Worries: 2nd Derivative, 3rd Degree And Surprises

by: Mike Lipper, CFA

The job of the analyst and leader is to worry about the things that most others don't worry about. The worries that most are concerned about won't happen as imagined, but others will. As is often the case with jargon, those in the know want to protect their position by defining a situation in terms that only they understand. The concept of the second derivative is known by sports people, hunters, and drivers.

In plain language, the first derivative is the speed of something moving and the second is the rate of change in that speed. When driving, we note the speed of one car overtaking another. What is of significance to avoid accidents is whether the overtaking vehicle is accelerating or decelerating. The risks of an accident happening is much greater if the overtaking vehicle slows upon passing, creating an unsafe gap between the moving vehicles.

Applying The 2nd Derivative

Quite foolishly, far too many investors believe that reported earnings will dictate future values. Foolish because in today's world, the validity of reported earnings is as accurate as the former Chinese Premier's distrust in reported GDP numbers, thinking of them as man-made and not reflective of reality.

One of the better consulting firms, the Boston Consulting Group (BGC), has published its "Value Creation Insights" on corporate activity. BGC noted that current prices include current expectations. This suggests that their clients can only raise stock prices by accelerating expectations, or for numbers-oriented people, by driving the second derivative higher than the first.

The problem facing investors today is that the current and expected 2nd derivative is negative. Through the third quarter most American companies were reporting record results driven by high profit margins. These expanding margins were the result of sales growing way above trend and by utilizing underused human and plant capacity.

Part of the driving power of these results was supplied by overseas workers, customers, and facilities. Most non-US markets have recently declined. The media and others have attributed this to the current trade conflict. While this is somewhat true, I believe an equal if not greater impact is due to consumer demand slowing and higher wages being paid.

Will The Saturday Night Truce Work?

Clearly, the Saturday night truce could dramatically change some of the trade issues, while creating others. While markets are likely to move this coming week, my guess is that the earliest we'll clearly see the impact will be the following week. Although that is likely to be a knee-jerk reaction, as the details will not be forthcoming until next year. Nevertheless, as much as I would like to be wrong, I do not think that trade itself will be enough to get the first and second derivatives moving in the right direction for investors. This is the logical view.

The Absurd View

Part of the training at my two educational institutions, the racetrack and the US Marine Corps, is to always be on the alert for surprises. Some of them may be so surprising as to be considered absurd or unbelievable. In that light I suggested in last week's blog that the US stock market could go to a new high this year. My reason for suggesting it was that in the light of the declines of the past few weeks, no one would have such foolish thoughts. Foolish me, I discounted radical swings in sentiment.

Global stock markets rose last week, probably in anticipation of a favorable result. Of the 30 top movers among the 72 market price indicators, 26 were stock market indices and only four were commodity indices. Thus, one can see that changes in sentiment drove stock buyers more than they did commodity or currency players. With the Dow Jones Industrial Average gaining +5.59%, S&P 500 +4.46% and the Nasdaq composite +6.19% in the week, new highs are only +4.81%, +5.81%, and + 9.04% respectively away from their former peaks. The absurd goes from impossible to possible and some may even say probable.

Whether or not the numbers play out as suggested, the key takeaway for investors is to expect surprises, some good. In the long run, markets move on supply and demand, which may or may not be seen. However, in the short term, changes in sentiment can make for dramatic moves.

The 3rd Degree

People need to find others to blame for their misfortunes. If they can find the culprits who did this to them, the culprits can be severely punished and possibly get restitution, ensuring this problem won't happen again. To accomplish this corrective goal requires some hearing in the court of law, or more quickly in the court of public opinion via the media.

This need has been present in societies throughout history. Because the guilty can be deceptive, they need to be questioned sharply, with or without appropriate protections. If headlines are generated, the prosecuting attorney or media can go on to bigger and better things, but this will not necessarily be better for the victims.

Despite repeated trials in court or the media these offending problems continue to reappear. Why? I suggest there are two fundamental generators of these problems. The first is the so-called victim, who in these circumstances possesses bad judgment. Bad judgment is often sourced from a school or the media trying to educate quickly, but not thoroughly. A similar source may be the staffs supporting various politicians, as well as the politicians themselves.

Since the main culprits won't acknowledge their culpability, there is a search for other perpetrators. Thus, all that serve as fiduciaries for others, as members of boards and advisers, are at risk of entering a 3rd degree chamber. Prosecutors are not interested in the number of years where things were done right, or the elements of sound judgment that didn't work at times, suggesting a failure to process rather than the quality of judgement.

Did you know, if not, why not? Type of questions. This is exactly why when sitting on a board or working for them I ask a lot of questions, with the hope that at least the questions, if not the answers, will hopefully be remembered in the minutes.

The reason for bringing this up now is that it has been a long time since we have had a bunch of scandals. (Because of human nature I suspect malicious things happen all the time and only occasionally bubble to the surface.) Often when the economy is not performing well there is a public need to find culprits. We know that some things will surprise people and therefore there will be a need to shift blame. These issues may not come out in force until there is a recession, which will come at some point.

Question of the week:

What do you think and are you planning to do anything about it?