November 22, 2011
Europe: Tougher on Them Than on Us
The Investment View from Prescott, Arizona
The potential for default on debts owed by Greece, Spain, Italy and other European countries has dogged the US stock market for months now, and when those defaults occur (notice I did not say “if” they occur) they will be tough on those who own the bonds. But there is also a ray of sunshine for the US.
If a bond defaults and becomes worth less than what it was, that is called a “haircut” in industry parlance. Half the original value is the level of loss being discussed for bonds issued by Greece which is leading the parade of defaulting nations. Considering Italy alone owes $2.6 trillion, a loss of half that amount will truly be a hairy problem, if you’ll excuse the pun.
But who will get hurt the most depends upon whose hair gets cut, so let’s look at who is most at risk.
Pension funds and insurance companies that invest in Euro government bonds will suddenly find themselves way short of the cash needed to pay all the annuities and pensions that folks have been promised when half of the government bonds go “poof” (technical term). Now you know why the pensioners are rioting in Greece. They just figured out that there is no money to pay their pensions since the bonds behind them are worth less if not worthless.
Banks that own the government debt will also take big losses, and French banks have more Italian debt on their books than anyone. When banks lose money, they can no longer make loans and often have to call in perfectly good loans made earlier to businesses in order to be able to repay depositors. So banks get hurt and business can get a real monkey wrench thrown at them even if they don’t own the bonds directly.
As you can see, individuals don’t have to own bonds themselves to have their jobs, bank deposits, or savings threatened by the domino effect of defaults.
Although I expect things to get bad in Europe as defaults unfold, the US is in much better shape because our banks have had 3 years to get healthy since the defaults of Bear Stearns, Lehmann Brothers, and a slew of other bank failures here in 2008. If things get really bad in Europe, I expect them to merely be uncomfortable over here. Let me tell you why.
As easy as it is to second guess what the Federal Reserve is doing and count all the wasted dollars, we have to remember that these are really smart people who are largely well intentioned.
In the past 3 years they have managed to infuse $1.6 trillion into the large US banks, money that is just sitting and not being loaned out to business, much to the chagrin of watchers like me. This amount is 20 times what used to be considered a normal amount of bank reserves and for a long time I kept wondering when the lending would resume. After all, banks make money lending money, so why not lend it?
Then the light bulb came on! This huge amount of money insulates our banks against a wave of defaults by European governments and banks, and the companies that do business with them, in case the European defaults do run down hill to this side of the pond, as expected.
At least US banks, the foundation of our economy, are not right at the bottom of the hill like they were in 2008. Now they are sitting on top of a mountain of cash which they can use to absorb bad bonds and loans before our depositors and businesses might be threatened.
A Slice of Life
I have found that moments of gratitude are some of life’s finest times, and at this time of year I find myself very grateful for all of my family, friends, clients and colleagues that make my life so fulfilling. If you are reading this newsletter, chances are you are in that group that I will be thinking about this Thanksgiving.
I truly have a lot to be grateful for. Thank you.
The word from postal workers who conducted a food drive for the local food banks last weekend is that donations are way down this year. I will be making a donation to the food bank, and if you would like to as well, you can drop it off at the office and we will make sure they get delivered. You can drop off non-perishable food, or checks made out to either the Prescott Community Cupboard, Chino Valley Food Bank or Yavapai Food Bank (PV) and we will deliver them for you.
I am grateful that we are in a position to help those in need, and I’m sure you will feel the same when making a donation.
Holiday Office Closure
In observance of Thanksgiving the office will close at 3:00 p.m. on Wednesday, November 23, and will be closed on Friday, November 25, although staff will be on call for trading as needed.
Wishing you and yours a very Happy Thanksgiving.
To Be or Not To Be? That is The Question!
By Bryan Jarman, CFA
Recently I’ve spoken to many investors who are asking whether it is better to be invested in the markets or is it better not to be invested, sitting on the sidelines.
From the perspective of a traditional investor it feels like there is way too much fluctuation in the market – it is scary. From the perspective of a trader the market appears to have no clear direction.
We are in a period of challenging times, but clearly not unprecedented. We have gone through periods of uncertainty like this in the past – the Gulf War, 9-11, impeachments, assassinations and more – and we have always come out OK. At the moment, however, there is no noticeable wind at our backs to help push the value of the markets up while there are glaring headwinds that keep us feeling knocked backwards.
The answer is that in the sideways – “Generational Bear Market” that we have been in for 11 years and that may likely continue for years to come, wise investors will have a strategy that can alternate between being “INvested” during uptrends and being “OUTvested” when the market turns down again.
It is highly improbable to consistently sell at the precise tops and buy at the exact bottoms of these market swings. However, it is possible to participate in the upswings by buying into strength – to be “INvested” – and to avoid the large downturns by selling into weakness – to be “OUTvested”. And, that is precisely what we do for our clients, here at Hepburn Capital Management.
Until we get out of this sideways trend many investors will continue to ask “To be or not to be”. I am confident that we will see another long-term rise in the markets since these down periods have always been followed by up trends. And once the next long-term uptrend gets underway the question will then be “To buy and what to buy?”
Q: What word can be written forward, backward or upside down, and can still be read from left to right?
Electronic statements, confirmations and notifications can save time, trees and reduce the paper clutter in your lives.
This is all now available through National Financial’s MyStreetscape online account access. If you are not already able to see your accounts online, call the office to get a user ID and password. If you are online, here is how to get e-statements.
1. Sign on to www.MyStreetscape.com/my/ceros
2. From the “Select Action” drop-down menu select “Account Details” for the account you wish to enroll.
3. Enter a valid email address under “Account Holder”. Select “Online” for each document type, and then click the “save edits” button.
How’s The Market Doing?
Last week, Bryan and I were doing a regular update of our list of 150 indicators, a chore that forces us to look at statistics and indicators we might not encounter in our daily work. I noted that the consensus of our indicators was slightly positive, but the market sure felt bad – sort of “toppy”, like it is getting ready for a larger decline that could take indexes and index investors on a stomach-churning ride.
This is the kind of market we are in. The investment compass that guided us steadily for many years is spinning wildly.
The markets used to take months to rollover before declining in earnest. Now they happen shockingly fast, like we saw in August of this year.
The hallmark of this market is high volatility – wild price swings both up and down. At HCM, we have developed a new indicator that alerts us to when volatility is creeping up to dangerous levels. This indicator would have warned us days before the August crash, and also days before the “Flash Crash” last year. Here is what it looks like.
This indicator has become our new “Safety Net” and it began to flash red lights at us last Thursday, only two days after our 150 indicator list update showed the market to be OK.
Time will tell if this Safety Net will work going forward as well as in back testing, but it looks like the missing link to keeping us on track.
What’s Going On In Your Portfolio?
As our Volatility Circuit Breaker flashed red last Thursday, we immediately began to cycle out of the stock market, moving Careful Growth* portfolios to 45% cash and tightening the sell triggers that moved us to 85% cash on Monday.
The Careful Growth* model reduced stock holdings and now holds 85% cash, 15% gold. All stocks and stock funds have been sold.
The Flexible Income* model sold off high yield bond funds and now holds 35% cash, 25% rising dollar fund and 20% each in gold and a floating rate bank loan fund.
We are introducing two new strategies to deal with the changes in the character of the market. A new Traditional Income* portfolio designed to be a lower risk version of Flexible Income* is ready to go, and I have been working on a new Adaptive Growth* strategy on and off for a couple of years and have been running it live in a couple of my own accounts since June with better-than-market results.
I did a presentation on the Adaptive Growth* strategy at the national conference Bryan and I attended two weeks ago. The response was strongly positive with lots of interest in our “secret sauce” which I will discuss in the next newsletter.
What really has me excited is the insight we gained at the conference for dealing with the missing piece of the puzzle – draw-downs in the markets that are occurring with little notice. The Safety Net indicator shown above looks like it can really reduce the risk of these sharp losses. I am working on materials to explain what we are doing before the strategy will be ready for “prime time”. I’m hoping to have this all ready for the next newsletter.
In the mean time we are hunkered down in lots of cash.
Our Spotlight Strategy
Our Municipal Income Strategy moves from high yield to high quality municipal bond mutual funds and ETFs to produce greater income than buy and hold, with lower risk as measured by fluctuation in principal values. HCM’s Adaptive Market Strategies® direct investments into parts of the municipal markets showing the greatest strength. If the price weakens, they are replaced with new investments that are going up or hedged until the market stabilizes. Repeat as needed.
* 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.