May 9, 2012
Beware the Alternatives
The Investment View from Prescott, Arizona
By Will Hepburn
InvestmentNews featured an article recently on investment brokers offering their clients more “alternative” investments, meaning other than stocks, bonds and mutual funds. Among the several classes of investments they mentioned were venture capital, hedge funds, private equity, real estate and collectibles like wine and art.
My comment to InvestmentNews that ended up being circulated nationally was that all of these “alternative” investments were much like stocks, in that you really were investing in ownership of underlying companies.
Like stocks, alternatives can occasionally produce great returns, but carry even greater risks. Unlike publicly traded stocks that are valued each day and can be liquidated with a moment’s notice, venture capital, hedge funds and private equity do not offer daily pricing and can’t be sold easily, if at all, and that is a big deal as real estate investors have found out these last few years.
Lack of daily pricing means an investor won’t notice the sometimes sharp, daily fluctuations in price that stocks are noted for, but that does not mean they are not there. Valuations are reported infrequently if ever, and are often only estimates when they are reported. Does that mean values do not go up and down like stock prices? Absolutely not. Prices may drop dramatically before the investor can even find out – or get out.
If you invest in one of these issues and decide to sell, in the best of circumstances, you had better be prepared to wait for months or even a year or more to get your money back. And you are subject to price fluctuations during that time.
Any investor who remembers the many Limited Partnerships (LPs) that crashed and burned in the 1980s and 1990s, know what I mean. Today they have labels such as non-traded REITs, LLCs, or “Tenants in Common” ownership, in addition to LPs. All of these investment forms are in the hard-to-value and harder-to-sell categories.
Hard-to-value “alternative” assets are one of the Top 10 Investment Scams listed in a recent report by the enforcement division of the North American Securities Administrators Association, so “buyer beware” when it comes to alternative investments.
Bryan and I have put together a presentation based on this report. It is titled “The Top 10 Investment Scams, and How to Avoid Them”. If you have a group that could use a speaker, this is an entertaining and enlightening program.
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How’s the Market Doing?
The US stock markets are only about 4% below their recent highs, not a terrible decline by stock market standards, but the index prices may be masking deeper problems. The number of stocks hitting new highs keeps diminishing, and the share volume of stocks closing up rather than down has also been slipping, even as the stock market indexes flirted with new highs.
The indexes are increasingly held aloft by a few strong stocks. This is what is called having weak leadership. Healthy markets are driven by a large number of stocks doing well, not just a handful of Apple type stocks.
US consumers are tied down with underwater home mortgages, debt reduction and a great uncertainty about what taxes will be next year, whether jobs will be available and so on. I don’t think we should expect consumer spending to provide the leadership we are looking for.
The European debt crisis may be heating up again, too, and this is no longer just a European problem.
Austerity measures have thrown much of Europe into recession. Falling exports to Europe have already sent Brazil, Russia, India and China (the BRIC countries) into bear markets, and have begun affecting Canada and Australia, who sell massive amounts of natural resources to the BRIC countries.
This is a global downturn. Ten (10) of the fifteen (15) major stock markets in the world are in bear markets. Just like the US market is doing poorly when only a few stocks are hitting highs, the global markets aren’t doing well when only a few have healthy markets. Nowhere is there strong “leadership” in any of the markets.
Greece has been at the center of the European financial crisis and may be back there now that politicians trying to deal with their crushing debt have been tossed out of office. New leaders have been elected on platforms of easing the battle against rising debt, which should be troubling for anyone Greece owes money to. Current efforts to rein in their budget deficits can be undone in a short time with the wrong leadership. Ditto for France on Sunday.
Spain will be interesting, because it may end up in the “too big to fail and too big to bail” category. Spain’s stock market is very close to the lows of the dark days of March 2009. A break down through that low price will be an ominous statement about affairs in Spain.
In this condition it would not take much to put the market into a tail spin, and bad news from Europe is a logical place to expect it to come from.
A Freudian slip is when you say one thing but mean your mother.
What We Were Saying Back Then
What Market History Can Tell Us to Expect
We have an interesting study, originally done by Robert Powers back in the 1990’s that we have updated and reported on periodically.
The study shows 7 major market cycles over the past 200+ years, each cycle having a weak leg (a “Generational” Bear Market) and a strong leg (the “good old days”)
An example of this cycle is the Generational Bear Market that lasted 16 years from 1966 to 1982, where the stock market lost money for 16 years. I call these generational bear markets, not because of time that passes, but because they either wipe out or so completely discourage a whole generation of investors that they never invest again. This down leg was followed by the 18-year bull market from 1982-2000, where just about everyone could make money in stocks. Ah yes, The Good Old Days!
We have clearly been in a Generational Bear Market since 2000, so what do the previous cycles tell us we can expect going forward?
The last 3 Generational Bear Markets have lasted 16, 20 and 19 years, and we are 12 years into this one. This would suggest that we should expect 5-8 more years of markets that repeatedly take back what they give – that is if you think our problems are no worse than average.
Also, the last 3 Generational Markets presented 4, 5 and 6 individual bear markets, where the stock market drops by 20% or more. We have had only two so far. If history repeats itself, we can expect 2, 3 or 4 more bear markets before we get back to smooth sailing.
More ominously, the two of the last three Generational Bears were caused by credit contractions, the same issue that is driving our current economic troubles. 1902-1921 was the period when JP Morgan had to bail out the US Treasury, and the Great Depression, 1929-1949 saw over 10,000 banks fail.
Those two Generational Bears presented 5 and 6 individual bear markets each, including 3 catastrophic bear markets, meaning losses of 40% or greater. We have had two of these “big bears”.
The electioneering this year will bring many rosy reports of economic improvement. History suggests that the reality might be otherwise. This is not a time for investors to relax.
What’s Going On In Your Portfolio?
Our Shock Absorber Growth* strategy has been back in sync with the market over the past couple of weeks after getting an unproductive “Safety Net” signal on April 9th which caused us to move to fully hedged.
Although the quick reversal of this signal was disappointing, at least half of our Safety Net signals don’t work, but we have to respect each small decline since every bear market starts out as a small decline. This signal would have protected us from the huge 2008 decline, from the sudden drops associated with the “Flash Crash” of 2010 and last summer’s 16% decline caused by the debt ceiling deadlock in Washington, DC, so it is worth being patient with.
Although we have not yet recouped the few percent loss from mid-April, for the past two weeks we have been outperforming the S&P 500** on all of the down days and most of the up days, which is all we need to have this strategy really work well.
We added financial and Internet funds to the retail and consumer stock funds we owned in Shock Absorber Growth* accounts, and have a current hedge level equal to 27% of the portfolio. We also hold about 20% in cash that is earmarked to quickly add more hedge if the recent market weakness picks up steam. This all means that we only have about 33% exposure to the stock market despite being about 80% invested.
Flexible Income* portfolios have strengthened over the past couple of weeks as our corporate high yield funds recovered their small losses. Our muni funds and Floating Rate funds have continued to perform well.
Of course, our blended portfolios, Adaptive Balance* and Adaptive Growth* include both Flexible Income* and Shock Absorber Growth* strategies.
Hepburn Capital is an adviser registered with the US Securities and Exchange Commission (SEC) and we continually strive to stay in compliance with its regulations. Part of those regulations involves keeping clients informed about our business and privacy policies.
These two items were sent out to you last week by email. If you did not receive them and would like us to resend them, just let us know by calling the office at (928) 778-4000. You may also see copies of these documents on our website. www.hepburncapital.com/form-adv.html
Our Spotlight Strategy
We strive to provide growth in all markets from a blend of both long and short equity investments.
We first select the strongest of about 40 different stock market segments, sectors and regions, and then select the most complimentary inverse funds to use a s Shock Absorbing hedge for those investments. 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. 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.
** The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market. Investors cannot invest directly in the S&P 500 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.