November 11, 2008
The Election’s Influence on Your Investments
Despite the efforts of pundits to define the stock markets as they relate to politics, the markets are not politically driven. They react to uncertainty, not party designations. Investing takes faith in the future, and most folks will not invest unless they are relatively certain about an outcome, causing markets to drift downward in uncertain times.
The stock market rallied into and through election day, then welcomed the new president-elect by dumping 10% of its value in just two days. Why? Because before the election, the outlook was increasingly clear. Barack Obama would become our next president. The market rose. Like two sides of the same coin, after the election things were increasingly unclear because investors realized that they were uncertain how Obama would govern. The market dropped.
Over the past month I was becoming more optimistic about the markets as the market low point of October 10 (839 on the S&P 500 Index) was not exceeded. If the market moves decisively through that low, the odds are very good that the crash is not over and we are in store for another major down-leg in the markets. If the lows hold at or above that level then the low point of the market and the greatest amount of risk is behind us.
For several reasons I also expect increased selling to hold the markets back between now and the end of the year.
Investors with gains will be selling to beat a perceived increase in the capital gains tax when our new president takes office in January. The current tax rate for most investments held longer than one year is 15%, and that could rise as high as 20% to 25%. Any tax increase will likely be made retroactive to the date of the announcement to avoid a sell-off in the market, but savvy investors know this and are selling now, while they can still dodge the increase.
There is a myth that Congress doesn’t raise taxes in a recession. Don’t believe it. Three of five major tax increases enacted over the last 30 years were during recessions.
Also, investors with significant losses will be making lemonade out of their lemons by selling during this tax year to lock in the tax write offs available to them. I’m thinking that even a slight increase in selling will hold this fragile market back.
It may be tough for the markets to make significant progress with that kind of headwind (selling), so I expect the markets to muddle through the rest of the year rather than take off like a rocket. The $700 billion the government is injecting into the economy will eventually get traction and a lot of that money will find its way into the markets where it will make good things happen for investors. But right now we need to be patient.
New Rules
The stock markets have a 200-year history of boom and bust cycles averaging 28 years in length – 14 years up and another 14 years down or sideways. Actual up and down legs range from 8 years to 20 years.
I call these generational bull or bear markets, not due to their length, but because they sour a whole generation of investors when the down legs happen.
The boom after World War II was missed by many investors who were in shock from the ordeal of the crash of ’29 and the great depression, and probably never again invested in stocks despite the huge bull markets to come.
Investors from the late 40’s to the 1960’s learned that stock investing was easy. Just buy and watch it go up. Those investors had to adjust to new rules as the calm and steady markets of that era gave way to the late 60’s and 1970’s which saw 4 bear markets in 16 years. The ones that adapted to the new rules did OK. Most, however, trusted their experience and the advice of “experts” and doggedly kept investing the way they had for 10, 20 or 30 years not realizing the rules in a bear market environment are vastly different than those that rule good markets.
I began my work with the stock market in the 1980’s, as the big bull market was taking off. Most of the “experts” back then learned their trade by studying market action in the generational bear market of 1960’s and 1970’s. Many were not very good at making money in the new bull market of the 1980’s and 1990’s because the market had become fundamentally different. The ones that did not adapt lost both opportunity and money for themselves and their clients.
The experts from the 1990’s – the same ones who said “buy and hold is the only way to invest”, and “no one can beat the indexes” are finding that the rules have changed once again. Active management is proving to be superior to buy and hold in the current market conditions.
I was fortunate to have a friend and mentor in Sir John Templeton who passed away at age 95 earlier this year. When Sir John retired and sold his mutual fund family to Franklin funds in the early 1990’s he had the best 40-year track record in the business. The invitation for Cathleen and me to visit him personally at his home in Nassau, Bahamas in 1997 was one of the highlights of my career.
One of Sir John’s favorite sayings was “All things cycle in and out of favor, investments and investment styles.” Sir John knew these cycles well and was ready for them. That is one reason for his success. It was his admonition that caused me to look for these rule changes and adopt the more active style of management I use today.
My clients have enjoyed great success this year relative to the stock market as a whole with losses in the 3, 4 or 5% range year to date while the market is down 35-40%. Is this luck? I think not. The two equity strategies I ran from 2000-02 both showed profits during a period that saw the stock market lose 48% if its value.
Those two strategies have evolved into the Careful Growth strategy I use today, but the underlying premise remains the same. Expect the rules of investing to change, and then change with them.
Unfortunately, it takes time to unlearn the lessons of the heady 1980’s and 1990’s, and we can still observe people using investment ideas that only work well in bull markets. By the time this current generational market phase is over, investors will all have learned new rules, but they won’t apply to the next 20 years.
When the market changes, we must change our tactics, strategies, and analysis techniques to accommodate the new market conditions. This is not a new idea, but it is one that is not very widely recognized, particularly when applied to the long-term. In most of my writings this year I have emphasized that we are in a bear market, and that we must play by bear market rules.
Whether or not I am correct in my current analysis of the market will have to be left to history to determine, but I am certain that we are no longer operating on the rules of the old generational bull market.
Words From The Wise
“Equities will almost certainly outperform cash over the next decade, probably by a substantial degree.” Warren Buffett
And Buffett’s reasoning? According to the New York Times article, it’s as simple as “Be fearful when others are greedy, and be greedy when others are fearful.” And most certainly, fear is now widespread, gripping even seasoned investors.
Strategy Updates
Despite the market suffering its worst month in decades, all Hepburn Capital model portfolios* finished October with positive results. (Tell your friends)
Hepburn Capital Portfolios
HCM Flexible Income1 +.08%
HCM Careful Growth1 +1.45%
Market Indexes
S&P 500 Index2 -16.8%
Merrill Lynch High Yield Index -16.3%
We are still substantially out of the market. Careful Growth1 is 60% in Treasuries and Flexible Income1 is 100% in Treasuries. I believe it is still time to be patient and not take a lot of risk.
Family and Friends Discounts
I have a habit of saying “Tell your friends” when good things are happening in your accounts. Referring your friends and family to me is one of the nicest things you could do for me – and possibly for your friends, too.
I also want to remind you that I offer “Family and Friends” volume discounts which can result in lower management fees for both you and your friends.
Family and Friends Discounts are created when I use the combined value of your accounts plus the values of any family members or friends referred by you who become HCM clients, to determine the management fee. Larger account values = lower fee percentage.
Your accounts will still be held in the strictest confidence and will remain separate from those of family and friends. I merely add up the values of all accounts in the Family and Friends group to determine the fee level.
So, please, send your family and friends in to see me for a free consultation. By introducing us you may save a chunk of money with our Family and Friends Discount while you help your friends out at the same time. And if their investments have been hit hard lately, perhaps they could really use the help.
Tax Planning and Investment Seminar
Big movements in the markets provide tax planning opportunities that may not be available in good years.
Discover how to thrive in tough economic times in this informative seminar, co-hosted by Prescott accountant, Shari Graham, of Tax Time and me at the Prescott Public Library meeting room Saturday, November 22nd either at 9:30 a.m. or 10:45 a.m.
I will be speaking for a few minutes on the New Rules of 21st Century Investing, and Shari will provide some great ideas about how to make lemonade out of investment lemons during this hour-long program.
Please join us to see what kind of tax savings you can generate from this current environment.
Feel free to invite a friend, but seating is limited, so please call the office for reservations at 778-4000
1 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.
2 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.
Information in this newsletter is 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 constitutes a solicitation for the purchase or sale of any security. Adviser will not transact business unless properly registered and licensed in the potential client’s state of residence.
