April 4, 2017

The Next Investment Bubble

The Investment View from Prescott, Arizona

Ned Davis, founder of Ned Davis Research does not manage money, but since 1980 has sold data-driven research to firms that do. Ned is the guy the gurus look to when they need data to make a decision.

In a recent article titled “The Passive Investment Bubble”, Davis discussed what might prove to be the next investment bubble ready to burst.

The craze for a passive buy and hold strategy of index funds seems to be sweeping the nation. In a rising market, index funds are one of the simplest, chea

pest ways to buy in. It seems everyone wants to buy in after hearing for years of a strong market. And what is not to like about simple and cheap?

Mr. Davis writes that investors seem to be thinking: “Don’t worry about fundamentals, or values; don’t worry about market timing; just buy the market and hold! Even if there is a small correction, the market has always come back!” His reply: “Sounds ‘bubbly’ to me.”

Investment bubbles are clear in hindsight, after they have burst and a market has collapsed, but investors get blinded to a bubble’s existence by the lure of easy money. The technology bubble in the 1990s, the housing bubble ten years ago, the ‘Nifty Fifty’ bubble of the 1960s, even the Tulip Bubble in the 1600s all had this in common.

In the run-up to the 1987 stock market crash, investors thought portfolio insurance schemes would keep their portfolio from getting crushed. During the Nifty Fifty period, people thought that if you bought good stocks, you didn’t have to worry about valuations. During the dot-com bubble of the 1990s stocks didn’t need earnings, only a good story. Today, Index funds are touted as the only thing an investor needs to own.

Mr. Davis notes that due to index fund buying the average stock in the Standard & Poor’s 500** stock index is much more overvalued than it was in 2000 or 2007. “In my opinion, this is clearly bubble territory,” Mr. Davis wrote.

Everyone wants to keep pace with the Indexes when they go up, but how about when they go down? We have had two 50%+ stock market declines in recent memory and when the next big decline happens, passive investing will deliver the entire loss to those investors following the Siren’s song of cheap and easy.

At some point earnings and balance sheets and market timing will show that the passive index fund emperor has no clothes. Or, as Warren Buffett was famously quoted as saying, “When the tide goes out is when you see who was swimming naked.”

 What the Markets Are Doing

March saw a pause in what has come to be called “the Trump Rally”, with the Dow Jones** 30 Industrial stocks, the S&P 500** and small company indexes closing down for the month by a small amount.

The European markets had another solid month, their 4th in a row. Economic activity across the Pond has picked up to a level not seen in many years, and deflation is turning into mild inflation there signaling that the European Central Banks intervention efforts have been successful in pulling Europe out of recession.

The strongest of all major indexes has been the tech-heavy Nasdaq Index**.

Barclay’s Total Market Bond Index was slightly positive, gaining .28% for the month.

Gold, despite a 4%+ dip mid-month, finished March down only a fraction of a percent.

The stock markets had been signaling an impending correction since early February, and it looks like March’s 2.27% min-month dip, as measured by the S&P 500**, was it for now.

 The Old Beer Truck Question

I learned long ago that I am not the kind of guy who is likely to ever retire. After all, I travel 60-80 days a year, I play golf once or twice a week, and can usually sleep late when I feel like it, what would I retire to? Plus I need something to do and this work has consistently held my attention for very long time.

Also, there is longevity in my family, with several members living to be 100 or more. Because of these factors, I have designed my business so that it runs with very little effort, which ought to allow me to do it for many years.

To answer the question I get asked often by prospective clients, “What happens to our money if you get run over by a beer truck?” I have designed several layers of protection into my business to make sure that a bad day for me does not become a bad day for you.

If the beer truck wins and I am not coming back, I have an agreement in place with a husband and wife advisory firm to take over my business. The wife is a Certified Financial Planner and the husband is an active money manager like me, so their skill set matches mine very closely. They are located in Texas, but within days of my demise, they can be in Prescott so you can meet them and discuss your investments.

And it is important for you to know that whenever I buy an investment in one of your accounts, I have an automated system of “when to sell” calculations. If I can’t work and an investment starts ringing alarm bells, the staff has instructions to sell that holding and move the money into cash for you. This means that if I am out of action, your investments that are going up will continue to work for you, but if they start to go down that money will migrate into cash and out of harm’s way.

The important point is that your money will not be in jeopardy if something were to happen to me, and the business of tending your investments will go merrily along – even without me.

But it is still appreciated if you want to pray for my health.

What We Were Saying Back Then

The Hole in Computerized Investment Advice

FINRA, the brokerage industry regulator, recently published an alert to investors concerning the risks of automated, “Robo Advisers”. 

These tools, called asset allocation programs, have been available for decades to investment professionals, but are now being rolled out in ways to make these automated investment advice platforms available to individual investors.

Most Robos are based upon Modern Portfolio Theory, ironically developed in 1960, which suggests that for any level of risk one is comfortable with there is a combination of investments that would deliver the greatest return. Computerization in 1960 allowed the vast computations needed for this analysis. Today it is a rather ordinary task.

The problem with this approach is that averaging risk is a dangerous way to invest. A good analogy would be the man who drowned wading in a lake that averaged only 3 feet deep. That average might mask the deep hole in the middle.

Stock and bond markets can develop holes too. There are periods when virtually every asset class goes down at the same time, and in those times the diversification represented by the pretty pie charts these programs put out won’t help. Only the ability to get out of the market completely will help at those times.

Also, not everything can be neatly programmed into a computer. Dealing with the unexpected – perhaps things that have never happened before – how does one program that?

These automated advisory programs will ask you a series of risk questions, and my experience is that on a 1-10 scale, the majority of folks will rank themselves 4, 5 or 6. Therefore asset allocation software tends to put most clients into the similar asset categories with small differences in amounts. Behavioral people will try to craft questions to identify fifty shades of 4, 5 or 6, but the same question will mean different things to different people, making the effort inconsistent at best.

Normally, you will answer risk questions differently before a market decline than after or during one, so Robos might end up being like the broken watch that is still right twice a day.

There are many ways robotic advisory services can cause losses, and that is why FINRA is cautioning investors about them.

 What’s Going on in Your Portfolio?

Our Shock Absorber Growth* portfolios were up a fraction of a percent in March, despite being very lightly invested. Most of March saw our stock market exposure (risk) at only about 20% of the S&P 500** Index’s.

I had increased our cash position to over 30% of the portfolio over the past two months and also carried a significant hedge, an investment that goes up as the market goes down (which it did not), in anticipation of a potential stock market decline. When it appeared that a significant decline might not be in the cards after all, I began the process of reinvesting last week.

Your SAGrowth* accounts will initially see 14 new stocks in very small amounts. Over the next few weeks the stocks that go up will have money added to them, perhaps more than once, and the ones that go down will be sold. This is a risk reduction technique called position sizing.

This investment activity has taken SAGrowth* portfolios from about 20% exposure to the stock markets, to about 57%. I am still holding a good chunk of cash, but if the market stays stable, much of the cash should get invested over the next few weeks.

During the past month I have made the first major realignment in our Flexible Income* portfolios in almost 2 years.

The long/short government bond strategy that had this conservative portfolio outperforming even the stock market in late 2015 and 2016 has had its longest period of under-performance during the last 4 months, contributing to a 3.9% loss in Flexible Income* portfolios during the 1st quarter. This strategy rocks (technical term) when interest rates are trending up or down, but struggles in choppy sideways markets like we have seen since December.

During its strong run, L/S Governments had grown to 50% of Flexible Income* portfolios, driving Flex Income’s* stellar performance during 2015-16. As with anything in your portfolio, when it stops working, it gets cut from the portfolio. Accordingly L/S Governments has been trimmed from 50% of Flexible Income* portfolios to 20%. When it catches another trend we can always add to it again.

The cash has been used to invest in several high dividend stocks, and an adjustable rate bond mutual fund which have been showing strength this year.

Adaptive Balance* (currently 50% growth and 50% income) and Adaptive Growth* portfolios (currently 80% growth and 20% income) are down between 1% and 2% YTD through March 31st due to the drag of the income portion of the portfolios.

I am known for making money in your accounts at different times than the stock market headlines would indicate, but I am confident that the changes implemented over the past few weeks will get us back in sync with the markets.

Disclosure Documents

Hepburn Capital’s SEC form ADV Part II and our Privacy Policy have been updated and are now available on our company website, www.HepburnCapital.com. There are no material changes being reported, but there you have them.

Mental Floss

 Our Spotlight Strategy – Flexible Income

With our Adaptive Balance Strategy we strive to provide high 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 indicator is designed to warn of sudden potential declines in which case stock market exposure is quickly reduced.

Click here to read more about Adaptive Balance.