12 Steps to a Market Problem - Weekly Blog # 500

Two Markets Principles: “The law of unintended consequences is the only real law of history.” - Niall Ferguson. And when markets move from being investment fundamentals driven to sentiment, directional changes may be volatile and dramatic. I believe that governments are increasing the risks of more unintended consequences as they change policies to address political rather than strategic needs. After an extended period of stock markets rising with comfortable complacency that most numbers and attitudes will be pro-growth, we have entered a new phase.

I have recently written about forthcoming declines that may be either of the normal cyclical nature or the far less frequent abnormal declines. I don’t know which type will be the next decline that we will be facing. In each case declines are followed by recoveries. The key difference in terms of the recoveries is the level of damage the declines cause due to the psyche of both individual and institutional investors. The greater the damage the longer it takes for the full recovery to do its restoration of capital.

Currently there are a number of signals being produced. Some of them will have little or no longer term impact. However, some will be signposts to the future. As a contrarian I am going to be focusing on possible negative signals. This is appropriate for two reasons. First in the current period of rising enthusiasm and excitement there are fewer voices of caution. Second, I believe that I owe to our managed accounts to look for possible problems on the horizon that are not already in today’s prices.

In no particular order the following are input signals to my thinking:

1.  Before we awoke last Monday morning, Samsung Electronics stock price in South Korea fell 5.1%. Over the next few days the leading FAANG stocks were also weak. At times Ex-US markets can trigger US markets.

2.  Of the eight major ten year sovereign debt yields, only Canada’s higher yield was greater than the 10 year US Treasury bonds. This means that investors found that six countries’ debt was a better investment than the US.

3.  In the recovering repurchase agreements market it is difficult to buy both US Treasuries and German Bunds in quantity. I believe that this indicates that these markets are not being largely driven by investment needs, but the need to find acceptable collateral. Today only Bank of New York/Mellon is clearing repos.

4.  Some believe in the run up to year-end banks and some other financial institutions are dressing up their balance sheets by reducing their loans and trading inventory. This may impact available liquidity.

5.  “Liquidity is that which moves the market,” said Stan Druckenmiller, who is said to be one of the soundest investors for many years.

6.  The law firm Williams & Jensen is tracking the SEC’s interest in Fixed Income Market Structure changes as are the Federal Reserve Bank of New York and the Treasury Department. The current and evolving structure is very different from what was in place during prior financial crises even though the new Federal Reserve Board Chair-designate believes that there is no longer any bank that is too big to fail.

7.  The stock and bond markets are interrelated in many ways. Fixed income investors and dealers are crucial to the supply of short-term credit to finance dealers, authorized participants, Money Market funds, derivatives and trading. They also play a role in the high yield bond and loan market that is experiencing a wave of “covenant lite” issuance. Further, fixed income investors are providing debt being used to both buy back corporate shares and also to invest in their businesses.

8.  Marathon Global Investment Review out of London regularly discusses the impact of the capital cycle on corporate results and stock prices. When borrowers can borrow cheaply in an undisciplined way, they get too much money that expands capacity which eventually forces lower prices to create demand or buy market share which is destructive to the issuer’s stock prices. Recent examples include the oil industry and reinsurance companies. Possible current longer term risks could be two stock market darlings: Tesla and Amazon. A significant problem with either will not be likely treated as an isolated event.

9.  At the March 2000 peak of the MSCI Europe, the ten largest stocks in the Index fell in the next 12 months twice as much as the index declined and in the following 12 months fell four times what the index did. Some 17 1/2 years from the peak, only one of the ten, Royal Dutch, has regained its full value. This highlights the difference between a “normal “ cyclical decline and an absolute one.

10.  Central Banks are utilizing stocks as a substitute for bonds in their attempts to stabilize their economies. The Bank of Japan owns 2/3 of the equity ETFs in Japan. The Swiss National Bank owns $10,000 dollars of US stocks for every inhabitant in Switzerland. Perhaps the ECB (if it continues to manipulate the market) could buy shares as it already owns 3/4 of all the eligible bonds.

11.  While Power Shares in its NASDAQ 100 ETF has gained 41% in the top five stocks (See point 1), perhaps connected, JP Morgan has pointed out that some ETFs have short positions greater than the shares outstanding due to re-lending.

12.  Jason Zweig reports that the fifth most popular stock among the brokerage customers of Fidelity Investments was Bitcoin Investment Trust that holds bitcoins. The stock traded at a 70% premium over the value of the underlying holdings. There were 40% more buyers than sellers. ( Is this a South Sea Bubble ?)

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A. Michael Lipper, CFA

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Normal or Abnormal Decline Approaching?Weekly Blog # 499

Introduction

Future stock market declines are inevitable unless we modify human behavior. Also, as days follow nights, after the declines there will be future rises. None of these statements are new or profound. The critical questions are, what to do in anticipation and during a decline?

John Vincent messaging through Seeking Alpha, regularly reviews the 13F reports filed by investment management organizations as to their stock holdings. In reviewing a number of independent investment managers with over $1 Billion in their portfolios for the third quarter, I have observed some trends.

First, many managers who have sold recently acquired positions did not report significant profits. Secondly, sales of shares acquired years ago are producing large returns, some on the order of two, three, or four times original cost. Since my investment clients and I are long-term investors, it is the second observation that becomes something of a guide to our management philosophy.

Since few or any managers consistently buy at the bottom (or sell at the top), there will be periods of time that they will likely hold positions at a loss before they eventually sell at a profit. Thus, the critical question is how big a loss is acceptable as a price to earning large profits? A further and more difficult question is, how long does one have to wait to get into a profit condition?

Accurately predicting the future without incorporating a mistake is a fool’s errand. However one can apply both logic and past history as a guide. Stock prices regularly decline for periods of one year or longer, “normally” two to three times over a decade. These corrections may be 10% or more up to so-called “bear markets of 20%+.  Few investors have experienced getting out at or near the top of a “normal” decline and getting back in before prior peaks have been achieved. Thus one is probably better off holding through a cyclical downturn and subsequent recovery.

On the other hand once a generation stock prices decline in the range of 50% or more. We have had bouts of these types of declines in 1973, 1987, and 2007-9. In the last two cases we held through the declines in part because we recognized the potential market risks after the decline had begun. There is a greater risk that the recovery period could be extended. The recovery from the “Great Depression” of the 1930s lasted until the mid 1950s for the average stock and in the case of one of the popular growth stocks, RCA, until the mid 1960s. Thus, there is a real advantage to attempt to sidestep an “abnormal” market decline.

Even if we can determine the odds of a forthcoming decline, particular diligence is required to separate a future “normal” decline when the odds favor holding through the decline and an “abnormal” decline when side stepping would be advantageous. I am considering to attempt the last task. I do this with the hope that my heritage will give me an advantage. The family folklore is that in the late 1920’s my Grandfather persuaded  his clients to pay off their margin loans and go to cash. The family legend is that they did.

Next I am examining the current conditions to separate which of the current trends point to a future “normal” decline and which could be indicating a larger problem. 

Trends that Presage a Decline

No single present trend guarantees a future event and even the aggregate weight of trends do not guarantee a particular result. One of the useful concepts learned at the race track and as an analyst is to assign odds to various factors that could influence the result. Always leave room for “racing luck” or “unknown unknowns” as well as unintended consequences. Nevertheless, reasoned analysis is better than relying exclusively on hope.

Sentiment Overriding Numbers

Utilizing the distinction that S&P* is making between Growth and Value components of the S&P 500, one can see two different stock markets being created. Value stocks are being evaluated on both the basis of their financial statements and the near-term price and volume trends in their business. Using many measures these stocks are being valued within the range of fair value. Their stock price trend is moving up in tandem with an economy that is somewhat errantly expanded. However, the value stocks are moving slowly compared to the growth component.

Led by a little more than a handful of stocks labeled as the FAANG group, Growth stocks are significantly outperforming the aforementioned Value stocks. This is happening globally and particularly in terms of Asian security prices.

One of the reasons that up to the present I felt that the next market decline would be of a “normal” type that we would hold our good stocks through the cycle, is the general lack of enthusiasm for stocks. I have not seen the kinds of enthusiasm I saw in the run up for the Dot Com bubble. Nor did it reach the levels of enthusiasm seen many years earlier in the South Sea Bubble or the Tulip Bulb craze. But the level of enthusiasm for certain stocks and for the market in general is worth watching. Two of the lenses that I look through are the research that Liz Ann Sonders puts out for Charles Schwab & Co.*  and the weekly survey by the American Association of Individual Investors (AAII). This is a very volatile time series. In the latest week only 29.4% of those surveyed are bullish as compared with the prior week when the reading was 45.1%. If, over time, the bullish contingent numbered consistently over 40% and the bearish group is below 30%, I would be nervous short-term, as I view this particular indicator as a contemporaneous measure.

Fixed Income Signals

As has been often pointed out that most of the modern declines in stock prices were preceded by some disruptions in the fixed income markets. We have already seen some price nervousness directed at the High Yield bond  market in spite of no generally expected increase in defaults by the major credit rating agencies. This nervousness has not yet been felt in the intermediate credit market. Barron’s has two bond indices, one labeled Best Grade Bonds which saw its yield rise 5 basis points this last week. The other  measure, for the Intermediate Grade bonds, saw its yield drop by a single basis point. This suggests to me that there is wide scale disenchantment with the credit market this week.

My main worry after the collapse of Lehman Brothers and Bear Stearns is not the price/yield of credit instruments but their availability in a stressed market. Recently I have mentioned that the market for US Treasuries is considered to be the most crowded and is under investigation for price manipulation in the related foreign exchange currency markets. There are some professional press articles raising concerns about liquidity. A liquid market is one where trades can be executed without moving prices. Most high grade markets are extremely liquid almost all the time. The meaning of the last sentence pivots on “almost.” At the final point of their crunch both Bear Stearns and Lehman could not access the repo market to satisfy their desperate need to refinance short-term debt.

I don’t have any independently derived measures of liquidity.  However, I may something of a mirror image of available liquidity looking at major Money Market funds. (Remember when Lehman went down it caused one large Money Market fund to “break the buck” or to be slightly valued below the level of its deposits including interest earnings? They had to suspend redemptions which could have created a “run” on Money Market funds if the government did not step in. Thus, liquidity is very important to Money Market funds.  JP Morgan has four large multi billion dollar funds in the US. These four range in size between $21 Billion and $140 billion. What is perhaps of interest in this matter is that three of the four have between 50% and 64% of their investments maturing in eight days or under. Only their 100% US Treasury Securities Money Market Fund is much more exposed to longer maturities, with only 21% maturing in eight days or less. This difference could be due to a belief that the owners of this fund are less likely to need cash as quickly as the owners of the other funds.

Two of the four funds have more than 50% of their holdings in repurchase agreements, largely with other capital markets providers. (What we do not know is whether JPMorgan is on the other side with the same organizations so their net exposure may well be much less.) The real key to the questions as to the size and nature of short-term liquidity is that it is a matter that is currently being worked on by the major participants - not because they want to for the tiny current interest rates - but because they must to keep the global financial system working.

The Thanksgiving Weekend Visit to the Mall

As many of our long term subscribers to these blogs may know, my wife Ruth and I visit the glitzy Short Hills Mall in New Jersey to frequently do our market/economic research. Due to family commitments, we could not get over to the Mall until Sunday afternoon. The Mall was crowded but not jammed. The high end stores were generally attracting a good crowd, but this was not universally true. While a number of jewelry stores were busy, Tiffany looked sparse as some of the others were almost vacant. Both Verizon and Apple* were doing good to great business, we think. While some couples had a handful of bags, they did not seem to be burdened down. There were a few empty store spaces and ads for sales help were generally lacking. I had the feeling that most merchants were not over-inventoried, as some were in the past. All in all a good but not a great beginning to the shopping season. We don’t yet have a view on the online business and whether shopping habits have shifted.

     

 From an investment viewpoint retail will do okay but won’t be a leader.

*Held personally or in the private financial services fund I manage.

Conclusion

We should be careful with our investing. There are too many moving parts to this puzzle to be dogmatic, but risk levels are probably rising.

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A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

Be Thankful for Risk - Weekly Blog # 498

Introduction

In the northern Hemisphere, this is the season of festivals to celebrate the gathering of a good harvest. In the US, we recognize this tradition as Thanksgiving. World Stock Markets have been quite kind to investors so far this year as seen through the eyes of mutual fund holders using category averages and highlighting some exceptional performance:

US Diversified Equity Funds	+14.34 %
Sector Funds.	+9.76 %
World Equity Funds	+16.73 %
Mixed Assets Funds.	+11.25 %
Domestic Long Term Debt	+3.51 %
World Equity Funds	+7.65 %
LeaderGlobal: Science&Tech	+46.84 %
LeaderPacific: Ex Japan	+38.22 %

Source: Lipper Inc., a Thomson Reuters Company.

If the calendar year ended last Thursday night these results would be above average on a historical basis but shows that investing in Asia and in global science & technology issues has produced extraordinary results.

Performance Always Comes With Risks

Investment history is a tale of gains and loses with hopefully some lessons that can be used in the current time frame. This last week we had an example of very long-term rewards from investing in the auction of Leonardo da Vinci’s painting of Salvator Mundi for $450 million. In the Wall Street Journal, our friend and columnist, Jason Zweig made a good attempt to quantify the painting’s return, from presumably its first sale to this week. By his calculations after an attempt to adjust for inflation using gold as a very rough measure, the annual return since the sixteenth century was an outstanding 1.35%. But even this, by today’s standard low return, was better than cash, gold, and bonds, but not stocks. Another author has calculated the gain after inflation in the equivalent of the S&P500 since 1871 to be 6.9%.

There are two important lessons from this data: 

• First, accepting risk can produce better returns than perceived safer investments. 

• The second that the $450 million price compared to an auction house estimate of $100 million did not appropriately consider that this may be one of only 20 finished works by  the talented artist. Scarcity has a value

This is one of the reasons we favor individual stock selection over sector bets. This has implications for our fund selection process of favoring funds with less than 100 positions and even a few under twenty positions over broad index funds or passive sector funds. To us differences do  matter.

Recently we have been reviewing reports on the 13F filings of a number of well-known investment managers. In an over generalization most seem not to have owned a lot of winners in the third quarter, but continue to own and enjoy good results from positions bought years ago. ⁺

+Email me at Mikelipper@gmail.com  for more info on our Timespan L Portfolios®

Whether we like it or not we are all risk takers anytime we get out of bed or cross a street, let alone make a long-term investment decision. In an over-simplified model any portfolio’s strategy can be summed up as capital preservation or capital appreciation or for most, a ratio of the two. In the above model of comparative returns to the value of Salvator Mundi’s portrait, it is important to note the better performance of the painting over cash, gold, and bonds. To me there is a quotient of risk in all three of the under-performers that has been viewed as “safe.” For example, cash is not protected against inflation, particularly the virulent type that has been seen periodically through history. In addition while most of the time the costs of holding cash on account is small, and with minor custodian risks, both have been known to create anxiety for cash owners. Perhaps the biggest risk in holding cash is a dramatic change in the needed use of the cash to meet needs. If these are true for cash, similar risks may be present in other “safe assets.”

At this time holding US Treasuries could be more risky than generally perceived - based on two bits of news not generally appreciated. The first is analysis by Merrill Lynch echoed by others, that Treasuries are the most crowded trade in the market. This suggests that there is a supply/demand imbalance with some of the participants not exercising price discipline which may explain why the yields on US treasuries are higher than agencies UK, German, and Japanese issues of similar maturity and perceived quality.

The second and perhaps related bit of news is an article headlined from the Financial Times which said “US Treasury dealers accused of collusion.” There are similar, other cases pending. The results of these cases one way or an another could cause disruption to not only the market for US Treasuries, but also to many markets that use treasury prices as benchmarks in setting the prices for other instruments and markets.

Accepting Intelligent Risks Can have Its Rewards

Obviously not every single risk works out for long-term investors, but many do.  The key, particularly for our longer term investment accounts is in careful selection of mutual funds. Two of the matrices that we study are prices and related valuations plus the underlying selectivity as evidenced in the portfolios of mutual funds. Currently we appear to be in a two-tier market with a couple handful of good performers becoming price performance leaders. This not true for a second tier.

One study points out unlike in 2000 the fifty largest companies in the S&P500 were selling at 31 times earnings. Today the fifty largest is selling at 17.9% which is generally in line with historic records. One explanation for the high valuations of some stocks is the Charlie Munger belief adopted by Warren Buffet that it is better to “buy a wonderful company at a fair price than a fair company at a wonderful price.” This philosophy depends on the ability to find wonderful companies at fair prices. In my mind, this is dependent on sound and smart investment analysis. A good investment analysis course could be taught exclusively on the wins and losses in Berkshire Hathaway’s^* history. Recently they have been reducing a large position in IBM which perhaps has not yet developed into a wonderful company and have been buying Apple*, still evolving as a wonderful company. While Berkshire is a very long-term investor in a number of securities, it is price sensitive, currently sitting on $110 Billion in cash and $180 Billion in investments.

*Held either personally or in the private financial services fund I manage.

Conclusion

Accepting the risks of disappointing results from time to time does not diminish the odds in favor of long-term gains. One needs to balance the goals of capital preservation and capital appreciation. The ratio should

probably shift inverse to near-term market performance.

Question of the Week:

If you were forced in terms of your own account how would you divide your portfolio into only two buckets between capital preservation and capital appreciation and is the mix different in your professionally managed accounts?