August 28, 2012
The Investment View from Prescott, Arizona
We have commented a lot over the past few years about the rate at which the government has been printing money.
Our main concern is that it will be impossible for the U.S. to balance its budget when the ever increasing interest paid on our federal debt becomes greater than our economic growth rate. At some point, something has to give. When our 10 year Treasury rate is higher than our GDP growth, it means that our interest payments will be growing faster than the rest of our economy, including long-term revenues.
It might take some time but eventually we will hit a point where interest payments become too large to be paid. Period. We can cut and cut other spending, but due to compounding (interest earning more interest) interest payments sill keep growing and growing relative to all other spending until it reaches a tipping point.
We simply must stop the growth of the deficit spending, or risk financial catastrophe. Since countries don’t go through bankruptcy in the business sense, their money just stops being accepted and the resulting inflation wipes away the debt problems. Unfortunately that kind of inflation can also wipe out traditional savings and create economic chaos, too.
The stock market is better able to adapt to inflation than traditional savings vehicles such as bonds, CDs and annuities, which is why we keep our focus on stock market investing despite the rough times we run into occasionally in the markets. The stock market may just turn out to be the healthiest guy in the hospital.
Seen on a T-shirt:
There are 10 kinds of people in the world, those who understand binary and those who don’t.
The Safest Places for Your Money
Traditional financial planning advice for many years has been that US Treasury bonds, notes and bills are the safest investments due to the financial strength of our government.
As I mention elsewhere in this newsletter, I have been concerned about the effect all of the Fed’s money printing will have on our economy. One gauge of this effect is the interest that the Fed has to pay to sell all the Treasury bonds they need to sell.
The laws of supply and demand indicate that the bonds with the highest demand will get purchased at the lowest interest rates. For most of my career, US Treasuries have been consistently among the lowest paying bonds around. Investors were willing to accept less interest because they were getting more safety.
However, right now the US has dropped all the way to tenth on the list of countries ranked by lowest bond yields. Those countries with rates lower than the United States on 10 year notes are: The United Kingdom, Finland, Sweden, German, Singapore, Denmark, Japan, Hong Kong and Switzerland. (Source: Tradingeconomics.com)
What this means is that the investors of the world think they get more safety investing in the bonds of those countries than in the U.S. This is a clear sign that the United States is no longer considered the safest of safe havens.
I hope someone in Washington, DC notices this change.
A Slice of Life
It sure is nice to see the Arizona countryside breaking out in green. We have had rain most days for the past month, and in this high desert, no one is complaining about having too much of the stuff. July posted above average precipitation and August is looking to do the same. I’m not sure if they will begin to call this a drought-buster, but since we have had drought for 8-9 years here, I’m sure ready.
One nice thing about rain in Arizona, it’s a dry rain.
How’s the Market Doing?
The stock market continues to climb the proverbial wall of worry. Despite being down a little last week because of continuing financial problems in Europe, slowing growth in China and mounting evidence of an economic slowdown occurring here, the stock market is lurching but at least it is lurching forward.
With the Federal Reserve continuing to stimulate the markets by holding interest rates down, it is possible that we might still have more of an uptrend in front of us. The markets have finally reached the peaks they were at back in April of this year. Often, breaking above old peaks proves problematic for the stock markets since selling increases as investors take profits each time the market approaches its old highs. We will have to wait and see if we are “bonking our head” on that resistance level or we will break through it.
Presidential elections often have an impact on the markets, too. The current administration has hundreds of billions of unspent dollars to put to work if it wants to make the economy seem rosy – perhaps rosier than it really is to enhance their re-election chances. That will help the markets. And if some of the key issues that seem like big concerns to investors seem likely to be resolved, that too will boost the markets.
However, the big picture is still troubling. I maintain a 200 year study originally done by Robert Powers that I first saw in 1999 which identifies 7 major market cycles over that 200 year period averaging 28 years in length. Each cycle has a strong (bull) leg and a weak leg. I call the weak legs “generational bears”, not just because they last that long, but because they either wipe out or so sour investors that they never want to invest again.
This table shows the last 3 Generational Cycles
The last bull leg was the 17 year period from 1982-99, which most of us remember as “the good old days”. The current generational bear began in 2000 and so far has brought us two whopping bear markets that each dropped the major stock indexes by more than 50%, and we have yet to see the stock markets get back to the levels they were at in the year 2000.
What really troubles me is that the three previous generational bears lasted 16, 19 and 20 years and brought us 4, 5 and 6 individual bear markets, defined as 20% or greater losses in the major indexes. So far we are 12 years into this one (five according to some analysts who think it was really 2007-08 when the world really changed) and have had only two individual bear markets in this generational bear.
If history repeats itself, we can expect somewhere between 4 and 15 more years of up-and-down stock market activity, and 2-4 more really ugly bear markets.
So, although the market is acting well at the moment, there are lots of bears in the woods, and no investor should get complacent and think it is time to go back to buy-and-hope-it-works-out investing. Staying flexible and retaining the ability to move quickly from one investment to another is the most valuable asset an investor can have in this environment.
Q: A man wanted to enter an exclusive club but did not know the password that was required. He waited by the door and listened. A club member knocked on the door and the doorman said, “twelve.” The member replied, “six ” and was let in. A second member came to the door and the doorman said, “six.” The member replied, “three” and was let in. The man thought he had heard enough and walked up to the door. The doorman said ,”ten” and the man replied, “five.” But he was not let in.
What should he have said?
A: Three. The doorman lets in those who answer with the number of letters in the word the doorman says.
What’s Going On In Your Portfolio?
In the past few weeks I’ve made significant changes in our growth portfolios to get them back to leading the market instead of lagging like we had been doing for a while.
We retired the “shock absorber”* hedging as an ongoing part of the strategy because it had proven too costly in practice and was keeping us from making gains in up markets.
To boost performance, I have also gone back to choosing individual stocks rather than mutual funds for portfolios large enough to absorb National Financial’s stock transaction charges ($15.50 per trade) without impacting performance. For smaller accounts we continue to use funds.
I first identify the strongest segments of the stock markets – currently biotech, real estate, telecommunications and retail. Then I look for a few growth leaders in each category in which to invest. In this way, we can focus on the strongest stocks in the strongest categories – a great combination.
Since we made these changes, as of this writing on August 26th, the stocks we own have outperformed the stock market, posting a small gain vs. the S&P 500’s** small loss. I’ll do my best to keep it up.
Flexible Income* accounts have stabilized in the past two weeks after dipping some due to rising interest rates. I sold one corporate bond fund last week and replaced it with two bond funds that were weathering the interest rate changes very well. All the investments we presently hold continue to do well.
Municipal bond* accounts continue to do well and are fully invested.
Scottsdale Office Date
If you would like to meet with Will and the Scottsdale office is more convenient than the Prescott office, just call for an appointment to meet with Will in Scottsdale. (800) 778.4610
Our Spotlight Strategy
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: [Adaptive Blance]
If you would like a current copy of our SEC Form ADV, Part 2, it is on our website at hepburncapital.com/form-adv.html
* 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.