June 25, 2013
Measuring Fear
The Investment View from Prescott, Arizona
The world h
as become less tolerant of risk, and this is related more to the length of the economic downturn we have experienced over the past 5 years, not the depth.I can hold my breath for a minute whether I am 5’ under or 25’ under the water. But people in only 1’ of water are drowning now because they have been under for so long.
If we experience another financial shock now, the difference in how we all react will be profoundly different than in 2008.
Declining stock markets are the earliest manifestation of impending economic problems, as they are the best leading economic indicator there is. This past week, the stock markets took a significant downward turn and investors have begun to act fearfully.
The fear driving the markets can actually be measured by the Volatility Index, called the VIX. A chart of the VIX is shown below, and you can see that it rises as declines in the stock market begin to take hold. The VIX is rising now.
It is important to track investor fear levels because many investors make bad decisions when they are afraid. Here at HCM we have predetermined systems to tell us what to do when fear increases. I comment on some of these systems in our What’s Happening In Your Portfolio section of this newsletter if you want to know more.
A Slice of Life
The window in my home office offers a dramatic view of Granite Mountain, just west of Prescott. Watching at night as the fires swept across it was both scary and breathtaking. My gratitude goes out to the 600 firefighters and many slurry bombing pilots who kept the fire confined to the wilderness area around Granite Mountain, sparing hundreds of homes in the path of the flames.
30 people took us up on the tickets to see balladeer Juni Fisher perform Saturday night out in Dewey. The weather was wonderful and a good time was had by all. The promoter had even arranged to do a performance at the fire camp in Prescott which I thought was a nice gesture.
Mental Floss
Q: A man leaves home and turns left three times, only to return home facing two men wearing masks. Who are those two men?
A: A Catcher and Umpire.
How’s the Market Doing?
A Falling Tide!
In a nutshell, stocks are going down, bonds are going down, gold and other commodities are going down, and even real estate is poised for a disappointing year, despite what you are reading.
The Federal Reserve Board, last week, reminded us that the rising tide of easy money that has floated the financial markets despite a weak economy is not going to last forever, and the rush to the exits is beginning. Markets everywhere are going down as investors take profits and move to the relative safety of cash.
Many emerging markets around the world are already in bear markets including important areas like China and Brazil. Europe is mired in recession and Japan has been stuck in deflation for over 20 years. There are just not many places to hide.
As I have said before, I don’t have a crystal ball, I never know what the stock market is going to do. I just try to block out all the noise and misinformation generated by Wall Street and focus on just the data so I can recognize what the markets are actually doing. When a market tells me what direction it is going, I invest accordingly.
Until last week, the stock market had been locked in a fairly tight trading range between its May 22nd high of 1,669 and a couple of lows in the 1,600 area. On Thursday of last week it broke below the recent lows with the zigs and zags of the market changing from the sideways trading range into a pattern of declining tops and declining bottoms. Imagine a down staircase. This is the most basic sign of a downtrend. So the stock market is clearly going down at the moment.
The bond market, that for a number of years has acted opposite to stocks, should be expected to be going up as stocks go down, but no. The fact that interest rates are going up, driving bond prices down, is what is fueling the selloff on Wall Street.
Going back 240 years, there is a pretty clear 60-year cycle to interest rates. The last peak in rates was 1982, telling us to expect the bottom in
rates to occur in 2012. In fact, the 1.43% yield on 10-year Treasuries last July does mark that bottom in interest rates. If that bottom holds, this bit of history tells us to expect 30 years of rising interest rates – not a good sign for buy and hold bond investors.
Like stocks, the bond market does not travel in a straight line but zigs and zags as it goes. Even if we get a 30-year bear market in bonds, which this study suggests, there will be multi-year periods where bonds will make good profits. But there will be other periods where bond buyers will get their financial heads handed to them. The only way to participate in this current bond market is with active management such as I do for my clients. You have to know when to hold ‘em and know when to fold ‘em as Kenny Rogers once said (sang, actually).
Gold took another big hit last week, also. Like stocks, gold had been attracting bargain hunters every time the price dipped below $1,400 per ounce. This kind of buying tends to turn prices back up and is called “support”. It looked as if the two-year slide in gold prices which began in the summer of 2011 at $1,900, might be over. All that was needed to mark the resumption of gold’s rise was a significant bounce off the recent low of $1375. That never happened. Instead, gold broke decisively down through the earlier price support levels losing another $100 per ounce and is in another clear downtrend – another down staircase. This is not a good time to be a gold investor.
The revival of the real estate market has been much in the news lately, but I fear the recovery has gotten ahead of itself and real estate may be in for another rough year or two. Although prices have stabilized, two important leading indicators for housing stocks are lumber futures and copper prices. Lumber futures have been declining for more than a year, and copper, dubbed “the metal with a PhD in economics” because of its ability to lead financial markets has also been declining for more than a year.
These two indicators have been on my radar charts, but were not quite bright enough to ring alarm bells. However, when I see new construction wherever I look, and I note that Prescott Valley issued as many building permits in May (150) as in the boom years (59 in September 2007, the oldest month available online) I start to think “overbuild”. With unemployment much higher than 10 years ago, many potential buyers with foreclosures and short sales on their credit histories frozen out of the housing market, and rising interest rates making homes harder to afford, who will be buying all of these new homes?
With this perfect storm of factors, I think real estate is very likely to disappoint once again.
When the price of everything is going up, that is inflation. When the price of everything is going down that is deflation. Japan has been struggling to get out of a deflationary spiral for almost 20 years. Let’s just hope that ours is much shorter.
The good news is that two items that are fairly reliable in forecasting what the stock markets will do in times ahead, energy prices and money supplies, are both pointing to higher stock markets beginning in 2014, so all is not bleak. However, we are clearly entering a trader’s market, not a buy-and-hope-it-works-out market. These are the kind of markets that I just love.
If you have investments we don’t yet manage and you are wondering what to do in these uncertain markets, call the office at 778-4000 for an appointment to discuss my work. I have strategies to deal with declining markets. And please tell your friends, too.
What’s Going On In Your Portfolio?
As you were reading the June 4th installment of this newsletter I had begun raising cash and hedging in both our Flexible Income* and Growth* portfolios. Hedging involves holding “short’ or “inverse” investments designed to go up if companion investments go down, offsetting some of the market risk.
A few days ago, when the market broke down through levels that had earlier provided support, I added to our hedges.
By holding only the strongest investments and offsetting their normal market fluctuations by hedging, it is possible to make money in both up and down markets while experiencing very low fluctuations in portfolio values. The chart below shows how this can work.
This chart is shown to illustrate the risk and reward built into our growth portfolio as it was positioned from June 4-20 with the first batch of hedges. It is not a normal total return chart. As the S&P 500** (in red) declined from its May 22 high, The HCM Growth Strategy* was able to make money with much smaller ups and downs. This is what we hope to accomplish with each hedging operation, although there is no assurance that we will do so every time.
Our model growth portfolio* now holds health care, consumer, retail, and Internet stocks, a diversified growth fund plus several hedging investments. The hedges added on June 21st are calculated to fully offset the market risk of our traditional (long) holdings and bring our stock market exposure close to zero.
The Flexible Income* model account holds 4 different bond funds and as of June 21st is also fully hedged. Although TLT a long term government bond index fund, is down over 12% and LQD a corporate bond index fund is down 7.98% from their highs on May 2, our Flexible Income* portfolio dropped a small fraction of that amount in May and is showing a profit in June, so our moves to defend portfolio values have worked well.
Municipal bond* accounts are mostly in cash since all ends of the muni markets are under pressure due to rising interest rates.
LOL
Rodeo Drive, pronounced Roh-day-oh Drive, is the very high-end shopping district in Beverly Hills, CA. A singer at the Blazin-M Ranch in Cottonwood said she had always wanted to be able to shop at Rodeo Drive and when she moved to the Verde Valley she was pleased to find out that the Cottonwood Walmart is on Rodeo Drive. True story.
Scottsdale Office Date
If you prefer to meet with Will in Scottsdale rather than Prescott, please call the office (928 778-4000) to schedule an appointment.
Our Spotlight Strategy
With our Shock Absorber Growth Strategy, we strive to provide growth in all markets from a blend of both long and short equity investments.
We first select the strongest of about 40 different stock market segments, sectors and regions, and then select the most complimentary inverse funds to use as a Shock Absorbing hedge for those investments. The HCM Safety Net indicator is designed to warn of sudden potential declines, in which case stock market exposure is quickly reduced. Shock Absorber Growth
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 an Index.
Traditional Income
Flexible Income
Adaptive Balance
Adaptive Growth
Shock Absorber Growth
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.
