'Horses for courses' is a racing expression which indicates that horses run differently at different racetracks. Not only different courses but different lengths of race.
As is often the case, what is true in the analysis (or handicapping) at the track is also true in the selection of managers, securities, and investment strategies. These concepts were the genesis of my developing different timespans to be used for managing investment portfolios.
In the first two timespans, Operating and Replenishment, significant financial losses are difficult to overcome and thus cyclical considerations dominate. The longer term Endowment and Legacy portfolios assume periodic declines, but that long-term secular trends will dictate their future performance.
As we appear to be entering a period of switching gears from complacency or frozen in place, to one of growing enthusiasm, the prudent investor should increasingly wonder what could go wrong.
Of the myriad of possible future events it is unlikely that one can accurately predict what will happen. At the current time I feel an obligation to point out possible unanticipated problems.
I will first focus on possible cyclical problems that can impact investment performance through an intermediary period of roughly five years and thus cyclical factors.
Cyclical factors for the intermediate term
As professor Robert Shiller points out, almost everyone acknowledges that a recession will happen. He further states at the moment that not too many investors are concerned about a future recession. The popular securities indices are regularly reporting new high levels.
However, the best performing of the three indices, Dow Jones Industrial Average (DJIA), Standard & Poor’s 500 (S&P500) and the NASDAQ Composite (NASDAQ) is the last one by a considerable margin, as small companies particularly those involved with information technology including Apple* performed well.
While the NASDAQ is slightly reporting new highs, it is not demonstrating a major breakout after hitting a new high and thus it may be questioning the strength of the move. This is not particularly upsetting because as in the past, Apple shares sell off after new product announcement run ups.
As a long-term owner of these shares I am much more focused to see the level of sales and deliveries in its fiscal second quarter ending in March 2018. While some market rotation is healthy if it does not include a strong NASDAQ performance, it would be demonstrating the “animal spirits” are getting tired.
Market leadership rotation is normal and expected, but when one or more of five sectors or asset classes lead, it will be an indication that investors are deserting the central forces of the economy. If you possess trading skills the five sectors could be very productive.
If you are like the most of us who move in and out late, be very careful. The five in alphabetical order are bonds, commodities, energy, gold, and TIPS. If you are an accomplished player, play. If not it would be time to build reserves, particularly if you are managing a current or replenishment account.
As mentioned last week the gains in earnings being reported for the first half of 2017 are due to expanding profit margins. Earnings per share are growing faster than revenues which are growing slowly and in some cases very slowly in the second quarter. To create sustainable earnings and employment we need to see revenue generation pick up.
The potential expansion in the level of enthusiasm for stocks may be heralded by the decline in neutral sentiment in the latest AAII survey, dropping from 36.7% last week to 32.7% this week, and a roughly similar increase in bearish attitudes. This suggests to me we can see an important increase in volume which in and itself engenders more volatility.
My real concern for the intermediate future centers on the bond market which is larger than the stock market but can be much more sensitive to short-term events.
I don’t know what can create a bond market bear market, but the following are thoughts that needs to be understood:
- The little understood bank for central banks, the Bank for International Settlements, has noted that many governments, including the US, are only identifying contingent liabilities in their financial statements. These include unfounded pension and medical costs. One potential concern of mine is a large size of unprofitable investments by China in building its One Belt One Road Initiative (OBORI) in neighboring and other Asian countries.
- Yields on high grade corporate bonds are rising which means prices are falling slightly, showing some lack of demand. At the same time yields on lesser quality bonds are holding up, showing an increase in demand.
- Just as yields go in the opposite direction, the contrarian in me suggests that flows follow performance late and stay too long. In almost every country that has a mutual fund business there is an increase of substantial size in the flow into bonds. They are easy to sell to people in view of the low manipulated rates dictated by central banks that impact commercial banks’ deposit rates. This excessive flow is augmented by the large number of financial groups offering new credit funds without sufficient experience in non-bank lending.
In sum, I grow increasingly wary in crowded markets.
For the intermediate term investor I see more performance/career risk than we have seen in sometime. Perhaps, we will escape but by the next US presidential election the odds are that we are going to be tested.
Michael Lipper is a former president of the New York Society for Security Analysts. He was president of Lipper Analytical Services Inc. the home of the global array of Lipper indexes, averages and performance analyses for mutual funds. His blog can be found here.