January 6, 2009

Ready For Some Growth?

It sure seems like we are due for some relief from the relentless bear market of 2008.  As of this writing on January 3rd, the stock market has put in several strong days in a row – an encouraging sign.  Could this be the relief rally we all have been waiting for?  Or perhaps the end of the bear market?  Let’s look at some history for guidance.

A study of the last 100 years by Thomas McNatt shows that market declines of 20% or greater (the definition of a bear market) occurred 19 times.    The average length of these 19 bear markets was 18 months.  Although the stock market crash in October 2008 is still fresh in our memories, the decline began a year before on October 9, 2007.  We are already 15 months into this bear, and history suggests that we are closer to the end of it than most folks realize.

Wikipedia reports that recessions last between 8 and 16 months.  Since the government has finally declared that the recession began in the 4th quarter of 2007 that means we are 13-15 months into this one and probably close to the end of it, too.

So what is an investor to do?  Like so many other things in this business, the answer is backwards from what it might seem.   Investors do best by looking beyond the current economic environment and positioning themselves for what comes next.  This means getting invested once again.

Conventional wisdom says bonds and defensive stocks do best in a recession.  Defensive stocks are grocery stores, utilities and consumer goods companies that make things folks will buy no matter how bad business is.

But as Jeff Colvin of Fortune.com points out, the time to buy bonds and defensive stocks is in the first half of a recession.  From the middle of a recession on, growth or value stocks usually outperform defensive stocks.

So, getting defensive now that the government has finally announced we are in recession may be too late and may actually be an expensive mistake.

Like I have said many times in these articles, if you wait to read about something in the newspaper, it is too late for an investor to act upon it profitably.  The stock market will begin to look ahead and react to coming changes long before journalists, most individuals and even professional economists see any changes in the economy.

Investor sentiment, always bearish at important market bottoms, has been extremely bearish and full of fear. This tells me that most of the investors that might sell have already done so, leaving us with fewer and fewer potential sellers and increasing the likelihood that buyers can begin to outnumber sellers for the first time in a long time.

Remember, this bear market has already equaled the declines of the most severe bear markets of the last 75 years. And on the other side of the picture we have aggressive government actions to get the economy going again.  Actions never before provided when previous recessions threatened.

There is an old investment adage that says “Never fight the Fed”.  With unprecedented economic stimulus being provided by the government, this is no time to stand in front of $700 billion steam rollers.

Of course, no one knows for sure, but the evidence is mounting that the market bottomed on November 20th and is beginning what could become a good run.

Can Money Market Funds Go Negative?

Regular readers of this newsletter will remember that money market funds are just mutual funds that buy very short maturity bonds.  The average maturity of a money market instrument is generally less than 100 days which gives them the stability they are noted for.

However the Fed’s low interest rate policies are going to force money market investors to make some harsh decisions in 2009.

The extremely low interest rates on T-bills are forcing money market investors to make some tough choices.  Large numbers of investors going for the highest level of safety – that offered by Treasury bills -have driven rates down to unthinkable levels.  For the first four weeks of December, 3 month T-bills paid out an average annual rate of 3/100ths of one percent.  That is .03%, an astonishing low figure.  One pays a lot for security these days.  In this case investors pay by passing up higher yields of other investments.

For investors with money market funds that invest in T-bills only, the manager of the money market fund needs to be paid, and .03% won’t cover the cost of running any mutual fund that I am aware of.  In fact, according to Morningstar, the average net expense to run the 113 money market funds it reports on was .64%.  If these low rates continue many money market funds will be under great pressure to keep yields from going negative due to the combination of fees and low interest.

Variable annuities have even higher fees than traditional mutual funds, so investors seeking the safety of a money market within their variable annuities may have already seen some losses caused by the high expenses of that investment.

Investments paying more than T-Bills usually involve more risk.  You as the investor may need to choose to accept small losses to retain the safety of Treasury-only funds or take additional risk to keep yields positive.  Those risks may entail using funds with longer maturity investments which increase market risk or those with lower credit quality which increase default risk.

Pick your poison.

Treasuries Becoming Toxic

The low yields mentioned in my article about money market funds also have the potential for dramatic affects on the values of longer term Treasury Bonds.  T-Bonds are Treasuries that are 10 years or longer from maturity. Like T-bills, T-bonds are immune from default as long as the feds have those printing presses, putting Treasuries of all maturities in high demand these days.

As with T-bills investors seeking safety have flocked to T-Bonds, pushing their prices up to unsustainable levels.  We have recently seen bubbles burst in the prices of real estate and oil.  And who can forget the tech bubble of the late 1990’s?  Bubbles all end badly.  And Treasury prices have been pushed to levels that are reminiscent of earlier bubbles.

Ten-year yields were down to as low as 2.08% a month ago.  Today, 10-year T-bonds are paying 2.46%.  These low yields represent astronomical prices and we should always keep in mind that the great investment goal is to buy low, not buy high.  Treasury prices are clearly very, very high right now.  During the decade of the 1990’s 10 year rates averaged more than 6%.  If yields were to return to 6% today, an investor holding a 10 year bond paying 2.46% would lose 26.34%. 

This is the time to be selling treasuries, not buying them.

In my Yavapai College classes I teach students that when someone says the word “safe” the wise investor should ask “safe from what?”  Treasuries are safe in terms of default risk, but right now carry huge market risk.  Huge.

On The Lighter Side

I am really concerned about this global slowing thing going on.  It never used to happen!

We were told we actually had to add one second to all the clocks of the world to allow the earth time to catch up.  Hellooooo.  Have you ever tried to add one second to the time on your clock.  I wasted a whole hour before I gave up.  Now I am really behind!

Can you imagine if the earth keeps slowing and slowing like this?  If the centrifugal force caused by the earth spinning at a certain rate becomes less, it will offset less gravity and we will all begin to weigh more.  Egad!  That is the last thing we need!

So remember.  The added weight you see when you look at the scale was not caused by all of the Christmas cookies and candy.  It is the result of global slowing.

We must eradicate global slowing.  Our way of life depends upon it.  So does our wardrobe.

Account Updates

The year end numbers are complete, and although it was not a great year, it was a great year.  If that sounds confusing, consider the results of our model portfolios*

Out of 7,392 equity funds, 157 beat my performance (-10.80%) for the year 2008.  7,235 funds had losses greater, sometimes much greater than ours.  This means Careful Growth* outperformed 97.88% of all mutual funds.  Tell your friends.

Out of the 157 equity funds that beat my performance, most took much more risk as measured by the amount of loss from peak values to lowest values during the period.  This measurement is called a “drawdown”.  Most investors are very sensitive to drawdowns which is why I use them as part of my yardstick.  Considering that the S&P 500 Index** experienced a 51.92% drawdown this year, drawdowns do bear watching (no pun intended).  This means that the average stock investor had lost over half of their money at one point this year.  Not my clients, though.

When we eliminate funds with drawdowns greater than the Careful Growth* drawdown of 17.77%, only 12 of 2008’s top-performing funds out of all 7,392 still outperformed us.  Hepburn Capital’s Careful Growth model* outperformed 99.86% of all equity mutual funds in 2008.  Please tell your friends.

So, we did indeed have a good year, despite the market environment.