October 3, 2017

The Future of Finance is Not Wall Street

The Investment View from Prescott, Arizona

It has been 10 years since the big financial crisis began in 2007, and some have already started to predict that the next one is near. But when it comes, it will likely have its roots in Silicon Valley, not Wall Street, according to TheWealthAdvisor.com.

The world of finance looks very different today than it did 10 years ago. In 2007, our biggest concern was “too big to fail.” Wall Street banks had grown to such staggering sizes, and had become so central to the health of the financial system, that no rational government could ever let them fail.

Aware of their protected status, banks made excessively risky bets on housing markets and invented ever more complicated derivatives. The result was the worst financial crisis since the Great Depression.

In the years since 2007, we have made great progress in addressing the too-big-to-fail dilemma. Our banks are better capitalized than ever. Our regulators conduct regular stress tests of large institutions. And the Dodd-Frank Act imposes strict requirements on systemically important financial institutions.

But while these reforms have managed to reduce the risks that caused the last crisis, they have ignored, and in some cases exacerbated, the emerging risks that may cause the next one. I’m reminded of the old adage that wars are lost when generals prepare for the last war and not the next one.

Since 2007, a tremendous wave of innovation has swept across the financial sector affecting almost every aspect of finance. New robo-adviser platforms have begun dispensing financial advice based on automatically generated algorithmic calculations, with little to no human input or restraint.

Crowdfunding firms like Kickstarter and Lending Club have created new ways for companies and individuals to raise money from dispersed networks of individuals. New virtual currencies such as Bitcoin and Ethereum have radically changed our understanding of how money can and should work.

These “fintech” (financial technologies) markets are populated by small startup companies, the exact opposite of the large, concentrated Wall Street banks that have for so long dominated finance.
By automating decision-making and reducing the costs of transactions, fintech has greased the wheels of finance, making it faster and more efficient. It has also broadened access to capital to new and underserved groups, making finance more democratic than it has ever been.

But revolutions often end in destruction. And the fintech revolution has created an environment ripe for instability and disruption. It does so in three ways.

First, fintech companies are more vulnerable to rapid, adverse shocks than typical Wall Street banks. Because they’re small and undiversified, they can easily go under when they hit a blip in the market.

Consider the case of Tokyo-based Mt. Gox, which was the world’s biggest bitcoin exchange until an apparent security breach took it down in 2014, precipitating losses that would be worth more than $3.5 billion in today’s prices.

Second, fintech companies are more difficult to monitor than conventional financial firms. Because they rely on complex computer algorithms for many of their essential functions, it’s hard for outsiders and even regulators to get a clear picture of the risks and rewards.

And because many of their technologies are so new and innovative, they may fall outside the reach of old and outdated regulatory structures. The recent proliferation of “initial coin offerings,” for example, has left regulators around the world scrambling to figure out how to respond.

Third, fintech has not developed the set of unwritten norms and expectations that guide more traditional financial institutions.

In 2008, when Lehman Brothers was teetering on the brink of bankruptcy, the heads of the largest Wall Street investment banks gathered in New York to coordinate their actions and prevent further panic.

It is hard to imagine something like that happening in the fintech world. The industry is so new, and the players so diverse, that companies have little incentive to cooperate for the greater good. Instead, they prioritize aggressive growth and reckless behavior.

So what can make fintech safer?

There are no easy answers, but a start would be to look beyond the U.S. Entrepreneurial governments in Abu Dhabi and Singapore have launched new “regulatory sandboxes,” where fintech companies can cooperate with regulators to ensure the safety and soundness of their businesses. London’s Financial Conduct Authority has created a similar program. These kinds of arrangements hold significant promise.

But more important than how we address fintech is that we recognize the need to address it. Wall Street is no longer the future of finance. Silicon Valley is.

 Slice of Life 

Clean windows are a simple thing that can make life brighter. For several years Jeron of Luminous Window Cleaning has been doing the windows at our office and at my home, and yesterday I happened to be there while he was working.

Jeron began by removing the screens and vacuuming out the window tracks, something that I had never bothered to consider would be needed. Needless to say, the windows look terrific, too.

Jeron is thorough, professional, punctual and priced right, so I don’t hesitate to recommend him to my friends. Give Jeron a call at (928) 899-3711. He is clearly one of the good guys.

 Earn a Discount on Our Fees

Would you like to save hundreds of dollars every year?  Simply refer family and friends to Hepburn Capital.   

We give a volume discount based on the total amount of money we work with for a family or other grouping of clients, including friends. The higher the amount of assets being managed for the group, the lower the fee percentage becomes for everyone in that group.

Besides being one of the nicest things you can do for us (and them), mentioning Hepburn Capital to your friends can save you real money. The easiest way to introduce someone to our work is to forward our newsletter to them.  (928) 778-4000.

 What We Were Saying Back Then – Bitcoin

In my June newsletter, I wrote about the debacle in bitcoin that I had foreseen due to the run up in prices to absurd levels as companies being extorted by ransom ware attacks were forced to buy bitcoins to pay hackers to release their computer data. I felt that would provide a rationale for a likely government crackdown on bitcoin use. That has not happened, yet.

The other thing that bothered me was a new bitcoin Exchange Traded Fund, Bitcoin Investment Trust, symbol BITC, that was trading at almost a 100% premium over the net asset value of the underlying bitcoin they owned. Most ETFs trade within fractions of a percent of their net asset values, so when this ETF finally drifts down to its underlying value, this will create a wave of losses for BITC investors. As the fairy tale goes, the emperor will eventually be seen to really have no clothes. I mean, why buy the ETF to own bitcoin, when you can buy the bitcoin itself for half of the price.

In the first two weeks of September, my vision began to come true with BITC losing almost half of its value. I don’t know if this is the beginning of the end for the bitcoin fad, but it is a good start.

What the Markets Are Doing

The US stock markets did thumb their noses at the historical pricing patterns for September, as I suggested they might in my last newsletter. Instead of posting poor performance, all of the major US indexes posted gains for the month.

As Warren Buffet has said, “If past history was all there was to the game, the richest people would be librarians.”

Small company stocks fared the best of all US stock categories.

Developed country international stock markets were also strong, with weakness in China holding back the Emerging Markets indexes.

The bond markets generally fell in September, led by sharp declines in US Treasuries as rates jumped up during the month. Corporate bonds were flat, and junk bonds posted gains for the month.

Strong gains in small caps and junk bonds suggest that there is good liquidity in the market place, so any declines that occur in the near future should not be too severe.

With that said, many markets appear to be overbought, meaning that it is likely that the supply of buyers is dwindling after so much buying in September. Keep in mind that the strength of a market is just the relationship to the number of buyers and number of sellers. A small imbalance is all it takes to cause a change of direction in a market, so don’t be surprised if the stock markets decline a bit before continuing their rise.

Gold turned down in September in what looks to be a meaningful trend change as its primary cycle suggests a low coming in December.

What’s Going on In Your Portfolio

Our Shock Absorber Growth* portfolio had a good month gaining over 1% in September, and over 5% for the quarter despite my decision to keep market exposure low during the high risk September environment.

The way I reduce market risk is to first sell stocks that weaken raising cash levels in the portfolio. Holding cash insulates that portion of the portfolio from market risk.

Since we continue to hold only the strongest performers, I can add a hedge to cushion the remaining stock holdings. As you may remember, a hedge is an investment that goes up as an index goes down, the shock absorber referred to in the portfolio name. This allows me to keep strong performers in the portfolio with greatly reduced risk during a declining market.

Our stock portfolios only had a 42% exposure to the stock markets in September, yet returned 88% of the S&P 500** Index. Shock Absorber Growth* portfolios outperformed the S&P 500** by almost a 2:1 margin in the 3rd quarter, but in fairness to the Index, we were more fully invested in July and August than we were in September.

This outperformance with minimal exposure to market risk is due to the superior stock selection driven by my Quality of Trend Analysis that I have been refining over the past few years. I only want to buy stocks that are in high quality uptrends.

What defines a high quality uptrend from one of poor quality? A smoothness to the upward trend. When a stock that has strong demand dips just a little, investors that have been watching it rush in to buy, cushioning any fall. This is called buying the dips.

I’ve developed ways to measure this phenomenon by applying an indicator called the Ulcer Index and then comparing the ulcers one might get from the investment with the returns generated, which is called the Ulcer/Performance Index.

By applying these indicators over several time periods and eliminating stocks which encounter volatility in any of the periods, I develop a short list of stocks with very smooth or high quality trends.

The short list is then screened for strong fundamentals (like earnings, growth and debt levels) and then my charts tell me which ones might be more timely buys. This process has been working very well for us as our stock performance shows.

Bond markets experienced rising rates that made profits hard to come by, but our Flexible Income* portfolios made a decent gain in the 3rd quarter, while being flat in September.

Two of the items related to the devastation of Puerto Rico are the concentration of biotech activity centered in the Caribbean basin and the potential for research or manufacturing activities to be impacted by recent hurricanes. We hold only two biotech stocks at the moment, and neither report having facilities in Puerto Rico or the Caribbean. Whew!

But Puerto Rico also has about $70 billion of municipal bonds to pay off, many issuers of which were already struggling before hurricane Maria blasted the island. Our municipal income portfolio has had steady gains this year, including the aftermath of Maria, so I don’t believe that will be an issue for Hepburn Capital clients, although I am watching it for you.

Adaptive Growth Portfolios* are currently allocated with 80% Shock Absorber Growth* and 20% Flexible Income*. Adaptive Balance* is currently 50/50.

College Classes

 Tell your friends about this new class at Yavapai College!

Fundamentals of Investing for Retirees

This course is designed to help investors become more confident about their financial decisions. In an easy-to-grasp format, this class provides a broad knowledge of investments preferred by investors approaching or already in retirement. Learn the ins and outs of stocks, bonds, mutual funds, annuities and more. Topics include recognizing risk, controlling the tax impact of IRA withdrawals, avoiding common investment mistakes and simple risk reducing strategies that anyone can use.

Class is on three Wednesdays, October 4-18th, 2:00-4:00 pm.
Call Yavapai College at 928-717-7755 to register for Class # FA17-121 $45 tuition

Mental Floss

Our Spotlight Strategy – Future Technologies

With our Flexible Income strategy, We strive to provide high total return consistent with Capital Preservation.

Your money will be invested in bond mutual funds and exchange traded funds (ETFs), including inverse and leveraged funds, currency funds, including precious metals that may be used as currencies and equity-income investments whose price trend is up. If the price cycles down, holdings are replaced with new investments that are going up, repeating as needed. Growth stocks are not used.

Click here to read more about Flexible Income.