May 22, 2012
The TIPS of the Iceberg
The Investment View from Prescott, Arizona
By Bryan Jarman CFA
The US Federal Reserve recently auctioned $13 billion of Treasury inflation-protected securities (TIPS). Buyers paid over $105 for every $100 in government guaranteed principal for these bonds.
The annualized yield over the bond’s 10 year life comes out to -0.391%. Yield, if you are not familiar with bond-talk, is the combination of interest paid and change in market value. And yes, that is a minus on the yield, a record.
Apparently, investors are so afraid of other investments that they are willing to take a certain loss to ensure the other 95% of their money is returned to them in 10 years.
Why would someone do this? Because the principal to be repaid on TIPS is adjusted for inflation, so they hope to make up the loss if inflation goes up with increasing purchasing power of TIPS. Potential for inflation is a popular topic these days, and is driving the sale of TIPS.
I’m guessing that these buyers are not considering that if inflation goes negative – called deflation – that the principal owed on TIPS can be adjusted downward, too.
A helpful role of TIPS in the market is the ability to gauge the market’s expectations of future inflation. With the current 10-year Treasury yield about 1.7% and the negative yield of .391% for TIPS, the markets expected US inflation rate over the next ten years is about 2.09% (1.7% + .391%).
So the market’s yardstick of measuring future inflation says to expect 2.09% inflation, but investors are saying “I don’t believe it” and driving demand up for TIPS as reflected by the initial negative returns.
As was mentioned in a recent newsletter, the rate of inflation (CPI) is calculated by the Bureau of Labor Statistics, the same government that issues the TIPS. Coincidentally, the method of calculating inflation has changed 11 times in 19 years. The government can and often does change the calculation to include or exclude certain items like food and energy.
And we wonder why it feels like we are paying more for our basket of goods while the government’s basket keeps changing to keep the price of their basket low??
With all this in mind, it is difficult to know where we are heading with regards to future inflation. The debt crisis has the world in a deflationary spiral that could last for a long time. The government is printing money like mad to combat deflation and restart inflation, but so far it is not working. Japan has been stuck in deflation for over 20 years, so the market could end up being right, saying inflation will be low for the life of the recently auctioned TIPS.
It won’t be surprising, with all the money printing going on, that we are only seeing the TIPS of the inflation iceberg ahead of us.
A Slice of Life
Chef Bryan’s Bistro seems to be the talk of the town these days. Bryan has worked in a number of restaurants around town, and is finally making his “French Fusion” food in his own place. Only open about two months, they are so busy they are already expanding.
Bryan has an interesting story focusing on recovery that I’ll let him tell you, but the food is different and terrific. Be sure to make a reservation, as this small place is full more than it is not.
436 Goodwin Street, 445-5431. Bryan is open for lunch and dinner.
Scottsdale Office Date
Will Hepburn is planning to be in the Scottsdale office on Thursday May 31st. If you would like to meet with Will, and this office is more convenient than the Prescott office, please call for an appointment for that date. (928) 778-4000 or (800) 778-4610
How’s the Market Doing?
Whistling Past the Grave Yard
The market is in a very fragile state. For months I have been mentioning financial problems in Europe, Greece in particular, that have cast a shadow over the financial markets.
Those who financed Greece’s roughly $50 billion in debt have been holding their collective breaths for the past two years since Greek default became probable. Europe, primarily using US and German money, has bailed Greece out twice so far to avoid an outright default. A few months back they declared Greek debt to be only worth 50 cents on the dollar, but somehow got away with not calling that a default. Go figure.
Now Greek voters have thumbed their noses at those who gave them bailout money that had certain austerity conditions attached to it. “Thanks for the money, but we will do what we have always done, ignore fiscal responsibility.”
If you weren’t aware, Greece has been in default or restructuring their debt for over half the time since their independence, according to 
Kenneth Rogoff’s, book “This Time Is Different: Eight Centuries of Financial Folly”. Screwing lenders seems to be a lifestyle in Greece.
Despite the historical warnings, greedy lenders showed up in Greece wanting a little better interest than our US Treasuries or German bonds were paying, and sort of whistled past the grave yard of default, hoping that someone would bail Greece and them out. It looks like that party ended with the election of free spending Greek-leaders two weeks ago. Greek default is again a distinct possibility.
So Europe’s economic downward spiral accelerates as fiscal responsibility is being tossed out the window in more places than Greece. Just about all European countries are in recession, causing collateral damage among those countries who export goods to Europe. Latin American and Chinese stock markets are in deep declines, and Japan is also very weak right now.
The US stock markets seem to be on the verge of a significant breakdown, with fewer and fewer stock able to buck the selling pressure. All we need is a spark to start off something ugly.
This market feels a lot like September 2001 when the market had also been going down for several months. Hepburn Capital’s growth accounts were already lightly invested and we sold our last stock holding on September 6th, moving to 100% cash. Then it was 9-11 that provided the spark for a sharp market decline.
In October of 1987 the market had also been weakening for a couple of months, and then on October 19th, all the buyers decided to just watch instead of buying and the S&P 500 Index** lost 23% in one day. And that was with no real spark, just an absense of buyers.
Bellwether Apple is down over 100 dollars per share since its high a few weeks ago and much hyped Facebook shares have found few friends and lots of sellers since they started trading last week. Who knows, the realization that there so few companies doing well could be enough of a spark.
There just is not much to like about this stock market.
Mental Floss
Q: Pronounced as one letter,
And written with three,
Two letters there are,
And two only in me.
I’m double, I’m single,
I’m black, blue, and gray,
I’m read from both ends,
And the same either way.
What am I?
A: An eye
Selecting a Money Manager
Let’s suppose this was June of 1998 and you were shopping for a money manager.
One manager had a 10 year track record of over 30% per year, so you decide to invest with this manager.
As Murphy’s Law would have it, this manager’s portfolio drops 28% in the first 3 months after you invest, rebounds fully in 6 more months only to lose another 43% over the next year. The volatility is shocking! Five years later in June of 2003 you realize your account is still below where you started. Five years of a losing record! Would you stay with a manager like that?
Again, your account lost almost half of the account value in 2007-09 and has earned only 3.12% per year in the 15 years since you invested with this manager through last Friday, May 18, 2011. And that included the technology boom in the late 1990s.
Would you stay with that manager? Many thousands of investors have. His name is Warren Buffett.
Warren has his system; a long-term, value-oriented one that makes no effort to defend against stomach churning drops in the markets.
At Hepburn Capital, we have our system, a very defensive bear market strategy called Shock Absorber Growth. We make modest gains in rising markets and often underperform when markets first rollover and begin to go down. However, when declining markets occur, like the ones we are experiencing in May of 2012, we may just be the best managers around.
Our clients who were with us during the bear markets of 2000-2003 or 2007-09 understand this.
What’s Going On In Your Portfolio?
Our Safety Net Indicator gave us a “take cover” signal on Wednesday, so we moved our Shock Absorber Growth* accounts to fully hedged to offset risk of a market decline.
Fully hedged means that for every dollar we have invested in the stock market we have a dollar invested that will go up as the stock market goes down. This is also called being “market neutral”.
As of the close of business last Friday, May 18th, The S&P 500 Index** was down 7.87% just since May 1, while our Shock Absorber portfolio* is down only 2.0% in that same time. This cushioning of the decline was a result of our ongoing hedging strategy. Last Friday the S&P** lost .74% and our portfolios made .15% profit. This gain in the face of a bad market is the result of our being fully hedged.
So if the headlines about the stock market get really bad, don’t worry. We have it covered for you. And if the market does recover, we will reduce our hedge to be more closely in sync with the market.
The Flexible Income* portfolio has been fully invested in high yield corporate and muni bond funds. The muni funds continue to do well, but the high yield corporates are beginning to decline, so there may be adjustments coming up there. As of this writing (Sunday May 20th) no changes have been made in the Flexible Income* portfolios.
Our Spotlight Strategy
Our Adaptive Growth strategy strives to provide high total return from a combination of investments from both the equity and income markets with the emphasis on equities.
Adaptive Growth* portfolios are now 80% invested in the Shock Absorber Growth* strategy and 20% invested in Flexible Income*.
You can see the details on Adaptive Growth* and how its holdings Adapt to Changing Markets® here: [Adaptive Growth]
* 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.
Traditional Income
Flexible Income
Adaptive Balance
Adaptive Growth
Shock Absorber Growth
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.
