July 1, 2020
Ready for a Double-Dip Recession?
That our economy is in a recession caused by stay-at-home orders is no surprise, but the recession was formally declared for the first time last week by some government group.
The recession is not directly caused by the virus, but more due to the avoidance of face-to-face contact required to produce many goods and provide services, once people decided to stay home.
For the past few months, the entire country has been breathing a sigh of relief as the economy and our lives began to move back toward normalcy. And the stock market’s rebound from the sharp losses incurred in March is a reflection in that change of mood.
What many investors are missing is that this first recession, focused mainly in service sectors of the economy, will cause a second recession, or perhaps just a double-dip type deepening of the initial one. These second (and third) order effects are not yet visible, but are beginning to be felt. Thousands of business will cut back as the lack of demand filters down into mining, construction and manufacturing of durable good such as cars, appliances and sporting goods.
Regardless of generous government assistance, many firms will fail because demand for goods and services is falling due to pubic fear of going out and doing things that we all considered normal until now. As business suffers, workers will be laid off and inventories will not be replenished, creating a more traditional type of recession.
Consumer spending is the largest part of our economy, making up a whopping 71% of all spending in 2013 (source: Wikipedia). A demand-driven recession can’t end until demand returns, and that is a confidence factor that is hard for me to measure or predict, but right now I see no end to the economic slide until consumer confidence can be restored.
Government stimulus to the economy is primarily through banks to keep them from failing in large numbers due to an expected wave of loan defaults. Until banks think the risk of making new loans is low, and it is very high right now, much of that money will stay in banks, not flow into the economy at large. Financial assistance to businesses is to keep employee paychecks flowing, not to restore profitability. Financial assistance to consumers is intended to pay for basic necessities, not improve standards of living.
Despite all the government’s monetary stimulus to the economy, I believe that the economy will continue to soften and both GDP growth, standards of living, and employment will drop further.
A wave of business bankruptcies is just beginning. There is a lag time in BK filings so we are at the very beginning of this event. Most mortgage defaults are not seeing foreclosure actions due to a government mandated waiting period called forbearance. The current forbearance order expires in August so personal bankruptcies will start to be added to the rising tide of defaults.
Many economy and market watchers, like me, are waiting for the other shoe(s) to drop and weigh down the financial markets. Bankruptcies are going to provide lots of little shoes dropping. When we reach a tipping point the markets will react negatively.
Although I hate to say it because I hate wearing them, the best, fastest and lowest cost solution for the economic woes we have is for us all to wear masks. This economic problem is caused by fear in the market place, and until consumers, especially those in higher health-risk categories, won’t begin to feel safe enough to get back to normal spending patterns with so many of us walking around without masks.
What Bank Stress Tests Mean to You
On Friday, June 26th, the Federal Reserve Bank released the results of recent bank stress tests where it puts banks through various adverse economic hypothetical scenarios to gauge whether they can withstand potential downturns.
I was watching this closely as previous stress tests were run under garden variety recession scenarios. No one imagined the economic problems being as severe as they are today, so I wanted to see what new tests said.
We don’t get a lot of detail on the results, but as a result of these tests banks are now prohibited from using their capital to raise dividends, a common way to attract new investors.
Furthermore, dividends are going to be limited to a bank’s net income, also forcing them to conserve capital. This does not bode well for a bank like Wells Fargo (NYSE: WFC), which reported only $0.01 in earnings per share in the first quarter and is not expected to do much better in the second quarter as loan losses mount. (source: The Motley Fool) Their current dividend is $.51 per share, so the cuts could be devastating to investors who rely on dividend income.
Banks are also going to be prohibited from buying back their own stock, a tactic used to keep stock prices from falling. This means fewer buyers of bank stock, and since the price of a stock is set by the balance of buyers and sellers, this will put the price of bank stocks under a lot of pressure.
We can count this as another shoe falling.
What the Markets Are Doing
Is the Fed Taking Away the Punch Bowl?
Softness in the stock markets began a few weeks ago at the same time as the Federal Reserve Bank stopped filling the punch bowl with money. Since June 10th, reports from the Fed show a slight reduction in assets they have bought, a sharp departure from the many billions per week they had been buying. Buying assets, mostly bonds, replaces them with cash in the seller’s hands, putting cash into the economy. It is the Fed’s preferred method of economic stimulus these days. Data from the past 3 weeks shows that Fed stimulus has been absent.
The fact that the stock market experienced a 7% drop in one day on June 10th and has been in a downtrend since should be significant for stock investors. We are in a bear market, and a second leg down may have begun on June 10th.
Big market bounces like we got in April are common in generational bear markets. The dot-com bubble led to the 2000-03 bear market in tech stocks. After the bubble burst in March 2000, the Nasdaq dropped 35% over the next two months. The index quickly staged a 43% rally and recouped much of the initial loss. When that rally fizzled, the Nasdaq ended up grinding 66% lower before bottoming in 2003. Today, it may be tempting to believe that the bull is back since the S&P 500 is now 36% above its March 23rd closing value, but please remember we are in a bear market and the average bear market takes 18 months to hit bottom. We are not yet 5 full months into this bear.
Bond investors had better be patient earning very low interest, perhaps for a long time. For investors living off the interest their savings produces, this will be a painful time. The Fed is sitting on the bond market and has stated their intention to keep interest rates close to zero through next year, at least.
Gold prices, after chopping sideways for a couple of months blipped up in the past two weeks. Gold bugs are worried about all the money printing being done at the Fed, thinking inflation is on its way. And we do have inflation in some areas, like food costs, but in many areas prices are dropping, so overall we have deflation, not inflation. Until we see a pickup in demand across our economy, prices will continue to fall.
The gold bugs have logic in their side when saying inflation is coming, but I am reminded of quote from an early editor of the Wall Street Journal, “The graveyards of Wall Street are littered with the bodies of investors who were right too soon.”
What’s Happening in Your Portfolio
As of this writing on June 29th, our Shock Absorber Growth* suite of strategies has outperformed the S&P 500** stock Index during June, with about 1/3 the volatility. Growth accounts are currently above the February 19th value, which was the high for the year for the S&P 500, so you are doing well despite all the carnage in the investment world.
We currently hold about 30% cash, with the balance heavy into biotech and Internet and online shopping stocks. With a couple of small hedges to dampen the volatility of the stock market – our shock absorbers.
Our Flexible Income* suite of strategies also had a good month, picking up about 3% in June.
Municipal Income* accounts were flat for the month.
The wild card in all of this is the shoes that are beginning to drop. All of my best analysis gets wiped away in one drop of a shoe. Then your most valuable asset is my ability to recognize what the new data means and react to it quickly. We are in an environment of rapidly deteriorating earnings power for many industries and much of it is not visible yet in terms of having hard data, but another shoe can drop at any time.
I am frequently asked what I think will happen in the stock market, and my best answer is “No one really knows, but I’m sure I will recognize it when it starts to happen and be able to react appropriately to it.”
And that is how we are staying in sync with this market.
- Shock Absorber Growth* is our 100% growth portfolio.
- Flexible Income* is our 100% income portfolio.
- Adaptive Growth Portfolios* are currently allocated with 80% Shock Absorber Growth* and 20% Flexible Income*.
- Adaptive Balance* is 50/50 between growth and income.
A Peek into the Future
Some experts are calling for some kind of a “reset” of debt as a way of dealing with it all. Marking it down to make it more payable is what they are after. Think of chopping 3 zeroes off the national debt. However, that will destroy the credit of the US government, and wipe out the savings of many folks who would see bonds in their retirement accounts lose 3 zeroes and drop to 1,000th of the previous amount.
Bank and insurance company solvency depends on the bonds they hold in reserve, so this is not a simple fix. Since most politicians always choose the least painful solution (for them) I’m guessing that they will do nothing and allow high inflation before they do a painful write off of debt. It just won’t be coming for a while.
A Pleasant Surprise Amid Covid
From The New York Times: “Philanthropy Rises in Pandemic as Donors Heed the Call for Help”
Giving has surged during the coronavirus crisis, eclipsing donations during the 2008 recession and after the Sept. 11 terrorist attacks, two reports show… (continue reading)
One good thing about the pandemic is the humor that is coming out of it…
- Wearing a mask inside your home is now highly recommended. Not so much to prevent coronavirus, but to stop eating.
- Not to brag, but I haven’t been late for anything for the past 21 days!
- Have to say that the Class of 2020 outdid themselves with Senior Skip Day this year.
- Cops these days will be like…” Come out with your hands washed!”
- People keep asking, “Is Coronavirus really that serious?” Listen up! Casinos and churches are closed. When heaven and hell agree on the same thing, it’s probably pretty serious.
- I stepped on my scale this morning and it said “Please use social distancing. One person on at a time.”
- I thought I might have Covid because I was having trouble breathing. Then I unbuttoned my pants and it was all ok.
Our Spotlight Strategy – Future Technologies
With our Future Technologies Strategy we strive to provide a high rate of capital appreciation using primarily equity investments in emerging technologies.
We invest primarily in stocks, mutual funds or ETFs, and a money market fund. The proprietary HCM Safety Net suite of indicators is used to warn of potential stock market declines in which case exposure may be quickly reduced or hedged using inverse funds.
Click here to read more about our Future Technologies Strategy.
Slice of Life
It is nice being at the age when slowing down is a positive thing. These days I have less travel, spend less time going to shows and events around town, fewer meetings and civic duties, and in general, I have less to do.
Most of my research and head-scratching work on investments has always been done at my home office, so even spending less time at Hepburn Capital’s main office is not a big change for me.
I feel for the young business owners whose livelihoods depended upon college students, entertainment or travel, and parents of children who now have to scramble to provide day care so they can continue to work.
And I am oh-so grateful that I am not a political leader having to make decisions balancing public health with economic health in the absence of reliable data.
Yep. Life is good at Hepburn Capital Management. And I hope you are getting a chance to enjoy your summer too.
* The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Performance and 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.
** Indexes are unmanaged lists of stocks considered representative of a broad stock market segment. Investors cannot invest directly in an 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.
In all investing, past performance cannot assure future results, and as such, our efforts are not guaranteed. Losses can occur. All strategies offered by Hepburn Capital Management, LLC, adapt to changes in the markets by changing the investments they hold, therefore, comparisons to broad stock market indexes such as the unmanaged indexes mentioned may not be appropriate. Sometimes client accounts are invested in stocks or markets not included in these indexes. Past performance does not guarantee future results. Investment return and principal value will vary so that when redeemed, an investor’s account values may be worth more or less than when purchased. Mutual fund shares and other investments used in our managed accounts are not insured by the FDIC or any other agency, are not obligations of or guaranteed by any financial institution and involve investment risk, including possible loss of principal. Advisory services offered through Hepburn Capital Management, LLC, an Arizona Registered Investment Advisor. Adviser will not transact business unless properly registered and licensed in the potential client’s state of residence.
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