses than the loser. When Marines are forced to go into a defensive position they continue to examine it for possible weaknesses. Most defenses are based on an orderly collection of principles. The two main fixed income considerations are duration/maturity and credit quality. 

Around the world the search for somewhat acceptable yield has led to record sales of bond funds and other credit bearing devices. Due to low and until very recently declining yields, investors have been lengthening their duration to get higher yields even though central banks/ governments are raising rates. The traditional ethos of investing in fixed income is that one makes money through receiving interest payments and hopefully reinvesting them wisely if they are not consumed. Most of the time investors are not concerned about losing principal as the bonds promise to pay off at par. Great theory, but when rates change and fixed income prices decline, bond fund net asset values decline. This is what has opened in the year 2018 up to February 8th. The average Core Bond fund on a total return basis declined-1.67%. This is the largest category for retail investors. Even more disheartening was the performance of the general US Government funds -3.83%. This demonstrates when rates move up a small amount investors can lose money. One needs to remember that there have been periods when high quality rates reached into the double digit range.

My real concern is the possibility of some credit instruments not paying off in full or on time. As someone that sits on investment committees that are besieged by the newest and latest credit instrument vehicles, my guess is that many will be okay, but some may not. For example, a credit fund for a management group that has had prior trouble announces its week even; with 40% in cash they have felt it needed to reduce its net asset valuation in half. Many of the new credit vehicles in the US and other markets  are staffed by bright people who believe in the numbers provided and their derived algorithms. As interest rates move higher, integrity throughout the system may not.

While one can certainly lose more money in stocks than fixed income securities, the expectations are different. In fixed, one expects most of the time is disappointment with the smallness of the gains. Most investors do not expect to have any loses in fixed income. At this point in the cycle, one should be aware that there can be losses and on an emotional basis of disappointment there can be more risk in fixed income than in recognizable volatile equities.

Question of the Week: What are you watching for in terms of fixed income risk?  

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Friday and Super Bowl Investment Lessons - Weekly Blog #509

Introduction

Sound investment thinking should not be isolated into an island of investment and economic numbers. The powerful future trends are not found initially there. The future is determined by people and how they think and occasionally react to what they feel about what they think they see. On this Sunday we are between Friday’s worst stock market decline since 2016 and the most significant Professional Football championship. Both or neither could be guides to the 2018 investment future.

Friday’s Stock Markets Actions

Depending on your personal favorite stock price measure, there was a low to middle digit percent decline was the beating headline. Far too many saw the fall as an automatic signal of potentially a much bigger slump. As usual, too many did not look further into it to see the significance. To me, they missed three important inputs staring with the smallest and moving through to more major structural issues.

Warehouses Provide Pricey Liquidity

Early in my investment career at a famous trust bank, I came across some large cap stocks that were unlikely to be price performers that were in numerous otherwise reasonably sound portfolios. The conservative investment still carrying the burden of the learned Depression experience were afraid in the 1960s that the then economic expansion would end with a substantial stock market decline. They had learned the risks of premature market timing and opted to put a portion of their client’s trust money in stocks that would rise in some symphony with an expanding economy, but would fall less than the market when the turn came.  The classic warehouse stock was AT&T which had not changed its common stock dividend since 1922. In effect it became a bond substitute and rose when yields declined and grudgingly held most of their value when interest rates rose in a contraction. (The current AT&T is not the same company and today may or may not be attractive due to its relatively high yield and the prospective benefit of the forthcoming 5th generation of the internet.) The owners of warehouse stocks were not criticized when they cashed in these stocks and used the cash to cushion the portfolio decline and eventually use the cash to buy more aggressive stocks at cheaper prices.

What appears to have happened Friday was several handfuls of large cap stocks fell more than the general market excluding these stocks. Many of these stocks were dominant holdings in Large Cap Growth mutual funds and similar ETFs. Numerous Mid and Small Caps fell much less. Is that due to the fact that they did not have a “warehouse function” on the way up or that their owners recognized that the trading capital in the market was unlikely to support significant sudden liquidation of the smaller brethren?

What I takeaway from Friday’s market action is a concern that there is not sufficient liquidity in today’s market to absorb easily a broad scale sell off.

Liz Ann Sonders/Minsky Moments Explanations

Liz Ann Sonders, Charles Schwab leading market analyst points out that there is a history of years with low stock price volatility and are followed by higher ones. As one of the better analysts on market sentiment and its limits, she points out that in the last three weeks in January the S&P500 went up over 7.5% and if annualized would have added 155% for the year.

Her caution parallels an earlier worry of the great Austrian economist who noted that periods of economic stability end with periods of instability.

Bottom line: too much complacency can be dangerous to your wealth.

Supply/Demand Better Analysis

All to often we make financial decisions based on numerical comparisons. Yet what we call judgment in many cases are human memories that our brains carry. For example, we tend to measure corporate success in terms of dollar revenues. Many automobile manufacturers are showing record dollar revenues, but in terms of units sold or even more important, number of customers/ families served, the results are more discouraging. The shift from two door sedans to five door SUV models hides these trends. The current enthusiasm for stocks is based importantly on better profit margins as taxes and burdens of excessive regulation are enlarging profitability. Most of the countries in the developed world have reached peak population except for immigration. In the US we have one birth every eight seconds, one death every ten seconds. Including migration, we are adding one person every eighteen seconds. Global population  is adding 4.3 births per second with deaths 1.8 per second which translates to 2.5 persons per second. This suggests that the US population’s future economic growth is more likely to come from serving and being served by people in the Southern Hemisphere with particular focus on Africa and Southeast Asia.

While I can direct our clients investment policies to these geographical   centers, until our society does we need to understand our loss of economic and financial ranking. What may make this task even more difficult for their own needs, government and central banks are attempting to manage inflation. They have not been particularly successful. Apparently inflation is actually a derivative driven by currency and trade. These in turn are propelled by a combination of consumers and commercial interests.

Hopefully Friday’s action suggests to all of us that we are living in a changing world where the future is not going to be copied from our old experiences.

Boston-Philadelphia Super Bowl Investment Lessons

Perhaps it is particularly instructive to search for investment lessons from a championship that puts football teams from these two cities against each other. While these two are no longer the largest or politically the most powerful cities in this country, they have contributed greatly to the formation of the US global financial community. Boston due in part to being the home port for the ships that spent years trading with Asia developed a culture of trusted capital management. Even today much of federal and other states’ law that directs much of the fiduciary principles that supervise the asset management industry. At one point there was more money managed by Boston law firms than the mutual fund business.

Philadelphia was not only the home of the Congress at the beginnings of the United States it also developed the key to capital equipment financing. Philadelphia lawyers created railroad equipment (boxcars) leasing certificates which created a global market for transportable assets and in turn supported the global market for mortgages.

For twenty years until I resigned, I advised on the management of the defined contribution plans for the National Football League and the NFL Players Association. From this experience, I believed that on any given day any team within the NFL could beat any other team. Thus as of this  Sunday afternoon I do not know which of these good teams will win. What I do know that the winner on a net basis will have the best combination of offense, defense, capitalizing on surprises, and leadership throughout their organization. These are the very same characteristics that I look for in selecting fund management organizations for our clients. Other inputs for us today are an assessment as to consumer acceptance and politics as seen through the eyes of the media which will color some of our investment thinking as well.

In Conclusion

I hope that we can draw appropriate conclusions from both Friday’s price actions as well as the Super Bowl; thus to be able to manage wisely the year ahead which is likely to be more difficult than 2017.

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A. Michael Lipper, CFA

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Four Investor Risks - Weekly Blog # 508”

Introduction

For equity investors and many workers, things are going well. While the upturn is relatively new it is pushing out fears of declines for many. Investing is an art form that pulsates through various themes and it would be wise to recognize past patterns of their ups and downs. Some look to history for specific fact bases to avoid. A more useful review of the past is identifying emotional/psychological patterns that repeat themselves throughout history.

One of the advantages of being steeped in the history of mutual funds is one can see repeated patterns which in the past have acted as beacons of troubled waters. These beacons identify past problems without promising avoidance of future ones. In my ongoing study of mutual funds and similar vehicles I am seeing four potential subsets of problems that current investors should be tracking in their investment thinking. Non mutual fund investors often have parallel concerns.

1.  High Growth Investing

In most stock markets most of the time there is a subset of traded securities that is leading the market higher. Often these are either reporting or expected to report higher earnings. Their products and services either at present or in the future have little in the way of completion. Some of their perceived advantages may be temporary. These high growth performers enjoy stock price momentum. In the current market place these would be the FAANG + Baidu & Tencent.  These leaders have driven the performance of a significant number of mutual funds and other managers. Their upward momentum can reverse quickly due to any real or perceived changes in their advantages.

2.  High Quality Growers

A coterie of high performing funds was divided into two groups of strongly performing funds and stocks, (1) high growth, and (2) Long-Term quality. Coming out of the recovery phase of the equity stock market decline, ending in March of 2009 and becoming more pronounced after 2015, the perceived to be high future growers gained momentum. A second group of stocks rose in prices but at a slower rate of appreciation. This second group was often developing a broader product line with a higher service component than some of their higher earnings competitors. An interesting question is when the high earnings stocks and funds enter a decline will the companies that have a better balanced business portfolio be treated better?

3.  Agent Career Risk

One of the emotional realities of employing an Investment Advisor is that often in the mind of the capital owner is the distinction as to who is responsible for the investment gains and losses achieved. Emotionally the gains are in part attributed to the wisdom of the owner and losses are largely consigned to the agent/investment advisor. 

As of the time of decision making whether an agent is to be retained or not there are two very different quandaries. The first is the past record of the account including the various alternatives that could have been used plus the cost and bother of execution. In addition, one needs to add into the mix the personality of the capital owner, including tax attitudes. Another important consideration what should be the measuring rod for comparisons and what is the relevant time period. The second set of questions starts with a belief as to the nature of the future investment period and the likely differences from the recently completed period.

4.  Capital Concussion

The future is always difficult to predict. This is particularly true today. We have entered the first of what I suspect will be a series of changes in tax laws, regulations, and court cases as well as state and local changes. Further these changes will impact both individual needs and desires of present and future beneficiaries. These evolving changes in total may dramatically alter not only each of its investments, but also the structure of the investment markets.  

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Misunderstanding Technology Can Be Dangerous - Weekly Blog # 507

Introduction

Investors do not understand the current stock markets. Globally most stock markets are rising and most have reported record highs in spite of political instability. The driving forces are both normal and novel. In many economies we are experiencing a normal cyclical recovery as both confidence is rising and memories of past crises are receding. What is more novel is the exponential growth in the use of technology to address many problems.

One of the advantages of being part of this blog community is that we have a large number of thoughtful members. One of the most responsive members has called to my attention a Financial Times article by Jim McCaughan, the CEO of Principal Group Investors with the intriguing title “Investors must get to grips with impact of technology.” While contemplating this article I examined a report on the S&P and the Dow Jones Sharia indices. These various stock market measures show that in many of the emerging markets and frontier markets that cater to those who wish to follow the Sharia laws for investing, that information technology is the best performing segment. This is appropriate because the growth of technology is accelerating economic growth. When illiterate farmers can price quotes and weather forecasts daily on their cell phones, they will manage their own economics better. Their families will also benefit when they can react with professional medical and nutritional experts. Perhaps these advantages will become the most effective birth control devices the developing world has ever seen.

In my continuing search for understanding why so many very intelligent people continually make more economic and perhaps political decisions that prove to be unfortunate, I suspect that they are using faulty memories of incomplete and in some cases faulty data. It almost seems the more PhDs and other credentialed “experts” that analyze a problem the odds of finding the “Aha moment” decreases.

Measuring The Impact of Technology

I suspect that no class of financial institutions has more learned PhDs than the central banks, particularly the Federal Reserve System. Yet as a mass they have been surprisingly unsuccessful in predicting inflation as it drives their policies. For example they rely on payroll data and other information from the IRS. There is little attempt to capture unreported income. In many countries the “informal economy” is of sufficient size to question the aggregate, growth, and relative ranking in global tables.

Perhaps the biggest failure to capture the economic reality is in the measurement of consumer and commercial prices. On the surface it is reasonable to assume that technology is deflationary otherwise it wouldn’t be bought. The deflation is not just in reported prices, but more significantly the added value that brought through technology. For instance how much are we better off in general with cell phones than landlines? What is the net benefit of shorter transportation time due to speed and safety of mass transit? These are not easy calculations but suggest that the real economy has been growing faster than realized due to the deflationary technological input. Is this the reason that no developed country has hit the 2% desired inflation target identified by the New Zealand central bank?

On the other hand we should also be measuring and understanding the disruption that technology has caused in terms of unemployment and wasted capital resources. Hopefully, we will see more re-engineering and rebirth of former sites. For example some shopping malls are becoming education, health, and service providers. Once services providers can demonstrate value added through sales and retention skills, these wages will move back to old industrial levels. They will accomplish this through smart applications with personal choices through the use of technology.

What Does The Future Hold for Investors? Avoid Reliance on Numbers

First, the question is flawed. The biggest single mistake most individual and institutional investors make is to think of the future as a singular event. One of the reasons we have evolved our TIMESPAN L Portfolios® is to force investors to allocate their resources to different timespans based on their own needs and proclivities. The allocation of capital and intellectual resources is the single most effective method to reach most goals.

Second, is how to handle the various types of price declines (seasonal, cyclical, secular, normal, abnormal). As we can’t avoid them, we need to set some policy goals as to which we “grin and bear it,” make partial adjustments, radical change, or more appropriately different actions for different timespan portfolios and/or different levels of fiduciary and commercial responsibilities.

Third, questioning to perceived wisdom based on unadjusted history. For instance, searching for persistence. Looking backwards for various periods of time which are heavily influenced by beginning and ending conditions there appears simplistically little persistence particularly in top quartile performance rankings. Most individual and institutional investors are goal oriented not ranking oriented. History suggests that the main value to an investor is the timing of the initial investment as well as flows into and out of the account. By definition the biggest gains come from buying into a lowly regarded price and selling into excessive enthusiastic prices. Persistence is rarely found in humans, sports teams, and political leaders. Allow me to demonstrate with the use of fund performance statistics from my former firm, Lipper, Inc., now part of Thomson Reuters.

For the five years ending Jan 18th, 2018 the average S&P 500 Index fund had a compound growth rate of 15.36%. Not only is this way above a historical average it is better than all other mutual fund investment objectives except five, including Large-Cap Growth which had a 77 basis point better return. This may show the advantage that we have maintained for a long time that for some remaining fund holders net redemptions can be a positive, as all portfolios can use some pruning. More importantly, performance while it does impact sales, is not particularly related to redemptions which are more time based. Referring back to the main topic of this week’s blog: technology, the best single performance group was the Global Science/Technology fund which gained 22.09% vs. the average S&P500 fund that gained 15.36%. While I don’t know who will be the winners for the next five years, I think it won’t be the S&P500 index or the Global Science/Technology funds.

Some Straws in the Wind

Before a significant storm often, there are some straws in the wind. The following anomalies are noted:

Barron’s Best Grade Corporate Bonds yields went up last week 8 basis points which means their prices went down a proportionate amount. However a similar index of intermediate credit grade bonds yields only went up 4 basis points. Typically high grade investors are more safety oriented and credit investors more income focused. The possible importance of these observations is to not worry about the safety of high grade corporates paying off their obligations in a timely manner. I believe the significance of the price decline is that these investors and their dealers are worried about their near-term bond prices because of a surge in the supply of high credit bonds. If these fears grow it can create instability in the bond market which could impact the stock market either because a change in outlook or a credit shortage supporting the stock market,

The AAII bulls are running again with 54% of their weekly sample bullish compared with the pull back experienced the prior week of 49%. The bears pulled in their teeth with a reading of 21% compared 25% the prior week. Momentum is continuing.

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Copyright ©  2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.