Investment Committee/Investors Prepare For Mistakes - Weekly Blog # 570

by: Mike Lipper, CFA
Summary

I am totally convinced that we will see record high prices for the major indices and I also have confidence that we will experience both recessions and substantial market declines.

Double-digit gains were achieved by the major stock market indices despite the global slowing of economies.

The latest Atlanta Fed Real GDP fan chart estimate ranges from under 2.5% to under 1%, reflecting market fears.

China appears to be the most important driver of global economic growth.

Mutual funds are now required to show their best and worst quarters. These are often next to or close to each other.

Bright People Are Sometimes Wrong

I have assembled and often chaired investment committees of bright, experienced investors. I have been curious as to why these bright investors make unexpectedly bad judgements. Individually, they have a history of making good choices in terms of securities and the timing of their transactions. I bring this up as we approach a general market turning point. I am totally convinced that we will see record high prices for the major indices and I also have confidence that we will experience both recessions and substantial market declines. The order, timing, and magnitude of these are unclear to me. What I am sure of is that many investment committees and most investors will get their timing absolutely wrong!!!.

Why?

We are social people who mostly prefer to agree with others than to express a strident minority view. The group dynamic in most investment committees is to move to a unanimous decision. Unless we have very deep-seated opinions, there is a tendency to go along with the sensed majority view, despite our own private opinion which may be better. This tendency has been labeled the "Abilene Paradox." I suspect that this is one of the reasons that political pools have proven to be inaccurate. One can often sense the answer the questioner wants to hear and we have sympathy for those who ask.

Current Factors

Double-digit gains were achieved by the major stock market indices despite the global slowing of economies. The gains if repeated would result in record price levels, led quite possibly by the Nasdaq Composite, the most volatile of the major stock indices. This volatility could be driven by the larger tech companies or less capital being committed to over-the-counter market-making.

The latest Atlanta Fed Real GDP fan chart estimate ranges from under 2.5% to under 1%, reflecting market fears.

China appears to be the most important driver of global economic growth. Some believe changes in Chinese policies are having a bigger impact than the Fed. In part this is true because interest rates driven by the Fed are currently in the mid-range. They have not gone high enough to attract savings (4%) or low enough to spur a declining economy.

One large fund of funds manager has re-juggled its list of managers in favor of concentrated "high-conviction" managers. Others are adding leverage to their portfolios to overcome low returns. From a market viewpoint the combination of leverage + volatility = dynamite.

Helpful Hints From Mutual Funds

Mutual funds are now required to show their best and worst quarters. These are often next to or close to each other. Often the magnitude of the gains and losses when linked together almost cancel each other out, although sometimes it may take two up quarters to recover the losses from the bad quarter. If the percentage gains and losses are large, it is an indicator that the fund is volatile.

The coverage of mutual funds can be misleading, as media and sales efforts focus almost exclusively on the best performers in relatively short time periods. The leaders and laggards are often highly concentrated in terms of the number of issues held, giving the impression that these mutual funds are bought for speculation, although that is not always the case.

The vast majority of the equity funds are in just four investment objective categories and are listed below in descending order of assets, which also appears to be at increasing levels of perceived risks as you work your way down the list:

Growth & Income: $4.27 Billion

Growth: 3.84

International: 2.48

S&P Index: 2.19

The first three investment objectives carry cash to meet extreme redemption needs and opportunity reserves. The biggest use for these funds is to meet retirement and for estate building purposes. Most redemptions are caused by life changes. Index funds always have no cash and buy the most popular stocks.

Turning Point Reactions Produce Relatively Small Gains And Large Losses

Historically, momentum becomes the enemy of capital preservation when we near peaks and troughs, unless an investor possesses trading skill. Investment committees at this juncture become captives of the "Abilene Paradox."

Don't say that you weren't warned, but good luck and stick to your convictions.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.