On The Road To Capitulation And Recoveries - Weekly Blog # 552

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by: Mike Lipper, CFA

Every connection to life has its own ups and downs. One of the major translation errors from the singular precision of mathematics to the real world in which we live and invest is the implication that the shortest distance between two points is a straight line. Not that it is incorrect, but in the real world of dealing with people and their money, straight lines are a fantasy. As sure as days follow nights, we deal with changing observations based on changing conditions.

Thus, we should educate ourselves and others about cycles. In the two-dimensional world these are linked in time by plotting ups and downs, or if you prefer the mathematical term, their representation is sinusoidal. Actually, even that picture of reality is incorrect, cycles travel in multiple dimensions. Meaning that we cannot totally rely on past cycles being repeated exactly in the future. Thus, in planning for our investments, we cannot rely solely on history. We need to be aware of the differences between past cycles and current conditions. Even more difficult is guessing the differences in future cycles.

As an investment manager for long-term institutional and individual investment accounts, I am now focusing on identifying the coming bottom for stock prices and more importantly, the nature of the recovery from the bottom. The answers to the second question are to an important degree a function of whether we will be hitting a cyclical or structural low point. There will be elements of both types of declines in the bottom, but one usually is more predominant.

Cyclical Bottom

Most cyclical bottoms are created by dramatic change in sentiments based on very current stock price changes. One example is the (AAII) weekly sample survey. Three weeks ago, the American Association of Individual Investors reported the percentage of respondents that were bullish was 41% and bearish 31%. This week AAII reported 25% being bullish and 47% being bearish. Barron's produces a confidence index based on the difference between high quality and intermediate quality bond yields.

Unlike the AAII statistics this index usually moves less than one percent from week to week and has only moved 2% over the last year. It moved 2% this week compared to the prior week, in a direction that demonstrates there is concern in the bond market. (While the AAII numbers are highly volatile and are often negative indicators for future stock price moves, history suggests concerns in the bond market precede those in the stock market.)

Another indication of concern is that 14 of the 25 best-performing mutual funds for the week were Precious Metals Funds, a rarity. A sudden surge in gold mining stocks and funds after a long period of poor relative performance indicates worry rather than hedging.

Most of the time recommendations from transaction-focused brokers and fee paid investment advisers are similar. However, brokers are currently recommending the building of cash positions (To build future buying power), whereas advisers are continuing to recommend holding on to stock positions. This dichotomy may reflect the "growth/value" dilemma. "Value" stocks, which are often significant dividend payers, usually fall less in down markets and underperform in up markets.

"Growth" stocks tend do better in up markets and did quite well into the third quarter, led by the FAANG + BAT stocks, although they have given a lot of that back in the less than two months since then. Investors traditionally feel that the loss of a dollar is twice as painful as the pleasure of a dollar of gain. Thus, while some more mature investors are concerned about the size of their money pile, those that have cash flow needs are more focused on the expected terminal value of their accounts. (As an investment manager, it is our job to work with accounts to achieve the proper balance.)

As Yogi Berra said, you can see a lot by observing. My wife Ruth and I did our usual "Black Friday" investment research visit to the glitzy Mall at Short Hills. Our overall observations were:

  • Mostly women shoppers, often in groups consisting of three generations
  • Good but unobtrusive security
  • Shoppers very selective, with some quite empty stores. Specifically:
    • Apple (NASDAQ:AAPL)(*) - Quite full, but no outside lines
    • Verizon (NYSE:VZ) - Better than normal, but not crowded
    • AT&T (NYSE:T) - Actually had a few people there
    • T-Mobile (NASDAQ:TMUS) - Some traffic, possibly due to being opposite Apple
    • Starbucks (NASDAQ:SBUX) - Jammed
    • Williams-Sonoma (NYSE:WSM) - Very busy
    • Canada Goose (NYSE:GOOS) - Lines outside, with limit access
    • Tiffany (NYSE:TIF) - OK
    • Hermes (OTCPK:HESAY), Gucci, and Chanel - All busy

Relative to prior years I would give it a solid B, perhaps a B+. (I wonder whether the strength of the women's shopping can be tied to changing demographics, economics, and shifting voting patterns and are these cyclical or structural?)

Market analysts might consider that this week the DJIA, S&P 500, and Nasdaq composite reached prior lows. This could represent a double bottom from which a price recovery could take place. If it were to happen, we would have experienced a cyclical decline with the relatively gentle capitulation that occurred this week.

Structural Decline

While most of the time the stock market anticipates a recession, it doesn't happen every time. The 22% one-day decline in 1987 was unrelated to an economic recession, whereas The Great Depression of the 1930s combined an overpriced stock market with an out of balance economy and government errors.

Historically, investors without trading skills are better off within a year or two after a cyclical fall, if they stay invested in their reasonably diverse stock portfolio or funds. On the other hand, a structural decline can take much longer to recover from and some companies and sectors won't come back. Thus, out of prudence, I look for signs of a future structural decline and there are a few that need to be watched.

  1. The Bank for International Settlements (BIS), the bank for central banks, is pointing to the rise of "Zombie" companies. These are companies whose return on invested capital is below their cost of capital. If these conditions continue the companies will not be able to generate the money to grow and will eventually consume their own capital and commit suicide. BIS sees the number of these types of companies growing. An expected rise in interest rates without an increase in return on invested capital will have them trapped.
  2. Several young people entering the financial services business have asked me where they should start. I have suggested that if they can get exposure to past mistakes in workout situations and/or bankruptcies, it is much better than focusing on the successes of the firm. Thus, I try to learn what I can when one of these surfaces. David's Bridal, a chain of stores selling wedding gowns and related materials announced it was going bankrupt. The press chalked up the problem to a change in young people getting married and wanting less flamboyant weddings, which may be true. However, I think there were other problems that an outsider could see. For example, too much inventory, slow cash conversion, sloppy credit extensions, and their second set of private equity owners over-leveraging their relatively high purchase price. (I cannot comment on the critical issue of management) The over-leveraging of a high acquisition price is far from unique in today's world. Years of interest rates not high enough to absorb credit loses combined with a sharp increase in relatively inexperienced people at non-bank credit institutions making loans is a prescription for trouble, although it does not parallel the sub-prime credit expansion that contributed to the last financial crisis. Interestingly, we are seeing some non-bank mortgage companies withdrawing from their market.
  3. I believe the financial services sector is critical to the workings of the global economy. As an investor in this segment, I know that at times one can make money in these stocks, but not always. Nevertheless, I study it because of their centrality to the system. I am seeing activities that suggest some career investors in this segment are concerned about growing concentration. Merger and Acquisition activity is increasing to improve revenues and reduce overhead (people). Suggesting that this is a drive to maintain or improve profit margins and returns on invested capital, rather than growing the business.
  4. Two of the sharpest minds in our business see this as both an opportunity and a challenge. The first is the very well known, often contrarian, chairman of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B)(*), who was working down an excessive amount of the $120 Billion in cash by buying an additional $13 Billion in financial services stocks, including $4 Billion in JPMorgan Chase (NYSE:JPM) (*) stock. He and Charlie Munger are still maintaining $100 billion for big opportunity investments at attractive prices. Less well known in the US is Paul Myners from the UK. Paul has had success in the investment management business in UK, US, and Hong Kong. Besides his investment management work he has also led the financial industry both in the UK Government and import industry bodies. His latest role is chair at Autonomous Research, a very good in-depth research firm covering Europe, the UK, and US companies. He is selling the firm to Alliance Bernstein which is partially owned by Axa (*), in part due to the shrinkage of research commissions, particularly in Europe.

(*) A long position is held in these securities either in a financial-services fund I manage or in personal accounts, if not both.

I always look for changes in the structure of the market that can disrupt how investors react. There are two aspects worth watching. The first is the large and still growing amount of money being invested away from publicly traded markets. Pensions & Investments magazine has published an article on foundations. It tabulated how the fifty largest foundations allocated their assets between stocks, bonds, and other investments. Other investments, which included private equity, hedge and venture capital funds, real estate, and direct investments, represented 60% of their total of $230 billion.

Fourteen of the fifty largest foundations have more money invested out of the market than in it. I have seen the pull of these investments in endowments and foundations whose investment committees I sit or sat on. For a number of years as a group they have underperformed, even before fees are deducted and certainly afterward. This is in spite of a limited number of quite spectacular results from individual funds or properties. If the flows away from the market slow down or reverse there will be less leverage available to private and public companies, which could lead to structurally lower returns.

All too many investment results are phrased in terms of risk-free returns, which is translated as superiority relative to US Treasuries. One of the more successful fixed income mutual fund managers, Michael Hasenstab of Franklin Resources, has a view that US treasuries are due for a perfect storm. His three reasons are:

  1. The US fiscal deficit will rise (This may be particularly true with the House Ways & Means committee in the hands of spenders who will want to match defense spending increases.)
  2. A decline in bond buying by the Fed.
  3. Inflation will rise.

If "risk-free" rates of return decline, it may materially impact asset allocation and overall rates of return.

Conclusion

As of the moment, because of a lack of enormous enthusiasm at the prior peak, my current guess is that we are dealing with a cyclical decline and good holdings should not be disturbed. However, I will keep looking for increases in the list of structural issues that need to be addressed before we have a structure driven fall.

What do you think?