January 17, 2012
I Thought There Was an Elephant in the Room
The Investment View from Prescott, Arizona
By Bryan Jarman, CFA
I recently attended a presentation where the Chief Investment Strategist of one of the largest US banks spoke about the 2012 economic outlook. I had met the man several times before in my previous life as a bank trust department portfolio manager, and I always enjoy hearing his opinion and optimism; however, I was surprised at the lack of attention given to debt and deficits. Two slides gave the subject passing mention. That was it.
The 2012 Global Market Sentiment Survey conducted by the CFA Institute shows that 52% of respondents predict the global debt crisis will get worse and 26% predict it will stay the same. Only 19% believe the situation will improve. The overall outlook from this survey was pessimistic yet the cheerleaders from Wall Street and Washington, DC all make the situation sound pretty rosy.
The US now has more outstanding debt than revenue we produce as a nation in a full year (GDP), more than $15 trillion. France and Germany have pension liabilities that are 3 times their GDP. It seems that, as individuals, we know that we are stretching ourselves too thin but collectively we continue in denial and embrace more and more debt and future obligations.
The general consensus is that we are in for another choppy ride in the markets this year. It was unfortunate that the mounting debt – the elephant in the room – went unaddressed at the meeting I attended. The long term economic recovery we all want hinges largely on fiscal responsibility.
In the meantime, we at Hepburn Capital have investment strategies to help our clients weather the storm which looks increasingly likely.
Slice of Life
Cathy and I recently returned from visiting our favorite camper park in the Palm Springs area, and along the way we discovered one of the best restaurants we’ve found in quite a while, the Elephant Bar and Restaurant on the 111 Highway in Palm Desert.
Not familiar with Thai food, I tried something new and ordered Pad Thai, and it was wonderful! The manager said the secret is that each of its 13 ingredients has to be added in just the right order for it to come out right. It is definitely worth going out of your way for if you are in that area.
And I discovered that using chop sticks is a diet all of its own because you just can’t pick up that much food at one time. At least I can’t.
How’s The Market Doing?
The U.S. stock market has cooperated nicely the past month or so, but world markets are being held back by Europe, which is the elephant in the room that no one is talking about these days. (I think we have a theme for this newsletter – elephants!)
Or, maybe the media is talking about it, but we all have had Europe right up to here (my hand is under my chin) and are just not hearing it any more. Conditioning is a powerful psychological concept, and after hearing about them for so long, we are becoming conditioned to tune out problems in Europe. But they are certainly there. And if you are not keeping track of them, know that I am doing it for you.
A flood of money from the U.S. and the European Central Bank is being injected into the European economy, but it probably won’t make their debt crisis go away. Hopefully, it will make it easier for financial systems to handle the repercussions of the crisis as it plays out.
A telling development occurred last week when German government bond rates went negative for the first time in history. This means that investors, instead of collecting interest, are willing to pay the German government to hold their money.
Why would someone pay to have the government hold their money? Because the alternatives hold significant risk of not repaying the money, and investors feel the security of German credit is worth paying for. So they loan the German government money, knowing they will only get back 99 cents on the dollar (Euro, actually), believing that this is more than what they would get back from European banks and other Eurozone governments.
This issue underscores the crisis of confidence in Europe right now. There ain’t none!
And it is eerily reminiscent of the fragile state of the U.S. finances when our Treasury Bill rate went negative in December 2008. Remember how scary those times were for us? During the Great Depression, US Treasury rates also went negative. Europe is in a similarly precarious position right now.
With industrial production in Germany falling sharply, and shipping demand suggesting that Chinese manufacturing is also dropping like a rock, despite our many problems, the U.S. may just be the bright spot in the world economy. Sort of like the healthiest patient in the hospital.
My point here is that despite the recent rise in the stock market, this is not a time to get complacent. This is a market to be played with an eye toward defending portfolio values.
Mental Floss
How is it that we put man on the moon before we figured out it would be a good idea to put wheels on luggage?
What’s Going On In Your Portfolio?
In my last newsletter, I mentioned a new Long/Short growth strategy* that we are really excited about. After a couple more weeks of back-testing, stress-testing and analysis, we are even more convinced that this strategy can weather the financial storms around us. We have even nick-named it the Shock Absorber* for its ability to smooth out the volatile market swings we have seen the last couple of years.
At its 10 year anniversary last March, my Flexible Income strategy* (if it were a mutual fund) would have ranked #3 out of over 1800 income mutual funds in terms of high returns with low risk. I think the Shock Absorber Equity strategy* has that same kind of potential on the growth side.
This is a strategy that is hedged against the risk of a market turnaround almost all the time. Since the rapid changes of direction have come to dominate the stock markets in the past year, this strategy is particularly well equipped to remain on a profitable track despite the ups and downs of the market. It has one of the lowest “surprise factors” I have ever seen in a growth strategy. Very little seems to affect it.
The strategy was conceived in early 2009 when I ran a successful set of trades using it just before the bull market of 2009 took off. When the market turned upward, I dropped the hedging side of things and never really went back to the strategy until the end of last year when I looked at it again.
In the short time I have been running the Shock Absorber* in my own account, through January 13, 2012, it has doubled the performance S&P 500, with much lower fluctuations in value.
Some slides about it were attached to the last newsletter, but without any explanation they did a poor job of conveying how cool this strategy is. In the next week or so, I expect to record and send you a short video that will show you what we are so excited about.
The Shock Absorber Equity strategy* is so well attuned to the current market that I am beginning to integrate it into all of our growth accounts, Adaptive Balance* (formerly Balanced) and Adaptive Growth*, (formerly Careful Growth).
Current holdings in the Shock Absorber Equity strategy* are Index funds focusing on Retail, Pharmaceutical, Home Builders and Real Estate stocks, with an inverse Euro fund absorbing the shocks.
Flexible income* is having a good month, showing nice steady gains from its holdings in a Strong Dollar fund, and several types of corporate bond funds.
Our stock market exposure indicator is approaching 50% for Adaptive Growth* and 30% for Adaptive Balance*.
Incidentally, Sheri and Yvette are busy programming into our newsletter delivery program a feature that will allow us to remind you which strategies we employ on your behalf, since it is often hard to remember. We hope to have this feature ready to include in the next newsletter.
Who, Me? Retire?
I occasionally get asked how long I plan to continue working. Sometimes I call this the “What if Will gets run over by the beer truck? question.” It is an appropriate question in my type of business, and I have not addressed it for two years in this newsletter, so let me assure you, you’re not going to get rid of me easily! 
Besides having longevity in my family (both of my parents lived to 90), I have structured my business so that the staff takes care of most of the work-work so I can concentrate on the markets, which is what I really enjoy. I have never found anything as intellectually stimulating as my investment analysis. I love it! I can do this for a long time, and I have no intention of quitting soon.
Ten years or so ago I was trying to build a big business, and had 10 people working with me when I had an epiphany. I realized that even if I were to retire right then I would still do the same thing every day that I had done for years. I get up in the morning and take my cup of coffee into the office at home to see what the markets are doing. I am often turning the dials and knobs on portfolios before breakfast. My insight was that if in retirement I were going to continue to do the same thing for myself that I do now for both of us, why retire?
From that point on, my motivation became to streamline the business so that it was easy, capital “E”, for me to run. These days the staff takes care of just about everything other than the investment decisions.
For several years now, I have traveled 60-80 days a year between business and personal time off, and I get to play golf almost every week. I already act like a lot of retirees do, so there is not much to change there.
The business runs so smoothly that I don’t feel any pressure to retire.
With Bryan Jarman now in the office, our plans are to formalize a partnership later this year in which Bryan gradually takes on a larger and larger role. Bryan is bright, highly trained and experienced, and very personable. He is also just approaching the age of 40. In short, I feel that he is capable of taking over completely if something were to happen to me and run the business for a long time.
Our long term plans have us looking at a point 10 years down the road where the partnership will be pretty equal, and my plans are to still be around then, but easing back on day-to-day operations.
Legendary investors have been known to function well into their 80’s and 90’s and I plan to be in that category. If not the legendary part, the 80s and 90s for sure.
Our Spotlight Strategy
The FLEXIBLE INCOME STRATEGY is designed for investors seeking either to avoid the volatility of equity (growth stock) investments or the balance in a portfolio that fixed income investments can provide, and who also wish to avoid having their money exposed to prolonged bond market downturns.
* 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.
