June 2, 2020
Waiting for the Next Shoe to Drop
It is difficult to address issues in the context of “getting back to normal” in the midst of a never-seen-before pandemic like we are experiencing. Yet that is what most of us yearn for, to get back to normal.
The financial markets have breathed a collective sigh of relief as well, as lockdown restrictions have been relaxed and reports of coming vaccines are in many newscasts. It was spooky two months ago to see our downtown deserted. Once again business districts are alive with people going about their business, so it is understandable that folks think that the worst is over.
Socially, perhaps the worst is over, but businesses by the thousands have been destroyed when our economy shuddered to a halt. So it is wise to keep our pink cloud of renewed social opportunities separate from our thinking about business, economics and your investments.
There would be plenty left to worry about even if there were to be a vaccine tomorrow. Inflation, deflation (more on that in a minute), a trade war, elections, the value of the dollar, riots, taxes and the national debt to name just a few. I fully expect a COVID-19 vaccine to be available by this time next year, but the issues I just mentioned are not going away.
Government stimuli are meant to keep paychecks coming to employees, not to keep companies solvent, and the COVID-19 shutdowns have pushed many companies into insolvency — a nice way to say bankrupt. Of the companies currently listed in the S&P 500 Index**, considered representative of the entire US stock market, the average profit margin is 12.95% (Source: Finviz.com), which is around 10% after tax. It takes only a 10% drop in revenues, with costs for rent and inventory fixed at pre-Covid levels, to make many businesses unprofitable. Do you want to invest in unprofitable companies? You shouldn’t, especially now.
Think about all the restaurants, bars, entertainment venues, hotels, airlines, hospitals (where elective procedures were the majority of their business) that have seen revenues drop sharply. All are candidates for insolvency.
A “zombie company” is one that pays more in interest on its debt than it earns from its business. Zombie companies must borrow money just to pay interest on their debt. According to Ned Davis Research, 36% of companies in the Russell 2000 Index—an index of smaller American companies—were unprofitable before the pandemic. But that hasn’t stopped investors from chasing zombie stocks higher. In fact, zombie stocks on the Russell 2000 are actually outperforming the overall index this year. Go figure.
This craziness reminds me of the 1999 market when tech companies didn’t need to have profits, only a good story, to soar on the stock exchanges. However, the when the tech laden Nasdaq 100 Index finally began to drop it lost 82.9% from 2000-02 and took 16 years just to get back to even. Are you that patient? Warren Buffet isn’t.
A while back Buffet said “In 1964, the Dow was at 874. Seventeen years later, in 1981, it was at 875. Now I’m known as a patient guy, but that is not my idea of a worthwhile holding.”
Add to all that, the plight of landlords, the majority of whom are small mom and pop operations and are seeing a wave of unpaid rents. Landlords still have mortgages to pay, meaning we are on the cusp of a wave of foreclosures similar to what we saw 10 years ago in the Financial Crisis.
On May 31st, the National Association of Realtors reported a 21% drop in home sales in April. Fewer buyers will commit themselves to a long-term mortgage with all the short-term uncertainty these days, so I expect home sales and home prices to keep declining for a while.
Brick-and-mortar retail has seen its decline accelerated as the coronavirus forced most physical stores to close their doors, many of them for good. Major retailers such as Pier 1 Imports, JCPenney, J. Crew, Tuesday Morning and Neiman Marcus have all filed for Chapter 11 bankruptcy this year. Hertz is a notable recent bankruptcy, probably one of the early casualties, in the hospitality industry. With storefronts shuttered and sales plummeting, many retail tenants have been unable to pay rent. This list is likely the first wave of a tsunami of bankruptcies. Many bankruptcy filings are on hold because liquidation sales are hampered by shoppers’ reluctance to come into brick and mortar stores.
As the news of one bankruptcy after another hits the news, and people we know begin to be affected by layoffs, business closures, foreclosures or the virus itself, the pink cloud of May 2020 will start to dissipate and the harsh reality of a deflationary depression will sink in.
Unemployment will stay high, perhaps for several years, because many of those unemployed due to COVID-19 will not have their old jobs waiting for them because many companies failed or changed their business model and laid off workers.
Due to all the financial insecurity, savings rates will increase, and borrowing will decrease. While this sounds like a prudent way to live, money saved is money not spent in the economy, meaning reduced demand for goods and services.
Borrowing is a method to move future consumption into the present. You take out a loan to buy that car today, rather than in 5 years when you have saved the money. But if people slow down their borrowing, that means even less demand for goods and services today.
Many expect inflation in prices as the government prints money hand over fist to stimulate the economy. However, we will see inflation in only a few areas, like groceries, where demand is fairly constant. As public health restrictions and societal expectations for social distance and greater cleanliness make businesses increase labor costs up and down the supply chain, someone must pay those costs, and that someone is you. Those costs will be inflating prices.
We won’t notice overall inflation right away because things we merely desire rather than need (like groceries) will see falling prices due to falling demand caused by issues mentioned above. Lack of demand causes price deflation. Energy prices will stay low as less energy is needed by industry. Electronics prices will fall as consumers buy less, causing price wars. Real estate prices will fall as consumers choose to pay off personal debt rather than incurring more in a mortgage. Auto sales will drop as consumers put off taking on payments during a time of great uncertainty.
All this talk of falling prices may sound good to us consumers, but it is murder on businesses whose profits are squeezed and squeezed. Companies that can’t compete will be forced out of business until the supply side of things, production of goods and services, drops due to shut downs and supply starts to equal demand.
When I was a growing up, I remember photos of block long factory buildings, empty and derelict, after they had failed in the Great Depression, our last real bout of deflation. This economic mess won’t be over until a lot of excess capacity is removed from the economy, worldwide.
Prudent investors will have a plan to be proactive to protect their savings. The most valuable commodity these days is flexibility to move in and out of markets. If you don’t know how to handle this market environment, get a copy of my book, Why Bad Things Happen to Good Investments, available on Amazon, or call me so I can tell you how I protect client account values from this bear market.
“When the tide goes out is when you discover who has been swimming naked.” ~Warren Buffett
Don’t get caught with no protection when this tide goes out.
College Classes Coming
Learn Fundamentals of Investing for Retirees from Your Easy Chair
This is the 30th anniversary of my teaching this class at Yavapai College. In fact my son, Matt, was born during the June 21, 1990 class. His birthday is a great marker.
With that depth of experience, it is sort of fitting that I become one of Yavapai’s guinea pigs for doing a class online with Zoom software. If you want to sit in on the class, Zoom is surprisingly easy to use. All you need is a computer with Internet access. You will be able to see me and the class materials on your computer screen, and if you have a video camera, I and the rest of the class will be able to see you too, if you choose to turn your camera on.
Join us for three 2-hour classes on Thursdays, starting June 11th. And if you have friends who are nervous about the economy or financial markets, invite them to tune in also.
“Fun-damentals of Investing for Retirees”
This fun class will help you become more confident making financial decisions. The easy-to-grasp format of this class provides a broad knowledge of investments preferred by investors approaching or already in retirement. Learn about stocks, bonds, mutual funds, annuities and more. Topics include recognizing risk, smart IRA strategies, avoiding common investment mistakes, and simple risk-reducing strategies that anyone can use. Bring your questions.
Here is a testimonial about my class that YC uses on its website:
“I learned a lot that about investing from your class that I did not know from years of watching the TV financial gurus. I only wish that I had taken the class years ago, before making the financial mistakes that reduced my retirement income. You offer a wonderful service to the community of Prescott.” ~MG
3 Thursdays: June 11th, 18th and 25th, 1:00-3:00 pm (online class). Tuition is $45.
Register online with the link below or call the college at 928-717-7755 to register for class #SU20-107.
Register for the class online: Fun-damentals of Investing for Retirees
What the Markets Are Doing
The stock markets declined sharply in February and March, with the S&P 500 Index** losing 33.9% between February 19 and March 23, 2020. It roared back in April and May but is still down 10.1% from its February 19th high, as of this writing on May 31st. The stock market rally might seem impressive, but only because it is an improvement from the dismal results of February and March.
The next big move in the stock markets is likely to be caused by fundamentals, specifically by an earnings collapse in 2nd quarter earnings reporting that starts next month. Right now, investors are focused on the reopening of our economy and news of vaccines, not on the economic destruction that the shutdowns have wreaked. Dismal earnings announcements and a surge of bankruptcy filings will shift their focus back to the stock market.
Investors buy stock in companies to share in the earnings of the company. Second quarter earnings will include about 2 out of 3 months of zero or drastically reduced revenues for most companies, meaning big losses for many businesses.
The historic price to earnings ratio (P/E) for the S&P 500 Index**, a key measure of value for stocks, has averaged 15.54 over 93 years, meaning on average, investors paid $15.54 for each $1 of company earnings (Source: DecodingMarkets.com).
Currently, the average P/E ratio for S&P 500 stocks is 31.24 (Source: Finviz.com), suggesting that the stock market is overvalued by about double. A 50% decline in stock prices would bring the P/E ratio in line with historic norms.
However, I have seen 2nd quarter earnings forecasts from the big national brokerages that are in the -30% to -40% range. If earnings drop by that much, it makes stocks even more overvalued.
Another indicator flashing red is the S&P 500 Index** popping above its average price of the last 200 days, which normally is a good thing. However, as of May 29th, 2/3 of the 7630 stocks tracked by Vinviz.com are below that 200-day average, telling us that the stock rally is not being shared by the whole market, but is being led by a small number of stocks.
This all means that the next downturn in the stock markets is likely to be a doozie. My work suggests the stock market decline will be much deeper than what we saw in March.
Passive investors, those folks that have been trained by Wall street to just sit tight and ride out market fluctuations, are likely to get hammered in the next downturn.
It took tech-heavy, Nasdaq Index investors 16 years to get back to even after the 2002 bottom. It took the Dow Jones Industrial Average 17 years to regain their 1964 high. If you have been a buy-and-hold investor in the past, but don’t want to become the poster child for 2020 losses, now is time to become proactive. Being proactive means acting before something happens, not reacting after the damage has been done.
If you don’t know to be proactive, call me at 928-778-4000 or email me at Invest@HepburnCapital.com and I can walk you through the process. Passive investors may not have needed a professional money manager during the up years, but you are sure going to need one now.
Profits for bond investors are stuck in a narrow range. The Fed is buying bonds whose prices drop due to a lack of buyers, providing a floor for bond prices. They will also be selling those same bonds into rallies, keeping prices from rising too much. This means that bond investors should not expect much profit beyond interest payments. Right now, interest yields are .65% per year on 10-Year Treasury Notes, or 3% per year on corporate bonds — some of which are destined for default.
However, there is still a lot of risk in bonds, risk of default in the short term, and inflation risk in the long term.
This may sound strange, but for a proactive manager like myself, who knows how to manage risks of investing in stocks, I think there is more risk in bonds right now than in stocks, and very little reward in bonds too.
“The best investors are those who can recognize and act upon new facts, even when they don’t like those facts.” ~Scott Minerd, Guggenheim
What’s Happening in Your Portfolio
The HCM Shock Absorber Growth* suite of strategies did very well moving to capital preservation mode in February, missing most of that decline. From the Feb 19th high to the March 23rd bottom, we gained 2.35% while the S&P 500 Index** was still down 33.92% during that same period.
Due to the potential for April-May earnings reports to upend the stock markets, I stayed in capital preservation mode (lots of cash, short term treasuries, gold and some hedges) during the stock market rally in April and early May. The sharp bounce in stocks (the S&P 500 rose 17% in just 3 days) was too quick for my systems to react to, and that was more than half of the market’s total gain since the March bottom, so I was hesitant to jump back in ahead of earnings reports.
Recently, the stock market gave me some more buy signals, so the Shock Absorber Growth* suite of strategies are currently close to fully invested for growth as the stock market has turned up again in the last 2 weeks or so.
The market’s leadership is very narrowly focused in just a few industries. So, our investments are narrowly focused too, primarily in biotech, Internet, robotics and software stocks.
Surprisingly, health care and pharmaceutical stocks weakened enough to be taken out of the portfolios in May. I suspect that losses in hospitals, due to the loss of elective surgery revenues, is dragging them down.
HCM’s Flexible Income* suite of strategies currently holds corporate bond funds, some high dividend energy infrastructure companies (pipelines, tank farms and terminals that earn fees for handling oil, but don’t sell it), funds holding mortgages and some short-term Treasury notes and bills.
Our Municipal Income* strategy is fully invested and the Muni market is back to making money slowly.
And that is how we are staying in sync with this market.
- 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 between growth and income.
A Peek into the Future
Here are three articles I thought you might find interesting.
“Microsoft to replace journalists with robots.” Maybe we will finally get fair and balanced reporting. Read the article here.
This one is about sleep issues and has some tips for improvement. Read the article “A Holistic Approach to Resolve Your Sleep Issues”
This next one should be no surprise to us in Arizona. Ford cooked up a coronavirus treatment. Read the article “Ford disinfects police cruisers by ‘roasting’ them”
Ready for a Review?
I try to not bug you about matters that you have asked me to take care of. However, it is important that we occasionally review your circumstances and investment portfolio to ensure that you understand what I am doing for you, that you are comfortable with my work and the strategies I am employing on your behalf are still appropriate for your life circumstances.
If your life circumstances have, or will soon change, or if you would like to see the details on a strategy we are using or review anything else about your portfolio, please call the office to arrange a time to talk, either in person or on the phone or by video chat.
Call 928-778-4000 or email Admin@HepburnCapital.com to schedule a review.
Mental Floss…
Our Spotlight Strategy – Shock Absorber Growth
With our Shock Absorber Growth Strategy we strive to provide an acceptable rate of capital appreciation while experiencing one half of the risk of the S&P 500 Stock Index**, using primarily equity investments.
Your money will be invested primarily in stocks and commodities mutual funds and ETFs, both foreign and domestic, inverse and leveraged, and a money market fund. The proprietary HCM Safety Net indicator is designed to warn of potentially sudden declines in which case stock market exposure may be quickly reduced.
Click here to read more about Shock Absorber Growth.
Slice of Life
As I’ve mentioned here before, I will probably never retire completely, but the COVID-19 restrictions have certainly slowed down my life, so I am starting to feel at least semi-retired.
Much of my “head scratching” work, the research and managing of investments, has always been done at home anyway, often early in the morning or late at night. So that much hasn’t changed. I go to the office every day, if not for a client appointment, to check the mail, but it is eerily quiet there.
I have found myself wondering if these restrictions are giving us all a glimpse of our futures.
* The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Performance and 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.
** Indexes are unmanaged lists of stocks considered representative of a broad stock market segment. Investors cannot invest directly in an 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.
In all investing, past performance cannot assure future results, and as such, our efforts are not guaranteed. Losses can occur. All strategies offered by Hepburn Capital Management, LLC, adapt to changes in the markets by changing the investments they hold, therefore, comparisons to broad stock market indexes such as the unmanaged indexes mentioned may not be appropriate. Sometimes client accounts are invested in stocks or markets not included in these indexes. Past performance does not guarantee future results. Investment return and principal value will vary so that when redeemed, an investor’s account values may be worth more or less than when purchased. Mutual fund shares and other investments used in our managed accounts are not insured by the FDIC or any other agency, are not obligations of or guaranteed by any financial institution and involve investment risk, including possible loss of principal. Advisory services offered through Hepburn Capital Management, LLC, an Arizona Registered Investment Advisor. Adviser will not transact business unless properly registered and licensed in the potential client’s state of residence.
Copyright (C) 2020 William T. Hepburn. All rights reserved.
