February 9, 2010
The Emperor Has No Clothes
I have mentioned several times that some of my work points toward weak financial markets later this year.
Part of my thinking is that by then pressure will be mounting for the Federal Reserve Board to begin to withdraw some of the massive infusion of money that re-floated our economy and financial system in 2008-09.
This is called “taking away the punchbowl just as the party gets going”, and the Fed is noted for being the party pooper for the markets at some point during just about every economic recovery.
And we are overdue for a rate increase.
The fall election cycle, with all its mud-slinging, often gives investors reason to pause. Anything that keeps investors wondering rather than investing has the potential to shift the balance of buyers and sellers and drive a market down. This election should have vitriol in spades as the joblessness and lingering economic problems are brought up over and over by election challengers.
However a more serious concern is that few real reforms have been enacted that would make the next wave of financial difficulties any different from the last one. None of the problems underlying our financial system have really been corrected.
Capitalism can be a harsh master as previous excesses, often only visible in hind sight, are punished by removing those investors from the investing “gene” pool, and rewarding investors who acted more conservatively, not getting caught up in the speculative excess, so that they may live to invest again.
The financial survivors are the most effective financial decision makers, which if you think about it, are who we should want to make our financial decisions.
Not fixing the root problems allows less-than-effective decision makers to retain their positions and keep calling the shots. I’m reminded of that old definition of insanity . . .
Specifically, my concern is that this financial crisis was caused by excessive levels of debt.
On one hand, corporate America and individuals are reacting rationally by reducing debt. On the other hand, however, the government is dramatically increasing debt and in that respect is undoing every bit of good caused by corporate and individual belt tightening.
The government perpetuates the problems by:
– shielding too many participants from feeling any pain at all resulting from their earlier mistakes,
– thinking that they can borrow their way out of debt, and
– not dealing with toxic assets, busted banks and insolvent insurance companies that are still with us almost two years after the problems became evident.
Financial institutions, which many of us expect to know better, blew it big time. Anyone who made the mistake of investing in them should be made to accept the consequences of their actions by allowing many more banks and insurers to fail.
The FDIC has the mechanism so that depositors – the innocent bystanders in all of this mess – are protected. One lesson of 2008 is that failures should be done in an orderly fashion to avoid the type of aftereffects we saw with the Lehman Brothers collapse. I believe that the regulators have the tools to accomplish that.
Those punished first would be stockholders and for the most part this has happened. Ask anyone with Fannie Mae stock who has lost 99% of their investment.
But the government needs to force bondholders to feel some pain, also. So far, the government has given 100% guarantees to the bonds issued by Fannie Mae, Freddie Mac and AIG, which insulates investors like Goldman Sachs, pension funds and insurance companies from facing up to their mistakes.
If bondholders were forced to accept losses, even partial losses of 10% to 25%, the managers who thought they could pump their performance with investments they really did not understand would quickly be seen as the emperor who had no clothes and would be replaced by more effective managers.
As long as the taxpayers continue to back-stop these financial dice-rollers, we will have more financial melt-downs. And I have seen nothing that makes me think that things have changed in this respect.
That is what really concerns me.
You Heard It Here First
Readers of this newsletter may remember in my August 11, 2008 article, when gasoline was still $4 a gallon I said, “I’m expecting gasoline will be $2 by the end of next year.” It happened even more quickly than I could imagine.
Since gasoline is a big factor in the CPI calculations, that unprecedented 50% drop in gas prices made overall inflation looked like it dropped too. Yet most of the hundred other items in the calculation kept on rising, but the effect was masked by the drop in gas prices.
On February 19th, the last of 2008 CPI data, including the last big decline in gas prices, will drop out of the CPI calculations and the real truth will be seen.
What is the real truth? Considering that the CPI number rose from minus 1.3% in mid-November, 2009 to plus 2.7% in January – an increase of 4% in two months – I expect the increase to continue, and perhaps approach 4% annual inflation in this report.
4% inflation is a level that sets off alarm bells at many levels, so I expect the shouting to be very loud on February 19th when the latest CPI numbers are released. In fact I’ll be very surprised if it is not a headline item that day.
Remember, you heard it here first.
A: A hole
How’s the market doing?
The period last fall where the markets moved mostly sideways in a tight range ended when the market began moving up in Mid December marking the beginning of a new uptrend.
That is what I wrote about a month ago. But things changed quickly. The decline of the last three weeks is why I always stand ready to change course on short notice.
The indicators I follow are mostly designed to inform me of changes in trend because investments that work well in one kind of market often don’t work well when the trend changes. I need to Adapt to Changing Markets®, as my motto says.
Typically these indicators tell me an investment is up or down compared to a time in the past. Often in a sideways market, one that is not really moving up or down much, the current price may not have changed much from the past price in the comparison. In this situation, it takes only a small price movement up or down to trigger the indicator.
This was the case in late December and early January when most of my indicators began flashing green lights. Although the trend had turned up by most measures, it was not totally convincing due to the small movement needed to trigger the indicators.
Fortunately, I recognized this and still had most of my client’s money out of stocks when the market rolled over and turned down on January 19th.
At this writing, on February 7th, the market is in a downtrend with major market indexes** having declined 7-8% from their January highs. And I don’t think we are quite done with this decline.
How long the downturn will last is hard to tell. There are many more positive signs than in 2008 when the market seemed to roll off the edge of a cliff. The action in the bond markets, which are many times larger than the stock markets, is saying that this decline doesn’t look to be “a big one”.
However, every major market decline has begun with a smaller decline much like what is going on now, so we still need to give the current market weakness a lot of respect, lest we possibly end up getting caught in a big decline.
What’s Going On In Your Portfolio?
About the time you were reading my past newsletter, our Careful Growth model* was out of the stock market, having just sold our last stock holding, electronics funds on January 28th. This past week even our gold holdings reached the limit of our loss tolerance so they were sold off, too.
At the moment Careful Growth* is hunkered down with holdings in a rising dollar fund, three types of bond funds and about 40% in cash. I’ll wait patiently for the stock market to turn back up before investing there.
Our Flexible Income accounts* finally saw some action two weeks ago, when I made the decision to bank some profits from the high yield (junk) bond holdings that had performed so wonderfully for us over the past 10 months.
We now hold only about half as many of the high yields that we had a few weeks ago, having added a rising dollar fund and government bond fund to Flexible Income accounts* to replace the junk bonds.
SRI accounts* have seen their stock market exposure trimmed to only 45%, and also hold government bonds and a rising dollar fund.
And the Municipal accounts* remain fully invested in high yield munis which remain in a nice, low volatility uptrend.
As always, we rely on you to tell us if there is anything about your finances that has changed since we last talked or if there is anything about the management of your account that makes you uncomfortable so that we can make adjustments necessary to ensure that our work is appropriate for you. Please call anytime for an appointment to talk about your accounts with Hepburn Capital.
I realize that you might have hired me because you are uncomfortable dealing with financial issues, but it is still prudent for us to review your accounts annually, either in person or on the phone.
I rely on these newsletters to let you know what I am thinking about the markets and your accounts. Our talks are so you can tell me what you are thinking. If you haven’t been in for a while, please call the office at your convenience to arrange an appointment to review your accounts.
In the next month I will also be updating Hepburn Capital’s SEC form ADV Part II which is the federal disclosure document that describes my business. You received a copy of our ADV when you became a client, but if you would like the updated version please call the office and we will send one to you.
Our Spotlight Strategy
We had a great year last year and our Balanced accounts* are at all time high account values. Considering the horrible markets of the past few years and the pain so many investors are still feeling, I am grateful to have done so well.
Referrals are a great compliment. Thank you for the many referrals you send us. If you like what we are doing, please continue to tell your friends.
* 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.