return potential for US stocks–suppose Goldman is right?

Yesterday I wrote about the view of Goldman equity strategist David Kostin that, on a capital changes basis (i.e. , not counting dividends), the US stock market will be flat over the coming 12 months and will edge higher at only about a 2% annual rate for at least several years after.  Collecting dividends will be a major source of total returns.  In fact, if the reason for this sub-par showing (by historical standards) is that earnings will grow but price earnings multiples will contract as interest rates rise (I’ve only read a bare-bones summary of Mr. Kostin’s view), then dividends may be the major source of returns.

Let’s suppose Mr. Kostin is right.  What does this mean for investors?

my thoughts

1.  Losing stocks will be devastating.  Large losses always hurt more than large gains.  But a strongly rising market tends to act somewhat like a safety net to cushion the fall, as well as offering a chance to catch the next shooting star to make up for the mistake.  A flat market is less forgiving, and will presumably offer fewer chances to recoup from losses.

2.  One or two winners will probably be enough to make a portfolio manager’s year.  Careful securities analysis will be rewarded with outperformance, provided a manager can avoid having big losers.  Again, this is nothing new–although the idea that having a ton of stocks you spend only a little about is not as good a strategy as having a few you know inside out has eluded academics until recently.

3.  Trading stocks, aka market timing–a tactic reviled in investment folklore–probably becomes more important as a source of performance (maybe this is why GS is content to let Mr. Kostin publish).  This will be doubly so for non-taxable accounts.

If we truly believe the major trend is sideways, buying and selling portions of positions based on valuation–especially in the case of stable, mature companies–becomes a more attractive strategy.  This is sort of like bunting for a base hit–you need a lot of successes to score a run.  But it may be the only way to get on the board if the market is throwing blanks.

4.  For institutions, trading through derivatives–maybe in the same fashion big bond funds operate–would provide liquidity and speed that gigantic portfolios can’t get otherwise.  Custom-tailored OTC derivatives may be the most preferred.  Not for you and me, but probably for the largest money management houses.  Great for brokers’ profits, too.


return potential for US stocks

Yesterday’s Wall Street Journal contains a summary of projections by Goldman equity strategist, David Kostin, for US stock market returns this year and beyond.

His view is that stocks will be flat over the coming 12 months–investors will collect dividends but no capital gains.  After that, stocks will average +5% yearly total returns for the rest of the decade, miniscule a meaning they’ll continue to collect dividends plus, on average, miniscule capital gains.

Of course, like any brokerage house, Goldman has a plethora of strategists, not just Mr. Kostin.  The ones waiting in the wings cover the waterfront from bullish to bearish with their views, so at least one is bound to be right–and can come off the bench to replace Kostin if need be.

Still, Mr. Kostin has the title, and he’s the one who makes the rounds of brokerage clients to present Goldman’s views.  So his is most likely the firm’s official position–and agrees at least  in spirit with the beliefs of Goldman’s top management.

Kostin’s is a peculiar stance for a broker, nonetheless.

In the real world, no brokerage research report is intended to be “pure” scholarship.  Yes, every document is intended to show off the firm’s deep factual knowledge and analytical skills.  But it’s also supposed to produce revenue by flattering the firm’s investment banking clients and persuading its money management customers to transact.

A bearish strategy may do the first but it certainly won’t do the second.  It won’t produce the kind of revenue a document like this is aimed at achieving.

So why publish something like this?

I can think of several reasons:

–it’s possible that Goldman figures that institutional money management clients aren’t going to generate much trading revenue from now on (the substitution of index funds for active managers?), so it no longer matters that much what the firm tells them,

–maybe Goldman senses that a pollyannaish story from, say, Senior Strategist Abby Joseph Cohen, would go down worse,

–perhaps the Kostin view is actually bullish, or at least as bullish as Goldman is willing to be.  Maybe Goldman anticipates a big stock market selloff as interest rates begin to rise and intends the idea that, given time, investors will steadily regain what they’ve lost (plus some) to stand as a beacon of hope.

–it could be that Goldman wants to sell non-traditional products to investment managers as a way of dealing with potential hard times.

More tomorrow.

Hope over experience?—S&P Indexology

I subscribe to the S&P Indexology blog.  It’s written by S&P staff involved in manufacturing the company’s well-known financial markets indices.  Usually it’s interesting, although the writers’ true-believer conviction that no active manager is capable of matching–to say nothing of outperforming–his benchmark index often shines through.

Yesterday’s post, titled “Hope over Experience, ” is a case in point.  It takes on a recent, pretty silly Wall Street Journal article that muses about an “Old-School Comeback”  of active stock mutual fund management, based on recent outperformance of the average active manager over the S&P 500.  “Recent” in this case means the first four months of 2015; “outperformance” means a gain of .33% versus the S&P.

The obvious observations are that the time period cited is extremely short and that the gain versus the index is probably statistically insignificant.  S&P Indexology goes on to say that the comparison itself is bogus. The S&P 500 is neither the appropriate or the actual official benchmark for many stock mutual funds, which have, say, growth, value, small-cap or other mandates and other benchmarks than the S&P 500.

So far, so good.

Then come two comments straight out of the university professor’s playbook:

–The first is the argument that because an active manager’s portfolio structure may be dissected, after the fact, into allocations that could have been replicated by indices, actually creating and implementing that structure in advance has no value.  That I don’t get at all.

–Indexology concludes by suggesting that because investing in the aggregate is a zero-sum game–the total winner’s pluses and losers’ minuses exactly offset one another, before costs–there can’t be any individual investors who consistently outperform.

I believe that life in general, and investing in particular, is a lot like baseball.  (I’ve been thinking about baseball recently because it’s in season).  The second Indexology comment is much like saying that the Giants’ winning three World Series in five years is a random occurrence.   …or that the change in ownership of the Cubs and the hiring of Theo Epstein have nothing to do with the club’s success this year.  Yes, bad teams get a preference in the draft each year, but the end to a century of futility?

…and what about the Braves and Cardinals, who consistently field above-average teams even though their draft positioning does them no favors.

To be clear, I’m an advocate of index funds.  My reasoning for this is not that outperformance is impossible (the ivory tower orthodoxy) but that it takes more time and effort than most people like you and me are willing to put in to locate and monitor active managers.  I’d be much more comfortable with Indexology saying this.

the Supreme Court and 401k plans

On Monday, the Supreme Court made a narrow ruling on a technical point that may have far-reaching implications.

Participants in the 401k plan offered by Edison International, a California utility, sued the company claiming that it stocked the plan with “retail” versions of investment products that charge higher management fees than the lower-cost  “institutional” versions that it could have chosen instead.

The company defended itself by successfully arguing in a lower court that the statute of limitations for bringing such a lawsuit had expired.  The Supreme Court said the lower courts were mistaken.  An employer has a continuing duty to supervise its 401k offerings.  So even though years had passed since the 401k offerings were placed in the plan, the statute of limitations had not expired.

So the case goes back to the lower court, where presumably the question of whether Edison was right to offer a higher cost product than it might otherwise have.

Was this a mistake?

Why wouldn’t any company have the lowest cost share possible in the 401k plan?

The short answer is that the company receives a portion of the management fee in return for allowing the higher charges.

Typically the company argues that the fee-splitting helps cover the costs of administering the 401k plan.  In practical terms,thought, the move doesn’t eliminate the costs.  It shifts them from the company to the plan participants.

If the Wall Street Journal is correct, this is the case with Edison, which is reported as pointing out that the fee-splitting is disclosed in plan documents.

I have two thoughts:

–the sales pitch from the investment company providing the 401k services probably sounded good at the time.  The 401k would be inexpensive (free?) to Edison.  High fees would shift the cost onto employees instead–which makes sense, the seller might argue, since employees are the beneficiaries of the plan.

On the other hand, to anyone without a tin ear, this sounds bad.  The amounts of money are likely relatively small.  Edison is probably spending more on legal bills than it “saved” by choosing the plan structure it did.  And if it turns out that Edison is profiting from the arrangement rather than just covering costs, the reputational damage could be very great.

–fee-splitting arrangements on Wall Street are far more common than I think most people realize.  This case could have wide ramifications for the investment management industry if the courts ultimately decide that Edison acted improperly.



an Intel (INTC) – Altera (ALTR) deal re-emerging?

Market gossip is that ALTR recently refused a friendly offer from INTC at $53 a share.

Speculation resurfaced yesterday with rumors that talks have started up again.

The catalyst seems to be the fact that serial acquirer Avago (AVGO–I own shares) appears to be considering a bid for ALTR’s rival Xilinx (XLNX).

AVGO seems to have a knack for finding firms that have excellent technology but which, for one reason or another, find it difficult to achieve consistent profit growth.  AVGo buys them, reorganizes them and puts the profit machine into high gear.

In this case, the sub-industry involved is the sleepy world of field programmable gate arrays (FPGAs), dominated by the cozy duopoly of ALTR and little brother XLNX.  AS the name suggests, FPGAs are chips whose program structure is not hard-wired (those are application-specific integrated circuits–ASICs).  So they can be reprogrammed, upgraded, debugged…even after they’ve been put into machines that are now in use.  This allows manufacturers to get, say, cutting-edge telecom equipment into customers’ hands very quickly.  The drawback is cost.

The AVGO move suggests the FPGA arena is about to become considerably more competitive.   AVGO/XLNX would be four times the size of ALTR, implying easier access to capital and the ability to offer a much wider variety of products to customers than ALTR.  This suggests ALTR realizes the status won’t be quo for much longer and it needs to be part of a bigger entity in order to compete.

To my mind, the big winner in all this would be INTC.

inheritance tax changes as a lever for structural change in Japan

value investing and corporate change…

One of the basic tenets of value investing in the US is that when a company is performing badly, one of two favorable events will occur:  either the board of directors will make changes to improve results; or if the board is unwilling or incapable of doing so, a third party will seize control and force improvements to be made.

…hasn’t worked in Japan

Not so in Japan, as many Westerners have learned to their sorrow over the thirty years I have been watching the Japanese economy/market.

Two reasons for this:

culturally it’s abhorrent for any person of low status (e.g., a younger person, a woman or a foreigner) to interfere in any way with–or even to comment less than 100% favorably on–a person of high status.  So change from within isn’t a real possibility.

–in the early 1990s, as the sun was setting on Japanese industry, the Diet passed laws that make it impossible for a foreign firm to buy a large Japanese company without the latter’s consent–which is rarely, if ever, given.

The resulting enshrinement of the status quo circa 1980 has resulted in a quarter century of economic stagnation.

Abenomics to the rescue?

Abenomics, which intends to raise Japan from its torpor, consists of three “arrows”–massive currency devaluation, substantial deficit government spending and radical reform of business practices.

Now more than two years in, the devaluation and spending arrows have been fired, at great cost to Japan’s national wealth–and great benefit to old-style Japanese export companies.  But there’s been no progress on reform.  The laws preventing change of control remain in place.  And there’s zero sign that corporations–many of whose pockets have been filled to the brim by arrows 1 and 2, are voluntarily modernizing their businesses.  Mr. Abe’s failure to make any more than the most cosmetic changes in corporate governance in Japan is behind my belief that Abenomics will end in tears.

One ray of sunshine, though.

Japan raised its inheritance tax laws at the end of last year, as the Financial Times reported yesterday.  The change affects three million small and medium-sized companies.

The top rate for inheritance tax is 55%, with payment due by the heir ten months after the death of the former holder.   This development is prompting small business owners to consider how to improve their operations to make their firms salable in the event the owner dies.  More important, it’s making them open to overtures from Western private equity firms for the first time.  Increasing competition from small firms may well force their larger brethren to reform as well.

For Japan’s sake, let’s hope this is the thin edge of the wedge.



cyclical growth vs. secular (ii)

Same topic as yesterday, different starting point.

When the monetary authority begins to tighten policy by raising interest rates, it does so for two reasons:

–the domestic economy is giving signs of overheating, that is, of growing at an unsustainably high rate, and needs to be reined back in before runaway inflation results

–too much money is sloshing around in the system, and finding its way into more and more speculative investments.

For stock market investors, the tightening process implies two things:

–the rate of profit growth in business cycle-sensitive industries is peaking and will begin to decline, and

–playing the greater fool theory by holding crazily speculative investments will no longer work as excess money is siphoned out of the economy.

However the Fed proceeds, the second effect will surely happen, I believe.  But the US economy can scarcely be said to be overheating.  Despite this–and the Fed’s promised vigilance to prevent a meaningful slowdown in economic activity, I think all stocks–and cyclical ones in particular–will be affected.


…because the Fed tapping on the brakes lessens/removes the ability of investors to dream of a possible openended future cyclically driven upsurge in profit growth.  Whether specifically aimed at this or not, Fed action will have the effect of tempering Wall Street’s avaricious dreams.

What about dollar weakness, EU growth, China…?

In every cycle there are special factors.  They don’t change the overall tone of the market, though.

The main effect of a weaker dollar and stronger EU economic performance will be to increase the attractiveness of EU stocks, and of US names–principally in Staples and IT–with large EU exposure.  Look for the stocks with big holes in December and March quarterly income statements.

As for China, who knows?   My guess is that the Chinese economy won’t deteriorate further from here.  But the main China story , as I see it, will be the country’s gradual shift to consumer  demand-drive growth along with the substitution of local products for imports.  To me, both aspects suggest that well-known US, EU and Japanese China plays won’t regain their former glory.

My bottom line:  the shift from cyclical to secular may be more modest than usual this time, but it will still be there.  A more conservative mindset argues against further price earnings multiple expansion for the market.  So future market gains will depend entirely on earnings growth. The larger immediate effect will likely be in the loss of market support for very speculative stocks.



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