Next Race Winner - Weekly Blog # 671

 

Mike Lipper’s Monday Morning Musings

Next Race Winner

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

My best education in picking my next winning investment was not taking the graduate course in Security Analysis as an undergraduate under Professor David Dodd, co-author with Benjamin Graham of the seminal textbook. While the course was very valuable in helping me understand markets, it was not particularly useful in helping me pick future winners, particularly if the future was different than the past.

My single best education in picking winning investments were from the grandstands and paddock at the New York Racetracks. Losing some of your hard earnings on foolish bets did wonders for concentrating the mind. The purpose of this blog is not to discuss handicapping horseraces, but to share an approach for avoiding losses and making betting profits overall.

For purposes of this blog, there are three analytical elements from the track I find useful in picking investments. These elements also help in limiting losses and produce winners over time. (Hopefully, some of my grandchildren and great-grandchildren will learn these approaches as they invest time, money, and emotion in their lives.)

While both security analysis and racetrack handicapping delve into history going back three generations or more, handicapping is more focused on future races or tomorrow’s newspapers than the extrapolation of current trends. One handicapper advantage is the identified conditions of the race are stipulated. How tomorrow’s headlines will impact tomorrow’s investments is unknown. The first analytical task at the track is to compare the conditions, including: distance, weather, track conditions, weight carried on the horse, the jockey, and equipment on the horse. These items, among other things, should be evaluated for all the horse’s recent races and for the upcoming races. (I only wish I had the same level of detail in making marketable invest decisions.) 

In studying the past races of horses, it is worth noting how the horse reacted under past conditions and what the anticipated changes are in upcoming race. Some horses, if they get to the front early on a muddy track, can hold on and win if they are not too tired. Others, that have a lineage or history of regularly coming from behind, particularly on a muddy track, can beat tiring horses. (Some CEOs have no experience being raided or losing a crucial patent case, while others have campaigned successfully in these contests.)

Speaking of the difference in CEOs. Some jockeys use their whip frequently and punish horses not running to their capacity, whereas others ride with a light touch and coax the best out their horses. While one might like one type of jockey over another, the horse owner and future breeder, or the trainer, is probably a better judge. (The Board of Apple fired Steve Jobs who was not doing a good job, but then rehired him after he got more experience at managing a company. They later replaced Jobs, who was ill, with a much different Tim Cook. I have made a lot of money investing in companies that had CEOs I would not want being the trustee of my children or on a desert island, although they did a great job running the company.)

Currently, one of the most useful techniques is to look for horses not moving the fastest in the previous part of the race. Although not winning the previous part of the race, they were passing tiring horses or were accelerating. They did this because it’s the way they run in the early part of a race, or because they didn’t have sufficient racing room. In science & tech, biotech, and entertainment companies, the future is dictated by what is in development, not past financial records.

Applying Track Lessons to Current Investment Policy

For the next generation, the investment world is likely to be dominated by China and the US. In future generations, India, Indonesia, and Nigeria could become fully competitive. Today, a dollar-based score card would have the US far in the lead, probably making it the single biggest component in a long-term investment account. However, China is the fastest moving economy. We may not like the way their jockey rides his horse (Nation), but he has been very effective. He has also recognized the provincial debt problem, which has political implications and needs to be watched. 

There is no reason to doubt China will exceed the US in many ways in the foreseeable future. The actual timing of their taking the lead is a function of the additional weight we are putting in the US saddlebags to slow us down. Thus, any investment should be analyzed with an eye toward what China is doing both at home and globally. Hedging large US investments may require some investment in Chinese enterprises.

A Slowing/Maturing US and Redistribution

On a secular basis, US operating margins have been slipping for some time. We have not noticed it in reported earnings per share due to a combination of issues, camouflaged by increased debt, lower taxes, more foreign earnings, and buy-backs. We have become a mature economy with a small working age population. Furthermore, our school systems are producing people with insufficient real-world education and poor work attitudes.

 

In many ways the current administration is repeating the errors of the 1930s, where the government took a somewhat normal recession caused by excessive leverage and turned it into a depression by attempting to use authoritative top-down social mandates. They terrorized private capital, leading to a slump in capital investment and the formation of new companies. 

As is often the case, one should not pay heed to what professional politicians say, but to the impact of what they do. The “COVID $1.9 Trillion Bill” rammed through the Senate should be relabeled “The 9% COVID Solution to Political Problems Bill”, “The First Redistribution Act”, or “The How to Kill Your Children’s Opportunity Bill”.  

The real intent of the Administration is to increase the deficit in any way it can, requiring taxes to be raised through one large omnibus bill or many separate acts. Their main purpose is to capture private-sector money and use it to fulfill socialist goals. What they forget is that close to half of all employees work for small companies, which large companies depend on to train their future workers. These small companies also produce products and services at lower cost, in part due to their lower compensation and benefits.

The initial capital supporting a small business is the after-tax savings of the entrepreneur. Support also comes from the after-tax savings of family and friends. The more successful small businesses can occasionally tap into private equity and debt funds, which are also funded with after-tax dollars. The pool of after-tax savings comes from the net profits after inflation, and the declining value of the US dollar will curtail the purchasing power of domestic earnings.

Looking to the future of our grandchildren and great grandchildren. They should be prepared to live outside of the US, possibly in Asia, as the reduction of private capital will reduce job opportunities in the US. Sound retirement planning suggests that US investments should be hedged by appropriate investments beyond the control of the US government.

There is Some Hope

Both the current occupant of The White House and his predecessor are doing a brilliant job adding to the base of their rivals. As both leaders pull more away from the center, some will want protection against the extremes. The 2022 congressional elections are an opportunity to accomplish a strong center by electing centrist Senate and House members of both parties. This could prevent The White House from accomplishing its redeployment of capital and other socialist goals. 

It could happen. The current topping of the US stock market and collapsing US Treasury prices, along with the declining value of the US dollar, should be enough of a warning. If not, we could see a copy of the long depression, leading eventually to an economically provoked war.

Questions of the Week:

1. Do you think this kind of problem set is possible?
2. Do you have any plans to include this possibility in your investment planning?

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

https://mikelipper.blogspot.com/2021/02/did-something-happen-last-week-weekly.html

https://mikelipper.blogspot.com/2021/02/debt-inflation-and-markets-weekly-blog.html

https://mikelipper.blogspot.com/2021/02/mike-lippers-monday-morning-musings.html

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A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Did Something Happen Last Week? - Weekly Blog # 670

 

Mike Lipper’s Monday Morning Musings

Did Something Happen Last Week?

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

Great Discomfort, Almost Panic, Large Growth Funds, Long Treasuries

Market participants apparently reacted to the further steepening of the US Treasury yield curve, with higher interest rates for longer maturities. (This was not a surprise to me, I have been focusing on higher inflation for a while. This week the JOC-ECRI Industrial Price Index reported a +47.91% rise from over a year over year. Also, my wife noted that supermarket prices are rising.) 

The impact on large “growth” stocks, as measured by large-cap growth mutual funds, declined by mid-single digits for the week. The connection between rising long-term Treasury yields and stock prices for companies with large amounts of cash and relatively low debt, surprised much of the public and some in the media. In theory, growth stocks are valued at what the market believes are their future stock prices, discounted by the cost of money until they are sold. The lowest discount rate used is the yield on long-dated treasuries. Thus, the reaction to the steepening of the Treasury yield curve makes growth stocks less valuable. Approximately ten of these stocks have been the engines of superior price appreciation in large institutionally managed portfolios.

Investors do not reveal the motivation driving their decisions and commentators consequently we use circumstantial evidence to ascribe motivation. As a skeptic, I look for other non-publicized explanations. 

Questioning the Gospel

The new administration has been fortified by the naming of the Treasury Secretary, a former chair of the Federal Reserve and former labor economist. For more than a year the previous administration believed in the long-term continuation of low interest rates. This belief comes from their indoctrination into Keynesian economics and has become the accepted dictum for governments since President Nixon announced, “We are all Keynesian, now”. Without any constitutional or legal authority, the function of government has now been determined to be the management of the economy to produce full employment. 

In John Maynard Keynes’ “General Theory of Employment, Interest and Money” published in 1936, he laid out the principle of the government (the people) funding contra-cyclical spending, providing money to hire out of work people through deficits or higher taxes.

Apart from the recent Trump tax-cuts, I don’t believe there have ever been tax cuts, other than as a “peace dividend” after a military war. Part of Keynesian policy was to set interest rates low during a recession and raise them in good times. To no one’s surprise there has never been an example of deficit reduction in good times. 

Keynes’ policies resulted in lenders being unable to make up for losses from defaults or late payments, which were critical in restoring the capital of lending institutions. That Keynes came up with this scheme in the mid-1930s is not surprising. In the US and around the world there was a movement toward more authoritarian government. Is it possible that this week’s “taper tantrum” was some glimmer of thought that governments might be responsible for the level of employment through low interest rates under Keynesian economic principles? Only time will tell, but very surprisingly it could happen now or in the immediate future.

What the Market Says?

The first two months of 2021 is now in the record books. The five leading mutual fund peer groups through Thursday night were:

   Natural Resource Funds         +26.38%

   Energy Commodity Funds         +24.80%

   Base Metals Commodity Funds    +18.36%

   Global Natural Resource Funds  +16.37%

   Small-Cap Value Funds          +15.83 %

Clearly, we are seeing energy and base metal prices rising, although some believe it’s not the result of short-term shortages. What is perhaps most interesting are the gains of the small-cap value funds. For years, small caps underperformed larger caps and “value” underperformed “growth”. On a year to-date basis the average small-cap fund has gained more than the average mid-cap fund, which in turn was up more than the average large-cap fund.

This change in performance leadership is broad and meaningful. The NASDAQ composite is leading the Dow Jones Industrial Average (DJIA) and the S&P 500 in both directions. I believe the reason for this is that most large index funds and closet indexed portfolios focus on NYSE listed stocks in the two senior indices. The more volatile NASDAQ attracts a higher percentage of traders and has a greater number of would-be growth companies.

The price chart for the NASDAQ is completing a “head and shoulders” reversal pattern, with the price pattern of the other indices not far behind. Valuations are high for the S&P 500, which has a price/earnings ratio of 21.5x, compared to 15.8x ten years ago. Also, because of both lockdowns and cash from the government, savings are 20.5% of after-tax income.

Investment Conclusion:

We may be near to both a short-term top and possibly a major revision in the long-term thinking of investors. 

Share your views, please.

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

https://mikelipper.blogspot.com/2021/02/debt-inflation-and-markets-weekly-blog.html

https://mikelipper.blogspot.com/2021/02/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/02/adjust-investment-tools-for-next-phase.html

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Debt, Inflation, and Markets - Weekly Blog # 669

 

Mike Lipper’s Monday Morning Musings

Debt, Inflation, and Markets

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

I. The Changing Value and Price of Money

As is often the case, when we speak of purchasing a good or service, we mention its cost in our local currency. We don’t view the purchase in terms of unrelated transactions, like a vacation vs. a month’s rent. If we were more intellectually rigorous, we would calibrate the purchase in terms of inflation and currency exchange rates. For those whose wealth is totally used up by spending, this thinking is understandable. However, for those who have savings/investments, this singular way of thinking reduces future wealth and spending power.

With the above predicate, all savers/investors should focus on prices and inflation. An agreed price is the result of supply meeting demand and the costs incurred in the present or future. As in a gunfight, don’t show up with only a knife. For serious purchases, don’t bargain without insight into the history of prices. In the modern world, where services are the largest part of an economy, we have difficulty grasping the costs driving prices. For manufactured goods, the costs of raw materials and industrial goods play a dominate role, excluding the cost of labor. That is why I pay attention to the weekly reading of JOC-ECRI Industrial Price Index, which saw a price rise of +44.83% year over year. Part of the price explosion is due to capital expenditures not keeping up with demand. For example, Goldman Sachs is warning of a copper scarcity in the coming months, leading to the largest deficit in ten years. A somewhat similar situation is occurring in the oil patch.

In analyzing inflation, it is useful to recognize who benefits, who hedges and who loses. The pure benefactors of rising inflation are the relatively few that gain from rising prices, due to it being the sole input to their financial well-being. Most people have a mix of prices received and prices paid. Some are naturally balanced, while others hedge offsets. Non-savers/investors who consume all their income are clear losers, as the losses created by the declining value of a currency are the equivalent of a tax. 

The motivations of the Federal government are mixed. When governments pay off their debts with inflated dollars, they net the difference between the purchasing power of the dollar and its contractual payment value. In addition, personal income tax payments rise on the inflated income. (Since corporations pay taxes on their pretax income, which may be offset by inflated costs, their pain of inflation is less.) 

From a political vantage point, the financial problems of the non-saving poor are intensified. However, for some politicians this problem has a “silver” lining, it encourages the redistribution of wealth through the socialization of the concern. In a healthy economy, increases in productivity often create gains that offset the pain of inflation, but US redistribution also leads to increases in jobs overseas and makes international investing more attractive. (The difference between international and global investing is that international investing excludes the home country, which global does not.)

Most investors ignore declines in purchasing power due to currency depreciation or inflation, if they are small. Due to current conditions and global political leadership, it may be prudent to adjust investments.

II. Breaking the “Bubble” Ahead?

Since the beginning of recorded history we have dealt with seasonal cycles and those that last longer. Trading markets adjust due to the relative strength of buyers and sellers, thus markets have they own cycles. Economic and market cycles do not always coincide, and when they don’t coincide the amplitude of the cycles is more limited. As long-term investors, we therefore need to examine the probability of the next declining phase, both in terms of economic and market cycles. In analyzing cycles it is useful to look at elements the popular media and marketers can spout quickly. You should also look for structural changes that can cause the foundation of the cycle to weaken to a point where it collapses. What are the signs I see?    

Economic Structural Issues

Debt is a major accelerator of most economic collapses, distinct from those primarily caused by political, medical, or climate changes. Debt is already growing much faster than the economy, even before the full increase in debt at all levels of government globally is disclosed.  Normally, the banking system controls the policing of debt. However, significant debt is being extended by non-bank credit groups in many countries, including China and the US. The problem with debt is that it replaces equity for temporary uses and speculative purposes, solving short-term needs, but doing little to generate long-term investment. While China and some other countries are spending on infrastructure to produce longer-term economic gains, it is not happening in the US. While both the past and current administration have discussed infrastructure programs, the private sector has not indicated a willingness to provide substantial equity. We don’t seem willing to get little or no cash return for a number of years, before the supposed gusher of profits arrive.

The steepening of the yield curve may be capturing this reluctance. There is great competition to supply short-term funds for margin debt and short-sales by brokerage firms and banks. Bank money market account interest rates dropped below 10 basis points this week, indicating banks have no need to attract new deposits to make additional loans, driving the front end of the yield curve even lower. On the other hand, interest rates at the long end of the curve are now higher than they were last year. One should remember that the published yield curve is for US Treasury paper and long rates for perceived lesser credit should be higher. This drives up the costs of long-term equity dollars, making them scarcer.

This week’s weather in Texas and the Midwest shows the need for much more capital spending on local infrastructure and power generation. The purported growth of electric vehicles will also shift energy needs from oil to natural gas, which should economically be distributed through pipelines, contrary to the present government’s wishes. The combination of new regulation and higher taxes means that many energy facilities will be taken off-line. Fitch believes the removal of these units for economic production will reduce the earnings of the energy companies, which in turn will lead to lower credit ratings that drive up their capital costs. Beyond the energy sector, the expected jump in taxes and regulation will reduce the ability of industry and individuals to generate capital for spending and investment.

Stock Market Structural Changes

Most of the time money follows performance. In the week ended Thursday, an index of the large S&P 500 index funds gained +4.47%. Five other equity fund indices were up at least twice as much:

  Lipper Small Cap Value           +13.13%

  Lipper Pacific Ex Japan          +13.10%

  Lipper Global Natural Resources  +11.66%

  Lipper Science & Tech            +11.48%

  Lipper Financial Services        +10.05%

There is no common denominator in the five leading groups, except they are not primarily large companies and the leading tech companies have less influence of in the portfolios of the largest funds.

The cash positions of many of the leading institutional investors are near a historic lows and the new speculators are heavy users of margin. The American Association of Individual Investors (AAII) weekly sample survey of bearish sentiment for the next six months has dropped 10.2% (25.4% vs 35.6%) in the last three weeks, with an almost concomitant rise in bullish sentiment (47.1% vs 37.4%). Professional market analysts view these as contrarian indicators and the combination of the three sentiment indicators could be significant.

Investment Conclusion

Rising stock markets have a habit of lasting longer than when structural problems are present, staying “bullish” until something changes mass opinion. I would use this enthusiasm to raise this year’s cash needs. I expect within two years we will have an opportunity to buy valuable investments with more knowledge and at better prices.

   

Important Note: 

I always want to hear from our subscribers, but I particularly appreciate hearing from subscribers that can correct or disagree with what I have written. That is how I learn to do a better job. In response to last week’s blog, a long-time subscriber and investment professional with non-Us experience, correctly noted that the Declaration of War between Germany and the US was declared by Germany a few days after the December 7th attack on Pearl Harbor. It was followed  by the US declaring war on Germany in a reciprocal move. This re-enforces my view that the main impact of an action is often the reactions of others to the event. In this case, if the move by the Germans was to support Japan, it had a different impact on both, as well as the US. In terms of Germany and the US, it led to a two-front war waged by the US, with the political decision to primarily focus on the European War. This in turn gave more force to the industrial mobilization of the US, which probably shortened the overall war effort,  leading to the surrender of both Japan and Germany. One should think through the reactions of others to the moves you make.

Question of the Week: What is the worst for which you are prepared? 

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

https://mikelipper.blogspot.com/2021/02/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/02/adjust-investment-tools-for-next-phase.html

https://mikelipper.blogspot.com/2021/01/is-gamestop-missing-event-weekly-blog.html

Did someone forward you this blog? 

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

This Week’s Implications for Our Investment Future - Weekly Blog # 668

 

Mike Lipper’s Monday Morning Musings

This Week’s Implications for Our Investment Future

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

Late-Stage Markey Surges

Through Thursday, the average US Diversified Equity Fund rose +2.49%. While not followed closely beyond the mutual fund business, it should be. The total assets of these diversified funds at the end of January were $ 10.7 trillion, compared to $16.2 trillion in all equity funds. These are the aggregate investment decisions of the largest group of individuals and institutions, distinct from measures developed by publishers.

Each week I look at the performance of 18 different types of diversified equity funds, which excludes more narrowly based specialty funds. Two observations of this week’s performance are:

1. This week’s performance is unsustainable. If annualized, the performance would be almost 260% for the year. 
2. Within the largest macro fund category, S&P 500 Index Funds gained +1.20% and ranked 17th out of 18.

These observations are like what I have seen or read about in the late stages of a “bull” market. In most markets, the performance for S&P 500 Index funds rank in the middle to top of their macro group. The reason for this is that they are low turnover portfolios, with no cash holding them back in rising markets.

Late-Stage Leaders

If the +2.49% gains for US Diversified Equity Funds is unsustainable, then look at the other four leading investment averages:

    China Region           +5.29%

    Equity Leverage        +5.10%

    Global Science & Tech  +4.22%

    Small Cap Growth       +4.04%

(Remember, these numbers are averages, several funds had substantially greater than average gains.)

Other Late-Stage Observations

• Contrarian indicators include an 8% increase in bullish sentiment for the American Association of Individual Investors (AAII) weekly survey, which now stands at 45.5%.
• 81% of Wall Street Journal prices rose this week. 
• Both the New York Stock Exchange (NYSE) and NASDAQ reported a 6% drop in short sales. (The reason a drop in short sales is viewed as a negative is that short sales need to be closed by a purchase, which adds to volume.)
• Market analysts become nervous or at least suspicious when formerly visible trades are hidden. 47.2% of equity trading-volume was not on the publicly traded stock exchanges. While this may lead to some investors getting better prices, it raises questions as to the validity of reported prices. This is not reassuring in highly speculative, volatile markets.

Possible Investment Implications Learned from the Impeachment Hearings with a look at History.

As much as possible, the following observations are intended to help make the investment decisions that will impact future investment performance. Words spoken by elected and unelected politicians are like hourly or daily temperature readings, good for conversations but not to be taken seriously when setting and executing long term investment policies. Actions have longer-term implications for historical purposes and provide some factual inputs in understanding what happened. Far more important are the reactions to actions, usually not by the original actor. 

The following is a historical example of this principle. The Imperial Government of Japan attacked the US naval and airfield installations in Pearl Harbor on December 7th, 1941.  The attack was timed with similar attacks in Asia to establish a “Co-Prosperity” Asian region, with Japan as its supreme leader. The attack on the US was designed to prevent a well-armed US from coming to the aid of the Asian countries being invaded. They were successful in destroying our aging battleships. (For the only time in recorded history, the US aircraft carriers were out at sea alone.) This was the deed, but the key to the future was the reaction. 

FDR used the attack to declare war on Japan, as was expected. But in addition, he declared war on Germany and the axis allies, which was not expected. (FDR did not want to be considered a President Wilson, who entered WWI two years late and changed the history of Europe, Russia, and WWII. He was conscious that his cousin, Theodore Roosevelt, had won a Nobel Peace Prize for settling the war between Imperial Russia and Japan. Later, he split the presidential vote in the US, which elected Woodrow Wilson as a minority President.) FDR resisted entering the War with Germany for two years, as it would have been unpopular in the US and would have added to the problems of his mismanagement of the economy, which resulted in the longest and deepest depression in US history.

What the Japanese did not count on, was the attack on Pearl Harbor and the saving of our aircraft carriers giving FDR’s the political power to galvanize the US. It enabled him to fight both a World War and push through various social moves which had not been possible beforehand. Regardless of how one feels abut my narrative, there is no question that the reaction to the attack on Pearl Harbor was much different than the Japanese had intended.

Could We Be in a Similar Position Now?

Some have suggested that the new administration is the most politically left leaning group since FDR. The staffing of the Cabinet and administrative functions with former Obama people is like FDR’s brain trust. To see the ambition of the current leadership, read the proposed Antitrust Merger Standards, which would allow the government to decide on all future mergers. (This is a backdoor way to establish an “industrial policy”, which numerous countries have thankfully tried, removing a lot of vital competition in the global market. Another example of the ambition of some in Washington can be seen in the “reconciliation budget” proposal from the Financial Services Committee in The House. It has a current spending plan of $38 Billion and would reach $72.9 Billion by 2031. (I would like to learn how much our taxes will have to rise for this relatively small desire of the party.)

The President Could Be Saved from Himself

Just as reactions to an action can be contrary to the expressed wishes of the actor, so too can the current actions of the President and The Speaker of the House. We are seeing them both play to their own majorities, but they are driving away more of the middle in the process. Considering both of their elections had smaller pluralities than expected, the House Leader is now the only person in her role to lose two impeachments, which could have been won if better managed. The President appears to be creating more unemployment, more businesses closings, and a reduction in the level of education at all levels. We will have to see if any foreign government does anything meaningful we want.

If Not, is a Long Recovery a Prospect?

Without meaningful political changes, an FDR length depression could occur. Right now, I believe most worried investors are still treating the current phase as a cyclical depression that should be complete within four years. That is what I am doing, but it could be a lot longer and I am not prepared for that.

Question of the Week: What is the worst for which you are prepared? 

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

https://mikelipper.blogspot.com/2021/02/adjust-investment-tools-for-next-phase.html

https://mikelipper.blogspot.com/2021/01/is-gamestop-missing-event-weekly-blog.html

https://mikelipper.blogspot.com/2021/01/are-we-strolling-promenade-deck-of.html

Did someone forward you this blog? 

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Adjust Investment Tools for Next Phase - Weekly Blog # 667

 

Mike Lipper’s Monday Morning Musings

Adjust Investment Tools for Next Phase

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

As Rules Change, or are Better Interpreted

For many years to the extent possible, I managed the Defined Contribution Plans for the NFL and the NFL Players Association. At the time of each Super Bowl, when asked which team I was rooting for, I replied “for those in the black and white uniforms”. I hoped the officials would see all the relevant plays and correctly interpret the changing rules of the game. As it turns out, that was good training for watching the constantly unfolding investment games between buyers and sellers, various regulators, shifting weather conditions, injuries, mistakes, and pure luck. None of the results were pre-ordained and would be argued about for many years into the future. I approach each market and market phase with the same weariness in preparing for the next market phase. Part of the preparation is examining the terms used to describe the game, and when appropriate improve definitions. This exercise may be particularly important this year, as it appears we are close to a crossroad.

Enthusiasm vs Crumbling Underlying Structure

Many global stock markets are rising in February, despite the historical odds that after a decline in January there is only a 22% chance that the remaining eleven months will produce a profit. The general media, revealing their political views, interpret the various executive orders and other political pronouncements as accomplishing their goals, and see an economic expansion beyond the release from the lockdowns. It could happen, but the odds of complete success are unlikely. 

The current small-cap +5.03% and emerging market +3.07% leadership in January is like other late stages of the past. Fixed income funds often lead equity funds in terms of direction. For the year through Thursday night, the average S&P 500 Index fund was up +3.16% vs -2.95% for the average General US Treasury mutual fund. Another worrisome note is the size of margin debt, which perhaps due to short squeeze actions has reached record levels.

A good investor should look beyond stock prices to see a different economic view, which I attempt to do. Large futures speculators are increasing their shorts in copper, Eurodollars, S&P 500 minis, emerging markets, and US Treasury bonds. In recent blogs I mentioned the Industrial Price Index rising compared to a year ago and this week it accelerated to a gain of +33.18%. The bond market recognizes these tensions and the yield curve has continued to steepen. Even the Congressional Budget Office sees that inflation will likely be over 2% by 2023. (My guess is that it will be a lot sooner, raising the cost of financing the politically generated deficit.)

Understanding the Tools of Security/Fund Selection

Headline writers and many marketeers prefer short words to describe complex tools, e.g., “growth” and “value”. These create good pictures or charts, with ever rising growth and ever declining value. Would it be so. As with the changing weather at a football game, conditions change, as do the useful definitions of terms. 

Speculators essentially bet on what others will pay for their shares, bonds, or loans in the future and a successful speculator primarily knows his/her markets. An investor is a partial owner of a company that at some point could be purchased by a knowledgeable buyer. It has been the motivation of buyers and sellers in marketplaces around the world since recorded time. Perhaps in response to the “great depression”, securities analysis became a separate academic subject, distinct from older economics courses. 

Benjamin Graham was a successful analyst/portfolio manager/investor. He was also a good writer as an adjunct professor at Columbia University and worked with Professor David Dodd in writing the first textbook on Security Analysis. Graham and Dodd were primarily interested in avoiding unnecessary investment losses in their writings and emphasized the use of financial statements, particularly balance sheets. In early editions of their six-edition book, they emphasized anticipated liquidating value, an issue appropriate during a depression.

While Ben Graham is often erroneously called the “Father of Security Analysis” and the first value investor, this is not where he and his partners in a closed-end fund made most of their money. The fund became a dominant shareholder in an insurance company which had no real equity left on its balance sheet. What it did have in this period of substantial unemployment was a customer base of relatively low wage employed government workers. They saved and ended up controlling Government Employees Insurance Company (GEICO), which Warren Buffett analyzed and eventually bought outright.

Years later I personally had the honor of taking the Security Analysis course under Dave Dodd, but I disagreed with him and believed that growth was an important factor in choosing investments. He  quickly shut me up by indicating how much money they had made on their investments. Years later, as a small entrepreneur, this led me to include growth and more importantly the evaluation of key people in making successful investments. (In evaluating three cases, one had to be closed, another was key to a bigger product, and the third was very successful). As a side matter, I was particularly pleased to receive the Benjamin Graham Award from the analyst’s society in New York for a private matter requiring some investigative skills a few years ago.

Today, when I review financial statements, particularly the footnotes, I have little confidence they will reveal the “true value” of the company. We live in a litigious world and accounting practices are designed to protect the accountant, the underwriter, or the company itself against lawsuits, rather than to ascertain value. However, there are some very good analysts that are pretty good at finding the range of values for a company. These analysts don’t publish their work, as they are employed by investment bankers, private equity funds, or serial acquirers. While they don’t publish, the price of their bids and deals are known, and this sets the market price for similar deals. If I can’t get enough data, I use the multiple paid for earnings before interest, taxes, depreciation, and amortization on successful bids. 

To understand value investing, one needs to understand where the current market is and what is best indicated by the price of deals. These in turn are influenced by the level of interest rates used to discount future growth and the cost of acquisition.

How to Measure Growth

Many believe that any number larger than the previous number is growth. For valuation purposes however, what is useable are growth comparisons. They should deduct inflation, exclude acquisitions, currency changes, and the impact of changes in regulation or competition. To me, each period may be different, so a long period growth rate can be misleading. 

I like to see the consistency of growth rates. There are times when highly variable growth rates leading to above average long-term trends are valuable and times where a more consistent return is more valuable, particularly for accounts that have finite payments requirements. (For mutual funds, we measure both total return and consistent returns.)

What about both Growth and Value?

In truth many companies go through periods of growth and value. IBM, before it changed its name and was under Tom Watson’s management, had so much debt that it was viewed as an underwater stock. Years later, it became the prime example of a growth stock and later still its growth slowed to the point where at times it was viewed as a value stock. Because of various recent changes I don’t know how to characterize it. What I do know, is that past financial history is not of much use to an outside investor. 

Since many companies go through numerous growth and value changes, I favor looking at many periods. However, it is more important to look at changes within the company, including the people hired at the senior and entry level, changes in product/service/prices, and the reaction to competition/regulation.

Conclusions

1. Look at how things are, don’t overpay for history.

2. Expect surprises!

3. Take partial positions initially.

4. Admit mistakes quickly and serially.

Your Thoughts?

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

https://mikelipper.blogspot.com/2021/01/is-gamestop-missing-event-weekly-blog.html

https://mikelipper.blogspot.com/2021/01/are-we-strolling-promenade-deck-of.html

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

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Is GameStop the Missing “Event”? - Weekly Blog # 666

 

Mike Lipper’s Monday Morning Musings

Is GameStop the Missing “Event”?

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

In the “Bubble”, Seeing the Trees and Not the Forrest

In recent blogs, I examined evidence of a stock market bubble about to burst. Is this week’s explosive coverage of the short squeeze battles of a handful of relatively small stocks, the classic unrelated event that leads to actions triggering the rapid deflation of general market prices? Could be, and it is worth thinking about.

Markets regularly fluctuate between high/low prices and valuations. Most of the time, they stay within an envelope around a loosely defined center. This is the type of period where stock and fund picking produces relative good and bad returns, getting the attention of both individual and institutional investors. The game dramatically changes at the two extremes. At both ends the driving force is the actual level of liquidity in the marketplace. The relatively few stocks that have high, two-way market volume get most of the action and attention. The others either don’t trade or have significant price gaps between trades. The deflation of a bubble is when prices rapidly collapse.

In the prelude before the bubble breaks, there are often signs of structural deterioration preceding some seemingly unrelated event, which spurs reactions. This can be the telltale sign of a bubble breaking. Two examples of these events come to mind. The assassination of the Austrian Archduke and the passage of the US Smoot-Hawley Tariff Act of 1930. In both cases, from a global standpoint, they were not earth-shattering events, but the reactions to them led to World War I and the global depression of the 1930s. 

In both cases, various political leaders used the event as an excuse to make aggressive moves, resulting in tragedy. The murder of the Archduke and his wife became an excuse for aggressive, militant nationalism and an attempt to change the political structure in central and eastern Europe. It in turn eventually brought the US reluctantly into the war and was a contributing impetus to WWII. 

The Smoot-Hawley Tariff was a political attempt to bail out the highly leveraged farm sector in the US. It raised import tariffs on agricultural and industrial products by 20% and was quickly followed by 20 other countries.

Possible Application to the GameStop Short Squeeze

Very little of the popular media coverage on the short squeeze of GameStop and a small number of other stocks starts with the recognition that short selling requires a margin (loan) account, funded by cash and/or securities. The buyer of the shorted shares looks to the selling broker, or in some cases a bank, to supply the shares. This requires the broker to borrow the shares from other shareholders or purchase them to make the delivery. If the broker borrows the shares, the firm must pay a rental fee or find another customer who owns the shares. To facilitate the trade, margin accounts permit the broker to loan out shares in margin accounts, using them as collateral to raise capital to support transactions. 

The broker is often forced to buy shares in the market to make delivery in less liquid stocks. The mere fact of the broker buying pushes up the price, turning the broker into a short seller, having delivered the newly purchased shares. The broker must recapture the money it spends and occasionally if it borrows too much it may face forced liquidation of the firm. If this becomes the experience of many, there can be an effort to get the regulators to declare a “corner” in the stock, where they order the cancellation of all trades above a given past price. It thus wipes out some of the gains of the short sellers and reduces the losses of the brokers. (This has not happened in many years.)

How Did this Happen?

1. In a period where there are large operating business losses, there is a political impulse to bail out the unfortunate to secure their future votes. To the extent the bailout is not quickly repaid with interest, it is in effect socialized, making the profitable portions of the economy pay the losses and any shortfall in repayments.
2. Payments to individuals during the current pandemic where in many cases saved and not immediately spent.
3. Many states have legalized both sports and casino gambling to tax it. This probably enlarged the gambling population and transferred public wealth to gambling interests.
4. Currently, many are working from home (WFH) and sitting in front of their computers. Some have temporary cash to spend and in the absence of their normal sports betting vehicles they have developed trading relations with electronic brokers. 
5. Our educational process in schools and at home does not distinguish between gambling and investing. Furthermore, people and many politicians don’t differentiate between borrowing to meet current expenditures and capital invested in long-term assets. Long-term assets, like new plant or other capital expenditures, create new earning assets which in many cases become new collateral.  

What May Happen?

1. The popular media will likely produce numerous stories of individuals with losses. This will provide politicians with an excuse to produce more regulation, which will be expensive and send more investment overseas, and/or into non-public activities.
2. The future “Debt Bomb” is now in the hands of the government, but with the shrinking share of the loan market at banks, credit conditions will loosen and the private sector debt burden will grow. Underlying every major collapse is the extension of too much credit and the resultant leverage. 
3. We live in a dynamic globe. Most financial systems are quite extended, with little room to handle medical, weather, technology, military, and political surprises.

What to Do?

For those portfolios structured to meet payment responsibilities over the next five years, this would be a good time to prune portfolios. The following actions may be appropriate.

1. Create a schedule to recognize all loses serially between now and June 30. Thus, create a capital gains shelter for sales of winning positions.
2. Examine winning holdings that need a current bull market to reach the investors’ price objective.  Sell at least half.
3. Sell at least half of all positions in stocks where current management’s decisions seem inappropriate.
4. Build an opportunity reserve for two new purchases.
5. Increase exposure to stocks that trade beyond your home market.
6. Expect surprises and usually invest against the first identified decision.
7. Read carefully what companies say. One Dow Jones Index company expects earnings in 2021 to equal those reported in 2019. Even if that happens, the company will not have produced sufficient earnings to cover the then expected growth rate for the two-year period, leaving their growth at least 10% behind the original plan. This should cause one to make some changes, either to the portfolio or to expectations.

Working Conclusion

Become more engaged and start managing your portfolio, holding a collection of investments that can both absorb some losses and find new opportunities. 

What Do You Think? 

 

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

https://mikelipper.blogspot.com/2021/01/are-we-strolling-promenade-deck-of.html

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

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

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

Did someone forward you this blog? 

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.