Money Matters Newsletter:
January 5, 2016
The Next Fed Debacle Unfolding Now
The Investment View from Prescott, Arizona
The Federal Reserve Board cultivates an image of transparency when the minutes of its meetings are released, but actual intentions of Fed leaders are harder to discern. They are, after all, the kind of secrets fortunes can be built on. However, history shows us that all Fed Chairmen seem to come into office with an agenda of some sort.
Paul Volker was appointed Fed Chairman in August 1979 and soon after announced he would tighten monetary policy hard enough to beat inflation that had taken hold in the US. Although he wished to avoid them, his actions led to two sharp recessions in 3 years as interest rates spiked to 20%.
Alan Greenspan became Fed Chair in August of 1987, and raised interest rates and tightened the money supply to rein in what he thought was a too-strong stock market. Although he did not mean to, his actions triggered the stock market crash of October, 23 1987, when the average stock price dropped over 23% in one day.
Ben Bernanke replaced Greenspan in February of 2006 and promptly made changes that began to deflate the housing market leading to the financial crisis of 2007-09 and devastating effects to the wealth of almost every American.
I’m sure that each of these leaders had good intentions in putting the economy on the paths that they chose, but the process of changing something as complex as our national economy with actions that have never before been tried is fraught with peril, and in each of these cases, the Fed overreacted. Their initiatives came off more as blunders than solutions and the unintended effects were painful to many.
Current Fed Chairman, Janet Yellen, has been in office since February of 2015, and one might wonder what her agenda is.
The S&P 500** ended February 2015 at 2104, and has dropped 2.88% as of this writing on January 1, 2016. Clearly, Yellen is not helping investors. We can now see that her agenda is to drain excess money from the economy. That trillions of new dollars were printed over the past few years is not news, and most will agree that this is an obvious problem that needs to be dealt with, the question is how?
Shortly after Janet Yellen was sworn in as its Chairman, the Fed began removing an average of over $100 billion per month in cash from the economy through complex securities dealings which I won’t bore you trying to explain. Stock markets, worldwide have been sagging ever since.
High yield (junk) bonds are one of the best leading indicators of financial market direction. For over a year now junk and other speculative issues such as emerging markets stocks have been sharply down.
It is a common idea that the financial markets are like giant cash registers that always have money in them to pay out to sellers of stocks or bonds, but that is not quite right. There has to a buyer on the other side of that cash register that agrees to put money in before you can take it out.
Last month a High Yield (junk) bond mutual fund took the drastic step of suspending redemptions by shareholders because it could not sell its holdings to fund redemptions. The cash register was empty. Junk is often the first to feel a shortage of liquidity in the financial markets, so this could be like the first rat leaving a sinking ship.
There are only two things that really matter in investing. One, how much money is there to invest, and two, how willing are investors to spend it. The liquidity crisis in junk and emerging markets sends us a clear message that there is a shortage of money to be invested.
The Federal Reserve has begun to raise interest rates, but that does not change the amount of money to be invested. It merely heats up the competition around which investment might offer the better return.
You might think that the Fed can see the same handwriting on the wall that I do, but as you can see from this article from last week http://tinyurl.com/HCM-Reuters the Fed’s withdrawing another $270 billion from the financial markets despite the general market weakness we are experiencing.
Janet Yellen is rolling the economic dice, just like earlier Fed Chairmen. Investors everywhere should wish her more luck than her predecessors had.
A Favorite Christmas Gift
A good example is my shortened version of Munroe’s response to the question “What would happen if you tried to hit a baseball pitched at 90 percent of the speed of light?”
From the ball’s perspective, the world appears to be standing still, even the molecules in the air. Air molecules vibrate back and forth at a few hundred miles per hour, but the ball moving through them would be traveling at 600 million miles per hour, so as far as the ball is concerned they would be hanging there motionless.
Aerodynamics don’t really apply either, since air molecules don’t have time to flow around a ball moving that fast, they are slammed into so hard that the atoms in the air would be fused with the atoms in the leading edge of the ball. This fusion of molecules is the stuff of thermonuclear explosions, so an expanding bubble of superheated plasma would grow outward from the ball, disintegrating the bat, the plate, the batter, the stadium and the neighborhood around it all in the first microsecond, while creating a sizeable crater a few hundred feet behind the former location of the backstop.
Major League Baseball rule 6.08(b) suggests that in this situation the batter would be considered to be hit by a pitch and would be awarded first base.
So if you are compiling next year’s Christmas list or need a fun b-day gift, What If? gets my hearty recommendation.
How Are The Markets Doing?
2015, The Year That Stocks Went Nowhere
The US stock markets rolled over in mid 2015, with all indexes except the tech-heavy NASQAQ index posting losses for the year.
The combination of the Federal Reserve pulling cash from the US economy and slowing economies in China and Europe leaving fewer buyers for our goods spelled a weak year in the US economy with the slowdown accelerating toward year end.
Bond markets languished, too. Even with the reinvestment of dividends the Vanguard Total Bond Market Fund (VBMFX) struggled to break even, gaining .07% for the year 2015. Compared to that, CD rates are looking OK. Tax-free municipal bonds were the strongest segment of the bond market in 2015, averaging about 3% for the year.
Gold continues to disappoint the gold bugs, but gold’s price swings have gotten smaller and smaller, telling me that the number of sellers in the markets is declining, a good thing for gold investors.
Real estate didn’t treat investors that well in 2015, either. The iShares US Real Estate Index Fund (IYR) ended the year below where it started, while the Homebuilder Index of stocks (XHB) was down 12% since the summer of 2015.
This is prediction season, but I don’t make predictions, I work with what is, not what I wish was so. People who make predictions want publicity more than profits. A prediction anchors one to the predicted ending causing decisions to be based upon a hoped-for outcome, when no one really knows what is going to happen. Worse yet, predictions can keep a manager from making decisions based upon what really is.
Currently, I see a stock market that is slowly rolling over. Several key liquidity indicators are telling me to invest cautiously. Investor sentiment, consumer sentiment and industrial purchasing managers all show lower confidence in the markets. Maybe by the end of 2016 all of my concerns will have resolved themselves and we will end the year smiling. Maybe not. But, right now I see a lack of investor money and a lack of willing investors, a double whammy that says expect a rough patch in the markets before we get back to good times.
What’s Going On In Your Portfolio?
We closed out the year 2015 with a significant amount of inverse funds in our Shock Absorber Growth* portfolios which hedge away what I perceive to be greater than normal risk of market declines.
Hedges go up as the market goes down, and they allow me to continue to hold our better stocks or stock funds, pursuing long term capital gains treatment, while managing the risk of doing so. In a market that is going sideways our performance won’t be much different than the market as a whole, we just make our money on different days. However, if the markets begin to decline rapidly, the hedges will become our standout performers and carry the portfolio.
If it turns out I am wrong and the market breaks out to the upside, I’ll just sell off the hedges and use that money to buy more stocks. The stocks we currently hold in our Future Tech* and Targeted Growth* strategies are all strong performers and worth keeping.
The Government Bond strategy I added to our Flexible Income* portfolios six months ago continues to provide strong returns with six monthly gains and no monthly losses.
I currently hold about 25% cash in our Flexible Income* portfolios as I sold some funds that might have been exposed to the liquidity squeeze mentioned elsewhere in this newsletter.
Both Income* and Growth* portfolios hold small amounts in a gold strategy that uses both long and short (inverse) gold funds, so it has the potential to make money in up or down markets.
Full size ($100,000 and larger) Flexible Income* and Shock Absorber Growth* accounts held at our primary custodian all saw small investment gains for 2015, outperforming both the stock and bond indexes while taking much lower risk than a buy and hold investor faced.
Your HCM managed accounts are positioned well for the current market, and flexible enough to change quickly and Adapt to Changing Markets® as necessary.
If you have friends or family that might be interested in my services, you can earn a discount in your management fees by referring them to HCM. The best compliment you can give me is a referral. Thank you.
College Classes Coming
Begins Wednesday Feb 3rd from 3:00-5:00 pm, running 3 consecutive Wednesdays through Feb 17th.
This course is designed to help investors become more confident about their financial decisions. In an easy-to-grasp format, this class provides a broad knowledge of investments preferred by investors approaching or already in retirement. Learn the ins and outs of stocks, bonds, mutual funds, annuities and more.
Topics include recognizing risk, controlling the tax impact of IRA withdrawals, avoiding common investment mistakes and simple risk-reducing strategies that anyone can use.
Call the college at 717-7755 to register for course # WS16-143. Tuition is $65.
If it is more convenient to meet with Will in Scottsdale, please call the office to schedule your appointment. 928-778-4000
Our Spotlight Strategy
Targeted Growth is an underlying strategy that makes up a part of HCM’s Shock Absorber Growth portfolio.
Much of HCM strategies have shorter time horizons to better manage risk during the ups and downs of the market. All big declines start with a small decline, so all small declines need to be respected.
However, some clients have need for long term capital gains, so Targeted Growth focuses on more established companies with favorable outlooks and momentum, with an eye toward holding them for more than one year. This strategy uses offsetting inverse investments to hedge, allowing longer term holdings without risk of significant loss.
Click here to read more about Shock Absorber Growth.
* 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) 2015 William T. Hepburn. All rights reserved.