April 30, 2020
Flattening the Curve or the Economy?
The economic shutdown is intended to slow the spread of Covid-19 and flatten the rising curve on the graphs of Covid-19 cases, but it is also flattening our economy.
The financial crisis in 2008 did not destroy industries, but the current economic shutdowns are going to do much more damage to our economy. This makes it a recession of a whole new kind, perhaps leading to an economic depression. There is no real definition of a depression beyond that it lasts longer than a garden variety recession.
Depression probably gets its name from the psychological malady that accompanies unemployment, bankruptcy and failure in one’s life goals.
I worry that the Covid-19 shut down might lead to a depression because a vast number of businesses in high employment industries will disappear due to changed social values about risk, social distance and rediscovery of what is most needed versus simply desired. Those workers aren’t going back to work.
Massive increases in public and private debt burdens will create enormous impediments to future growth because companies that need to repay loans can’t buy as much equipment or hire workers.
We must keep in mind that Federal stimulus or bailout funds are being used to stabilize businesses, not to fund new growth. Loans must be repaid at some point, or they will default, wiping out their company’s owners.
On April 29th, it was announced that the economy (GDP) contracted at a 4.8% rate in the 1st Quarter (Q1) of 2020. Economists at Goldman Sachs, Bank of America, Morgan Stanley and JPMorgan now all agree that the contraction in US GDP in the second quarter of 2020 will be in the order of 30%-40% – six to eight times worse than Q1 and by far the largest quarterly contraction in US economic history, including the Great Depression.
The only reason the stock market did not go bonkers when Q1 GDP was reported to be so bad was that the market expects bad news right now, so it doesn’t react negatively to it. At some point another shoe will drop with worse than expected news and the market will again react to the destruction of wealth that is happening.
Despite the many bailout programs, enormous losses of income by individuals and businesses will go uncompensated due to unemployment, reduced work hours, lost commission sales and incentive-based compensation that won’t be earned.
The macroeconomic importance of this is that drastic losses of income will translate into similarly drastic reductions in consumer spending, and massive reductions of profits for businesses.
Consumers are shifting from spending to saving. Just as depression era citizens became great savers, people today will be more motivated to put money away for a rainy day now that Covid-19 has shown them what it feels like to have life dreams washed away in an instant.
Increased savings sound good until you realize that money saved means less money that can be spent on new cars, vacations and tickets to events – more drag on our economy.
Social distancing, now mandatory, will grow to be expected by fearful consumers and will make many industries less productive. Supply chain disruptions as we are seeing in certain industries – the meat processing industry being the current one in the news – will cause huge waste of perishable foods, increasing the cost of food.
Both small and large businesses will be suffering as productivity falls and many businesses take on debt, diluting shareholder equity. I expect shareholders of many companies to be wiped out in a wave of bankruptcies that is coming for companies in energy, casinos, hospitality, restaurants, movie theaters, and live entertainment industries. Even hospitals and doctors are being hurt financially by the prohibition on elective procedures.
The federal bailout programs are designed to provide liquidity for operating companies to meet payroll and keep working. However, the types of business mentioned above do not have a liquidity problem, they have a solvency problem. Even if they can pay workers, they can’t make a profit. Many will be forced into bankruptcy, wiping out shareholders.
I believe there is very little the Fed can do to prevent massive numbers of bankruptcies and long-term unemployment of displaced workers from these industries.
In past recessions, the service sector provided stability to the economy while other industries crashed, as financials did in 2008, and tech did in 2001. Now our service sector has been decimated by the shutdown.
Consumer spending is the largest single driver of our economy, greater than government spending, defense, or construction, and this is why this current economic collapse is a bigger problem that past recessions.
If you are not already a client of Hepburn Capital Management, please call today for an appointment for a free portfolio review to ensure that your portfolio is positioned correctly for the upcoming market.
Appointments can be done in person, by phone or by video conference – whichever you prefer.
What the Markets Are Doing
The stock market, measured by the S&P 500 Index**, has had a good month, but as of April 29, 2020 still needs to climb another 15% to reach its February 19th high. Investors are breathing a sigh of relief as Covid-19 statistics become less scary and certain areas of our economy begin to reopen. However, the market is also poised for another leg down in the near future.
There are two primary types of investment analysis:
1. Fundamental analysis, looks at things like sales, profit margins, net earnings, and debt or dividend payment ability.
2. Technical analysis is the study of market cycles, momentum, numbers of companies and shares traded in a market move, all which can be reflected in charts. If a picture is worth 1,000 words, a chart can be worth 1,000 numbers.
Technicals are showing a slowing, perhaps a stalling of the market rally that began in March, as the past two weeks have only produced a small gain.
Fundamentals have held up fairly well with first quarter reports that have come in so far. However, many companies only had business disrupted for a few weeks in Q1. Most are refusing to provide any guidance about what to expect for Q2 earnings, so Wall Street analysts and investors are flying blind about what to expect going forward. Uncertainty drives selling, and lack of guidance increases uncertainty.
At best, the reopening of our economy will be very disorderly, and it may be well into 2021 before anything approaching normalcy will be attained.
Based upon Q2 2020 estimates of 30-40% contraction in the economy as a whole, it is reasonable to expect many companies to report huge losses, enough to make a big dent in shareholder equity. With no guidance, many investors will be Shocked by Q2 earnings reports. Shocked with a capital S!
If the stock market has not already been in decline as other shoes drop, then Q2 earnings should create a big downward move.
Interest rates on Treasuries will be anchored close to zero for the foreseeable future. This means no income from bonds, but a LOT of risk if interest rates rise.
The way the Fed is supporting the bond markets reminds me of a bouncer grabbing a drunk by the back of his belt to hold him upright as he is escorted out. The Fed announced they will “do whatever is necessary” to keep the bond markets from collapsing and began buying corporate bonds after no one wanted to buy some of those bonds and prices plummeted in early March.
So far, the Fed has committed $750 billion to buying corporate bonds, which sound like a lot, however that is only about 2% of all corporate bonds. What if they need to buy 20% of all bonds instead of 2%? Will they spend $7 trillion on failing companies? We may find out what they mean by “whatever is necessary” when there is another run on bonds as the likelihood of default becomes more obvious.
Dividends stocks have fallen farther than growth stocks recently, as the specter of dividend cuts looms large. Federal bailout money is precluding companies that get help from paying dividends, so many companies will be cutting or dropping dividends altogether.
Right now, bonds pay very little interest, and have huge interest rate risk as well as increasing default risk. Prudent investors who hold bonds or bond funds may wish to rethink their position.
Gold hit its highest point since 2012 recently and gold mining stocks have responded with their own rally.
Oil prices continue to bounce along the bottom with West Texas Intermediate Crude at just over $15 per barrel. These low prices will create a wave of bond defaults and bankruptcies over the summer. But enjoy the low gasoline prices.
What’s Happening in Your Portfolio
With the stock market stalled out, and ripe for another major leg down in this bear market, our Shock Absorber Growth* portfolios are lightly invested with only 43% of our holdings in stocks, 36% in cash or short-term Treasury bond funds and about 12% in gold or gold mining stocks.
Cash holdings will allow me to quickly add hedges to protect market values and perhaps make some money for you when the next leg of this market starts down.
Our Flexible Income* suite of strategies holds about 40% cash, US dollar currency funds, and short-term Treasury securities. We hold about 20% in gold or dividend-paying gold mining stocks, and the balance of our holdings are in a couple of bond funds, inverse junk bonds funds (those calculated to go up as the junk bond market goes down) and a high dividend energy infrastructure stock (think owners of pipelines, tank farms and terminals, not producers).
Municipal Income* portfolios are being reinvested after last month’s “pothole” in the bond market and now hold about 40% in short-term US Treasuries along with 60% in muni bond funds.
And that is how we are staying in sync with this market.
- 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.
Have You Received a Statement This Quarter?
We arrange for independent custodians to send you account statements at least quarterly, even if there is no activity in your accounts.
Bernie Madoff made off with billions because he was allowed to produce his own phony statements. Your independently produced statements, sent to you directly from the custodian, are for your protection.
Whether you choose to get paper statements or electronic ones you can print when you choose to, it is very important that you receive statements one way or the other. If you have not received a statement this quarter, please call the office so we can correct that situation for you. (928) 778-4000
Mental Floss…
Wouldn’t it be wonderful if we could put ourselves in the dryer for ten minutes, then come out wrinkle-free and three sizes smaller?
Our Spotlight Strategy – Adaptive Balance
With our Adaptive Balance Strategy we strive to provide high total return from a combination of investments in both the equity and income markets with an emphasis on the income markets.
Our proprietary indicators are used to determine a stock market exposure that adapts to both strength and weakness in the market, directing exposure to the HCM Shock Absorber Growth strategy from 0% to a maximum of 50% of account value. The balance, 50% to 100% of account value, is invested in the Flexible Income Strategy. The HCM Safety Net indicator is designed to warn of sudden potential declines, in which case stock market exposure is quickly reduced.
Click here to read more about Adaptive Balance.
We Are Open
We are open for business by appointment only right now at Hepburn Capital Management. The staff has been sent home to shelter in place so you may have to be patient while I fumble with the admin parts of the operation, but I am holding consultations whenever asked to.
Meetings can be held in person (the office is wiped down after each client visit), by Zoom or over the phone – whichever you prefer.
* 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) 2020 William T. Hepburn. All rights reserved.
