July 3, 2018

The Investment View from Prescott, Arizona

Cracks in the Junk Bond Markets

High Yield, the polite name for junk bonds, refers to bonds issued by companies with lower credit quality, those rated BB and below, whose issuers have to offer higher interest to entice investors to take the added credit risk. The top-quality segment of the corporate bond market, called Investment Grade, includes AAA, AA, A and BBB rated bonds.

Junk bonds may have a lousy name, but they can be great investments at the right time. This does not seem to be the right time however, and rising interest rates are only part of the problem.

Cord-cutting—as the consumer shift from cable-TV subscriptions toward streaming services is known—is particularly troublesome for high-yield bond funds because technology, media, and telecommunications, or TMT companies, comprise about one-quarter of the $1.25 trillion junk-bond market, according to the ICE BofAML U.S. high-yield index. As cord cutters move away, cable TV revenues drop, making already weak credits even weaker. Buyers shy away and prices drop which is what has been happening to junk bonds.

As corporate credits have weakened, the share of Investment Grade corporates rated BBB has risen steadily for 10 years and is approaching almost half of all Investment Grade bonds. Rating downgrades from BBB to BB in an economic downturn will force many Investment Grade bond holders to sell because their policies do not allow them to hold junk.

The junk bond crisis of 30 years ago was caused by a California regulator who said insurance companies in that state could no longer hold junk bonds. A huge amount of junk was forced on the market, depressing prices and causing a wave of defaults in banks and Savings and Loans across the country that had invested in junk. The problem kept echoing for many years. Credit downgrades can trigger the same forced selling of bonds and start another spiraling crisis.

In 2008, we saw a subprime mortgage debt crisis bleed into the rest of the markets. I think this time, a high-yield debt crisis may have the same result. At first only a few companies will have problems but the problem will snowball and it will all flow downstream to other lenders. That’s how problems in one market spread to others.

Rising interest rates leave this daisy chain of lenders no place to hide. I am seeing classic end-of-cycle behavior in the junk bond markets and since junk is often a leading indicator for the stock markets, cautious investors everywhere will take note.

What the Markets Are Doing

The US stock market is showing a split personality, with the larger indexes, the S&P 500** and Down Jones Industrials**, struggling while smaller segments of the market such as the tech-heavy Nasdaq** and small company indexes are doing better.

The overall positive momentum through June 29th suggests profitable market conditions, but several major market cycles are entering periods with tendencies for market declines, a number of market indicators are weakening and volatility is rising. I’ve found that higher volatility is a warning sign, so I remain cautious on the markets.

Foreign markets are hitting multi-month lows due to the strength of the dollar, and consequently US investments have done better than internationals this year. China’s Shanghai Index is down over 20% and is officially in a bear market. Emerging markets abroad have fared worse than developed markets.

Increasing trade tensions between the US and the rest of the world have rattled markets everywhere, especially stocks of US multinational companies which make up a large part of the 30 Dow Jones Industrial** stocks.

The US is a net importer of goods, suggesting that it has less to lose in this stare-down than its trading partners. An example provided in the Systems & Forecasts newsletter, is that the US imported $506 billion from China and exported only $130 billion which means that China has a lot more to lose in a trade war. As a result, investors are favoring US stocks over foreign stocks which has led to the stronger dollar in recent months.

There are three things that contribute to the strength of a currency: (1) Military might, which is not an issue in these trade talks. (2) Political stability, which the US has in great amounts compared to major trading partners in Asia and Europe. (3) And economic strength. The rest of the world is voting with their dollars, saying our economy is where they want to be. To be involved in the US economy, foreign investors must first sell their local currency and buy dollars that they can then invest in the US, driving the value dollar up and other currencies down in the process.

The OPEC countries have just agreed to increase production, and this increased supply should lead to lower oil prices as the summer unfolds.

All segments of the bond industry continue to struggle as interest rates remain stubbornly higher than last year. Emerging market bonds fared worst due to a combination of higher rates, weaker local currencies compared to the dollar, and weaker credit standing behind the bonds. Municipals continue to be the strongest segment of the bond market with US Treasuries in the middle of the pack and still showing losses for the year, even when adding in the effect of interest collected on T-Bonds.

Gold continues to drift down as it has for the past 5 months, having lost almost 8% of its value since late January.

What’s Happening In Your Portfolio

Our Shock Absorber Growth model* portfolio is showing small gains for the month, 3 months and year-to-date. The S&P 500** has also shown small gains for these periods but its price swings have been several times wilder than ours. If the market gets weaker, as I expect, we should greatly outperform the broad market indexes like the S&P 500**.

The past two weeks have seen several of our holdings trigger Safety Net sell prices, so our cash position has increased as holdings were sold. Increasing volatility has also led me to increase our hedges slightly. Hedges are investments that go up when the index goes down and stabilize portfolio values during market declines. These holdings, along with the cash, reduce our Shock Absorber Growth* portfolio’s exposure to stock market movements to below 50%. If my stock selections remain good, we can come close to stock market returns with much lower risk this way.

Changes made in the holdings of our Flexible Income model* have allowed us to begin to outperform the Total Market Bond Index ETF (Symbol: AGG) in June, although both the index and our model are down for the year-to-date.

Our Municipal Income* accounts are up for the 1-month, 3-month and year-to-date periods and continue to be stronger than traditional income investments. If you have Flexible Income* or Adaptive Balance* (50% Flexible Income* at the moment) objectives for your accounts and would like to change that allocation to Municipal Income*, please call the office to discuss making the change. It is simple to do and would have produced better performance over the past 12 months (although past performance is not indicative of future results.) The phone number is (928) 778-4000.

• 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.

If you haven’t had a review of your account for a while, please call the office to arrange a time to talk in person or on the phone.

Mental Floss

 The Inside Of This Guitar Looks Like An Apartment That I Can’t Afford

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How High Will Marijuana Stocks Get?

Occasionally I am asked about investing in the burgeoning marijuana industry. Isn’t it a slam dunk for growth? Maybe, but that does not make it easy to invest in.

Banks who do business over state lines cannot violate federal law without the risk of being shut down. Conflicting federal and state laws concerning the legality of marijuana mean most marijuana production and sales are done on a cash basis because banks avoid doing business with these firms for fear of federal retribution. As a result, marijuana companies take no credit cards, get no bank loans, have no checking accounts, can’t do electronic transfers of money, and importantly for us, can’t be listed on US stock exchanges.

Corporations that do business across state lines come under federal jurisdictions and have similar fears so avoid the marijuana business. As a result, the US marijuana business remains fractured into many small mom and pop type operations. This makes it almost impossible for most of us to invest in.

There are two Exchange Traded Funds that hold marijuana related stocks, but one trades in Canada making it expensive for US investors to buy, and it holds almost all Canadian stocks. The other looks a little funny to me because until last December its name was the Tierra XP Latin America Real Estate ETF, (ticker symbol: LARE), and information that is available about holdings, etc., is sketchy. As a result, I would avoid both.

Even those that subscribe to the “sell shovels to the gold miners” theory of making money in boom times will be surprised to know that the share price of Scotts Miracle Grow (Symbol: SMG) is down for the year, so even this obvious play is not responding to the surge in marijuana cultivation like one might expect.

When the legal clouds clear over the marijuana industry, I expect the big names in distilling, tobacco and pharma to move into the marijuana business, making investment in these companies much easier. Until then, I’d say just chill out.

Our Spotlight Strategy – Flexible Income

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 equity-income investments 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.

A Slice of Life… 

The Meaning of Erieau

This is a photo of some benches atop a large sand dune overlooking Lake Michigan, in Door County, Wisconsin. Door county is the peninsula that separates Green Bay from Lake Michigan and is a delightful place referred to as the Cape Cod of the Midwest. Needless to say, the moonrise was spectacular! Yes, that is the moon.

I just love that technology can allow me to write part of a newsletter on top of a sand dune. This morning I began this article with the daytime version of this photo as my view, before boarding the SS Badger, the ferry connecting Manitowoc, WI to Ludington, Mi. Seeing the signs that the ferry is considered part of US Highway 10 made me smile.

I am finishing this newsletter in Erieau, Ontario, on a 200-yard-wide stand of village, sandwiched between Rondeau Lake and the northern shore of Lake Erie. Erieau had the first signs of commerce we had seen after an hour of driving through farmland. We showed up late on the eve of Canada Day (their Independence Day) with a bass fishing contest underway. A boat to be given away, plus $4,000 in prize money meant the village was packed! We had no reservations and no idea where to eat. This was the adventure part of the trip! At the end of the road (literally) we found a terrific seafood restaurant and then a rustic 1945 era fishing cabin to spend the night in. They were the finest accommodations available for miles around.

We are pretty sure that Erieau means “end of the road” in some language, we’re just not sure which one. 

* 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) 2018 William T. Hepburn. All rights reserved.