March 3, 2020
A Black Swan Named COVID-19
A few hundred years ago, Europeans could not imagine a swan being any other color than white, because they had never seen a black swan until explorers returned from Australia with one. A black swan event is something no one can envision until it happens, sort of like the Fukushima nuclear accident, the 9/11 attacks on the World Trade Center and now the virus newly named COVID-19.
COVID-19 brings two sets of problems. One is public health, and the other is economic, and financial market implications.
I’m not afraid of getting sick. We live in a clean, uncrowded place with a great national health service that is already swinging into action to contain and cure this virus. And besides, I’ve had the flu a few times and survived, so I’m not worried about the illness part.
The media talks about Chinese cases of the virus leveling off, but they have not. They are still rising, just more slowly. Over the past week, epicenters of the outbreak have moved from China to the rest of the world. Cases outside of China are now growing at a pace much faster than in China so this thing is not going away.
Even if the heavy-handed quarantines in China manage to contain the outbreak there, COVID-19 will have a sharp, deep impact on both the US and world economies, so we should be ready for that as control and containment measures hinder business everywhere.
The global economy has become dependent on imported components and raw materials. “Just in time” manufacturing means plants don’t keep much inventory on hand. An entire factory can be forced to shut down for the lack of a single component, so the potential for disruption to global supply chains is significant as industrial paralysis, caused by transportation closures, workforce quarantines, or lack of materials created by issues elsewhere, spreads throughout the world economy.
I’m thinking this will be a long slog as the virus spreads slowly but widely. Unlike the US economy which entered 2020 strong, the economies of China and Europe were already weak and vulnerable to a shock like I expect from COVID-19.
Auto sales in China declined 92% in the first half of February according to FordAuthority.com. I’m sure you understand that a 100% drop would mean zero sales, so 92% is awful close to no sales at all in that huge industry. And factories of all sorts have been closed across wide swaths of China, which will likely impact global supply chains.
Usually when countries face extreme drops in demand like this, governments respond by pumping money into the economy to increase demand. But that kind of economic stimulus won’t stop ongoing factory closures, transportation blockages and material shortages, so I expect this issue to take a long time to resolve itself.
On the Bright Side:
- The US begins with the strongest economy and the least reliance on domestic manufacturing, so impact here should be minimal. Enough to avoid recession? I don’t know.
- US labs have geared up testing capabilities quickly. A few weeks ago, only a handful of US labs could test for coronavirus. As of this last weekend 93 labs had testing facilities, according to John Mauldin. And 70 companies are working on a bedside diagnostic.
- Vaccines may be widely available by the end of this year, adding a COVID-19 vaccine to your regular flu shot routine.
- In the future, infrastructure created for fighting COVID-19 will be available for the next bug that comes along, making the next outbreak less worrisome.
My advice: Stay calm and wash your hands. Life will go on.
Stock markets around the world are reacting negatively to the potential impact of COVID-19, with all major markets reporting double digit declines over the past few weeks. The S&P 500** Index which accounts for 80% of all dollars in US stocks, is down 8.54% year-to-date through February 29, 2020. However, major US indexes, including the S&P 500**, are down more than 12% from their highs on February 19th.
No stock market or industry anywhere in the world has escaped without losses since the market peak on February 19th. Although markets often bounce from these extreme downtrends, I expect the zig-zagging downward to continue as we have clearly entered a downtrend. Recently there has been no place for growth investors to hide.
Bonds are suddenly where the action is, with high quality bonds leading the way with healthy gains as investors fleeing the stock market look for a place to put their money. US Government bonds suddenly look so good that investors are accepting record low interest rates (1.12% on the 10-Year bond as of Feb 28th) to hold bonds.
This reminds me of the old Will Rogers quote, “I’m not so concerned with the return on my money as I am with the return of my money.” Wise investors are looking for capital preservation
I think this virus scare is going to take many months at a minimum to work itself out in the stock markets. The markets are telling us that a global recession is underway. I’m not sure if this will be a textbook, two-quarter-negative-growth recession, but savvy investors won’t want to wait to read about it in the newspapers. The results are going to be a sharp and deep decline in economic activity worldwide.
As far as what to expect from the stock market, the SARS virus knocked the US stock market, represented by S&P 500** Index, down 14% over three months in 2003 and took six months to recover those losses (Source: Investors Fasttrack). It took nine months to get back to even, and the SARS outbreak was nothing compared to COVID-19.
When the Ebola epidemic hit in 2015, we had Chinese (symbol: FXI) and Emerging Market’s (symbol: EEM) stock indexes to compare to ours. The US stock markets stayed stable for months while China and Emerging markets dropped 26% and 21% respectively. Then the S&P 500** Index played catchup with a 14% decline over the next six months. The emerging markets index ended up with 33% loss for the nine-month period, while the Chinese index dropped a whopping 44% of its value. It took FXI and EEM almost 3 years to regain their 2015 levels while the S&P 500** took one year.
Commodities in general are down a lot, signaling weak demand from industry. Oil prices are down almost 20% and even gold was down 4.76% last week after a strong 3 month run upward.
There are ways to make money in down markets using inverse, or “short” funds. These funds are calculated to earn the inverse of a market index. In theory, if the index goes down, the fund will move a similar, but opposite amount. However, if the index goes up, inverse funds will go down causing losses, so they are not mean to be held long term. The math of gains and losses confirms that these are trading vehicles, not traditional investments. In other words – kids, don’t try this at home.
Call or email me if you are not already a client and want to learn how we can make money in a down market. The number is 928.778.4000.
Remember, all large declines (think 50% losses like we saw in 2000-03 and 2007-09) begin with small declines like we’ve seen the past couple of weeks, so every decline needs to be respected. Read the “What’s Happening in Your Portfolio” section of this newsletter to find out how I am protecting client portfolios in this market environment. If that sounds good to you, call for an appointment to talk.
As you remember two years ago, our primary custodian Trust Company of America was purchased by E*Trade. There have been a few upgrades in service, but no significant changes in our operation due to becoming part of E*Trade Advisor Services.
Last month Morgan Stanley (MS) announced it was buying E*Trade. Their stated purpose was to give an in-house place to go for the flood of Morgan Stanley brokers who were leaving for the independence of becoming Registered Investment Advisers, like Hepburn Capital Management. It’s nice to be envied that much, I think.
Just as with the sale to E*Trade, I don’t expect many changes to our business operations from the Morgan Stanley acquisition, and any that may come will be years away. Stay tuned . . .
COVID-19, the Coronavirus that I described as “troubling” in last month’s newsletter has proven to be just that, with the S&P 500** Index losing 12.76% of its value in the past two weeks, as of this writing on March 1st.
Since the Coronavirus became an issue in late January, I have gradually moved your portfolio to a very conservative position. I was a little early in getting conservative, because the market kept going up for several more weeks causing small losses in our growth strategies. However, experience has shown me that it is much less expensive to be early in getting conservative than late.
As a result of these moves, declines in our managed accounts from peak values in late January through March 1st have been 1/3 to ½ of the index’s losses. More importantly, our Shock Absorber Growth* suite of strategies now holds 60% in cash (a money market account, actually), preserving account values and giving us buying power for when the market finally bottoms out.
During the sharp market decline from Feb 19th to the time of this writing on March 1st, our conservative holdings and large cash position limited our losses to the 2-4% range depending upon your strategy. Compared to the average investor’s 12% loss represented by in the major US stock market indexes, you are doing well.
Please remember that small losses like this are inevitable because I’m not signaled to change the portfolio until losses begin to register. My job is to keep them small so you have more money to invest coming out of the other side of this market, and I feel I have succeeded in that for you.
Our growth portfolios also hold inverse (short) funds in China and emerging market indexes. Inverse funds go up when an index goes down, and are often called hedges. I’m shorting China and emerging markets since they performed most poorly in the Ebola outbreak of 2015-16, and therefore offer the greatest gain potential if those indexes drop sharply again this time. Oddly, Chinese indexes have not dropped as much as the US markets as of this writing on March 1, 2020, but I believe they will be catching up allowing us to make some nice gains in a down market.
Over the last 20 years of pro-actively managing money, my greatest periods of outperforming the stock indexes is in down markets like we have just entered. If the market continues down, which I expect, the holdings in our Shock Absorber Growth* strategies should do very well for you.
Our Flexible Income* suite of income strategies has seen us move completely out of dividend stocks. As I said elsewhere in this newsletter, there is no place to hide in the stock markets, not even high dividend stocks are safe.
Flexible Income* portfolios are now invested in various bond funds, including US Treasury, Municipals, high yield and gold funds with an additional 20% held in cash.
And that is how we are staying in sync with this market.
- Shock Absorber Growth* is our 100% growth portfolio.
- Flexible Income* is our 100% income portfolio.
- Adaptive Growth Portfolios* are currently allocated with 80% Shock Absorber Growth* and 20% Flexible Income*.
- Adaptive Balance* is 50/50 between growth and income.
The World’s Next 10 Big Innovations
Every year, MIT Technology Review combs through recent inventions and picks the 10 new technologies most likely to break through into the mainstream and change the world. This year, legendary Microsoft founder Bill Gates curated the list as reported on inc.com.
Both Gates and the magazine have an impressive track record predicting big innovation. Prior magazine lists correctly predicted the huge impact of data mining, wireless sensor networks, reality mining, engineered stem cells, cloud streaming, crowdfunding, genome editing, reusable rockets, Slack, Babel-fish earbuds, and dozens more game-changing innovations.
Gates, of course, has correctly predicted the impact of personal computers, graphical user interfaces, online home monitoring, smart advertising, and more. And while nobody gets it right all the time (Zune, anyone?), I find these lists incredibly informative.
Here’s this year’s list, which was published in February:
- Robot dexterity
- New-wave nuclear power
- Predicting preemies
- Gut probe in a pill
- Custom cancer vaccines
- The cow-free burger
- Carbon dioxide catcher
- An ECG on your wrist
- Sanitation without sewers
- Smooth-talking A.I. assistants
Some may prolong life. Others focus on improving the quality of life. All 10 have several things in common.
Have you heard of the Rogers adoption curve? It demonstrates that adoption comes in waves starting with innovators and early adopters.
Each of the items in this year’s list already has startups working on them, and several of those startups already have minimum viable products to demo. Every one of these “breakthrough technologies” has begun the long journey to wide adoption. Some may never make it, and that’s fine.
Take predication No. 8: An ECG on your wrist. The Harvard Medical School agrees with this prediction, sharing recently: “Currently, some 50 million people wear activity-tracking devices, a figure that’s expected to rise to more than 160 million as smartwatches become increasingly popular.”
Each of the inventions on the list will take millions, if not billions, of dollars to get to market and be widely adopted. To earn the reward for taking the risk, you need the kind of deep intellectual property that these 10 categories share.
Adoption assures that you have a sustainable competitive advantage. Take the smartwatch example: In April, Apple won 50-plus patents covering multiple Apple Watch inventions. That’s how the tech giant plans to stay ahead.
Blue Ocean Strategy
In a book by the same name, authors W. Chan Kim and Renee Mauborgne write: “Blue ocean strategy is the simultaneous pursuit of differentiation and low cost to open up a new market space and create new demand. It is about creating and capturing uncontested market space, thereby making the competition irrelevant.”
The success of Netflix, Tinder, Wikipedia, and Airbnb are all examples of blue ocean strategy. Similarly, the startups driving Gates’s top 10 new technologies hope to cause sea changes in their industries.
They can do so by focusing on solutions that are both exponentially more valuable to end-users and lowering cost–whether that’s fiscal, environmental, or something else entirely. Look at prediction No. 6: the cow-free burger. According to MIT:
Depending on the animal, producing a pound of meat protein with Western industrialized methods requires 4 to 25 times more water, 6 to 17 times more land, and 6 to 20 times more fossil fuels than producing a pound of plant protein.
That’s why startups like Impossible Foods and Beyond Meat feel confident that they can disrupt their massive industry.
Economist Joseph Schumpeter writes in his book Capitalism, Socialism, and Democracy that the “gale of creative destruction” describes the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”
In plain English: Creative destruction occurs when a startup displaces an incumbent market leader by offering an exponentially better solution. Those meat-free burger companies hope by offering a healthier and eco-friendlier alternative, they will disrupt the cattle industry. Your startup needs the same type of advantage to succeed.
The 10x Rule
The 10x Rule states that to dislodge incumbent market leaders, you must be 10 times better–faster, cheaper, stronger, or otherwise. All of Gates’s favorite new inventions follow the 10x Rule.
Take predication No. 7: the carbon dioxide catcher. This technology can reportedly capture up to 90 percent of CO2 emissions produced from fossil fuels in electricity generation and industrial processes. That’s at least 10 times better than the current alternatives (like carbon taxes). Startups including Carbon Engineering (which is monetarily backed by Gates), Global Thermostat, and Prometheus all are jockeying to lead this space.
You should take note, no matter your industry. Ask these questions: How could this impact my business? If Gates is correct, how will this affect my business model?
If you answer those two questions effectively, you can leverage these 10 breakthroughs–and hopefully follow Gates into the successful founders’ club.
The SECURE Act, signed into law on December 20th, among other things, changes the distribution requirements for inherited IRAs and other retirement plans.
If your trust is named as your retirement plan beneficiary, this may have significant implications for you.
This is a good time to review your beneficiary designations and review trusts for appropriate “conduit provisions.”
With our Flexible Income Strategy we strive to provide high total return consistent with Capital Preservation.
Your money will be invested in bond mutual funds and exchange traded funds (ETFs), including inverse and leveraged funds, currency funds, including precious metals that may be used as currencies and income producing stocks whose price trend is up. If the price cycles down, holdings are replaced with new investments that are going up, repeating as needed. Growth stocks are not used.
Click here to read more about Flexible Income.
* The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Performance and activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account. Not all trades are profitable. It should not be assumed that current or future holdings will be profitable. A list of all trades in these accounts for the past 12 months will be provided upon written request.
** Indexes are unmanaged lists of stocks considered representative of a broad stock market segment. Investors cannot invest directly in an Index.
This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy. Please discuss any legal or tax matters with your advisors in those areas. Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.
In all investing, past performance cannot assure future results, and as such, our efforts are not guaranteed. Losses can occur. All strategies offered by Hepburn Capital Management, LLC, adapt to changes in the markets by changing the investments they hold, therefore, comparisons to broad stock market indexes such as the unmanaged indexes mentioned may not be appropriate. Sometimes client accounts are invested in stocks or markets not included in these indexes. Past performance does not guarantee future results. Investment return and principal value will vary so that when redeemed, an investor’s account values may be worth more or less than when purchased. Mutual fund shares and other investments used in our managed accounts are not insured by the FDIC or any other agency, are not obligations of or guaranteed by any financial institution and involve investment risk, including possible loss of principal. Advisory services offered through Hepburn Capital Management, LLC, an Arizona Registered Investment Advisor. Adviser will not transact business unless properly registered and licensed in the potential client’s state of residence.
Copyright (C) 2020 William T. Hepburn. All rights reserved.