April 15, 2014
A Dangerous Knowledge Gap
The Investment View From Prescott, Arizona
Over my 27 years in the business, I’ve learned that many investors don’t understand bear market declines – ones that cause stock market losses of 20% or more.
One common misconception is that bear markets are rare events. Actually, there have been 25 bear markets over the last 113 years, or one on average of every 4.5 years.
In fact, the last two big bear markets, 2000-03 and 2007-09, arrived just about on that historical average. It is easy to think that the 1990’s bull market, which lasted for a record ten years, was typical of bull markets, but it was not. Bull markets last only a few years on average.
Surprisingly, investors in mutual funds and variable annuities are at even greatest risk from bear markets because there is a dangerous gap in what investors expect from mutual fund management and what funds are structured to deliver.
If you think the fund manger is going to protect you by moving your money out of harm’s way in the event of a market decline you may be sadly disappointed.
Most funds have a policy to stay fully invested, no matter what, so their managers are not allowed to move your money out of the market when it begins to decline.
One of my great insights into the working of the mutual fund business came in early 2001 when I went to Denver to meet with the managers of the Invesco family of mutual funds.
I had a private breakfast there with Brian Haywood, the manager of the Invesco Telecommunications Fund, at that time one of the largest telecom funds in the business. The fund had dropped $500 million (25%) of investor money in 2000, and at breakfast Brian looked scared as he said “This is really a bad decline. We see it going on for another year, perhaps two.” Believing in selling high and buying low, I asked him why he stayed fully invested if he knew things were going to get worse? Brian looked at me like I had just fallen off the turnip truck and responded, “When people invest in our fund, we assume they want their money in telecom stocks, and we assume if they want to be in cash they will withdraw from the fund.”
How many times have you ever had a financial adviser tell you that?
Traditional financial advisers often say “Of course I’ll watch the funds I sell you” but are powerless to really do anything. When they are paid on commission, regulations discourage them from moving your investments around due to the potential for illegal “churning”, the movement of investments that generate extra commissions for the broker – commissions that come out of your pocket.
So, mutual fund investors who expect full management of assets are usually disappointed when the market turns down and they see even good investments take stomach-churning losses.
The kind of “fully invested” policy Invesco had is usually written in fund prospectus. It does give investors certainty about how their money will be invested, but in bad markets it can also limit fund managers to doing little more than rearranging deck chairs on the Titanic.
Hepburn Capital’s niche in this market is to fill that gap between what clients expect and what mutual funds are structured to deliver. Although we don’t trade all that often (we’ve held some investments since 2011) we are prepared to move entire portfolios to cash or other safe harbors in times of trouble.
As we approach the end of the market’s more favorable winter season, with the market over-valued by most measurements, and the Federal Reserve rapidly cutting back the financial stimulus that has been so important to the five-year bull market, this might be a good time to think about risk management for your investments.
Waiting until a serious downturn is underway before beginning to think about how to handle it does not work. One must make moves ahead of market events. Reacting to them after they have hit the news is too late.
Call the office for an appointment to talk about assets you have that are not currently being managed by us. And please, tell your friends, too.
A Slice of Life
As we all know when we stop growing up, we often begin growing out, meaning wider. Even skinny ol’ me has to watch my weight these days since I’m too frugal to buy new larger clothes.
For several years I have had fun telling people about my “Tomorrow Diet” which most folks assume is a joke – thinking that I’m saying that I’ll start dieting tomorrow. But what I do is remind myself that there will be more food tomorrow and that I don’t have to eat everything that is in front of me. My goal is to leave about 1/3 of the food on my plate, and when I remember to do it it works. I eat what I like, just less of it, and it’s simple. I like simple.
Mary O’Neill, the newest of the Hepburn Capital crew, came to our staff meeting last week about 15 pounds lighter than where she began the year. When we fussed over her she told us about her “Two-day Diet”, where two days a week she counts calories, and the rest of the week she eats what she wants. Simple.
So there you have it, the Two-Day Diet or the Tomorrow Diet. No more excuses!
How’s the Market Doing?
Losing the Game of Chicken
In my last newsletter, March 25th, I likened the deteriorating market conditions to playing a big game of financial chicken. Fewer and fewer stocks were going up and the major indexes were creating deceptive headlines of “new highs”.
The best analogy is that of foot soldiers getting picked off or retreating in wartime. The generals will eventually realize there are no troops to lead and they, too, turn and run.
The generals turned tail last week as the US stock indexes tanked. The heavy volume of selling is a warning this could get ugly.
Is this the beginning of the much anticipated “payback” decline needed to correct the overly strong markets of the past year or two created by Fed easy money policies? No one knows for sure, but I believe that one should treat all small declines seriously, because all big declines start out as small ones, and they all look and feel the same early-on.
As of the close of business on Friday, April 11th, the S&P 500 Index** is only down 3.98% from its all time high set on April 2nd, so this decline still qualifies as small. So far.
Personally, I think it is time to defend portfolio values.
What’s Going On In Your Portfolio?
Although the US stock market didn’t peak until April 2nd, the market had been giving off signals of weakness which kept me from reinvesting money from holdings sold off in late March. This cash cushion has kept the shock absorber in our Shock Absorber Growth* model working well.
Current holdings include aerospace and defence, transportation and bank stocks, a diversified growth fund, along with more than 50% cash.
I have not begun to hedge yet, but may do so soon depending upon what the market does over the next week or two. Hedging is the technique of buying an inverse fund, one that goes up if the market goes down, to offset declining values in remaining holdings. This allows us to hold onto our strongest positions, even if they are going down, with minimal risk. When done well, hedging may allow us to make money in a declining market.
If the market continues its decline, I will probably put on a hedge or two. If the market stabilizes I will use our cash reserves to buy the new cycle leaders at the new, low prices after the correction has run its course.
The Flexible Income* model holds a mix of high yield and floating rate bond funds along with about 20% cash.
Of course, Adaptive Balance* and Adaptive Growth* hold blends of both our Growth and Income models.
Municipal Income* accounts are fully invested and doing well.
Protecting your personal data at Hepburn Capital is a high priority, and with the news this week of the super flaw in computer security systems, dubbed Heartbleed, we were glad we put in the extra work in protecting your data.
Our primary custodian, National Financial Services was not affected and our policy of frequently changing complex passwords has protected your client data. In some of the news reports, the LastPass password manager program we use to track and generate complex passwords is rated the best in the business.
I don’t often talk about specific aspects of our technology, but much of what we use is available and useful for individuals, too. LastPass is a good example.
If you would like a system that is better than writing your passwords down on pieces of paper that could fall into the wrong hands, be eaten by the dog, or go through the washing machine leaving you passwordless, this kind of password managing software may be for you. A single app will even coordinate your passwords between computers, smart phones and tablets.
Lastpass, a $12 program, recognizes a website once you have been to it and can automatically log you in. It will generate complex passwords which are harder for malware programs to crack – and the good part is that LastPass will remember them so you don’t have to.
The classic mistake is using your one favorite password for all sites. If one site gets hacked, the bad guys now have all the passwords for any site you might visit. Not good.
At the press of a button, LastPass can analyze all of your passwords – in our case for 1123 websites – and tell you which ones are stale or need to be upgraded. It even tells us to wait because some sites have not yet patched their software to protect against the Heartbleed bug.
Other efficient technologies we employ are:
Fingerprint readers. No entering passwords to start up your computer, just give it the finger!
ScanSnap for fast, double sided color scanning of paper into electronic documents. Ridding myself of stacks of paper files is like a headache going away.
Google Calendar can become a central calendar for your whole family which you can access from cell phones, tablets or computers.
PDFill software suite allows you to print a PDF from Word and even edit PDFs.
And my favorite command, “Ctl +”, to make the type on my monitor larger. Ctl – gets it back to normal size.
Laurel Taylor Fitzhugh has been HCM’s technology coordinator for many years and, as a side job, makes house calls for folks who need computer troubleshooting. If you have computer issues you need help with or need software recommendations, don’t be afraid to ask for Laurel’s help. Call the office for Laurel’s contact information.
Scottsdale Office Date
Please call the office (928) 778-4000 for an appointment if it would be more convenient to meet with Will in Scottsdale.
College Classes Coming
My Spring classes at Yavapai College are all complete. My next class, Fundamentals of Investing for Retirees, will begin on June 5th and run on Thursday afternoons through June 19th. Stay tuned for details.
Updated Form ADV
New Office Hours
Attempting to become a more benevolent dictator I have decided to shorten the Hepburn Capital office hours a bit, opening at 9:00 A.M. and closing at 4:30 P.M. each day except Friday when we close at 3:00, as usual. Please don’t worry, I will still make myself available for appointments after hours if needed to accommodate your schedule.
It also makes sense to start having our newsletter published at the beginning of each month rather than every 3 weeks as it has been, to better accommodate a monthly wrap up of market activity and our responses to it. As a result of this change, the next issue of Money Matters will be in your mailbox on Tuesday, May 13th.
Thank you for your support.
Our Spotlight Strategy
With our Adaptive Growth Strategy we strive to provide high total return from a combination of investments from both the equity and income markets with the emphasis on equities.
Our proprietary Stock Market Exposure Indicator is used to determine a stock market exposure that adapts to the strength or weakness of the market, directing exposure in the HCM Shock Absorber Growth strategy to range from 20% to a maximum of 80% of account value. The balance, 20% to 80% is invested using the HCM Flexible Income strategy. The HCM Safety Net indicator is designed to warn of sudden potential declines in which case stock market exposure is quickly reduced.
* 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.
Copyright (C) 2014 William T. Hepburn. All rights reserved.