Sunday, December 10, 2017

Same Answer to two Questions Disturbing? - Weekly Blog # 501

What drives stock prices? In this sound bite world of media and academic pundits what drives stock prices is earnings per share. The progress of e.p.s. determines the appraised value and therefore the future price.

What is the most massaged number of all that is published? You guessed it, earnings per share. When was the last time that a modern chief financial officer or CEO knew one year in advance the number of shares that will be divided into the reported net income on an average number of shares or year-end number of shares outstanding? To be honest, net income, at best, is a representation of a perceived reality. Revenue recognition is a semantic guess. The value of inventory consumed and the remaining value as to what is left is heavily influenced by current or year-end prices and the recognition of taxes currently owed to various taxing authorities. In truth e.p.s. numbers are not manipulated necessarily with malice.

This reality suggests to me earnings should not be the sole measure of a stock’s value or perhaps not even the leading measure of future prices.

I am led to this view after reviewing Berkshire Hathaway’s* investment experience and looking at a number of 13f reports reviewed by John Vincent as well as my own long-term portfolios. In each there are some losers. In general from the time the losers become big losers they disappear or have a greatly diminished percent of the portfolio due to the rise of the winners.
*Held in the private financial services fund I manage

Warren Buffett claims he does not make future earnings projections. Even if he did I doubt that he would have much confidence in ten and twenty year projections. Then what is the rubric or rubrics he uses? I believe staying within his circle of competence it would be based on his understanding of the nature of the business that the company is considering acquiring. In 2000 he purchased a big position in Moody’s Corp. that was spun out of Dun & Bradstreet. The current price of Moody’s is fifteen times his cost. This is a clear example of thinking long-term, with an understanding of the functions and quality of a potential investment.

Not long after Berkshire’s purchase of Moody’s, I independently bought the stock for the private financial services fund that I manage. When I bought this stock I believed that I understood the nature of the credit rating business and the essential need of the company’s clients for its services. I also knew a little about its management compared to its main competitor. It was the quality choice. Thus, investing in the highest quality of an essential business worked well for me. I did not project earnings, recognizing that most of the analysts reporting on the company regularly underestimated current earnings. As I was a bit late in my purchase, the current price of Moody’s is only eight times our cost.

There is another lesson from this experience. It is not just finding a great investment, but continuing to hold on through both the changes within the investment, the market, and the needs of the account. Both Berkshire and I sold some of the original position along the way for reasons that proved to be wrong. Thus the same level of diligence needs to be practiced as we, in effect, re-purchase our liquid investments everyday.

Challenge Ahead

Perhaps too many of the portfolio managers that I speak with, while concerned about the near-term future due to the identified unpredictability of events, are not raising their cash levels. In numerous cases the hesitation to act dynamically is due to career risks. As a contrarian long-term thinker I have already accepted the realization that there will be a stock price decline ahead of us which may be combined with a recession, fixed income collapse or military actions.

There remain two critical questions. First, the size and duration of the decline, and second, should we trade in and out of the decline or do we stay pretty much fully invested to benefit from both the recovery and the expansion beyond?

As usual I look at the current data and the misdirection that most are following. Economists and politicians are being led by the lack of sufficient productivity, actually labor productivity. This is defined as revenues divided by wages. Governments around the world have found within their constitutions a “requirement” to create jobs. In particular they want to create jobs for union workers and other politically active individuals with eyes on the next election.

While these are important, they are not addressing problems that are broader and deeper in scope than unemployment which can be summed up in different measures of productivity.

In all of our societies there are more consumers than workers. What has happened all over the world is that consumers are buying more and better quality products and services due to both technology along the way and world trade. I suggest, unaided by government or perhaps in spite of government, consumers are better off today than ever. Clearly more is desired. If we create jobs that raise prices and/or reduce quality, that is a step backwards.

The second productivity measure which is not highlighted globally is the productivity of capital, particularly retirement capital. I do not know of a large government retirement plan that is fully funded against any standard, let lone the fact that we are all living longer and our last years are very expensive. We must support increased investment into retirement capital vehicles but this will have the effect of lowering current consumption.

Net Flows into Mutual Funds and ETFs

The next set of numbers that is not getting enough attention is the net flows into mutual funds combined with flows into ETFs. Domestic Equity funds particularly Large-cap Growth and Large-cap Core funds have been in net redemption for a considerable length of time. Despite the average performance of Large-cap Growth funds this year is close to a gain of 30%, they are in net redemption. This is largely an aged base, as the fund holders who were sold Growth and Core funds years ago are at the stages of life where they need the money for other purposes. This is not new and has been happening for decades. What is new is that the long- term profitability of selling funds and managing accounts invested in funds has changed.

But there is a more important message from net flows. Global and International funds are adding assets at almost the same rate as the Domestic-oriented funds are being redeemed. What this is saying is that the Domestic funds are suffering from the lack of sufficient retirement capital. Plus today’s active fund buyers are hedging their retirement against a perceived long-term decline in the value of US assets. This is backed up by the current yield on long-term government bonds. There are ten large countries with ten year government bonds. The yield on the US ten year is second highest of the ten. This means that the market participants view that there are eight better places to invest their bond money and will take lower yields to insure their safety on a post-inflation basis.

Equity = Opportunity/Risk

At the current global level of interest rates we will be far short of filling the retirement capital deficit. The best opportunity to fill the gap is equity. Equity has imbedded within it both opportunity and risk of loss. In general the larger, more mature corporations have the least risk but also the least investment returns, as shown below utilizing the three S&P market capitalization indices’ investment performance since 12/31/1999:
S&P “Market Cap” Indices                        
Average %
Range: High to Low %
+  194.89 to (51.36)
+  874.74 to (69.38)
+1198.12 to (95.89)

This table suggests that mid and smaller market cap companies can produce higher returns than the more mature, larger companies in general. The market risks are greater also, but not relative to the size of the gains.

Betting on Change

None of us know for sure what the future may bring, but the wise equity investor hopefully recognizes changes earlier than many others. There are many possible disruptive changes which could impact all of us. I am not sufficiently knowledgeable to have an appropriate view on autonomous driving vehicles but they could change or disrupt almost every element in our societies. It is the marriage of technology and lifestyle changes.

There are a number of other disruptive forces that can change our world, hopefully for the better by addressing the two missing productivity measures.  Because I believe that some of these changes will occur, I will continue to be largely an equity investor.

Question: What are the changes that you are expecting?
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Sunday, December 3, 2017

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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Sunday, November 26, 2017

Normal or Abnormal Decline Approaching?
Weekly Blog # 499


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.


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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Contact author for limited redistribution permission.