August 4, 2020

Zombie Apocalypse Hits Markets

No one is right all the time in this business, and I’ll admit that I expected the stock markets to be doing a swan dive right about now as company earnings reporting is in full swing and much of the news is dismal. But the markets seem to be defying gravity even as earnings in many companies decline. I must give kudos to the Fed for levitating the markets like this, I underestimated their abilities.

However, even though the stock market is not collapsing, it does not mean that we are out of the woods economically. The economy experienced a severe 9.5% drop as shown in second quarter GDP. This is a time for cautious investing.

One of my rules for investing it to consider what happens if I am wrong and always err on the side of caution. This, and my trademarked proactive approach of Adapting to Changing Markets®, is the reason why when markets collapse, my clients do not get hammered like index fund investors.

My reasons to recommend caution right now for investors are many.

Last month, Fed Chair Jerome Powell said that economic growth remains well below the pre-pandemic level and that the economic recovery has slowed since mid-June when parts of the country saw spikes in coronavirus cases.

I read recently that 131 publicly traded companies have filed for bankruptcy in the first half of 2020, more than in all of 2009 during the great financial crisis. The list includes Borden Dairy, Brooks Brothers, Chuck E. Cheeses, Cirque du Soleil, one of America’s largest telecom companies – Frontier Communications, Gold’s Gym, Hertz, JC Penny, McClatchy newspaper company, Nieman Marcus, Pier 1 and a whole slew of energy companies. New bankruptcy announcements are coming almost every day now.

Newsletter writer John Mauldin said just last week, “By the end of August, I expect well over 100,000 small businesses (and a few large ones) to have permanently closed.”

A “Zombie” company is one that has no earnings and high debt, which in normal times would push it into bankruptcy. But Zombies are being kept on financial life support with low-cost, or even no-cost loans from the government. Without continuing injections of this “free money” these companies could not continue to operate. Currently 734 of 3,383 publicly traded companies are Zombies (Source: Finviz). That suggests that 21% of all index holdings are close to failure. How long before they are forced to file bankruptcy is anyone’s guess, but they are on their way.

Trouble trickles down from Zombie companies as employees get laid off, suppliers do less business and landlords missing rents are forced to tighten their belts too. Earnings declines ripple out from failed and failing companies, up and down the economic food chain. Since earnings are a fundamental element of a stock’s value, the value stock investors are getting for their money is going down, even if prices are not.

This is not the first time stock market investors have ignored declining market fundamentals, but usually does not end well when it happens. In 2000, the air began leaking out of the dot-com bubble, but the S&P 500 did not really head south in a big way until 2001 and 2002. Cracks began appearing in the mortgage markets in early 2007, but the S&P 500 peaked many months later and did not start down in earnest for a full year.

One influence holding the markets up right now is the large number of small investors who have entered the market speculating with ‘free money” sent out from the government. Industry changes allowing the purchase of fractional stock shares encourage this new wave of day traders and dice-rollers. Today’s speculative fever feels a lot like 1999 just before the dot.com bubble burst.

I am reminded of the old story of Joe Kennedy, JFK’s father, who was a sharp stock operator himself. On a hunch, Kennedy decided to get out of the market just before the 1929 stock market crash led to an 89% decline in the Dow Jones Industrial Average. His hunch came when his cab driver started offering him stock tips. Kennedy realized that when the man on the street is buying stocks, everyone is already in the market and there are few buyers left.

Today, all these speculative stock owners are no longer potential buyers, they are only potential sellers, and the balance of buyers and sellers is what makes the markets work. I think Kennedy is nodding in agreement.

Overvalued markets don’t turn down on their own. Something usually triggers them. I assumed that dismal 2nd quarter earnings would be a catalyst, but it doesn’t seem so. What could it be this time? And when will it be triggered? I don’t really know, but I am confident that I will recognize the event for what it is and be able to react quickly. I will cautiously await that moment.

If you or your friends worry about our economy, give me a call and I will be happy to explain how my system of Adapting to Changing Markets® works. 928-778-4000

Some Perspective

If you think our COVID-19 experience is bad, think what it might have been like to be alive during the 1918 Spanish Flu, or 1349 when the Black Death wiped out half of Europe. But even those dire times pale compared to the year 536 CE when a cataclysmic volcanic eruption in Iceland blanketed Europe, the Middle East and parts of Asia in a fog of ash that led to the coldest decade in 2,300 years.

According to the article “Why 536 was ‘the worst year to be alive’” on Sciencemag.org, snow fell in China during the summer, crops failed, people starved. Other massive eruptions followed in 540 and 547, leading to a century of economic decline that plunged Europe into the Dark Ages.

COVID will turn out to be a blip compared to the really big events in history like these, and life will go on. Yes, we have a lot to be grateful for.

What the Markets Are Doing

Get Ready for More Inflation

I often use the S&P 500 index** as a proxy for the stock market as a whole because 80% of all dollars in the US stock market are in S&P 500 stocks. Although still down about 3% from its pre-COVID high in February, year-to-date, the S&P 500 has posted a 1.25% gain as of this writing on August 2nd. However, these days, it pays to take a closer look at the S&P 500.

It turns out that much of the year’s S&P 500 performance has come from just 6 giant tech stocks: Microsoft, Apple, Amazon, Google, Facebook and Netflix, collectively called FAANGM. As a group FAANGM stocks are up 63% since the beginning of the year. As a group, the other 494 are down more than 6% (Source: Fasttrack).

Watch the FAANGM stocks. They have been leaders in the recent rally, but if they falter, they can also become loss leaders in a market decline.

The Fed continues to lean their considerable weight on interest rates, holding rates on 10-Year Treasury Notes down at .55% as of the close on Friday, July 31st. Reward in bonds remains low, while risk remains high.

One cloud on the horizon is that the Fed actually withdrew $130 billion from the economy during July. Compared to a $1.8 trillion financial stimulus in March-June, $130 billion is not much, but when the Fed has reversed itself and withdrawn stimulus in the past, the market has often responded negatively.

As necessary as Government pandemic actions may have been, they have many unintended side effects, some of which will not be known for years. One is a potential for inflation.

I think inflation is picking up, but due to other side effects, inflation is not yet showing in overall consumer prices. We certainly are seeing inflation in asset prices as one can see in the stock market. Food and healthcare costs have both risen sharply in recent months as well. Only declining energy costs are keeping overall inflation in check. Your personal inflation rate will depend on what you buy.

Gold has long been an inflation bell weather, and gold hit an all-time high at $1,994 per ounce on July 31st, another signal of surging inflation.

Savers who depend on interest bearing investments (CDs, bonds, mortgages and annuities) for their income run the risk of having their lifestyles hurt by persistent inflation which makes dollars worth less each year (I don’t mean worthless, just worth less than before) and requires larger and larger cash flows to keep up with. As prices rise and incomes are fixed, groceries become harder and harder to afford.

Inflation is called a silent tax, because it robs citizens of the purchasing power of their savings. To deal with our mounting debt, politicians have 3 choices, raise taxes, cut government programs that many people depend upon, or inflate the money supply so that debt can be repaid with cheaper dollars. Being a bit cynical, I expect political leaders to make the decision least painful to them, meaning inflation. Get ready for more inflation in your lives.

If you are concerned about inflation and how it may affect your financial security, call me at 928-778-4000 to find out how my strategies that Adapt to Changing Markets® can protect you and your family from inflation.

What’s Happening in Your Portfolio

HCM clients had a good month in July, with our Shock Absorber Growth* (SAGro) suite of strategies (100% growth) up over 5% in July and had hit new highs for the year-to-date, as of Friday, July 31^st.

Following the resurgent inflation theme mentioned elsewhere in this newsletter, SAGro clients have about ¼ of their portfolio invested in inflation-sensitive issues such as funds holding gold and stocks of gold and silver producers.

Being close to fully invested, as you might expect, we also hold a bunch of tech stocks along with ETFs holding funds with of Solar, Lithium, Cannabis and online retail stocks.

Our Flexible Income* suite of strategies was up nicely in July, and holds a gold fund, along with an Inflation Protected Treasury bond fund, a declining dollar fund also as protection against inflation, plus a corporate bond fund and a Treasury Bill fund.

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.

Your Future Might Include Fewer Electric Cars

In 2019, the world produced about 160 gigawatt hours (GWh) of lithium-ion batteries. That’s enough for a little more than three million electric cars — and only if we use those batteries for cars, and don’t build any smart-phones, laptops or grid storage facilities. That sounds like a lot until you see that the world produced nearly 100 million cars, vans, buses and trucks in 2019 alone. (Source: theconversation.com)

The world needs either a lot more lithium or a new battery technology. If not, there won’t be batteries enough for all the electric cars everyone is expecting.

Notice to IRA Owners

There are several changes affecting retirement plans and individual tax returns as a result of the COVID-19 relief packages passed in Congress. Below are highlights for some of the more significant changes that may affect you.

Waiver of 10% Early Distribution Penalty

The 10% early withdrawal penalty for withdrawals up to $100,000 from qualified retirement accounts (IRA, 401(k), and other defined contribution plans) has been waived for retirement plan participants who qualify for COVID-19 relief. Income tax on the distribution would still be owed but could be paid over a three-year period. The distributions may be re-contributed to the plan over three years to avoid the income tax on the distribution. While the law allows for these types of penalty-free distributions, individual plans can set more restrictive policies, so check your plan document.

Qualifying individuals include those who are diagnosed with COVID-19, have a spouse or dependent who is diagnosed with COVID-19 or experience adverse financial consequences as a result of COVID-19, including quarantines, layoffs, business closures or child care responsibilities

Waiver of Required Minimum Distribution (RMD) Rules

Required minimum distributions that otherwise would have to be made in 2020 from defined contribution plans, such as 401(k) plans and IRAs, are waived. 2020 RMDs that have already been taken may be rolled over back into the retirement plan and avoid taxation. No COVID-19 qualifications are required. Clients who wish to repay 2020 RMD distributions to their retirement account have until the later of August 31, 2020, or 60 days from the distribution date, to repay the distribution and have it treated as a 60-day rollover.

Charitable Donations

Individuals will be able to claim a $300 “above-the-line” deduction for cash contributions made in 2020 when they claim the standard deduction. The limitation on charitable deductions for individuals that is generally 60% of modified adjusted gross income will not apply to cash contributions made in 2020. This allows for a deduction of charitable contributions of up to 100% of income for itemizers.

Mental Floss…

Paraprosdokians are figures of speech where the latter part of a sentence or phrase is a complete surprise or unexpected, also frequently humorous. (Winston Churchill loved them).

Where there’s a will, I want to be in it.
Since light travels faster than sound, some people appear bright until you hear them speak.
We never really grow up – we only learn how to act in public.
Knowledge is knowing a tomato is a fruit. Wisdom is not putting it in a fruit salad.
To steal ideas from one person is plagiarism. To steal from many is research.
You do not need a parachute to skydive. You only need a parachute to skydive twice.
I used to be indecisive, but now I’m not so sure.
You’re never too old to learn something stupid.
I’m supposed to respect my elders, but it’s getting harder and harder for me to find one now.

Our Spotlight Strategy – Flexible Income

With our Flexible Income Strategy we strive to provide high total return consistent with Capital Preservation.

Your money will be invested in bond mutual funds and exchange traded funds (ETFs), including inverse and leveraged funds, currency funds, including precious metals that may be used as currencies and income producing stocks whose price trend is up. If the price cycles down, holdings are replaced with new investments that are going up, repeating as needed. Growth stocks are not used.

Click here to read more about Flexible Income.

Slice of Life

You may have noticed the “For Sale” sign on my office building, but don’t worry, I’m not going far.

This COVID experience has shown me that the majority of you are happy with telephone, video chats on Zoom, or meetings at your home. I even have a client who likes to meet in a park, sitting in our lawn chairs! But fewer and fewer of you are coming to the office in person.

Back in early March, my staff was sent home to shelter in place and stay healthy. As the months wore on, I realized I was running the Prescott office by myself, just fine. Yvette Zurita, my long-time operations guru, who got married and moved to Fresno, still works from her office there and does most of the operations work, leaving me to focus on the investment management.

I have a very nice office in my home that I spend more time working in these days. So much more, that it seems that the office building and on-site staff are just not vital to my work for you. So, it just seems like time to part company with the office building.

I am also exploring ways to outsource my regulatory compliance work, one of my least favorite chores, and possibly partner with another money manager to spread the work load, something which will allow me to continue to serve you for a long, long time. Stay tuned.

* 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.