January 4, 2012
Darkest Before the Dawn
The Investment View from Prescott, Arizona
By Will Hepburn
Even if you don’t think the world is going to end this year, you will probably agree that 2012 contains perhaps the greatest range of political risks to the global economy in memory.
Leadership will be changing in the most powerful countries as elections unfold. Europe continues to struggle with financial crisis. The Middle East is in turmoil and economic hardship is driving unrest and discontent everywhere.
Remembering the riots during the summer of 1968, I am concerned that the Occupy protests could grow more violent as the anarchists behind them hone their skills. We should be prepared for 2012 to be just as volatile as 2011, if not more so.
But 2012 also looks to be a turning point as there are an increasing number of encouraging signs. Sales tax revenue, a basic measure of economic activity at the grass roots level, is rising. More building permits are being issued, and with construction and real estate being such big part of our economy, that could mean a lot more people working in future months. Most of our banks are on solid economic footing compared to other parts of the world, and corporations here are strong financially, so credit problems in Europe are not likely to force them into insolvency. In fact, when the Euro crisis does finally come to a head, our banks and corporations are in position to benefit greatly.
Slice of Life
Prescott has a new New Year’s Eve tradition, the Boot Drop. If New York can drop an apple at midnight in Times Square, we can surely make a party out of sliding a 6′ lighted boot down the flagpole atop the Palace Saloon on Whiskey Row in downtown Prescott.
Longtime friend Tracy Horn, who did my advertising for many years, was the brains behind this new event and she really hit a home run.
The celebration filled Montezuma Street with several thousand revelers… a good crowd for a small burg. And it provided a perfect bookend for the Christmas season in Prescott with the Light Parade, Christmas parade, Courthouse lighting, and the Acker Music Festival on successive weekends before Christmas.
I really appreciated Tracy adding an early show at 10 p.m. for those of us who don’t do midnight that well any more. Well, I’m sure it was midnight somewhere. 
How’s The Market Doing?
If Rip Van Winkle had slept through 2011 he might have thought he didn’t miss a thing because the S&P 500** Index ended the year exactly where it started. This was despite a stock market decline that began in May and qualified as a bear market, losing more than 20% of its value from the April peak.
The math behind the S&P 500** showed it breaking even, although only 185 of 500 S&P stocks made money. Three hundred and fifteen (315) or 63% lost money in 2011.
The Dow Jones Industrial Average** was the only positive major index in the world. Unfortunately the Dow is made up of only 30 stocks, only 18 of which made money for investors last year.
Out of 1,420 growth mutual funds, only 301 made a profit. And 1,119 funds, almost 3 out of every 4, lost money last year. Of the giant funds, those with $3 billion or more being managed, the ratio was 1 fund in 6 making a profit for their investors.
Here is how some major indexes and Stock Markets fared in 2011.
Index/Symbol ’11 Return
Dow 30 5.53%
S&P 500 0%
Nasdaq 100 -2.96%
Russell 2000 -5.45%
Europe (IEV) -11.37%
Japan (EWJ) -14.78%
China (FXI) -17.56%
Lat. America (ILF) -18.48%
Brazil (EWZ) -24.17%
India (INP) -39.97%
Even gold, after a huge run-up, dropped 17% from its highs and only managed to hold onto single digit gains for the year and appears to still be in a clear down trend.
I read an article from one of those continually optimistic Wall Street sources that said since the 4th quarter was strong, momentum ought to carry us into a good 2012. Actually October was very strong. Since October, stock indexes in only 3 of the 23 world markets that I track have produced more than a 1% gain. Not really much momentum, but good material for the Wall Street cheerleaders.
As important to investors as the direction of the market is the character of the markets, and that was the biggest change in 2011. The way a market acts as it tops out before beginning a decline is a key piece of information for money managers. This year it was clear that the markets had changed in this key respect.
We used to get months of “topping action” before a big decline. These days we get very little warning before the markets change direction. The market peaked 9 days before the Flash Crash in May 2010 and 11 days before the August 2011 bottom. The speed with which markets are turning around is a big change that money managers have to deal with.
Track records from several years back don’t mean diddly as the markets enter their “new normal”. Being able to cope with fast changing markets is what is needed these days.
With all the uncertainty in the economies of the world, I expect more wild gyrations in the stock markets as we saw in 2011. The difference between Hepburn Capital and other financial advisers is that when we recognize a change like this we develop methods to deal with it. We don’t plan to use last year’s strategy in this year’s market, we Adapt to Changing Markets®. (more about this in the Portfolio section of this newsletter).
What is that old definition of insanity? Doing the same thing and expecting different results?
Money managers need to be responsive to the new reality of the financial markets. If they are stuck in the same old pattern, investor beware.
Mental Floss
Why do you have to ‘put your two cents in’… but it’s only a ‘penny for your thoughts’? Where’s that extra penny going?
What’s Going On In Your Portfolio?
As you might surmise from my market comments in this newsletter, Hepburn Capital’s growth strategies* stumbled this year like most as we tried to get a handle on the new, faster changing stock market. In fact, the growth side of things pulled down our returns on our balanced strategy*, which was 50% growth, to levels we hadn’t seen since 2008.
Only our Flexible Income* model was profitable this year, and that just barely. As I mentioned in our last newsletter smaller Flexible Income* accounts that missed out on a single trade ended up in negative territory because of it.
In short, 2011 was a miserable year. So what are we doing to make sure 2012 is better?
Our adjustments to our Balanced Strategy* will allow it to greatly reduce growth from its former 50/50 mix. We have begun calling it Adaptive Balance* since the balance between growth and equity investing will change with the strength of the stock market. And our Safety Net indicator is a circuit breaker designed to greatly reduce stock holdings, and risk, during declines, something that will really help.
Careful Growth* strategies are now more methodical in determining the amount allocated to stocks, which can be as much as 80% of the portfolio. It also uses the Safety Net indicator to back-stop the portfolio.
Our newest strategy, one that I am really excited about, is one that I have been running recently in one of my own accounts, and is called Long/Short Equity*. It involves a (usually) fully invested stock portfolio hedged to reduce the ups and downs of the market. This strategy may be the one that is best equipped to deal with the volatile market conditions we have today. Click here to see a brief description of what we are doing with this strategy (PowerPoint Presentation). (Click here for a PDF version).
No changes are anticipated for the Flexible Income* model. Two of its major components are bonds and currency trading. The bond rotation strategy went flat and contributed very little last year. It has done this a couple of times in the 10-years we have used this strategy and it always bounced back. It’s not “broke” so we aren’t going to fix it. The currency strategy lost money for us the past 6 months which held the Flexible Income* model back, but it has been through 3-4 similar periods in the past few years and always bounced back, so we are being patient with this strategy, too.
I would like to speak with you to go over these new strategies and make sure the ones we have in place for you are the most appropriate. I can make changes within strategies, however only you can make the decision to change from one strategy to another because that determines the level of risk we can take on your behalf.
If you would like to schedule a review, please call the office at 778-4000. If not, I will be giving you a call in the next few weeks to talk it over.
All in all, I think we are in great shape for a successful and profitable 2012.
Wishing you a very Happy New Year.
What We Were Saying Back Then
Many times over the years I have pointed out that the troubles we face are no worse than those we have faced in the past. In our lifetimes we faced down the threat of nuclear annihilation at the hands of the Soviet Union, defeated the Axis during WWII, broke the back of inflation in the 1980’s and survived (4 years now… can you believe it?) the mortgage mess that threatened to bring our country to its knees, all terrifying tasks at those times.
Our problems today are certainly different, but really no worse than those we have faced before.
Greece is frequently held up as the poster child of the European financial collapse, with “if Greece defaults, won’t everything else follow?” being a frequently asked question. Well, actually, what is going on in Greece is nothing new.
In “This Time Is Different: Eight Centuries of Financial Folly”, an encyclopedic look at credit crises throughout history, authors Reinhart and Rogoff point out that Greece has been in default or in the process of renegotiating loans – a kind of controlled default – over 50% of the time since its independence. We should have grown to expect Greece to be in financial trouble, not be surprised by it.
At one point during the 1980’s there were 29 countries in the world defaulting on their debt at the same time. The Federal Reserve did some fancy maneuvers and we survived that experience with no domino effect.
So, as bad as today’s times seem, this too shall pass.
Now that I am thinking about it, I think that anyone who would loan Greece money with a history like that ought to have their head examined and probably deserves to lose money, but that is probably a subject for another article.
* 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.
