May 31, 2011
When the Music Stops
The Investment View from Prescott, Arizona
“Quantitative Easing II”, the Federal Reserve’s easy-money program, printing new dollars to buy back bonds sold to finance the federal deficit, is scheduled to end in a few weeks. The program is designed to goose the economy back to life on a rising tide of cash. Uh-huh.
Ironically, QE II is really the third round of efforts like this, not the second, but I digress.
Unfortunately, the first two rounds both ended with the stock market entering significant declines after the easy money stopped flowing. Not right away, though – few things are that obvious in this business – but declines did follow in the weeks and months after the first two rounds of easing ended.
The rally in the stock market over the past eight months began when the Fed announced its intentions for another round of easy money. Since then, the Fed has pumped $80 billion per month into the economy, holding down interest rates in the process.
That $80 billion a month has allowed the Fed to buy more than half of the Treasury bonds that were issued to finance the deficit spending in Washington DC since the beginning of QE II. This makes me wonder – who will buy all those Treasuries when the Fed doesn’t?
If no one steps forward to buy a lot of bonds, T-bond prices will sink and interest rates rise until the bonds start attracting enough buyers. In some recent newsletters I have said that the two things that have caused more recessions than anything else are rising oil prices and rising interest rates. When both of those factors start sucking money out of your pocket it means bad things for the economy.
I expect the end of QE II to feel like a game of musical chairs, with some investors left standing out in the cold when the bond or stock markets retreat, signaling that the music has finally stopped.
The final round of bond buying by the Federal Reserve is currently scheduled for June 9, 2011, ten days from now.
How long it will take for the economic impact to show up or for investors to find their chairs is a good question. I will be watching every day to be sure we get a seat, probably on the sidelines, early in the process.
What really has my antenna twitching is that this turning off of the easy money spigot coincides with a number of other factors, each with the potential to negatively affect the stock markets. These include a traditionally weaker summer season for stocks, a cyclical downturn in the markets due this summer, a recent downturn in a number of growth indicators and some liquidity wave research done by my friend Tom McClellan, editor of the McClellan Market Report. The confluence of all these events suggests a rough summer for buy-and-hope investors.
I’m glad we have the ability to just step out of the way and move to the money market fund (cash). And I am doubly glad that we have investments available that go up when the market goes down. They may come in handy this summer.
So, over the next few months, I plan to be reducing our exposure to risk and looking for gains from places other than the stock markets.
The old Chinese curse “May you live in interesting times” comes to mind. Changes are afoot, and it could be an interesting summer for those who don’t know how to handle them.
A Slice of Life
“Austerity bumps”. That is what we began calling the rough roads we encountered last week on I-40 and Highway 89 as we traveled to St. George, UT for the junior college national championship softball tournament (Our girls won – Yeah!!). Even with the truck-sized tires on the motorhome it was really jarring.
I sure hope the state can find the money to repair the roads. If they continue to deteriorate, an increase in gas taxes will certainly be in our future. As bad as that sounds, it will probably be less expensive than car repairs caused by potholes and rough roads.
Signs of the times, I am afraid.
Q: Until I am measured,
I am not known.
Yet how you miss me,
When I have flown!
What am I??
How’s The Market Doing?
The character of the market seems to have changed in recent weeks. For the past month it seems to have been in a three-steps-backward, two-steps-forward pattern – not a huge decline, but not what we have been used to, either.
It is difficult to say for sure what is causing this. It could be the global slowdown of growth that is becoming apparent, the economic drag of high oil prices, the impending end to the Fed’s easy money policy (QE II), European debt crises, Mideast concerns or something not yet evident.
Despite being uncertain about the cause it is not too early to recognize the change, accept it and get ready for what may come next, as a stock market decline this summer looks increasingly likely.
Hepburn Capital clients do not need to be concerned, as I am your designated worrier. We are ready to quickly move into safe havens if the markets begin to decline significantly.
If you have friends who are blissfully ignorant of what is coming, now is a good time to suggest they come in to see what I can do for them. I am never too busy to be a resource for your referrals.
A good way to introduce your friends and family to my work is to forward my newsletter to them. To forward this newsletter just click the link in the top left corner to email this page to them. Thank you.
The American Youth Character Awards
At the end of each school year, Hepburn Capital sponsors the American Youth Character Awards at Prescott Mile High Middle School.
These awards are designed to motivate the kids who are not in the running for the many academic or athletic awards given out. I wanted to give these kids a reason to dig a little deeper to develop some character. After all, good character will get you through life when a lot of other things fail.
These kids are not high achievers in the traditional sense, but have each displayed an ability to overcome adversity and succeed.
Cash gets attention, especially at middle school ages, so I decided that the best way to immediately get our awards noticed would be to make them cash awards. Our 6th and 7th grade winners each get $100, along with their names on a perpetual plaque at the school, and you should hear the “oohs” and “aahs” from the kids when someone in the 8th grade is awarded $300 cash.
This year’s winners, nominated by their teachers and selected by the staff at the school, are:
6th grade, Ashley Perry,
7th grade, Nakai Lake, and
8th grade, Angeles Estrada
Each is a leader and an inspiration to those around them. Congratulations, kids!
What’s Going On In Your Portfolio?
During the first week in May, both our Flexible Income* and Careful Growth* portfolios gave back some of April’s prodigious gains, but are still ahead for the quarter.
Both our growth and income models* still hold 15-20% in Gold, which declined a little bit in sympathy with silver’s stunning plunge a month ago and has recovered nicely since then. Gold will probably be our best friend if inflation stays strong.
Both models also hold between 20-30% in cash at the moment as is often the case as the market shifts gears. Investments that weakened have already been sold off and with new opportunities still unclear, the cash remains safely in the money market fund for now.
The Careful Growth* model is about 60% invested in growth stocks – mostly technology and health related companies. Several of our stocks came close to triggering sell orders twice in May, however, each time they recovered nicely so they will be held for a while longer.
Flexible Income* accounts have a mix of bond funds, including floating rate loan funds, diversified bond funds and high yield bonds funds. High yield bonds are sometimes called “junk bonds”, but despite the funky name have produced stellar returns for us over the past two years.
I’m excited about some work I have been doing on a new currency trading strategy that looks very promising.
I always have to be careful designing systems using historical data, since history often does not repeat itself exactly and what worked in the past may not work in the future. Trading systems are both an art and a science. The design using historical data can be very scientific and precise. The art is recognizing when history is not repeating itself, or even rhyming very well, when a system is being used with real money. Knowing what to do when that happens is an art form itself. Experience counts at times like that.
The new currency system will be a composite of two trading systems – one to tell me whether the primary trend favors a rising dollar or a falling dollar. A second system is overlaid over the first to then generate buy and sell signals on the appropriate investment.
The time to implement a new system like this is not in the middle of a primary trend movement, but at an inflection point where the primary trend is changing. So although I have the methodology worked out, I am waiting to pull the trigger, so to speak.
More to come, as this exciting new system develops.
Our Spotlight Strategy
The Municipal Income Strategy moves from high-yield to high-quality municipal bond mutual funds and ETFs to produce greater income than “buy and hold”, with lower risk as measured by fluctuation in principal values. HCM’s Adaptive Market Strategies® direct investments into parts of the municipal markets showing the greatest strength. If the price weakens, they are replaced with new investments that are going up or hedged until the market stabilizes. Repeat as needed.
* 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.
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.