February 19, 2013
Not Your Father’s Dow?
The Investment View from Prescott, Arizona
Some headlines last week touted “Dow Jones Nears New Highs”, which certainly is good news. But why are so many investors frustrated because their investments have trouble matching the performance of an index?
Because the Indexes are moving targets, that is why.
Most folks assume that indexes are static lists of stocks against which other things are measured. Whether it is the Dow Jones Industrial Average of 30 stocks, or the S&P 500 Index, 500 stocks which represent about 80% of the entire stock market’s value and is considered by many to be representative of the entire market, this is just not true.
The reason the Dow is flirting with new highs is it is not the same Dow that dropped more than 53% between 2007 and 2009. The Dow is reconfigured every few years – the lineup changes. When they fell on hard times, former Dow components Altria, Honeywell, AIG, General Motors and Citigroup were replaced with Chevron, Bank of America, Travelers Insurance, Cisco and United Health Care.
No wonder the Dow performs well, when turkeys are replaced with solid growth stocks whenever performance falters. I call this active management. Some folks are stuck on the term “indexing”.
In the 1990s, the Dow Jones Industrial Average went up over 400%. If you had bought the 30 stocks of the Dow in 1990 you would own companies like Bethlehem Steel, Navistar, Woolworths, Westinghouse and Goodyear which struggled just to survive in the 1990s. Those companies were replaced by go-go growth stocks like Disney, Microsoft, Home Depot and Wal-Mart.
So when you see headlines that such-and-such index is hitting new highs, please take it with a grain of salt, because it is not the same group of stocks that stumbled so badly a few years back.
It does make for feel-good reading though.
A Slice of Life
At the Shrine Club meeting last week, it was reported that we helped another local child get care at one of the 22 Shrine Hospitals around the country. That made me smile.
Shrine Hospitals specialize in treating children with burns, orthopedic issues and cleft palate, all at no cost to the family.
If you know of a child that needs care, please contact me and I will be happy to help get the admission process started.
How’s the Market Doing?
The stock market continues to climb the proverbial “Wall of Worry” as it makes gains. Certainly there are a lot of things to worry about – increasing taxes, recession in Europe, high unemployment that appears to be a permanent part of the landscape – but the fact is the market is up since its swoon last Fall.
My guess is that it is the additional cash the Federal Reserve is pumping into the economy that is finding its way to the stock market. I am nervous about the long term effects of this brand of narcotic, but I can’t change the facts of the moment.
The big change in the markets is the bond market. The Vanguard Total Bond Market Index Fund which is easy to use as a proxy for the entire bond market has been declining fairly steadily for three months. Interestingly the timing of this decline matches the Fed’s announcement that they would be buying even more bonds, theoretically propping up bond prices and holding interest rates down in the process.
It ain’t working. Interest rates are creeping up and bond prices creeping down despite the Fed’s massive spending (almost a $1 trillion planned this year). I’ve long maintained that the markets are bigger than anything, even the federal government, and maybe the Fed is finding that out.
History suggests that major interest rate cycles run for an average of 30 years. I don’t know whether this recent interest rate rise qualifies as a major turn of the market, but if it does, the bond market is in for a strong headwind for many years.
Bill Gross, the renowned manager of giant bond firm PIMCO, was sharply cutting the firm’s investment in U.S. bonds in the 4th quarter of 2012. He had an interesting comment regarding the Federal Reserve’s massive buying programs of Treasury bonds, saying “Central banks are where bonds go to die.”
That sounds a bit ominous, especially when you add to that phrase “when no one else wants them”. Interest rates are rising. How high will they have to go before investors will want to buy all the Treasury bonds there are? That is the $64 trillion dollar question.
The gold markets appear to be breaking down after trying to find a bottom in the last few months. This means fears of imminent inflation might be premature – gold ought to be going up during inflation, but is not right now. That is a good thing for the general economy, although it confounds the conventional wisdom that when the government prints money gold goes up.
Whenever something in the market does not make sense to me, I have learned that there is usually a force working that I am just not aware of yet. For anyone to assume that the market is wrong and they are right is an ego-based, and often a very expensive, way to invest. Twentieth century economist John Maynard Keynes wrote one of my economics text books and once said “the market can stay irrational longer than you can stay solvent”. I believe him.
I’m not sure what is driving the gold markets right now, but gold is going down, and I’m staying out of its way.
Q: What is the longest word in the dictionary?
A: Smiles, because there is a mile between each ‘s’.
What’s Going On In Your Portfolio?
Both our Flexible Income and Growth strategies have made nice gains this month, which means our Adaptive accounts which combine the two have also done well, too. Flexible Income has already produced more gains this year than last, only 45 days into the year, as of this writing on February 15th.
With my comments elsewhere in this newsletter about the bond market’s struggles you might wonder how we can make profits in our Income strategy. The reason is that the bond market is dominated by Treasury and high quality corporate bonds that are very “interest rate sensitive”. With interest rates creeping up, those bonds are creeping down in value. But we don’t own any of those.
Flexible Income gets its name from the flexible approach we take. I use any investments that are primarily income oriented investments. These days this includes floating rate, municipal and high yield bond funds and high dividend (5-6%) paying real estate investment trusts, which are all doing much better than treasury and traditional corporate bonds. Your managed accounts own no gold or currency accounts at the moment.
Our growth strategy is fully invested, going without any hedge for the first time in several months. This is a reflection on the current strength of the stock market. Our growth model currently owns a mix of home construction, energy and real estate stocks, plus two growth funds.
A Yavapai College Class
Advanced Investment Analysis Using Charts
If a picture is worth 1,000 words, a chart is worth 1,000 numbers. Most of us find it easier to relate to pictures than pages full of numbers. By using charts you can feel better about your investment decisions and perhaps become a better investor, too. Topics will include use of moving averages, trend-line analysis, relative strength analysis, ulcer indexes, breadth and volume indicators and more. We will also explore several web based charting services available to the public.
Thursdays, 1-4 p.m. February 28 – March 7, 2013. Tuition, $65 payable to Yavapai College.
Call Yavapai College at 717-7755 to register for class.
And tell your friends. Many years we have groups attend class together to make it a social as well as a learning experience.
Scottsdale Office Date
If it works better for you to meet with Will in the Valley, please call 928-778-4000 to set up an appointment.
What We Were Saying Back Then
Bank Failures Fading
I’ve talked a few times over the years about the rate of bank failures being a barometer of economic health. Here is some good news and some bad news from the FDIC.
The real yardstick of bank failures was the 1930s when over 10,000 banks failed. During the 4 calendar years 2004-07, only 7 banks failed in the U.S. Good times, for sure. However during the 5 year period between 2008 and 2012, 465 banks failed!
That is certainly an improvement over the 1930s when banks were hardly regulated at all, but considering all the regulations in place to keep banks from taking too much risk with your money, I’m not sure whether 465 failed banks is a good number or not. It does not feel good.
The really good news is that bank failures in 2012 dropped to only 51, the lowest number since 2008 when the financial crisis was just beginning to unfold.
One reason that banks have stabilized is the massive amount of money the Federal government pumped into banks in the wake of the 2008 financial collapse. Collectively, the banks are sitting on over $1.5 trillion in non-borrowed reserves. This is a level 15 times higher than the cash most banks carried until 2008, so banks are awash in cash they have gotten from the Fed. That is why they are not dropping like flies as they were a few years back.
I read two things into this set of circumstances: First is that the banks and the regulators that control them must be worried about another big shock to the financial system to be carrying 15 times the normal amount of cash for over 4 years now. Second is what will business be like in the U.S. when the banks find customers to borrow those reserves? Business will be good, but will it be inflationary? It’s hard to tell right now.
I’m Never Too Busy…
Although I am a specialist these days, limiting my practice to portfolio management, and although I spend my time in 3 different offices (and occasionally the golf course), I am never too busy to sit down with you and review accounts or answer your questions in other areas.
I spent many years practicing as a Certified Financial Planner, and although I no longer hold myself out to the public as a planner, I still retain many of those skills for the benefit of existing clients. Membership has its privileges, so to speak. So, if you have any financial questions, I would be happy to answer them for you.
I also would be happy to meet with your friends who might have questions. If I can help them I will. If not, I can probably tell them who can help them.
One of the nicest compliments you can give me is to tell your friends about my work. An easy way to do this is to use the link provided in this newsletter to forward this letter to your friends.
Our Spotlight Strategy
With our Adaptive Growth strategy, we strive to provide high total return from a combination of investments from both the equity and income markets with the emphasis on equities.
Our proprietary Stock Market Exposure Indicator is used to determine a stock market exposure that adapts to the strength or weakness of the market, directing exposure in the HCM Long/Short Equity strategy to range from 0% to a maximum of 80% of account value. The balance, 20% to 100% is invested using the HCM Flexible Income strategy. The HCM Safety Net indicator is designed to warn of sudden potential declines in which case stock market exposure is quickly reduced.
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.