January 2, 2019

What Really Caused This Bear Market?

The 3-month stock market decline that appears to have ended on December 26th is more notable for what wasn’t happening than for what was. There wasn’t much bad economic news. Banks aren’t failing as in 2008-09. Tech companies aren’t dropping like flies as in 2001. The trade war is on the back burner while the US and China have declared a truce. So what is the problem?

Investors flee uncertainty, and investors were certainly fleeing markets in the 4th quarter of 2018. One factor that created uncertainty was the change in the balance of power in Congress, with Democrats winning a majority of house seats and Republicans controlling the Senate. Although this does create uncertainty, gridlock in Congress is often good for the financial markets.

The bigger factor, in my opinion, is the action of the Federal Reserve (FED) and central banks around the world tightening money supplies. Money is the mother’s milk of the financial markets as all trades are settled with cash. You want to sell? There had better be a buyer with cash or you are stuck.

For years the stock markets thrived on easy money as the FED, plus Europe and Japanese central banks, flooded the world economy with cash to stave off bank failures and boost economies. In 2017 the FED began draining cash from the economy, slowly at first and picking up the pace to an annualized rate of $600 billion in late 2018.

Europe also turned off the cash spigots this past year delivering a double whammy to financial markets.

What really complicates things is that our FED was also raising interest rates at the same time they were draining cash from the system. Which of these actions hurt the stock market the most? We will never know, but I’m hoping the FED is paying attention and backs off on one of these factors or the other so we can find out.

To keep things in perspective, interest rates, specifically the FED Funds Target Rate is only at 2.25%, barely above inflation which is currently reported at 2.2%. The long-term historical average of interest rates is just under 6% so rates are not really very high. But giving the economy and the markets enough time to digest the recent rate hikes might be a wise move by the FED before continuing to raise rates or pull cash from the economy.

What the Markets Are Doing

What Goes Down Must Go Up

The S&P 500 index**, considered representative of the US stock market, was the last of the major indexes to confirm that a bear market actually was upon us as it registered a 20.08% drop from its September 20th high to its mid-day low on Dec.26th. All other indexes, both US and foreign, were already clearly in bear market territory.

Bond prices rose as Treasury yields have rolled over, with the 10-year T-note dropping from 3.24% in early October to 2.69% as of December 31, 2018. Lower rates should draw less capital out of lower-yielding equities, and are always welcome in the real estate industry, one of the drivers of our economy.

Stock valuations are more reasonable today, with the S&P 500** Price to Earnings ratio easing from 21 in September to 17 today which also makes stocks more attractive than they were earlier.

The economy remains strong, despite downward tugs from other world economies. If our GDP growth slips from 3% to 2.3% in 2019, as the Fed projects, the US will still be growing near capacity and avoid recession.

Credit quality in the bond markets is slipping due to rising interest rates affecting the debt many companies took on during the easy money times. With rates creeping up, some companies are having a tougher time making their bond payments and credit ratings are being downgraded.

There is a large amount of bonds that currently are considered investment grade, BBB ratings or higher, but are edging closer to being rated BB, the point at which they will be considered junk bonds.

This could create problems for many institutions that are not allowed to hold junk bonds, because if bonds they own are downgraded to junk status they will have to be sold. This has the potential to overwhelm the junk bond markets and drive rates even higher for lower credit companies that need to borrow to support operations.

This could create a domino effect as consequences ripple through the entire bond market, making it harder for all companies and even countries to borrow needed funds. Harder means higher and higher rates. Higher rates mean smaller corporate profits and larger government deficits as interest expense takes up more of the budget edging out other programs. And the dominos will continue to fall if this situation becomes a reality.

This dynamic, if it unfolds, has the potential to be as big a financial problem as the 2008 financial crisis. Right now it is not a problem, and I can’t say at what point it will become one that is evident in the financial markets, but I am confident I will recognize it when I see it and be able to take swift action for my clients.

If you are not yet a client, you still have time to call the office for a free portfolio review and have me watch your portfolio, ready to move to a safe haven when necessary. That number is 928.778.4000.

A New Website for HCM

When you access your accounts through the Hepburn Capital website don’t be surprised by the new look.

Laurel Fitzhugh, my technology coordinator, and operations manager Yvette Zurita, along with a team of professional website designers have been working hard for months on our new website that is more readable, has greater interactivity, more functions and just plain makes us look good.

I hate to say they are dragging me into the 21st century, but it’s true and I really like the new site.

It will be live tomorrow morning, Thursday, January 3rd. Check it out by clicking this link www.HepburnCapital.com

What’s Happening in Your Portfolio

My Adaptive Balance Formula Says to Reduce Stock Allocations

Our performance during December was much better than the S&P 500 Index**, considered representative of the US stock market because about 80% of all dollars traded in stocks are represented by this one index. The S&P 500** had one of the worst Decembers on record, losing 9.18%. HCM Growth strategies, Adaptive Balance*, Adaptive Growth*, and Shock Absorber Growth*, dropped 2.43%, 5.37% and 5.17% respectively.

The bear market in US stocks began on September 20th, and performance for the S&P 500** showed a loss through the intra day low on December 26th of -20.08% confirming the bear market status normally determined by 20% or greater losses. The S&P 500** was the last major US index to break down below -20%. The three HCM growth strategies lost only 4.63%, 10.67% and 10.61% during the same period.

When our losses can be held to half what the stock market experiences, as I have done for you, that tells us that the risk reducing strategies that I employ on your behalf are working. If the stock market continues down, I expect our outperformance to become greater and greater.

The stock market seems to be trying to turn itself around after hitting bottom on December 26th. Things have been generally positive since then. We are not out of the woods yet, but I did sell our stabilizing hedge (an inverse fund that goes up as the market goes down) on the 26th, and that action says that I think the decline is over for a while at least. I still hold about 20% cash in our models with which to buy another hedge if the market rolls over and begins to decline again, or to add stocks if the rally continues.

Current Shock Absorber* model stock market exposure is about 75%, with about 5% held in gold funds.

One way I keep on the right side of long-term trends is with my Adaptive Balance* formulas which reduce stock market holdings during longer declines.

Due to stock market weakness over the past few months our calculations are directing me to reduce stock market exposure by about 20%. If the stock market rebounds, which I am expecting, I will adjust stock allocations back to normal levels. However, the processes I have developed over the past 20 years have worked well to keep our losses smaller than Index investors experienced, so I am sticking with this proven set of tactics.

For this reason, accounts that follow my Adaptive Growth* suite of strategies which previously held 80% growth investments will now be holding 60% growth investments at a maximum. Please understand that a few weeks ago, during the worst of the recent bear market my growth model experienced only about 34% of the risk of the stock indexes, so that 60% is a maximum exposure. It can be much less as I dodge bullets for you.

My Adaptive Balance* model, instead of holding a 50/50 blend of growth and income as it has for a while, will be holding a maximum of 30% Growth with the balance being in our Flexible Income* model portfolio.

These calculations were made with data from closing prices from December 31, 2018 and these changes will go into effect with my next set of trades.

• 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.

Changes that are queued up will reduce stock allocations during our next trading sequence.

IRA Limits Increased

Good news for savers in 2019: You will be able to put more money in your IRA or other retirement plan accounts.

IRA accounts: The contribution limit will be $6,000 (up from $5,500). This is the first increase since 2013.

The “IRA catch-up provision” allows taxpayers aged 50+ to add an extra $1,000 to contributions.

Mental Floss

In a Podiatrist’s office:

“Time wounds all heels.”

On a Septic Tank Truck:

“Yesterday’s Meals on Wheels”

On a Plumber’s truck:

“We repair what your husband fixed.”

At a Tire Shop in Milwaukee:

“Invite us to your next blowout.”

Good News for Taxpayers

Tax Credits You Can Claim

If you don’t like what the Arizona government does with your money, here is a chance for you to decide for them. Arizona tax credits are available in four categories, listed here:

Source: Schutte & Hilgendorf, CPAs

College Classes Coming

Tax Tips for Arizona Newcomers

Tell your new friends that they can discover valuable tax savings from details about Arizona taxation that may differ from States in which they have lived in the past. Tax deductions, tax credits, investment and estate planning considerations unique to Arizona will all be discussed. Thursday, January 31st from 2:00-4:00 pm at Yavapai College. Register online with the link below or call the college at 717-7755 to register for class #WS19-210. Tuition is $45.
Sign up here.

Fundamentals of Investing for Retirees

Designed to help investors become more confident about 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 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. Thursdays, Feb 7-21 from 2:00-4:00 p.m. Register online with the link below or call 717-7755 for class #WS19-131, Tuition is $45.
Sign up here.

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.

A Slice of Life…

Peregrine Bookstore Book Discussion

My new book, Why Bad Things Happen to Good Investments will be the topic at this Peregrine Bookstore Reading.

In this book, I look at the great American investment creed — buy low, sell high — as a two-part goal in which one must sell at some point to be successful, which, interestingly, is also the one thing Wall Street discourages investors from ever doing.

This may sound a little strange, but investors rarely buy bad investments. They all start off doing well, but then things change and if the investments don’t change too, large losses can occur. Discover industry secrets that work against you and learn how to protect yourself and your money when markets head south.

Saturday, January 19th at 2:00 pm, at the Peregrine Book Company, 219 N. Cortez in Prescott.

* 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) 2019 William T. Hepburn. All rights reserved.