November 30, 2010
It Is Time To Stop Digging The Hole
The Investment View from Prescott, Arizona
There is an old saying that the first thing one should do when they find themselves in a hole is to stop digging.
When it comes to the federal deficit this is easier said than done. However, now you can be in control of the deficit.
The New York Times recently ran an article on the problems of trying to cut here or tax there: http://www.nytimes.com/2010/11/14/weekinreview/14leonhardt.html?_r=2
The article itself is a good one, but the link embedded in it entitled “the deficit puzzle” will take you to a fascinating exercise in solving the deficit problem that anyone can try.
You get to pick your favorite mix of program cuts or tax increases, each listed with the estimated cost savings or revenue, allowing the reader to craft their own solution, and when you get the right combination a banner pops up stating that “You Solved The Deficit!”
You can go directly to the puzzle at: http://www.nytimes.com/interactive/2010/11/13/weekinreview/deficits-graphic.html
I wonder what Congress would do if each of us completed this exercise and sent the results to them so they could legislate the true will of the people.
I know, I know, it’ll probably never happen.
Anyway, it is a fun and instructive exercise about a vitally important issue. Check it out if you have a few minutes.
Being a fiscal conservative, my solution combined 27% tax increases and 73% spending reductions. I’ll be interested to hear about your solution.
The slogan of the Yavapai County Shrine Club is “having fun, helping kids”. The local Shriners are committed to hosting 200 children at this year’s Clothe-A-Child event. There are so many kids that we have to split the event into two weekends.
Needy children are referred by school counselors and social service agencies, picked up early on Sunday morning, given breakfast and taken to Wal-Mart on Highway 69 for a shopping spree complete with Santa himself in attendance. It is heart-warming to see the looks on the children’s faces as they pick out new clothes and toys for themselves.
It costs the Shriners about $100 per child to do this, $20,000 in total, so Clothe-a-Child is a year round fundraiser for the Club. If you would like to feel a little like Santa Claus by sponsoring a child or two, just make a check out to the Yavapai County Shrine Club and drop it off at the office. I will see that it gets delivered to the Clothe-a-Child committee.
Thanking you for all the kids.
Bond Investors Playing With Fire
Treasury bond rates have begun to rise after dropping below 2.5% in early October. Ten-year bonds are now paying 2.87% as of Friday, November 26th.
Rates rising 3/8% may not be that big of a deal, but the fact that the trend of the rates appears to have turned up should be disturbing to anyone who is invested in interest rate sensitive investments because bond prices go down as interest rates go up.
With the Fed’s thumb on the scale as they buy truckloads of bonds in QE II you would think interest rates would stay down for a while, but market forces can be bigger than the Fed, as bond investors have found out in the past month or so.
Treasury bonds are considered among the safest of all investments. However, in my college classes, I taught students that whenever anyone says the word “safe”, your response should be “safe from what?”, because nothing is safe from every risk, even Treasury bonds.
They may be safe from default due to the power of the Treasury’s printing presses, but there are other risks that many people overlook.
The potential for inflation or erosion of purchasing power due to the government’s printing of extra money can depress resale levels of bonds. This appears to be what it happening now.
Since 85% of all bonds are not held to maturity but are sold in the open market, let’s take a look at the current market risk vs. market reward on T-bonds.
I’ll use 10 year maturity Treasury bonds for this example. Currently they pay 2.87% interest. If an investor was to buy a $100,000 bond today at this rate and interest rates were to immediately drop to 2%, a little below the lowest rate of the past 50 years (as reported by Finance.Yahoo.com), the resale value of your 2.87% Treasury bond would jump to $107,870 as rates dropped.
However, if prices were to rise back to their historical average since 1962 (not counting the five highest yielding years of 1980-84) of 6.18%, the resale price of your 10 year Treasury bond would drop to $75,700.
From today’s rates this represents a potential gain of $7,870 and a possible loss of $24,300 for anyone holding bonds for the long term. That is 3 to 1 ratio of risk to reward. I prefer my risk reward relationships to be slanted the other way. This one is slanted against me and for that reason I am not a buyer of Treasury bonds these days.
Unless you hold bonds in an actively managed account such as my Flexible Income accounts, which give you a chance to get your money out of harm’s way when rates rise significantly, I’d suggest you pass on most bond investments right now.
What We Were Saying Back Then
My November 2004 newsletter included an article on active versus passive investing styles that holds true today. This is an excerpt from that newsletter:
When to Use a Passive Approach
In what areas of your life do you normally pursue clear goals with a passive solution rather than an active one?
How about in raising your children? Is it a good idea to be passive? Not really.
How about in advancing your career? Would it be a good idea to be passive while attempting to climb the corporate ladder? Probably not.
Well, how about on the athletic field? Would a passive approach work in your favor? Of course not. Rarely does an athlete with a passive attitude succeed.
Why then, do so many financial professionals promote the idea of passive investing? It’s beyond me.
What’s Going On In Your Portfolio?
There is a lot of high stakes tension in the world today that has led me to increase cash holdings in both Careful Growth* and Flexible Income* portfolios since my last newsletter.
One concern is over the North Korean attacks on the South and what form a show down with China, North Korea’s closest ally, might take. Another is with the potential for financial defaults in Ireland and Spain. Each has the potential to become a big deal if things get out of hand.
As a result, I have been closing out stocks in the Careful Growth* portfolios at their first sign of weakness and have raised cash levels over the past few weeks to about 47% of account values.
Careful Growth* accounts continue to hold about 10% in gold and the balance in growth stocks and cash.
Flexible Income* accounts have seen the weakening bond market begin to erode returns, so I have been raising cash there too. Currently Flexible Income* accounts hold gold, a currency account, an inflation protected bond fund and a diversified bond fund along with about 37% in cash.
I don’t hesitate to sell off investments when they begin to decline in value. Some investors wait, blindly confident that the markets will turn up again, soon. They probably will at some point, but the potential depth of the decline before things turn up again is what concerns me. No one really knows for sure when the market will begin to move back up, and that is why I think it is safer to increase cash levels in uncertain times.
Also, the leading segments of the markets will usually be different in each leg up, and holding cash will allow us to buy into the new leaders when they emerge.
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Our Spotlight Strategy
For our Socially Responsible Investments clients we invest using the same methodology as our Flexible Income*, Careful Growth* and Balanced* non-SRI portfolios. What changes is our use of socially screened mutual funds and ETFs when they are available in the appropriate market sectors.
If how your returns are generated is as important to you as how much your returns will be, this strategy may be for you.
* 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.