What should be normal for an investor and particularly for a portfolio manager of other people’s money after a particularly good investment performance, one should question what can go wrong. Traditionally, September is the worst performing month of the year. Not only was it a positive month in 2017, but most of our advised accounts produced better than their individual performance benchmarks. In the first 9 months of 2017 we are producing returns at two to three times normal long-term annual expectations. We have invested some of our clients’ money in mutual funds that have gains of over 20% and a few in the 30% range. Following what should be the normal reaction after such results I am casting around as to what can go wrong.
A lot can go wrong. At the moment the three most prominent concerns all have a political base. As a classically trained securities analyst, I normally ignore the political world, in part I have observed that contrary to most people’s logic, news follows the market rather than the other way around. For example the so-called Trump Bump actually started in July of 2016, not at the election time. Another reason for generally ignoring the shifting currents of the political world is that I am a securities analyst, more comfortable with financial statements and operating conditions than attempting to be a political analyst.
Nevertheless the three biggest risks to stock portfolios emanate from political decisions. Remember that Bernie Baruch when testifying before the US Congress was defending himself and his transactions that were labeled speculative. Reminding the Members of the derivation of the verb ‘to speculate’ was to see far (into the future). Recognizing that I may be wrong about any one or all three political risks, I will discuss each in order. The order chosen is in the probability of happening and the inverse order of magnitude of potential risk.
Risk #1: Top Potential Casualties
Politicians strive much more for power than policy. In a capitalistic society there is almost always conflict between political power and the power of money. Often it is hidden but rarely is it not present. The battleground between the opposing forces is public awareness which is in control of selecting the levers that make our society progress. The following is an incomplete list of industries that the federal government curtailed through various measures since the aftermath of our very destructive Civil War, in roughly historical order. After identifying the industry or company in parenthesis are the government actions.
Railroads (Interstate Commerce Commission on tariffs); Life Insurance (licensing by individual states), Banking (Federal Reserve and Federal Deposit Insurance Corp.), Steel (tariffs and labor disputes), Standard Oil (trust busting), AT&T (breakup) and commercial airlines (deregulation). I am not suggesting that some of these actions weren’t in response to public concerns, but in these cases the net results were to force the companies to drastically change their ways which may or may not have helped the public more than it hurt them.
As a very powerful Speaker in the US House of Representatives once stated, “All politics is local.” In most communities the movers and shakers typically are a small group with a lead the following sectors: Banking, Newspapers, Auto or Farm Equipment dealers, Doctors, Insurance Agents, Retail trade and Real Estate. If a number of these feel threatened by new types of competition, they have an easy access to their political leaders in Washington - particularly when their regular political campaign contributions are remembered.
Today the five largest market capitalization stocks in the Standard & Pours’ 500 are increasingly being looked at as threats to the established commercial and therefore political order. The five are Apple*, Facebook, Amazon, and the two classes of Alphabet (Google). Their combined market cap is $ 2.9 Trillion or in the same region as the annual incremental addition to the US national deficit. Clearly their very market successes create envy, both in the financial markets and public sentiment. Much more important in my mind is each of the leaders can be seen as an unintended threat to the cabal that runs our political structures on both sides of the aisle. I will very briefly identify the threats that can be conceived:
Apple is encouraging communications at numerous different levels which is destroying land line phone companies, local newspapers, and local financial institutions. Facebook in the last US election was the source of both valuable and manipulated news.
Alphabet (Google) is the ultimate supplier of “authoritative” information putting our teachers and professors to shame.
Amazon has just about destroyed the local book store and is seriously hurting the retail trade. Their very success has driven its stock prices up at a greater rate than the rest of the stocks in the S&P500, accounting for perhaps 25% of this year’s gains in some measures. It also is one of the reasons that active managers who own more of these and similar stocks are outperforming the identified indexers as well as the closet indexers. European governments have been among the first to try and corral these companies and could reduce their residents’ use of these products (which has happened in China.)
I don’t know how the political power class will attempt to rein in the power of the new uses of technology, but they may only be as successful as the Luddites in delaying the march of automation. While at the moment I am worried and expect the rumors or actual governmental moves to force a give up of some of the large stock price gains, I am betting that these companies’ lobbying and other efforts will blunt any serious moves. However, my tolerance is perhaps at the 33% level. If your level of tolerance is less, be aware of the perceived risk.
Risk # 2: Repatriation: Pandora’s Box
Be prepared for disappointing results from the temporary repatriation tax holiday. Politicians and to some degree central bankers are steps behind investors and corporations in their recognition that we are in a post national world. A good bit of the foreign earnings of US corporations has been generated from sales of products and services to non-US residents. To the extent that the foreign branches and subsidiaries have paid for their US capital and research services, the foreign activities represent potential spin off candidates. This is the case for a number of multi-nationals.
If they fall for the tax trap and bring all of the foreign earned capital back to the US, they are probably good candidates for sale as they don’t believe in their own future particularly if the bulk of the repatriation goes to buy backs which helps the existing management and hurts future owners as the company does not believe in its future.
Often when we invest in a foreign to the US fund, we are investing in foreign multi-nationals. This is similar to when non-US residents invest in our funds. In truth all over the world, most large financial institutions invest in large caps globally. They assume that the companies will be managed to achieve the highest prudent return long-term, not to solve local tax issues to reduce the size of unwise deficits. It may take awhile for the politicians to recognize that investors have felt the need to defend themselves from their own local governments, at least by diversifying into different legal and tax jurisdictions. Whether we like it or not we have entered a post-national world. One can expect the politicians to fight it and try to refocus investors on their home market, but it won’t work unless they encourage the locals to make their market the most attractive in the world. This probably won’t happen, unless we drastically shrink the size of government and regulation.
The risk is that when repatriation for sound reasons does not produce the flow of money into the US that the politicians were expecting, the politicians won’t see that they are the crux of the problem. Most likely they will wish to penalize international investing, which will be counterproductive and hopefully won’t last too long.
Risk # 3: Lessons from French and Russian Revolutions
The overall theme of recent elections in India, Great Britain, US, France, Germany, and possibly Japan and Catalonia is that voters are angry as to their current position and want change. Many, if not most, of the current leaders were seen as change agents to solve the perceived deep problems. However, the problems are indeed deep and have been growing for forty to eighty years, Thus, they won’t be solved quickly in all likelihood. That is where the risk comes to the surface and the fearful lessons from the French and Russian revolutions. In each case the initial uprooting were lead by middle class leaders who were attempting to fix the old system. It didn’t happen fast enough and there was some mismanagement of resources due to their inexperience. In an unfortunate short time the awakened masses lost patience. The mob or perhaps an organized crowd consumed the change agents and became enthralled with more radical leaders. For forty years I had been expecting a wave of change agents which could have come from either the right or left. If they can’t produce quickly, they will be replaced. Again the replacement can come from either extreme, but almost certainly will be extreme. This threat can only be headed off if the change agents get some quick early victories and start to come up with some extreme approaches themselves to head off more extreme approaches of the new radicals.
As I stated in the introduction in listing the three political risks, the last one is hopefully the least likely but would be the most destructive to our portfolios.