Introduction
“Horses
for Course” 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. In the second part of today’s blog I will focus on Asian,
African, and Latin American factors that could impact the longer term secular
trends.
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.
*Held personally
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 around 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.
Secular Concerns for Longer Term Investing
"Cyclical and Secular Concerns Vary with Time Horizons - Weekly Blog # 490"
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