June 30, 2008
What’s Up (or Not) with the Stock Market?
For the past month or so, the stock market has been roiled by stories of misery, malfeasance and mismanagement in the economy. For readers of this newsletter this is no surprise. I have repeatedly warned that the unwinding of the real estate market was going to be a big, big event. Add $4-5 gas prices and the economy is getting a double whammy.
I can’t tell you what the future holds, but recently I have been concerned about the possibility of a renewed and significant decline in the stock market this year. This week proved that I was right. I felt strongly that the market’s rise from its March 17th lows was an intermediate term rally, meaning an uptrend that lasts weeks to months. Some more hardened types might call it a “sucker’s” rally. In any event, the rise is over for now.
Summer often brings stock market weakness, however election years normally see stock market strength at least into July. The fact that the markets have been so weak heading into July suggests greater than normal weakness this summer.
I expect that corporate earnings reports, due in July will not be pretty, so all of my managed accounts are positioned for capital preservation right now.
Whether the US economy is technically in a recession or not, is still subject to debate and won’t be settled for many months. It will be way too late to protect your money when you read it in the paper. But there is no doubt that business is bad – unless you own oil wells. This is certainly a time for an abundance of caution.
For pro-active investors, recessions and stock market declines are not a time for despair because they provide the opportunity upon which outsized returns are built. At the end of a bear market environment there will be a chance to make strong gains without much risk. The key is to come through the difficult times with your investment capital intact so that you are ready when the opportunity presents itself.
This can be shown by comparing a buy and hold forever investor vs. a hypothetical active investor starting with $100,000. The time frame is 2000-02 when the S&P 5002 Index lost 48% of its value (-$48,000), leaving the buy and holder’s account value at $52,000. Where as, the active investor, upon taking a small initial loss, moves to a money market fund and earns just enough interest to move the account back to $100,000, essentially gaining nothing for two years. Not fun, but a lot better than losing 40-some percent.
This is about where we are in the process. We may not have made money over the past year, but we are way ahead of most folks. Successful investors are patient investors. This is a time for patience.
When the market began to bounce back (2003 in our example), it bounced 38% from March 11 to December 31, 2003. The buy and holder reaps the entire 38%, moving his account value from $52,000 all the way back up to $71,760. The proactive investor won’t know it’s time to get back in right away, and will miss part of the initial upswing. So, let’s say they only get a much smaller 10% gain in late 2003. This makes the buy and hold account value at the end of 2003 $71,760 and the active account value $110,000. Which account would you rather own?
And think of the money you saved on Alka-Seltzer, too.
The type of strong market opportunities like we saw in 1999 and 2003 often come with little notice, so we have to stay ready to act. That is what I try to do every day for my managed account clients, be ready to act to both protect and grow principal values depending upon what kind of market we are in.
Inflation . . . and its Cure.
A few newsletters ago I mentioned that some signs of inflation may be running out of steam. Well, it isn’t happening. Sorry.
The US Bureau of Labor Statistics reports that inflation is running at about 4.2% per year – that’s if you don’t count food and energy costs. No telling what the real inflation rate is, but I’m guessing it is higher than what the government lets on.
However inflation is even higher in China, Indonesia, Saudi Arabia and India, all reporting inflation over 8%, as stated by Sy Harding. Russia and South America are experiencing inflation well into double digits, with the booby prize for developed countries going to Venezuela with almost 30% inflation.
Historically, the best tool to fight inflation has been economic recession which reduces the ability of consumers to continue to keep bidding up prices. Falling home prices have spread to many other areas of the world, wiping out many credit providers in the process – this is the “credit crunch” you hear about in the news. Without the ability to borrow, many businesses can’t grow and often shrink. A shrinking economy is all that a recession really is.
So far this year, the Fed has been pumping money into the economy at a record setting pace trying to overcome the effects of the credit crunch. However that trend may be coming to an end as the Fed puts more focus on fighting inflation. They need to step back a bit to allow the recession to unfold or risk having a possibly devastating round of inflation. I think that may be what is happening now.
Inflation makes prices, like gasoline, go up and diverts your spending money from items that make your life easier to paying for gas. Your lifestyle doesn’t necessarily go backward, but it certainly does not improve.
But this reduced spending is the seed of the recession. As business slows down, both here and abroad, the demand for things, even gasoline, drops off and prices begin to fall. Gasoline usage in the U.S. has already begun to decline measurably, so perhaps the recovery process is well underway
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Account Updates
The S&P 5002 Index is showing a loss of 13.79%
The average of 1,272 bond funds has lost 1.73%
Source: FastTrack
Hepburn Capital’s Flexible Income model1 is up 1.07% for the year, and is currently 2/3’s in cash and 1/3 in a fund that goes up as interest rates go up. Pretty conservative stuff.
Our Careful Growth Model1 has held a combination of hedges (holdings that go up as the stock market goes down) and cash that made this portfolio the rough equivalent of only 30% in stocks and 70% in cash for most of June. Last week I actually went net short, which means if the stock market continues to go down we make money.
Growth models1 have recorded losses in the 2-4% range for 2008 before moving to cash. Not great, but way ahead of the stock market index noted above, which represent the “average” investor. Some fared much worse. For June we are down 2.65% vs. the S&P 500’s2 8.85% loss.
These models1 represent accounts held at National Financial, our primary custodian in these two strategies, or blends of them. Accounts held at other custodians, or managed differently (socially screened or municipal income accounts) may have slightly different results, but all are currently positioned for capital preservation, and all have done better than the stock market averages this year.
All Hepburn Capital managed accounts are very conservatively positioned right now.
As you can tell by the fact that our managed accounts are largely “out of the market” I am concerned that risk of loss is very high right now for people who choose to stay fully invested. Tell your friends to call me at 778-4000 if they are concerned that their broker may not be pro-active enough in managing their money.
1. 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.
2. 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.
Information in this newsletter is 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.
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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 listed above 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 are not insured by the FDIC or any other agency, are not guaranteed by any financial institution, are not obligations of any financial institution, and involve investment risk, including possible loss of principal. Advisory services offered through Hepburn Capital Management, LLC, a Registered Investment Advisor.
Adviser will not transact business unless properly registered and licensed in the potential client’s state of residence.
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