October 31, 2017

Would Automated Investment Advice Have Saved You on Black Monday?

The Investment View from Prescott, Arizona

We have just marked the 30th anniversary of Black Monday, October 19, 1987, the day the stock market crashed and the Dow Jones Industrial Average** dropped 23% in one day. With artificial intelligence and automated investment advice being in the news these days, an article in Financial Planning magazine posed the question about whether “robo advice” would have protected investors from the Black Monday crash?

“Since most automated advice platforms don’t actively trade, they would have done little in the mass sell-off”, says Don Riley, chief investment officer at Wiley Group in Conshohocken, Pennsylvania. This means most robo investor clients would have taken the full hit on Black Monday.

“Robos are programmed to rebalance and harvest losses, and to buy similar replacements when mathematically attractive”, says Bill Winterberg, who runs industry blog fppad.com. “Based on that formula, I don’t see automated investment services reducing market volatility.”

Winterberg adds that software can’t control human fear or investors disregarding advice to hold or buy. “Line up enough human investors, retail or institutional, with their finger on the sell button and you will have a market crash,” he says. “Human psychology will continue to determine stock market dynamics, not brute force emotionless software programs.”

It’s hard to stop panicked investors from taking some action, says Anthony Stich, chief operating officer at technology services firm Advicent. “Human intervention would still have occurred in this particular case, likely overriding any pre-determined robo advisor behavior.”

Huge index-following mutual funds like BlackRock and Vanguard currently manage total assets on par with the GDP of China. We are more at their mercy than ever before in the event of a market crash which forces them to sell index leading stocks in massive amounts to pay off their investors.

Sometimes it takes a bear market to educate people about the risks of investing, especially in the latest fad. Hopefully this time it will be different. 

 California Living 

For the past 12 days or so I have been doing a road trip around California, including a stay at the Central Coast, exploring everything from Hearst Castle to Pismo Beach and then into the Sierras to Yosemite and the Lake Tahoe area. I probably don’t have to tell you that the scenery is spectacular, but it is.

Perhaps the best nugget I found on the trip was the Sea Chest restaurant on the beach in Cambria. Get there early! We arrived 20 minutes before the 5:30 opening and found 30 people already waiting in line. But the calamari steak was the best I have ever had, so the wait is definitely worth it. 

 A Thanksgiving Gift from Hepburn Capital

During the year, we at Hepburn Capital quietly go about our business worrying about your money so you don’t have to. Although we don’t always get to say it, we are thankful for your business. Here is one way that we can say “thank you.”

If you are like I am, you probably hate having to stand in lines. The post office just before Christmas can be especially frustrating as last minute package mailings create long lines. If you share my sentiment, Hepburn Capital can help by giving you the use of our UPS service this holiday season.

Our office maintains a UPS account, complete with the ability to weigh packages, pay for and print UPS labels online. Bring your packages to Hepburn Capital’s Prescott office and in a few minutes our staff can weigh, process and take your payment for your shipping costs. Since we won’t have to wait in line, we will even take them to the UPS store for you if you would like us to.

This is just Hepburn Capital’s way of saying thank you at Thanksgiving and making the holidays a little brighter for those in our circle of clients and friends. Happy Thanksgiving!

And, while you are at the office, please pick up one of our letter openers that make cutting wrapping paper a breeze.

 What We Were Saying Back Then – Problems in China

I’ve written several times over the past year about unsustainable trends in the Chinese economy. Command economies can dominate certain sectors for a while until market realities set in. Some statistics from Elliot Eisenberg, Ph.D., of Graphs and Laughs LLC underscore my concerns.

At present, China’s non-financial debt is 210% of its Gross Domestic Product (GDP). When Japan’s economy collapsed in 1992, its ratio was 210%, and when Spain collapsed less than a decade ago, their non-financial debt to GDP ratio was 215%.

While shrinking the ratio can be done, doing so without slowing economic growth is impossible. Thus, each time China attempts to reduce their debt, growth weakens and as the specter of hundreds of millions of hungry and unemployed peasants grows large, China backs down and starts more unneeded projects – creating more bad loans.

Their banks don’t have much ability to say no to the government, so they are forced to make more loans that are destined to default. Despite China’s reserves of US Treasury bonds (which they have been selling off to raise cash, by the way), China’s banks are among the weakest in the world.

This ballooning debt in China is a huge concern as banks teeter on the verge of default. 

What the Markets Are Doing

The late market guru Marty Zweig once said that there is nothing more bullish than a failed bearish signal. The stock market ignored the traditionally weak seasonality of September and October, creating a testament to the strength of this market. All major indexes, both in the US and internationally did well over the past few months.

Bond prices are in a downtrend, and the strong economy message of rising interest rates says that bond prices have further to fall. This fits with the long term outlook for generally rising interest rates over the next decade or two, creating a tough market for bond investors.

Gold has also entered a downtrend, probably headed toward a major cycle bottom due at the end of the year. However, this is not the end for gold as the longer term picture looks to be brightening.

Bitcoin and other “cryptocurrencies” appear to be frothing their way into bubble territory with bitcoin prices topping $5,000 and a bunch of other new cryptocurrencies being offered. This environment reminds me of the tech bubble in 1999, when companies did not need earnings nor cash or even sales to be listed on the stock exchanges yet reaped hundreds of millions of dollars, sometime billions. All they needed was a good story.

I have commented in the past about the discrepancy in the price of bitcoin and the Exchange Traded Fund (BITC) created to allow investors easy access to bitcoin. The price of BITC dropped 50%, from $1,064 to $518 in two weeks ending September 14, 2017.

In my investment classes we talk about investment value. If a company has cash in the bank, real estate for offices and factories, and a steady history of making money, those are items from which a true value can be placed on a company. The price one pays above that investment value is speculative, and can disappear quickly in a business downturn.

Cryptocurrencies have no investment value and are a pure speculation. When their market collapses you will be left with no cash value, no real estate and no business value. Even investors in the tulip bulb mania of the early 1600s ended up with a tulip bulb for their troubles. Cryptocurrencies, like bitcoin, have the potential to leave investors with even less.

What’s Going on In Your Portfolio

Shock Absorber Growth* portfolios have outperformed the S&P 500 Index** of stocks for the past 3 months despite having large cash holdings and a hedge to guard against seasonal market weakness. With the seasonal period of stock weakness behind us, I will be putting that cash to work, hopefully increasing returns a bit more.

My proprietary quality of trend analysis used to select stocks for your accounts has proven itself successful in identifying stocks that the huge institutional funds, including mutual funds, hedge funds and pension funds are buying, creating strong uptrends. This new software is one of the items that gives Hepburn Capital clients an edge over ordinary advisers.

Flexible Income* accounts dropped 1.46% from Sept 7th through October 26, 2017, after all fees and expenses. It appears more and more certain that the interest rate low of July 2016 is indeed the low of the 60-year interest rate cycle. This means that rates can be expected to generally rise over the next umpteen years, meaning that bonds will struggle to break even.

As an example, the Vanguard Total Market Bond Fund, which follows the widest bond index, gained a measly .49% over the 12 months ending October 27, 2016. Flexible Income* accounts earned 1.36% after all fees and expenses, beating the index. This does not really make me smile since the returns of Flexible Income*, since its inception in 2001, are above a 5% average annual return, after fees and expenses.

If you are a Flexible Income* account holder (100% income) and weak bond markets continue, you might consider moving to our Adaptive Balance* portfolio (maximum 50% stocks/50% income). A-Bal*, as I call it, has some stock market exposure, but is not held back by weak bond markets as much as Flexible Income* is. Right now, I estimate the bond market to be moderate risk with very low return potential. Our growth portfolio, managed as it is for lower risk, holds about the same risk as the bond markets, but with greater return potential.

Call the office for an appointment to talk about this if you hold Flexible Income* accounts or even Adaptive Balance* accounts and would like to get more growth in your accounts. The number is 928.778.4000

• 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.

Our Spotlight Strategy – Future Technologies

With our Adaptive Balance Strategy we strive to provide an acceptable level of total return from a combination of investments in both the equity and income markets with an emphasis on the income markets.

Our proprietary indicators are used to determine a stock market exposure that adapts to both strength and weakness in the market, directing exposure to the HCM Shock Absorber Growth strategy from 0% to a maximum of 50% of account value. The balance, 50% to 100% of account value, is invested in the Flexible Income Strategy. The HCM Safety Net suite of indicators is designed to warn of sudden potential declines in which case market exposure is quickly reduced.

Click here to read more about Adaptive Balance